Chemical Industry.doc

Chemicals2006 Second Quarter OutlookIndustry Risk Rating* U.S. 3.9 EMU 4.3Asia Pacific 3.5Top Producers 2005 Chemical Sales (US$, Bil.)1. BASF (Germany) 50.42. Dow Chemical (U.S.) 46.33. Bayer (Germany) 32.34. DuPont (U.S.) 26.65. Lyondell (U.S.) 18.6 Market SnapshotRegionMarketDriversPricingPowerMainEnd-marketsRegulatoryImpactMarketStructureBiggestThreatU.S.Consumer/CorporateSpendingModerateConsumer GoodsConstructionBusiness EquipmentHighOligopolyRising Natural Gas/CrudePricesWorldConsumer/CorporateSpendingModerateDiversified Manufacturing/IndustrialsHighOligopolyRising CrudePricesIndustry Events and Trends to Watch U.S. output has rebounded from the major supply disruptions caused by the 2005 hurricanes. Asia ex. Japan and the Middle East continue to lead the worlds growth followed by Eastern Europe, Latin America and NAFTA. Western Europe and Japan are showing modest improvement. Prices, which surged to record levels in the aftermath of the hurricanes but subsequently weakened, are on the rebound again led by low inventories and high energy costs. The capacity build-up in Asia and the Middle East is aggressively moving ahead. We expect only minimal expansion in NAFTA, Western Europe, and Japan.* Composite risk rating ranges from 1 to 10 with “1” representing the least risk and “10” the greatest riskForecast Overview and Market RisksFollowing growth of 4.5% in 2004, world petrochemicals volume expanded just 1.7% in 2005. Growth in 2005 was severely crimped by the temporary shutdown of a large amount of North American petrochemical capacity located in the U.S. Gulf as a result of the major hurricanes that hit the area last fall. U.S. production has rebounded since then, as physical damage to the plants was light, which made it easier for those plants to resume operations once logistical problems were resolved. Globally, the petrochemical industrys performance has been quite uneven in the last few years. Thanks to Chinas booming economy, Asia excluding Japan has led with near double-digit volume growth, followed by lower but solid performance by the Middle East and Eastern Europe. Western Europe has lagged quite a bit with declines in 2003 and 2004 and only meager growth in 2005. Japan has also done poorly, with declines in 2002-04 and very modest growth in 2005. North America rebounded 4.1% in 2004 following a drop of 2.2% in 2003, but plunged more than 6% in 2005. We expect total world output of petrochemicals to increase 4.8% in 2006. Asia Pacific and the Middle East remain in the lead, followed by Eastern Europe, Latin America and NAFTA. Western Europe and Japan settle for modest growth. Growth in NAFTA in 2007 will be constrained by slower economic activity in the United States. We forecast a global petrochemical oversupply to begin in 2009, when a considerable amount of new capacity from the Middle East and Asia is set to enter the market.China still boasts the worlds highest industrial growth, and offers the best growth opportunities for petrochemicals sales during the next few years, from the perspective of both local production and outsourcing. China is fast expanding its chemicals capacity base, but will remain a net importer of ethylene-based petrochemicals for the foreseeable future. Consequently, we see imports from other Asian players and the Middle East rising to fill the gap between Chinese local demand and supply. Another country that is emerging as a considerable market for chemicals is India, as this country continues to develop its consumer sector and industrial infrastructure. In the U.S., end-market activity is mixed but generally positive. The consumer sector is expected to ease in the second half of 2006 and into 2007, due to sky-high gasoline prices, stretched budgets and higher interest rates, before picking up in 2008. Growth in spending on machinery and equipment is strong but slowly decelerating. Nonresidential construction has finally begun to recover from a prolonged period of weakness. On the other hand, residential construction has peaked, and auto production has hit a slow patch that will extend through 2007. Petrochemical exports took a beating late last year and in the first quarter of 2006 due to the high price of U.S. products on global markets (mostly a legacy of the hurricanes), and imports increased. With U.S. prices now at or close to parity with rest-of-world prices and the U.S. dollar weak against most currencies, exports have strengthened and imports have eased. However, we see the continued aggressive chemical capacity buildup in Asia and the Middle East hampering U.S. exports in the long run and encouraging imports of petrochemicals and derivative products into the United States.Petrochemical prices surged in the aftermath of last falls hurricanes, which cut U.S. supply and pushed energy costs to record highs. Prices subsequently declined through April 2006, with only a few product exceptions, as supply was rebuilt. Since then, however, prices have rebounded as supply tightened and oil tags continued to rise. We see petrochemical prices gaining more strength in the next several months with support from firming natural gas. We anticipate a trough in 2009-10 as the global petrochemical market becomes oversupplied. Ethylene is the most important petrochemical building block, followed by propylene and benzene. The feed-stocks used in ethylenes production in the United States are mostly natural gas liquids (NGLs), in particular ethane, which account on average for 70 to 80% of ethylenes feedstock slate. Naphtha and gas oil account for the rest. NGL prices are driven by natural gas prices, while naphtha and gas oil prices follow crude oil tags. In Europe and Asia, ethylenes production is primarily naphtha based, while natural gas is the predominant feed in the Middle East. Traditionally, the U.S. had a competitive cost advantage in the ethylene derivatives market over most of its counterparts in Europe and Asia due to its access to low-cost local gas, priced historically at around $2/mmBtu. However, the price of U.S. natural gas has ballooned in recent years. As a result, and because the North American market is maturing and the opportunities for growth have migrated overseas, primarily to Asia, U.S. petrochemical producers have refrained from expanding their local operations. In stark contrast, the Middle East (Saudi Arabia and Iran) and Asia (China and increasingly India) have been aggressively expanding their capacities to take advantage of Asias vast and rapidly growing markets and the Middle Easts cheap gas. The prices of natural gas and crude oil, and, consequently, NGL, naphtha, and gas oil, have fluctuated wildly in the last three years, but on average have risen considerably. Strong growth in demand, driven by North America and China, and limited spare capacity by both OPEC and non-OPEC producers have caused oil prices to increase substantially. Political instability in the Middle East and production disruptions around the world have made the oil market more nervous still, adding to price pressures.WTI prices climbed to a new high of $77/barrel at the height of the Israeli-Lebanese conflict but have eased to the low $70/barrel as of mid-August. Our baseline forecast assumes that oil prices will continue to hover around $70/barrel over the next two years. This scenario is not without major risks, however. Prices could spike beyond that level, spurred by further political tensions in the Middle East, increased terrorist activity, or additional supply disruptions.U.S. natural gas prices, which surged from a historical average of $2.03.0/mmBtu to more than $8.0/ mmBtu in 2003, topped $15/mmBtu following the hurricanes in the fall of 2005. Subsequently, however, a warmer-than-usual winter reduced demand and improved supply causing prices to fall to $6.0/mmBtu. by the end of June 2006. We see natural gas prices heading back up, as the market tightens due to rising demand and declining production, ending 2006 at $9.6/mmBtu and averaging $10.0/mmBtu in 2007. Peaks c