New Profit Formulas In Oils And Chemicals

Just as yesterday's glamour stocks have become today's lacklusters, so today's favorite can easily be tomorrow's wallflower. A growth rating can return to one industry as easily as it departs from another.

Take the oil industry, for instance. Once the prime growth favorite of Wall Street, it has lost much of its attraction. Formerly, oil securities were so highly regarded that the market evaluated them primarily on the basis of reserves or acres, rather than earnings. Now they are called "cyclical" and "unsuitable for widows and orphans." During recent years many investment companies and trust funds have even made large scale liquidations of oil shares from their portfolios.

The chemical industry is another example of how the market can sharply revise its evaluation of equities. It was not too many years ago that the chemical industry was heralded as the nation's number one growth area. Diversification-minded companies regarded chemicals as their prime outlets, just as they regard electronics today. In the thirty years between 1929 and 1959, chemical and allied products increased about 450 per cent against only 170 per cent for total U.S. industrial production. In the last decade alone the chemical industry advanced 140 per cent in production against 60 per cent for all manufacturing.

But the very success of the chemical industry invited new entries into the field just as today the electronics boom has made everybody electronics-conscious. Thus, companies from outside the industry have become producers of chemicals. The oil industry in particular has made significant inroads into total chemical production in the form of petrochemicals.

Is the Chemical Industry Too Big To Grow?

Whatever might be the effect of oilmen's inroads on chemical growth, the chief limitation to the growth of the chemical industry is its own size. The industry has so permeated every area of the economy that it tends to lose immunity to the general business cycle. When the demand for basic chemicals becomes closely correlated with the general business, it has become as cyclic as the over-all business activity. Surely, you can't be substantially different from something of which you are an integral part.

Hence, some of the leading chemical equities are now viewed primarily as high-quality, minimum-risk holdings for conservative accounts seeking a combination of cyclical gains and moderate longer-term growth.

Remember the comparatively poor performance of chemical stocks in 1960? In about a year's time ending September 1961 chemical stocks fell 25 per cent in market valuation against only about a 10 per cent decline for the industrial average.

The Future for Chemicals

What's in store for chemical stocks? Some experts see new profit opportunities just around the corner. They predict a fundamentally long-term growth factor in the industry. Perhaps as much as 8 per cent annually or two-and-a-half times the growth rate of the economy as a whole.

Of course, this growth will not be enjoyed by all the thousands of chemical products. Some will boom. Some will grow slowly. And, inevitably, some will decline.

Although it is impossible to foresee which chemical products will forge ahead and which will drop behind, it is more than likely that the best opportunities for growth will be found among the smaller, more specialized companies.

Specific Areas of Chemical Growth

1. Electrochemistry. One important area of chemical growth has been created by increased integration between chemistry and electronics. Particularly exciting to chemists is the synthesis of new materials as superconductors of electricity. For instance, Bell Labs has been experimenting with materials which could conduct electricity at 100 per cent efficiency.

Another new area in the field of electrochemistry is a fuel cell for converting chemical energy into electricity without any moving parts. The attraction of fuel cells lies in their capacity for converting 70 per cent or more of the input energy into electrical energy compared with the meager 40 per cent top efficiency of even the most advanced heat engines.

The potential applications of fuel cells are virtually unlimited, with their most immediate uses in military communications and space exploration.

2. Radiation Chemistry. In the field of radiation chemistry, researchers are beginning to divert the awesome destructive power of massive atomic radiation to the peaceful service of mankind. Sweeping rearrangements of atoms through radiation result in new products of extraordinary strength and versatility. An irradiated polyethylene plastic, for example, is five times stronger than the ordinary polyethylene plastic.

3. Petrochemicals. Perhaps the fastest-growing segment of the chemical industry is "petrochemicals," though some are a little confused about its status. Is it a chemical invasion of the oilman's domain? Or is it an intrusion into chemicals by oilmen? For oilmen, "petrochemicals" are as much petroleum as chemicals; otherwise they would not have been investing more money in chemical plants than in refining facilities.

Essentially, petrochemicals are any one of the organic compounds from oil or gas. They sprang from the success of scientists in unlocking the vast potential stored inside the molecules of petroleum. They have improved on nature by breaking up and rearranging these hydrocarbon molecules. More than 3,000 different hydrocarbon compounds have been produced from oil and natural gas. So far, some 300 of them are commercially important. But scientists believe there are many more useful hydrocarbon derivatives still to be discovered. The word "petrochemicals" describes one of the fastest growing industries in the United States today.

Nylon is probably the petrochemical synthetic the public knows best. Nearly as well known is polyethylene, the glamorous petrochemical that became the first billion-pound plastic. An up-and-coming plastic is the rugged, lightweight polypropylene, which is expected to create another new generation of plastic applications.

4. Plastics. Plastics have successfully invaded areas ranging from household detergent containers to missile nose cones. You only have to look at the following brief statistics to see the dramatic growth of the U.S. plastics industry. In 1934 there were three-quarters of a pound per person, and by 1970 we are told this will increase to 51½ pounds.

No one in our modern civilization can go through our average day without using and being influenced by plastics in some manner. And much of the future growth of the industry will be based on materials we haven't even discovered, products no one has yet thought of.

Recently The Wall Street Journal had an interesting story under the heading of "Plastics vs. Plastics." It concerned the internecine war among the plastics, which was considered the natural result of the continuing development of new and improved types of plastics. As better plastics come along, they push older material out of some of their markets. Many of the newer plastics offer more versatility or greater economy than the old materials.

"Today," according to the Journal, "there are more than 30 families of plastics on the market and within these families there are thousands of variations. Some plastics are flexible, some brittle, some hard as steel; almost any desired characteristic."

Together with synthetic fibers, plastics account principally for the strongest individual segments of the chemical industry, with their rate of growth substantially ahead of the industry as a whole. In the decade ending in 1960, plastics production rose 170 per cent and for synthetic fibers growth in output has increased by 300 per cent.

Solid Earning Support for Oil Shares

The profitability of the petrochemical business has been largely built by upgrading refinery products that were formerly of little value, particularly in such big-volume items as plastics and synthetic fibers, which have been doubling every five years.

Indeed the petroleum industry is expected to struggle for many more years with the same old problems of surplus crude supplies, ample refining facilities, price wars and other forms of competition. All these adverse factors, however, appear to have been already discounted, if not over-discounted. With most of the leading oil stocks priced at a level, in terms of earnings multiples, not far different from that prevailing in the prewar period, they appear to have ample earnings support, with their present earnings providing a reasonable yardstick of their basic or even minimum earning power in times of adversity.

Also, the market tends to overlook positive factors when the gloom is the thickest.

The New "Energy" Market

What's behind the new surge of growth in the oil industry? Energy! Oilmen, for instance, hope to get a larger market share of the energy used in making iron and steel. As of now oil, natural gas and electricity, each are getting about 11 per cent of the business. Coal still is the primary energy source for the steel industry. However, fuel oil has a prospect of getting more of this market, especially in underdeveloped countries planning their own steel industries which have little or no coal.

Petrochemical researchers seek to perfect a device to get electricity directly out of oil without combustion. The fuel cell which would create electricity directly out of oil could be applied to home appliances and industrial devices. Potential applications range from creation of synthetic protein from oil to help feed underdeveloped areas to quantity use of asphalt in upholstery.

Although there is a growing concern over the possible impact of a gas turbine auto engine on demand for gasoline, indications are that it would merely bring about a gradual shift in the type of petroleum products used rather than reduce the total demand.

Historically, the petroleum industry has demonstrated its ability to adapt its output to developing markets. This was evidenced by the transition from kerosene to gasoline and from aviation gasoline to jet fuel. Similarly, atomic power seems more likely to create new energy demand than to displace petroleum as a source of energy.

Global Growth in Oil

The annual energy consumption in the United States and Europe is the equivalent of around one-half billion barrels of fuel oil, with the expectation of reaching 700 million barrels in a few years. Basically, the global oil industry is still an industry with growth characteristics, with increased industrialization throughout the world. During the postwar period, domestic oil demand increased about 5 per cent per year whereas the growth in the foreign free world averaged about 10 per cent per year with the greatest increase occurring in Europe. Most of the growth in demand in Europe has been for industrial fuel, although sales of gasoline and other products are showing large percentage gains.

The industry is also planning substantial expansion in the use of oil for residential heating. Since the population of Europe exceeds that of the United States, any appreciable percentage increase in such use would have a tremendous impact upon petroleum consumption. While the growth in such consumption is projected at the rate of 3 or 4 per cent in the U.S. over the next decade, a doubling of that growth rate is expected in foreign countries outside the Iron Curtain, with European growth likely to equal American experience since 1940.

Generally speaking, the chemical industry has suffered from an excess capacity. This, however, is characteristic of an industry which must build production facilities in anticipation of rising demand. This excess or unused plant capacity always exists in the chemical industry when there is a moderate slowdown in business, such as in 1960.

How To Project Chemical Stock Prices

Emil Weiss, of Bache & Co., has developed an excellent pattern for projecting earnings and stock prices on the basis of historical data.

According to him, earnings are a function of: (a) profit margins, which vary directly with changes in the business cycle; and (b) sales per dollar of gross plant, which also vary directly with changes in the business cycle. In other words, both of these ratios decline together during recessions and rise together during recoveries.

Stock prices, contends Mr. Weiss, are a function of historical price-earnings ratios which, in the case of well-seasoned chemical stocks, have been quite firmly established for years. Thus, after determining the potential peak earnings attainable by individual companies during the expansion phase, we next apply the average price-earnings multiple range of high and low recorded during the past five years.

In Mr. Weiss' opinion, earnings of companies in the chemical industry reached bottom in the first quarter of 1961 which should serve as a base for rebound into a new business recovery. "Using historical data as a guide to the future," he says, "we believe the chemical industry's earnings could rise about 20 per cent from the previous peak in 1959, while the prices of the five stocks included in this survey could rise as much as 50 per cent without in any way exceeding the bounds of well-established historical precedent."

The five stocks used in the survey were Rohm and Haas, Union Carbide, Olin Corporation, Monsanto Chemical and Hooker Chemical. Should this projected earnings rise materialize, Mr. Weiss believed "the price-earnings multiple for the entire chemical group will move from 18.5 times (peak estimated earnings) where it is now to about 26.2 times earnings, the average peak level of the past five years for this group as a whole."

Historically, chemical stocks enjoy comparatively high price multiples, ranging from 18 to 26 times earnings. According to Mr. Weiss, these high multiples are due to (a) above-average growth in earnings and (b) the dependability of an earnings growth pattern, since all major chemical companies are highly diversified and are seldom, if ever, seriously hurt by severe trouble in more than one or two products at any given time.

I describe Mr. Weiss' method at some length in order that with some variation, readers should be able to project stock prices in other industry groups by studying their historical data and projecting stock prices on the basis of their relationships to business cycles and earnings patterns.

Profitable Selectivity in Chemical Purchases

The term "profitable selectivity" used by market analysts to describe the "new approach" to chemical stocks actually can be applied to other industry groups.

As most industry leaders represent rather broadly diversified areas which sometimes have the effect of offsetting one another in earnings variations, more profit should be found in the smaller companies specializing in more attractive product areas. Such a company is Onyx Chemical, which Hugo Kappler of Boenning & Co. called a growing firm with an exciting future.

Onyx Chemical makes surface-active agents, resin-polymers, catalysts and wax emulsions. Its growth will probably come from new products, new applications of existing products, and acquisitions. Its antistatic compound, for instance, is new; there is nothing like it on the market. And its emulsifying agent for rocket fuels demonstrates a new use for an existing product.

In the medium-sized group, Tennessee Corporation is an example of specialization in some attractive product areas. With an outstanding growth record, it engages in a major expansion program aimed at increasing demand for concentrated phosphatic chemicals. According to Shirmer Atherton & Co., the company has grown in the past ten years at the annual rate of about 9 per cent, or 16 per cent compounded, and is expected to grow at least that fast for the next five years. An annual growth rate of even 6 or 7 per cent in the chemical industry is considered good.

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