This report does not constitute a rating action.

The petrochemical industry can expect somber operating conditions for the next 12 months or so, as demand remains stagnant, and new capacity ramps up operating rates, amid high inflation, and overall slowing economic growth.   Fortunately, many producers built ample credit metric cushions in 2021 through the first few quarters of 2022 that could help fend off downgrades depending on the extent and duration of the downturn. S&P Global Ratings expects petrochemical producers will be wary of mergers and acquisitions (M&A) and other growth spending and remain measured in their approach toward shareholder rewards, while maintaining a balance sheet commensurate with the ratings.

Here, we examine the credit quality of 10 large global public chemical companies that we classify as at least partly being commodity chemical producers. We discuss how the industry, in general, and some companies, in particular, are adapting and reacting to market oversupply, margin weakness, high input and operating costs (in certain regions), geopolitical and economic challenges, and other industry risks. Overall, we view the petrochemical industry outlook over the next 12 months as somewhat negative.

Where We Were--The Good Times

In 2021, through the first half of 2022, U.S.-based petrochemical companies underwent a sharp recovery in EBITDA and EBITDA margins from the troughs triggered by the COVID-19 pandemic. Following the 2020 recession, with U.S. GDP declining by 3.4%, the U.S. experienced its biggest expansion in 37 years, with GDP growing an average 5.7% in 2021. This led to, in some cases, record EBITDA and cash flow generation, mostly due to the strong recovery in global macroeconomic growth, generally favorable supply-demand fundamentals, and a booming housing market. Additionally, U.S. natural gas-based facilities have generally maintained their cost advantage compared to naphtha-based European and Asian plants.

In the 2020 trough year, BASF SE, The Dow Chemical Co., Evonik Industries, Formosa Plastics Corp., Huntsman Corp., LyondellBasell Industries N.V., Olin Corp., Saudi Basic Industries Corp., Wanhua Chemical Group Co. Ltd., and Westlake Corp. saw an average EBITDA decline of about 20% and an average EBITDA margin drop of about 270 basis points (bps) from around 17%. These companies then reported a staggering improvement the next year with an average EBITDA increase of nearly 140% and an average EBITDA margin increase of 800 bps (For year over year changes from 2020-2024, see charts 1 and 2).

Chart 1

Chart 2

Even more importantly, several companies used this period of improved earnings and cash flows to pay down debt and de-lever balance sheets. For example, LyondellBasell Industries repaid more than $4 billion of balance sheet debt (more than 25% of their total balance sheet debt) in 2021 and Dow Chemical decreased balance sheet debt by about $4 billion (or, roughly 25%) from the end of 2020 through mid-2022.

As a result, there was a slew of positive rating actions in 2021 through the first half of 2022. Then, in the second half of 2022, cloudy skies emerged, stalling additional upgrades.

Cracks In The Armor

While the year and a half run from 2021 into 2022 were the best of times for many industry players, we knew it would come to an end (although less abruptly than it occurred).

The COVID-19 pandemic delayed the ramp-up of new capacity, along with certain one-time weather events, such as the freeze in the U.S. Gulf Coast and Hurricane Ida, which tightened the country's petrochemical supply through 2021. Additionally, demand in key markets such as housing remained solid and ongoing shipping constraints likely led to customers pre-ordering more product than needed to avoid shortages. Then, around mid-2022, the party came to a crashing halt, with earnings plunging in the second half of the year. As a result, for the 10 companies in our sample set, the average EBITDA decline was 15% and the average EBITDA margin decline was 520 bps for the full year (versus 2021). These drops were heavily weighted toward the second half of the year.

In August 2022, Dow (the second-largest global polyethylene producer) announced it was temporarily cutting its global polyethylene production rates by 15% to deal with high inventory, logistical constraints, and dynamic conditions in Europe. Since then, some other producers have followed suit, particularly in higher-cost regions, such as Europe. On the demand side, persistently high inflation constrained customers' purchasing power and the U.S. housing market began to cool due to the rise in interest rates and tighter lending standards, leading to a drop in new mortgage applications. Many producers noted pronounced destocking from customers in late 2022, which compressed operating rates and margins.

Where We Are--Uncertain Times

Thus far in 2023, demand has been challenging for petrochemical producers and we expect demand to remain subdued this year, particularly with our expectation for stagnant growth in U.S. and Eurozone GDP, and a somewhat challenging housing market (despite some recent positive indicators).  Some of the key macroeconomic indicators that are good barometers for chemical products demand are: real GDP growth (both in the U.S. and key regions in which the company has facilities in or exports to), consumer spending, industrial production, housing starts and light vehicle sales (see table for S&P Global economists' forecasts).

To the extent that persistently high inflation weakens consumer confidence, we believe this sentiment would be felt across various chemicals chains, putting some pressure on volumes. In addition, the significant drop in travel during the height of the pandemic led many consumers to shift spending from services to goods. As economies have re-opened, consumers are shifting spending from goods back to services. This will have a mixed impact on the chemicals sector, depending on the end market exposure of each company. Additionally, destocking, which reared its head late last year, depressed volumes for the first half of this year. Several companies have pre-announced that second quarter earnings would be coming in below previous expectations, largely on account of destocking and weaker-than-expected demand (particularly in China).

On the flipside, an improvement in the automotive market will likely temper some of the demand weakness. Also, we expect ongoing recovery in the aerospace market as consumers travel more, which will likely boost demand for some companies (e.g., Huntsman Corp.'s advanced materials segment will likely benefit). Additionally, we're keeping a close eye on the expected rebound in demand in China, following the relaxation of its zero-COVID policies. Thus far, the rebound following Lunar New Year has been uneven, and generally slower than our initial expectations. For example, Cabot Corp. recently cited weaker-than-expected market conditions in China as a key reason why it expects to fall short of its full fiscal year 2023 earnings guidance. It also remains to be seen whether the timing and impact from any potential stimulus measures taken by China will spur overall demand. Still, China remains an integral country when we look at global chemicals demand, and our forecast for 5.2% and 4.7% real GDP growth in 2023 and 2024, respectively, bodes well for chemical producers.

We have a bearish outlook for the global olefins market into 2024, as softened demand and new capacity coming online will lead to oversupply in the industry.  The bulk of the new petrochemical capacity being brought online the next few years is in Asia, and to a lesser extent, the Americas. S&P Global Commodity Insights is forecasting that new ethylene, propylene, and derivatives supply globally will continue to outpace demand, leading to a deterioration in 2023 operating rates, prices, and margins. Specifically, there is an expectation that global ethylene operating rates will decline to 80% in 2023 from 85% in 2021, before hitting a low point in 2025 of about 78%. The story is similar in propylene, with global operating rates dropping to the low-70% area from 75% in 2021 through 2024.

As a result, we expect a compression in key ethylene and propylene prices, as well as EBITDA margins, from levels that were in many cases very strong in 2021 through mid-2022. When looking at polyethylene, we're more bearish on prices and margins for high-density polyethylene (HDPE) and linear low-density polyethylene (LLDPE) producers as capacity expansions are much higher than those in low-density polyethylene (LDPE). For the 10 companies we reviewed, we expect average 2023 EBITDA margins to be lower than in 2019, and hover around depressed 2020 levels. The forecast is for a gradual improvement in EBITDA margins in 2024 (improving closer to 2019 levels), as demand recovery is able to soak up some of the excess supply.

Chart 3

A key focus area of ours will be on how much existing higher-cost capacity is either temporarily or permanently brought offline, to soften some of the impact of the large impending new capacity additions. To date, we believe most existing capacity rationalizations have been temporary, either with companies running at lower utilization rates, or accelerating or extending planned and unplanned turnarounds, given the weaker operating environment. We believe that more permanent capacity shutdowns will likely be necessary to support a sustainable improvement in global operating rates and margins. We would expect these shutdowns to come from higher-cost regions (particularly in Europe and Asia) and at older and less efficient sites.

We expect U.S. plants will maintain their cost advantage over those in Europe and Asia.  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. Following a runup in Henry Hub natural gas prices in 2022, prices retreated thus far this year. We expect that costs for U.S. producers will remain toward the lower end of the global cost curve, trailing Middle Eastern producers, but still better off than petrochemical companies in Europe and Asia. Energy also remains an important input cost for petrochemical producers, and lower-cost natural gas will continue to benefit U.S. producers.

Chart 4

While the oil to natural gas ratio (based on the prices of Brent and Henry Hub) narrowed some in 2022, it shot back up in 2023. We expect it will remain well above the 6x-8x range that typically would mark global parity (excluding shipping costs) for at least the next three years. 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. We would expect that ethane will remain the most used feedstock in the U.S., and that ethane prices will support U.S.-based facilities, remaining toward the lower end of the global cost curve.

The Road Ahead

While the industry outlook is currently bleak, a saving grace for many of the companies we reviewed in this commentary is the cushion they built in their credit metrics to withstand this downturn. Three of the 10 companies (i.e., SABIC, BASF, and Evonik) improved their credit metrics over the past few quarters, and we believe they have ample cushion at the current rating. This was primarily due to a decrease in adjusted debt balances, through some combination of lower underfunded pensions and other postemployment benefits (which we tax-effect and add back to debt), a paydown of balance sheet debt, and building up cash balances (we typically net a significant portion of cash against debt). While credit metrics have weakened for the other seven companies over the past few quarters, all but one of them has credit metrics that are currently in line with, or exceeding, the target we have set for the current rating. The lone exception is Formosa Plastics Corp., with year-end 2022 debt to EBITDA slightly weaker than we expect for the rating.

Chart 5

We believe that key determinants during this upcoming downturn for 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--which has been slower to ramp up than initial expectations. We will also closely monitor how companies adapt their financial policy decisions to more difficult 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.

Tommy Pendleton contributed to this report.