A wind of change is sweeping through chemical businesses

Implications: Private equity has been very active in chemicals M&A, accounting for 50% of all deals in 2006.  Now the chemicals downturn has finally arrived.  Ineos Group, the UK’s biggest private company and one of the world’s biggest chemical producers, has been listed as one of the six most vulnerable companies in the sector by S&P.

Analysis: Chemicals companies are facing unprecedented challenges.  The global economic downturn has hit operating rates, whilst the sector has been unable to pass through today's higher oil/feedstock costs.  As a result, unit costs are rising whilst volumes are falling - a most unhealthy cocktail for profits.

At the same time, as the article points out, many chemicals companies are carrying far too much leverage.  This because private equity investors and managements often have a misguided view of industry fundamentals.   They do not understand that profits literally 'fall off a cliff' during a downturn - there is no 'soft landing'.

The reason for this misunderstanding is that the last major global recession took place took place nearly 20 years ago. This means that nobody under 35 has any first-hand experience of what a recession is really like. In fact, only people over 45 have actually managed chemicals businesses through such a recession.

I have heard Board members of major companies suggest to analysts  that olefin margins 'only' fall 20% during a recession.  In fact, the average fall in margins after 1980 and 1991 was around 60%.  They don't know this, because they weren't around at the time.

It is also not widely recognised that major recessions go on for several years, not just a few months.  There is a tendency to confuse relatively minor recent chemical industry downturns, such as 2000/2, with real global recessions.  As yesterday's boom now turns to bust, some companies and investors may pay dearly for their lack of historical perspective.