The Most Important Question to Ask on Earnings Calls – Q4 Demand!
We have touched on the subject of inventory drawdown in Q4 in a couple of recent reports, but the more we think about the subject and refer back to history, the more we believe that this could be the most significant year-end surprise across a number of industries, but most significantly those where crude oil is a major input.
Outside the US the economic news is worse, demand growth is slowing in Europe, and in large parts of Asia and Latin America. Local sellers and distributors will likely look to lower inventories as a consequence of expected lower offtake. Within our Industrials and Materials universe inventories are not low in absolute terms – see exhibit, but not particularly high as a percent of revenues.
More significantly, with the almost 25% decline in Brent Crude Oil pricing since its summer peak, any international consumer of products made from crude oil or its fractions, will be expecting much lower pricing going forward. Consequently, if historical behavior is any guide, they will drop purchased volumes immediately (this will have already happened in October) – to the minimums that contracts allow, and wait for pricing to drop. This behavior was very pronounced among Chinese plastics importers amid the crude oil volatility of the late 1980s and 1990s, and was last seen most obviously in the early months of the GFC, when demand vanished for a quarter or two. The second chart is a repeat from recent work which shows short periods of negative demand surprises as crude oil prices fall.
As an example, Dow Chemical’s sales in Q3 2008 were 13% higher than the prior year – in Q4 they were 25% lower than the prior year and in Q1 2009 40% lower. This was a combination of volume and pricing – with part of the volume swing driven by destocking as crude oil prices collapsed and part was the ensuing price response both to lower crude prices and lower demand. We are not calling for a decline this significant this time, but we do expect a negative surprise for Q4 and possibly Q1 for all chemical producers and possibly for most industrial companies with significant international business.
The counter of course is that lower crude is likely very good for economic growth – longer term things should improve and our expected demand shortfall should be no more than a one or two quarter event.
Further, there are conflicting signals in the US as international chemical pricing specifically could fall much more quickly than US domestic pricing (because the US market is very short of some chemicals today) – it could take a couple of quarters for the US to catch up. Additionally, given the constraints on rail and road traffic in the US today, consumers of chemicals and plastics will likely be reluctant to play the inventory game because of supply delay fears – at the margin we have seen inventories creep up in the US for supply security reasons in recent months.