The profits of China's chemical industry are rebounding. This is a much-needed balm for sector players, who need to invest to meet demand in new-economy markets, and to reduce waste in line with national guidelines on greener production. S&P Global Ratings expects our rated Chinese chemical companies to better navigate the broader policy trends that are reshaping the sector.

Fatter margins will also likely restore general growth appetite, prompting more investments to expand capacity. Nonetheless, the government's tight grip on financial leverage should rein in debt-funded capital expenditure.

Higher Earnings Restore Investment Appetite

Chinese chemical companies will likely raise their capital spending in the coming two to three years, supported by their stronger earnings. The higher price environment and a revival of demand this year also favor profitability evaluations of upcoming projects.

A recovery in China's manufacturing activity should fuel chemical demand and improve product spreads, a key profitability indicator for chemical companies. We assume Chinese GDP will expand 8.0% in 2021 and 5.1% in 2022, rebounding from the 2.3% growth of pandemic-hit 2020. Tight supply due to outages and output restrictions will further support prices for some products. For instance, average domestic prices for acetic acid have doubled from last year because of plant outages in Jiangsu and Henan provinces. The domestic price of polyvinyl chloride should remain elevated, as regions such as Inner Mongolia attempt to curb energy intensity by limiting the production of calcium carbide, a key raw ingredient.

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We believe cracking margins in China this year will match levels seen in 2018-2019 (see chart 4). However, they will likely stay below the peak levels set in 2016-2017 due to higher raw material costs. Higher input costs associated with crude oil prices are attributable to supply cuts by the OPEC+ countries. We assume Brent crude oil will average US$60 per barrel for the rest of 2021 and 2022, higher than the average of US$42 per barrel in 2020. Coal-based chemical producers also face higher raw material costs this year. Thermal coal prices have climbed because of higher electricity demand amid the economic upturn. The recent rise in bulk freights and restricted coal imports from Australia also puts a floor under raw material coal prices.

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Domestic Policies To Shape Industry Landscape

China's environmental and industrial policies will likely attract investments in two areas: higher value-added products and chemicals that the country isn't fully self-sufficient in. In our view, projects meeting these objectives will tend to obtain better funding access from banks and domestic investors, as well as receiving smoother approvals from authorities. Fixed asset investments in the domestic chemical industry rose 42% in the first quarter, though this is against a low base in the same period in pandemic-struck 2020; this is 3.5% higher than the same period in 2019.

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Development and production of higher value-added products is in line with China's 14th five-year plan (2021-2025), which calls for upgrading product innovation and technological capabilities. Chemical firms will likely invest and benefit from higher demand for fine chemicals, such as those used in batteries and computer chips. We also expect companies to focus on developing environmentally friendly products, including biodegradable plastics that are cost-competitive.

The second area of investment interest relates to chemicals that China now largely imports. We anticipate greater capital spending to increase domestic capacity for chemicals such as polyethylene, polystyrene, and other products for which China is currently import dependent. This is consistent with the government's vision of a "dual circulation" economic model that emphasizes the importance of self-reliance.

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Tightening Debt Controls Should Curb Firms' Leverage Growth

Despite potentially higher spending, we believe debt-funded investments by Chinese chemical companies will grow at a milder pace in the coming few years compared with the past. In our opinion, the government's continuing emphasis on financial stability will translate into additional measures to keep financial risks under control. This is particularly the case for the chemical industry, given its capital-intensive nature.

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The state may introduce industry-specific controls or regulations to restrain highly leveraged chemical companies from funding their growth with debt. These measures could follow the tighter controls introduced to curb the leverage of domestic real estate companies last year. As a result, companies may increasingly partner with domestic or foreign peers to pool funds and share risks. An example of this trend is Zhejiang Petroleum & Chemical Co. Ltd. The company was formed in recent years by several companies for the construction of large petrochemical facilities.

With Great Opportunities Come Greater ESG Responsibilities

China's commitment to reach peak carbon emissions by 2030, and carbon neutrality by 2060 means chemical projects will face greater scrutiny. We expect new plants to be more capital intensive as they will require more investments to meet stringent environmental standards.

We anticipate the industry will lean toward large-scale, highly integrated facilities, which are more energy efficient and involve less waste. These projects reduce energy intensity by reusing certain byproducts as fuel, such as hydrogen produced during the naphtha reforming process for aromatics. Residue from a chemical production process can also be used as input for another product to reduce waste. For smaller and less integrated projects, entities may still have to invest in building additional facilities for environmental protection, such as emissions control.

The upcoming combination of state-owned Sinochem Group and China National Chemical Corp. Ltd. (ChemChina) under a new entity, Sinochem Holdings Corp. Ltd., will also likely shift the country's agrochemical industry. The new entity will likely be tasked by the government to lead the transition to agricultural practices that have a lower carbon footprint. This is supported by the research capabilities of the company's subsidiaries, which will likely be led by Syngenta AG (BBB-/Positive/A-3). One potential method is to capture carbon in the soil by reducing tilling, which is enabled with the help of new agricultural products.

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China's plan to roll out carbon trading nationwide and across different industries will also involve costs for some chemical players. As the country tightens carbon emission quotas over the coming years, carbon pricing and operating costs for companies could increase. We believe companies will therefore invest more in the short term to reduce their need to buy carbon emissions quota in the future.

The winners in this environment will be companies that have invested to improve energy efficiency and reduce reliance on fossil fuels. These firms may even benefit from selling unused quota in the carbon market. On the other hand, players that have not prepared to cut carbon emissions will likely be hit.

Rated Entities Are Better Positioned To Adapt

The Chinese chemical companies that we rate are typically the larger and more prominent players in the domestic market. Their production processes are generally more integrated, facilitating the reduction of waste and emissions. Compared with their domestic peers, the entities have greater financial resources and funding access. They also tend to have strong research abilities to cope with the transition in the chemical industry.

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Higher earnings and lower leverage of rated entities in the coming two years will provide larger rating buffers to support their investments. We view that these rated entities will likely align their growth strategy with the country's policy.

For instance, Wanhua Chemical Group Co. Ltd. has been pushing ahead with its development of biodegradable plastics. Elkem ASA, a Norwegian subsidiary of China National Bluestar (Group) Co. Ltd., recently announced it would expand its capacity to produce silicone materials in China. Sinochem International Corp. has been expanding its capabilities in lithium battery and cathode materials, as well as in lightweight material commonly used in autos, such as acrylonitrile butadiene styrene.

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Related Research

• Wanhua Chemical Group Co. Ltd., May 7, 2021
• Shanghai Huayi's Earnings Rally To Restore Rating Headroom , May 7, 2021
• ChemChina To Reduce Leverage On Earnings Recovery , May 6, 2021
• China's Yingde Can Add Capex With Little Leverage Hit , May 6, 2021
• Sinochem International's Growth Ambitions To Weigh On Leverage, April 30, 2021
• China National Bluestar's Leverage Likely To Decline On Earnings Uplift, April 29, 2021
• Why The Tie-up Of ChemChina And Sinochem Led To Outlook Revision, April 20, 2021
• Outlook on ChemChina Revised To Positive; Outlook on Bluestar, Sinochem HK, SIC Revised To Developing; Ratings Affirmed, April 9, 2021
• China National Chemical Corp. Ltd., March 4, 2021
• China National Bluestar (Group) Co. Ltd., March 4, 2021