Chemical Sector Overview

For the chemical sector overall, the key credit risks arising from the current macroeconomic environment include:

Demand weakness.  Our base-case expectation is for a choppy economic outlook involving recessions in key chemical en dmarkets, including the U.S. While our long-term forecast is for global chemical demand to grow, in the near term, risks around an economic downturn and weakness in key end markets--such as housing, automotive, and general industrial--are rising. Recent reporting--at least by some chemical companies, such as Eastman Chemical Co. and Dow Chemical Co.--signals a high chemical inventory-to-shipment ratio at U.S. manufacturers, which could signal a period of slowdown in U.S. demand.

A notable exception to a GDP-led demand weakness scenario is agricultural companies, especially fertilizer manufacturers. Their growth could be independent of GDP growth, at least for brief periods. What this means for our credit analysis is an increased focus on scenarios that involve greater stress on demand. Although the likelihood of demand weakness is rising, we believe it's too early to be definitive about the timing and extent of any such weakness in the U.S. In China, the risks to demand include COVID-19-related shutdowns and lower economic activity, while in Europe, energy availability and pricing could ultimately hurt demand.

Pricing power and inflation.  Shrinking demand could have several spillover effects, including the inability of companies to increase prices to keep up with inflation. This pricing capability has softened the blow to credit quality from the recent period of rising raw material prices. If companies lose this capability, the loss would hurt EBITDA and debt leverage across regions.

Supply increases.  There are multiple risks around the potential for increased supply. In some subsectors--such as fertilizers--constraints that have held back supply could ease, lowering prices and earnings to closer to midcycle levels from their current extraordinary highs. In other sectors such as petrochemicals, supply increases could result from additional capacity and hurt margins. For specialty producers, input material might become more freely available if supply constraints ease, a potential positive credit factor in areas such as paints and coatings.

Potential positive credit factors

In the face of inflationary pressures and high raw material costs for chemical companies, there is some potential for a tempering of input costs. For example, olefin derivative prices are lower due to potential oversupply. This could be caused by an imminent supply overhang in petrochemicals that should theoretically benefit the vast majority of commodity, intermediate, and specialty chemical producers we rate, many of which use ethylene or propylene derivatives as raw material. However, in reality, each derivative has their own supply/demand, competitive, and pricing dynamics. As a result, while declining input costs are favorable, it's not entirely clear that raw material pricing across the board for chemical companies will decline in tandem with profitability declines at olefin producers.

Lower oil and gas prices.  Our base case assumes that oil and natural gas prices decline in 2023 relative to 2022. Prices should remain high by historical standards, especially in Europe, but we believe they will be lower in 2023. This should benefit downstream chemical intermediate and derivative producers.

Many chemical companies, especially those with investment-grade ratings, started 2022 with cushions in their credit metrics.  These cushions have thinned in some instances as rising raw material costs, supply-chain issues, and general inflationary trends have eaten into margins. Still, many companies continue to enjoy some level of cushion, especially at investment-grade specialty chemical companies. At the lower end of the rating scale, especially in the 'B' rating category, cushions tend to be more volatile. In the U.S. and Latin America, for example, based on the latest available financials for 2022, there are more companies with credit metrics above our range of expectations than there are at or below expectations.

Petrochemical Sector Outlook

In 2021, U.S.-based petrochemical companies had a sharp recovery in EBITDA and EBITDA margins from the trough levels in 2020, at the onset of the COVID-19 pandemic. This strength has continued through the first half of 2022, in some cases leading to record EBITDA on a trailing-12-month basis. While the drivers vary by producer, common factors include a strong recovery in global macroeconomic growth, generally favorable supply/demand fundamentals, and a booming housing market. In addition, despite some narrowing, U.S. natural gas-based facilities have generally maintained their cost advantage vis-à-vis naphtha-based European and Asian plants. As a result, we have taken a slew of positive rating actions in 2021 and thus far in 2022, with many U.S. petrochemical companies returning to their pre-pandemic ratings. With cloudy skies on the horizon and pressures likely to mount in the next one to two years, we believe upward rating pressure has likely stalled. However, given the use of free cash flow to reduce debt and improve balance sheets during this booming period, we believe U.S.-based petrochemical companies generally have a cushion in their credit measures to withstand some upcoming earnings pressure.

We believe the macroeconomic environment will prove more challenging for the rest of 2022 and into 2023, which could dampen demand for chemicals.  Following the 2020 recession, when U.S. GDP declined by 3.4%, the U.S. had its biggest expansion in 37 years, with GDP growing at an average rate of 5.7% in 2021. However, since then, economic conditions have deteriorated, with real U.S. GDP declining 1.6% in first-quarter 2022 and at a 0.9% annual rate in the second quarter. While our economists are projecting full-year GDP growth of 1.6%, the risk of recession has been steadily increasing. They estimate that the risk of a recession in the U.S. over the next 12 months is about 45%, within a wider 40%-50% band.

In the first half of 2022, demand for chemical products held up well, though this will remain a key area of focus for us through the remainder of 2022 and into 2023. To the extent that persistently high inflation weakens consumer confidence, we believe this would be felt across various chemicals chains, putting some pressure on volumes. In addition, the significant drop in travel during the height of the COVID-19 pandemic led many consumers to shift spending from services to goods. As economies re-opened, consumers have shifted spending from goods back to services, which could have a mixed impact on the chemicals sector, depending on each company's end-market exposure. Lastly, there's been some cooling in the U.S. housing market. With interest rates continuing to rise and lending standards tightening, new mortgage applications have dropped.

Some of the key macroeconomic drivers that are good barometers for demand for chemical products include real GDP growth in the key locations that the company has facilities in or exports to, consumer spending, industrial production, housing starts, and light vehicle sales. The table below depicts our economists' latest forecast for some of these drivers.

Overall, S&P Global Commodity Insights and Platts Analytics are forecasting global ethylene demand to rise by a compound annual rate of 3.8% between 2022-2027 and 2.7% from 2027-2032. This is relatively in line with their projection that global propylene demand will increase at a compound annual rate of 3.4% from 2022-2032.

Coupled with potentially weakening demand, new capacity coming online will lead to a period of over-supply in the industry.  The bulk of the new petrochemical capacity being brought online over the next few years is in Asia and, to a lesser extent, the Americas. S&P Global Commodity Insights and Platts Analytics are forecasting that new ethylene, propylene, and derivatives supply globally will outpace demand in the second half of 2022, leading to a deterioration in operating rates, prices, and margins. Specifically, their expectations are that in the period from 2020-2023, global capacity expansions in ethylene and propylene will exceed demand in the high-single-digit percentages. This is expected to lead to global ethylene operating rates declining to 82%-83% in 2022-2026 from 84% in 2021 and global propylene operating rates dropping into the low-70% area by 2024. As a result, we expect a compression in EBITDA margins from what were in many cases peak 2021 levels. We believe that 2021 margins had been elevated for several reasons, including the delay in some new capacity coming online as well as extreme weather events--such as the Texas freeze--leading to unexpected shutdowns and reductions in operating rates.

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Despite some deterioration, our base-case forecast is that most U.S.-based petrochemical companies should still be able to maintain decent EBITDA margins, particularly given their expected cost advantage. A key focus for us will be on how much existing higher-cost capacity is either temporarily or permanently brought offline, which would soften some of the impact of the large impending new capacity additions. In August, Dow (the second-largest global polyethylene producer) announced that it is temporarily cutting its global polyethylene production rates by 15% to deal with high inventory levels, logistical constraints, and dynamic conditions in Europe.

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Our expectations are that U.S. plants will maintain their cost advantage over European and Asian ones.  We believe U.S. petrochemical producers will continue to benefit from the availability of lower-cost natural gas-based feedstocks compared to the more naphtha-based producers in Europe and Asia. Despite a material uptick in natural gas prices in 2022, U.S. producers remain toward the lower end of the global cost curve, trailing Middle Eastern producers but still advantaged compared to petrochemical companies in Europe and Asia. Energy also remains an important input cost for petrochemical producers, and relatively low-cost natural gas will continue to benefit U.S. producers.

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While the oil to natural gas ratio (based on the prices of Brent and Henry Hub) has narrowed somewhat, we expect that it will consistently remain above the 6x-8x range, which typically would mark global parity. The higher the ratio, the greater the cost advantage for producers that primarily use natural gas-based feedstocks, such as in the Middle East and the U.S.

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What Lies Ahead?

Despite our expectation for oversupply conditions over at least the next one to two few years, we believe that by and large, U.S.-based petrochemical companies have a cushion in their credit measures to maintain current ratings. For example, Dow's key ratio of funds from operations (FFO) to debt was 43% for the 12 months through June 2022 (compared to a 20%-30% target at the current rating), while LyondellBasell's FFO to debt for the same period was 65% (compared to a 30%-45% target). During this upcoming downturn, we believe that the key factors affecting how much margins decline and for what duration will be how demand holds up in potential recessionary conditions, how much existing higher-cost supply gets rationalized, and the ramp-up time and operating rates of new capacity. (In general, new capacity in the industry has been slower to ramp-up than initially expected.) We will also closely monitor how companies adapt their financial policy decisions to more challenging operating conditions--including pulling back on M&A and other growth spending and being more cautious in their approach to shareholder rewards--while maintaining a balance sheet commensurate with the ratings.