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The strong projected 2010 year-on-year growth rates for most segments must be viewed in the context of the exceptionally sharp declines seen in 2008 and continuing into 2009. It may take years for activity to recover from these steep drops to reach past peaks. The industry is sensitive to a number of risks, most particularly high and volatile energy costs. A double-dip in the U.S. economy and industrial activity would dampen domestic demand further while a weak world economy would adversely affect exports. Another downside risk might arise if significant output from new capacity in the Middle East and East Asia finds its way into traditional U.S. export markets and even North America.
With a slow recovery of volumes, overall operating rates rose to an average of 74% in 2010 — see CP's Economic Snapshot. Further modest gains in chemical industry production volumes suggest slowly improving operating rates in 2011. Further capacity reduction coupled with strengthening production volumes could boost capacity utilization to 79% by 2012. This implies the industry is operating far below its optimal capacity utilization levels.
CAPITAL SPENDING PROSPECTS
Narrowing margins, austere market conditions, lower operating rates and a high level of uncertainty spurred the stringing out or delaying of a number of chemical industry projects in recent years. Furthermore, companies slashed capital spending budgets to conserve cash flow. As a result, U.S. capital investment in chemistry fell by more than 9.2% to $25.3 billion in 2009. This followed a 9.3% drop in 2008 from a peak level in 2007. Despite a recovery, lingering uncertainty concerning future demand combined with lower-than-average operating rates hindered investment again in 2010, with capital spending falling 1.0% to $25.1 billion.
Capital spending cycles generally lag cycles of industry activity with profits and operating rates leading determinants of investment. In general, improving production and utilization rates, cost containment from earlier cost-reduction efforts, modest increases in raw material costs and higher gains in selling prices have resulted in a strong recovery of profits during 2010. In addition, utilization rates have improved, although they still don't match the levels of several years ago and are below the long-term average.
Figure 5. A large portion of investments will go for replacing worn-out assets rather than adding new capacity.
Other factors influencing the level of capital spending include the business cycle, long-term business expectations, taxation policies, the cost of capital, the burden of debt, the supply of credit and mandated expenditures. The business cycle was in a repressed stage in 2009 and a muted recovery occurred in 2010. Lingering credit tightness, companies' debt reduction efforts to repair their balance sheets, and uncertainty over taxation and other policies as well as long-term demand are hindering capital spending. On the other hand, low interest rates make for a low cost of capital.
The stage is set for improving operating rates and profit margins. This, in turn, could lead to moderate increases in investment in new plant and equipment in the United States. The need to replace existing assets is apparent and will be a driver. By 2011 the industry investment cycle should re-engage, with U.S. spending rising more than 6% and accelerating to a 9% gain in 2012. Capital spending should reach $29.2 billion in 2012 (Figure 5), which still falls short of the most recent peak. The largest proportion should continue to go toward replacement of worn out assets. The majority of the expansion of production capacity should target existing product ranges and largely be incremental. As the recovery strengthens into an expansion, spending should rise in future years. With improving competitiveness resulting from developments in shale gas, the United States may once again become a favorable location for investment.
Chemicals output now is on the upswing, especially in developing countries. Worldwide production should increase moderately in 2011 and 2012. The U.S. chemical industry should share in these gains and should boost its capital spending, with much of the investment aimed at replacing aging plant and equipment. However, the prospects of abundant and cheap natural gas ultimately may make the United States again a location of choice for new capacity.