Fitch: Global Chemical Producers Prepare for a Weaker 2007 With Slowing Demand.

CHICAGO -- Overall, chemical producers globally are likely to close the current year as another good one on the back of robust domestic demand as well as continued strong pull from China, which benefits the Europe, Middle East and Asia (EMEA) manufacturers in particular, according to Fitch Ratings. Chemical producers in the EMEA region and in North America have experienced solid financial results during the first nine months of 2006. First-quarter margins were solid; however, during the second quarter production in the petrochemical segment declined and prices remained stagnant as inventory de-stocking resulted in softer demand. Third-quarter financial results were strong, primarily affected by plunging natural gas and crude oil prices. Demand in the third quarter was robust and in combination with an elevated level of supply constraints, the supply/demand balance remained tight for ethylene and certain ethylene derivatives.

Raw material prices including natural gas and crude oil remain on the high side but some reduction has taken place. Chemical companies were at least in part able to push this into higher selling prices, although not in all cases to a degree sufficient to compensate for a higher cost base. This is particularly true for the specialty chemical producers.

Commodity producers in the fourth quarter are currently experiencing weakening demand with a surplus of supply. Therefore, prices and margins are expected to trend flat to slightly lower into 2007, indicating that the peak profitability levels are currently being reached or have just passed. Raw material prices, including natural gas and crude oil have backed off from their record prices but still remain high. Fitch expects commodity producers will realize weaker margins during the last three months of the year due to the current downward trends in demand and this should continue through the beginning of 2007.

2007 Outlook

Fitch believes fundamental market and economic conditions for the chemical industry continue to be good, despite the instability caused by energy markets. The sharp drop in crude oil prices in third-quarter 2006 helped boost chemical producer's margins, but quickly slowed demand as many buyers stopped buying in anticipation of lower prices. Demand growth should return as end-users work off excess inventories and need to start buying product again. Fitch is expecting a modest level of demand growth for North American commodity producers in 2007 as consumption bounces back. End-users are expected to work off excess inventories and begin buying product again. However, the recent slowdown of U.S. economic activity, falling real estate sales, inflation, and rising interest rates all put pressure on consumption and consequently on demand going forward. Therefore, while still positive on balance, Fitch expects demand growth to slow on both sides of the Atlantic.

Therefore, 2007 may have lower prices and margins but still be a profitable year for suppliers. The duration of solid margins will depend on economic growth and volatility in raw material prices. Raw material prices such as for natural gas and crude oil are expected to remain elevated; however, Fitch continues to anticipate a continued softening of energy prices through 2007. Fitch's energy team is using a price deck of $50 for WTI crude oil and $5.50 for Henry Hub natural gas. Supply/demand balances should tighten during the first half of 2007 from the weaker 2006 fourth quarter, as lower prices and low inventory levels will stimulate demand. With inventories throughout the supply chain at low levels at the end of 2006, producers are likely to see restocking of inventory in addition to real demand growth during 2007. Volume growth is likely to remain healthy but slower in 2007.

Looking to the end of 2007, the chemical industry expects to face challenges from outside factors, with the greatest threat coming from capacity additions in emerging markets. Energy costs will also continue to affect business.

The new European Chemical's legislation seems to be in its very last stages. A compromise between the negotiating parties has been found, but still needs to pass the parliament and council. While this legislation will be associated with some additional financial expenses, Fitch does not anticipate a significant impact on credit profiles.

2007 Credit Implications

Credit metrics for most producers in 2006 improved beyond mid-cycle levels and are expected to weaken slightly but remain appropriate for their rating category in 2007. Fitch has repeatedly highlighted that the 2005 and 2006 credit metrics are likely to draw an overly optimistic picture of the credit profile within the universe of the global chemical producers and therefore current rating levels encompass some downside headroom. Therefore, Fitch does not anticipate industrywide rating changes in 2007. Any changes will be company specific as certain producers meet debt repayment targets and gain greater financial flexibility or acquire additional businesses to build efficiencies. However, Fitch has observed that a number of issuers have embarked on more shareholder-friendly policies, at a point in time when the industry is at its peak.

In the past 18 months a number of chemical companies have announced or expanded share buyback programs. The most notable of these in the U.S. were DuPont's $5.0 billion repurchase program, Dow Chemical Co.'s (Dow) expansion of its program with an additional $2.0 billion to offset dilution, and Air Products $1.5 billion program. Nova Chemical stated in its conference call that it will be conserving cash for a possible share repurchase program sometime in 2007. While the value of such a program is a source of controversy, DuPont's program did cause a two-notch downgrade in its ratings. In Europe, BASF AG in 2005 repurchased shares of EUR1.4 billion and in February 2006 announced a further buy-back program of EUR500 million. This has been reported to be completed recently and a new buy-back program of EUR500 million is put in place. Also DSM has announced a share buy-back program of EUR750 million.

In addition, mergers and acquisitions are expected to continue as chemical companies continue to consolidate businesses and try to further diversify or become dominant players in a sector. A significant part of the consolidation may be in the form of alliances and partnerships, rather than mergers and acquisitions. The two largest chemical companies in the world, BASF and Dow, have just given support to this statement. BASF stated that it was considering entering into a joint venture with Dow to build the world's biggest toluene diisocyanate plant (intermediates), which would come on stream in 2011.

The main drivers of consolidation will continue to be ongoing restructuring and business portfolio rearrangement. Traditional strategic buyers are likely to continue shopping for bolt-on acquisitions to compliment existing businesses or achieve efficiency through further integration. Also, the past year has seen some significant acquisitions strategically chosen to improve diversification and scale. BASF/Engelhard (approximately US$5 billion) and Linde-BOC (approximately EUR12 billion were prominent examples in the EMEA region, and other players are considering acquisitions as well. For example, Lanxess stated that it would be prepared to temporarily sacrifice its investment grade ratings if a good acquisition opportunity arises and has recently reiterated that it wants to grow through acquisitions. Fitch views acquisition risk as Event Risk and would deal with it as and when it materializes. Also, financial buyers are expected to continue playing an important part in the industry's consolidation, as they are still benefiting from high levels of liquidity in the Leveraged Finance market.

Fitch anticipates refinancing activity by issuers will be about the same in 2007 when compared to 2006, but will be low in the EMEA region. Fitch expects certain producers to repay upcoming maturities while others will look to refinance existing bank debt to further extend maturities in anticipation of softening market conditions later in 2007 and 2008. Producers that have not already extended bank credit facility tenors will likely take advantage of the opportunity to put in place five-year deals. Upcoming maturities are Air Liquide EUR200 million, DSM's EUR400 million, and Rohm & Haas EUR160 million 6.0% notes. Fitch-rated North American chemical companies had outstanding debt of approximately $32 billion at the end of the third quarter of 2006. Scheduled debt maturities for companies in the North American chemical sector total approximately $4.8 billion in 2007.

Subsector Outlooks

Olefins and Polyolefins:

Fitch expects operating rates for ethylene and polyethylene to continue to remain high, but not at peak levels, in the first half of 2007 as demand rebounds from the drop in crude oil prices in late 2006. Buyer's inventories are likely to be replenished in early 2007, improving operating rates from the drop we are currently seeing in fourth-quarter 2006. Dow Chemical Co., Equistar Chemicals L.P., and NOVA Chemicals Corp. are expected to realize steady operating earnings as raw material costs decrease faster than the decrease in selling prices. Most petrochemical producers will see some degree of relief on the raw materials side of the equation in 2007; however, Fitch expects natural gas and crude oil costs to continue to be volatile.

Capacity additions in North America and EMEA are expected to be minimal next year. Most additions are likely to replace high-cost production and offset additional plant shutdowns in 2007. Producers have remained disciplined when considering starting up idled plants in the United States and Mexico. With minimal additions to North American and EMEA supply in 2007, operating rates are expected to be in the upper eighties to low ninety percent range. Demand growth is expected to be slower in 2007 when compared to 2006, but energy remains the wild card. If buyers see prices coming down, they will only buy what they must. If they see stable or rising energy prices they will buy more to ward off higher prices later. With winter quickly approaching it is Fitch's expectation that energy prices will inch upward into the first quarter 2007.

Titanium Dioxide:

Fitch expects the titanium dioxide (TiO2) market to continue to strengthen in 2007 as a result of steady demand and tight supply. Lean inventories, steady demand and some production snags should keep operating rates at or near the 90% range. No major new capacity additions are expected until at least the end of the decade. As long as the economy does not stumble, producers are likely to realize strengthening selling prices as the economy continues to grow and market conditions remain tight. All the major TiO2 producers including DuPont, Lyondell Chemical, Tronox, Huntsman, and Kronos Worldwide announced price increases in the late third and early fourth quarters in 2006. Some producers have also announced productivity improvements. Thus, Fitch expects to see increased operating earnings from this segment during 2007.

Intermediate Chemicals:

Even though crude oil prices have come down from their peak, intermediate chemical producers will continue to realize pricing pressures as pricing for most building blocks will continue to remain high. Fitch expects demand to remain solid in 2007, and therefore, intermediate chemical producers will be able to push price increases through the chain over the next several quarters. The uncertainty is how quickly their selling prices will increase. As long as demand remains steady, Fitch believes buyers will be more concerned about availability of product versus price. Operating margins will continue to be under pressure from quarter to quarter due to turbulent raw material costs. However, intermediate chemical producers are expected to maintain and even expand margins by the end of 2007. The amount of margin expansion realized will primarily depend on the level of demand for their respective product areas.

PVC:

The year 2007 may be the last good year of earnings for PVC resin producers before a slug of new capacity forces the market into a cyclical downturn. Fitch expects the domestic PVC resin market to remain tight in 2007, most importantly through the seasonally stronger second and third quarters, as long as U.S. GDP remains fairly robust, driving demand. Supply should be stable until the first half of 2007 until Shintech's new vinyls facility comes on line late in 2007 or early in 2008. Once significant new capacity comes on line, industry operating rates could decline below 90%, producers could lose pricing power, and resin prices may weaken from the record levels seen over the last few years.

One of the PVC companies to watch over the next year is Georgia Gulf. Execution will be critical as the company integrates Royal Group Technologies into the portfolio with soft market conditions looming ahead. Downstream, PolyOne's new CEO, Stephen Newlin, is expected to make significant changes to meet the aggressive goals he laid out during the recent third-quarter conference call.

Fertilizer:

Fitch expects North American fertilizer producers to show stronger profitability, earnings, and cash flow in 2007 due to favorable market factors that may encourage greater planted corn acreage in the U.S. and strong fertilizer demand abroad. Growing domestic corn consumption, backed by demand for ethanol; high corn prices, especially relative to soybean prices; and projected lower corn inventories are positive factors in favor of higher corn acreage in the U.S. next spring. More generally, very low world coarse-grain stock-to-use ratios also favor strong fertilizer import demand abroad. As usual, the wild card will be the weather, since inclement weather conditions, or lack thereof, can influence the volume of fertilizer movement during the planting season.

Over the next 12 months, fertilizer producers could make decisive moves toward expanding capacity outside North America in low-cost natural gas regions. In particular, CF Industries and Terra Industries could decide on whether to move forward with a new ammonia/UAN (urea ammonium nitrate) solutions production facility in Trinidad. Additionally, Agrium could announce its decision to build a new ammonia/urea plant in Egypt. If these projects are approved, Fitch believes the respective companies could realize long-term beneficial gains to earnings and geographic mix from these capital investments.

Specialty Chemicals:

Specialty chemical producers will likely see improving margins in 2007 as raw material costs come down. Fitch expects specialty producers will continue to push product prices higher to continue to mitigate the impact of past higher raw material, energy and transportation costs they experienced in 2006. However, most specialty producers do not price their products based on scarcity of supply as do commodity producers, and therefore have less pricing flexibility. For specialty producers, a rise in costs results in a lag between specialty chemicals producers selling price hikes and those announced by their suppliers. Many of the specialty chemical producers have been successful in implementing price increases in 2006 due in part to favorable demand and Fitch expects that this will continue to be the case in 2007. Just about all the competitors in this sector have been forced to raise prices to offset costs. But looking forward, demand and volume growth are a concern for the specialty group, as a greater portion of their sales go into interest rate sensitive durable goods markets like autos and housing. Both of these industries are currently experiencing significant slowness.

Fitch also remains concerned that demand may cool as consumer prices continue to escalate. Rohm and Haas, DuPont and Lubrizol are all expected to continue to improve operating margins with higher pricing. Volume growth, however, will continue to be spotty depending on the product and the end-markets.

Following is a list of Fitch rated issuers and their current Issuer Default Rating (IDRs) in the Chemical Sector

North America:

--The Dow Chemical Co. (DOW) ('A-'; Outlook Positive)

--Eastman Chemical (EMN) ('BBB'; Outlook Stable)

--E.I. duPont de Nemours and Company (DD) ('A'; Outlook Stable)

--Equistar Chemicals L.P. (EQC) ('B+'; Outlook Stable)

--Georgia Gulf Corporation (GGC) ('BB-'; Outlook Negative)

--JohnsonDiversey, Inc. ('B-'; Outlook Negative)

--Kronos International, Inc. ('BB'; Outlook Stable)

--The Lubrizol Corporation (LZ) ('BBB-'; Outlook Stable)

--Lyondell Chemical Company (LYO) ('BB-'; Outlook Stable)

--Methanex Corporation (MEOH) ('BBB'; Outlook Stable)

--Millennium Chemicals (MCH) ('B+'; Outlook Stable)

--Mosaic Global Holdings Inc. (MOS) ('BB-'; Outlook Stable)

--Nalco Company (NLC) ('B'; Outlook Stable)

--NOVA Chemicals Corp. (NCX) ('BB'; Outlook Stable)

--Omnova Solutions Inc. (OMN) ('B+'; Outlook Stable)

--PolyOne Corporation (POL) ('B'; Outlook Stable)

--Rockwood Specialties Group (ROC) ('B'; Outlook Stable)

--Rohm and Haas Company (ROH) ('A-'; Outlook Stable)

--Terra Industries Inc. (TRA) ('B+'; Outlook Stable)

--Tronox Worldwide LLC (TRX) ('B'; Outlook Stable)

--Union Carbide (UK) ('BBB'; Outlook Stable)

--Valhi, Inc. (VHI) ('BB-'; Outlook Stable)

EMEA:

--Air Liquide ('A+'; Outlook Stable)

--Akzo Nobel N.V. ('A-'; Outlook Negative)

--Basell ('BB-'; Outlook Stable)

--BASF AG ('AA-'; Outlook Negative)

--Ciba ('BBB'; Outlook Stable)

--Cognis ('B'; Outlook Stable)

--Royal DSM N.V. ('A-'; Outlook Stable)

--Lanxess ('BBB'; Outlook Stable)

--Rhodia ('B+'; Outlook Stable)

--SABIC ('A'; Outlook Stable)

--SABIC Europe ('A'; Outlook Stable)

--Solvay ('A;' Outlook Stable)

--OJSC Concern Stirol ('B-'; Rating Watch Negative)

--Petkim Petrokimya Holding A.S ('BB'; Outlook Positive)

--OJSC Kazanorgsintez ('B; Outlook Stable)

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.