Profit outlook improves for processors.

After nearly three years of struggling to make ends meet, plastics processors can finally look forward to healthier bottom lines. Over the next few quarters, revenues in the plastics market will slowly but steadily increase while the costs of manufacturing will ease. And while domestic and global markets for manufactured products will remain challenging to be sure, profit levels for many U.S. manufacturers, especially plastics processors, will improve gradually over the next few quarters.

After a year of little or no growth in 2003, total U.S. output of processed plastics products will rise 4% to 5% in 2004. This increase will bring the industry close to, but still below, the peak in total production that was hit in 2000. The need to enhance productivity and to replace worn or obsolete capital equipment will push U.S. purchases of plastics machinery, both primary and auxiliary, up 10% to 15% next year. This will follow an estimated decline of 5% to 7% in machinery orders in 2003.

Energy costs weigh in

The most important variable in this forecast is a sustained downtrend in the price of energy products, especially natural gas. Its price spiked to an all-time high in the first quarter of 2003, but since then it has slowly drifted lower. Gas prices remain quite high by historical standards, but the good news is that producers are bringing more gas to market in an effort to cash in on these higher prices. At current price levels, there is a strong incentive for suppliers to produce natural gas, while at the same time there is strong disincentive for consumers to purchase it. So far this fall, market demand for natural gas has been moderate to low. As a result, gas inventories have risen well above their previously low levels and are now close to their historical averages.

Barring an unforeseen and drastic change in these circumstances, the price of natural gas and most other petroleum products will continue to decline. Lower energy costs will benefit virtually all sectors of the economy, but the plastics industry will benefit more than most. Consumers' discretionary incomes will rise, giving them more money to spend on goods and services other than energy products. It will also cost manufacturers less to operate their factories and ship their products. But the most important benefit to processors' balance sheets will come in the form of lower materials prices.

For many sectors of plastics processing, materials costs account for anywhere between 40% and 70% of the total cost of manufacturing. In 2003, the average cost of resins jumped a whopping 25% to 30% over the year before. To make matters worse, the low rate of overall inflation in the U.S. combined with increasing competition from low-cost imports meant that none of this increase in plastics-product manufacturing costs could be passed through to customers. So lower energy prices will bring much needed relief, and those processors who have managed to survive the past three years should see most of this relief fall right to the bottom line.

While the cost to make plastics products is expected to decrease in the coming year, the demand for these products will rise. The U.S. economy is now well into the second year of a cyclical recovery period. Since World War II, these recovery periods have lasted an average of three to four years. The first year of a recovery is typically a period of slow growth as markets make the transition from a cautious mindset and start to prepare for future growth. Once the market accepts that economic conditions will most likely continue to improve for the foreseeable future, business activity accelerates. This is the present situation.

Total U.S. industrial output is steadily expanding, and this is generating a rise in demand for plastics products. The U.S. economy's most crucial leading indicators suggest that this trend will continue. Along with the aforementioned decline in energy prices, interest rates remain quite low by historical standards, and the value of the dollar is also at a cyclical low point. The lagging indicators such as employment figures and spending on capital equipment have also started to rise off their cyclical bottoms, and they too will now start to contribute to the recovery.

Capital spending on equipment is closely correlated with profits, and as processors' margins improve, much of these gains will be invested in new, more productive machines. Consumption of plastics machinery will rise in 2004, but will accelerate more substantially in 2005. This investment will sustain the rising trend in the industry's productivity rates.

The import threat

As always, there are some threats to the outlook for an accelerated recovery next year. The topic that is foremost on most manufacturers' minds is the rapid erosion in the U.S. manufacturing base caused by a sharp rise in imports from low-cost countries, most notably China. At present, it is impossible to predict how the politics of this issue will play out, but the fact that 2004 is an election year means that the problems associated with our burgeoning trade deficit with China will receive more attention than they have so far.

As far as most other countries are concerned, a rise in the U.S. economy means that the outlook for the rest of the world will also improve. The global economy will still not perform at optimal levels, but the vast majority of countries are expected to do better than they did this year.

Bill Wood, an independent economist specializing in the plastics industry, heads his own firm, Mountaintop Economics & Research, Inc. in Colrain, Mass. He may be contacted by email: [e-mail]