Overview - Neutral

OPPORTUNITIES

The industry is divided into commodity chemicals (45%) and specialty chemicals (55%). The commodity segment tends to be more concentrated. In the commodity segment, cost reductions, improving yield from better technology and economies of scale are important. In the specialty segment, margins are higher due to better pricing and more efficient operations.

Demand for fertilizers is driven by crop prices that are high levels. At these levels, fertilizer demand should be steady at worst, and with reduced capacity prices should stay firm. The chemical industry is a large consumer of oil, natural gas and energy. However, oil and gas prices are falling, and this is providing a windfall.

Many chemical and fertilizer companies have excellent balance sheets. This bodes well for the industry in these times of tightened credit and financial instability.

WEAKNESSES

Demand growth is slightly negative currently. Demand for chemicals tracks global industrial production and global GDP very closely. Housing and auto markets could continue to weaken. Nearly 10% of chemical demand is directly tied to the housing sector, and an additional 10% is tied to the auto sector.

The global slowdown in economic growth will directly affect the chemical industry. Prices may fall in this industry. Pricing power is a function of three variables: inflation, capacity utilization and raw material price changes. Inflation is low (but could increase with aggressive monetary policy), capacity utilization levels are weakening, and oil prices are falling. This suggests a high probability of falling prices.

There is the chance of accelerating capacity growth in 2009-2011, assuming that projects do not get canceled. This is at a time when demand is slowing and operating rates are falling.

BUY/SELL RATINGS

Celanese (CE) is rated a Sell due to weak demand growth. Eastman (EMN) is rated a Sell due to weak demand, overcapacity in the PET market and a decline in free cash flow.?

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