The U.S. chemical industry continues to ail, with profits still flagging. In fact, this year's first quarter bears a striking resemblance to last year's lackluster first quarter. Just like the same period in 2002, chemical producers are struggling with skyrocketing feedstock costs. And they are failing to counteract them with price increases—which means that profit margins will be tight for the eighth consecutive year.

At best, chemical firms issuing estimates expect first-quarter earnings to equal that of 2002, and at worst, they anticipate a loss. Many factors are eating away at profits. Aside from raw material costs, energy costs are also going through the roof, and many firms are unable to set higher selling prices and energy surcharges in pace with these rapidly rising costs. For example, Dow Chemical anticipates first-quarter feedstock and energy costs to exceed last year's figures by a whopping $1 billion.

Prices for natural gas and ethane, which account for nearly 70% of U.S. ethylene feedstocks, have fluctuated the most dramatically. Hitting a record $18 per million Btu in late February, spot natural gas prices have gone down to $5.50 per million Btu for April contracts on the New York Mercantile Exchange (NYMEX)—but they're still more than twice as much as last year's prices.

Aside from volatile feedstock and energy costs, the industry must also contend with overcapacity and weak demand—exacerbated by security concerns and the industry's image problem. The industry is not popular with the general public, categorized somewhere between "big tobacco" and "big oil."

U.S. petrochemical makers have been hit especially hard. Because natural gas liquids are responsible for roughly 70% of ethylene production—as opposed to only 15-20% in Europe and Asia—natural gas price volatility has been extremely damaging. It has caused U.S. producers to lose their cost advantage over most European and Asian competitors and will also harm U.S. exports, analysts say. What's more, prices are not expected to moderate in the long run because of a supply shortage.

"The U.S. ethylene industry has suffered a permanent loss of competitiveness due to the lingering uncertainty about future supply and pricing of natural gas," says Leslie Ravitz, an analyst at Morgan Stanley, NY. "A chronic supply shortage will keep gas prices elevated for the long term, and crush the cost advantage that users had enjoyed." Morgan Stanley predicts that prices will hover around $4.00 per million Btu this year and in the long term, will range from $3.50 to $4.00 per million Btu—certainly not encouraging news for the industry.

U.S. rubber chemical makers are also hurting and for the same reasons—hefty raw material costs, rising energy prices and overcapacity. All three are restricting the amount that chemical makers can charge their customers. Moreover, tire makers, the biggest consumers of rubber chemicals, are trying to put a lid on costs because their largest customers, auto manufacturers, are setting price caps.

Due to their size, the three major tire makers, Goodyear, Michelin and Bridgestone, "carry a lot of weight when they negotiate prices," says Chris Exton, rubber chemicals vice president for Crompton Corp. The outcome has been slumping prices since the mid-1990s. Fortunately, the rubber chemicals sector can look forward to more moderate oil prices, which will translate to less expensive raw materials derived from oil, such as aniline, benzene, acetone and toluene.

"We believe crude oil will settle back to historically normal levels once the political turmoil ends, but we don't believe U.S. natural gas prices will ever return to $2.00-$2.50 per million Btu," says Fran Keeth, executive vice president of customer fulfillment and product business units at Shell Chemicals. This means that to be globally competitive, the petrochemical sector will need to undergo a long-term change, and that will entail more restructuring through mergers or capacity rationalization.

Indeed, the entire chemical industry is grappling with a loss of exports and a surge in imports. In December 2002, chemical exports dropped while imports increased, enlarging the chemical trade deficit. For all of 2002, chemical exports only rose by 1.6% while imports jumped by 8.2%. "The last bastion of competitive advantage in North America is related to electric power, which is good news for vinyls producers," says Gary Adams, president of Houston-based petrochemical consultancy Chemical Market Associates Inc. (CMAI).

Cutting costs is another industry-wide concern, and employment is feeling the pinch. The past few years have seen a steep employment decline not only because firms are curtailing costs but also because they are decelerating output, making many production workers redundant. According to Labor Department data, average employment in the government's chemicals and allied products sector dropped by 1.4% in 2002 from the previous year—continuing the sharp descent that started in prerecessionary 1999. Between 1999 and 2002, average industry employment declined by 2.4%.

And employment numbers are even bleaker if the pharmaceutical industry is not figured into the equation. This is because this industry has been bolstering employment in chemicals and allied products, with pharmaceutical companies actually expanding their workforce by 10.6% since 1999. Therefore, the chemical industry minus pharmaceuticals—or what some dub the "real" chemical industry—actually posted employment declines of 3.2% year-to-year or 7.9% since 1999 to 679,200 workers. In fact, the last time the "real" chemical industry registered an employment increase was in 1990. Thus, declining employment has been a long-term trend.

Fortunately, there are some encouraging signs. For one, January chemical industry sales managed a 1.6% increase, after a flat December. Also, so far this year, chemical production has rebounded slightly after dropping by 0.9% in both 2001 and 2002. And the Institute of Supply Management's latest data shows that in February, new order backlogs for chemicals rose as well as chemical exports and imports.

Even if these figures do not portend a recovery, chemical companies can certainly ride out more difficult times because of the inherent unpredictability of the industry. "Chemicals, by nature, are a quite volatile industry," says Sergey A. Vasnetsov, a chemical analyst with Lehman Brothers, a global investment bank. Chemical companies' "earnings estimates and actual results can vary significantly." Also, chemical prices are easily influenced by economic news and supply disturbances.

And despite narrow profit margins, chemical companies continue to be vital. Indeed, the U.S. chemical industry remains the world's largest producer, responsible for about one-fourth of world chemical production. It's crucial to the country's economy, turning raw materials, such as oil, natural gas, air, water, metals and minerals, into over 70,000 different products. And this central role will remain undiminished through the ups and downs of energy prices, raw material costs and public popularity.

Primer Links

Organizations

American Chemical Society http://www.chemistry.org/portal/Chemistry

American Institute of Chemical Engineers http://www.aiche.org/

National Association of Chemical Distributors http://www.nacd.com/index.cfm

Synthetic Organic Chemical Manufacturers Association http://www.socma.org/

Publications

Chemical & Engineering News http://pubs.acs.org/cen/index.html

Chemical Engineering http://www.che.com

Chemical Processing http://www.chemicalprocessing.com/cp/index.html

Chemical Week http://www.chemweek.com

Sources: Feedstock Costs Hammer Earnings
William Storck
Chemical & Engineering News, March 31, 2003
http://pubs.acs.org/cen/topstory/8113/8113notw5.html

Petrochemicals: Gas Surge, War, Economy Keep Industry On Edge
Peck Hwee Sim and Robert Westervelt
Chemical Week, March 26, 2003
http://www.chemweek.com

Scandal Free?
Alexander H. Tullo
Chemical & Engineering News, April 2, 2003
http://pubs.acs.org/cen/today/april2.html

From the Editor: Here's to Better Days Ahead
Kathie Canning
Chemical Processing, April 11, 2003
http://www.chemicalprocessing.com/Web_First/CP.nsf/ArticleID/CBOH-5LHM6K/

Rubber Cure-Alls
Marc S. Reisch
Chemical & Engineering News, April 14, 2003
http://pubs.acs.org/cen/coverstory/8115/8115rubber2.html

Employment Picture is Still Dark
William J. Storck
Chemical & Engineering News, March 25, 2003
http://pubs.acs.org/cen/today/march25.html

Leading Indicator
Arnold Pearlman
Chemical Week, April 2/9, 2003
http://www.chemweek.com

Vital Statistics
Arnold Pearlman
Chemical Week, March 19, 2003
http://www.chemweek.com

Chemical Industry Analysis Brief
Energy Information Administration
http://www.eia.doe.gov/emeu/mecs/iab/chemicals/index.html