NEW YORK ( TheStreet ) -- After the sharp declines in the last two years, we expect worldwide chemical production (excluding pharmaceuticals) to recover, albeit at a slow rate. At a global level, we currently expect chemical production to require another couple of years to recover to levels seen before the crisis.

In industrialized countries, severe declines in production as a result of the recession will have longer-lasting effects. The North American chemical production is expected to experience above-average growth in 2010, with domestic demand improving from the key customer industries on the back of a recovering global economy. Chemical giant BASF is expecting about 10% growth in the US chemical industry on the back of rising demand for exports.

In response to the slow recovery in demand, chemicals companies have been disciplined in bringing capacity onboard, resulting in meaningful improvements in the bottom line. We believe aggressive efforts in working capital reductions, supply chain optimization and productivity improvement should yield margin benefits. There is also a chance of accelerating capacity growth in 2011-2012, assuming that older projects do not get cancelled. We expect a strong cash flows and underleveraged balance sheet to support growth opportunities for chemical producers going forward.

End-Market Scenarios

Demand for chemicals tracks global industrial production and global GDP very closely. The chemical industry was particularly affected by the weak industrial demand in the second half of 2008 and in the first half of 2009. The drop in production in the chemical industry has been almost in sync with lower production in the key customer industries of housing, construction, automotive, electrical, furniture and paper. Nearly 10% of the chemical demand in the country is directly tied to the housing sector, and an additional 10% is tied to the auto sector.

The automotive industry has started showing signs of recovery while the housing sector continues to be sluggish. We expect automotive production to be higher in North America, though a weakness is expected to persist in Europe . Production in the paper and textile industry is expected to improve, primarily as a result of growth in emerging markets. The electrical industry is expected to pick up with increased industrial investment.

Other industries including food and agriculture are also likely to gain pace with the recovering economy. The construction industry, however, is expected to remain weak.

Trends in Raw Material Markets

The chemical industry is a large consumer of oil, natural gas and energy, which are widely used as an energy and feedstock input. During 2009, oil prices rose 87% from about $40 per barrel to more than $75 per barrel, re-attaining Oct. 2007 levels. Prices for the chemical raw material naphtha soared in almost exactly the same way as the oil price; naphtha rose throughout 2009 from an average level of $340 per metric ton in January to well over $600 per metric ton in October.

In both the U.S. and Europe, natural gas prices fell during 2009 before increasing in the last quarter of the year. The average annual gas price in the US was around $4 per mbtu, less than half the cost in the previous year. In Europe, the average gas price was well over $8 per mbtu. Natural gas prices are expected to remain weak in the near-to-medium term, boosting profits for North American chemical manufacturers.

Opportunities

The overall chemical industry is in a consolidation mode, driven by the need for creating scale economies in operations, supply-chain management and capital market needs. Major players are expanding activity through mergers, acquisitions, alliances and joint ventures. While we can cite multiple examples from recent history, the more noteworthy ones are those of Dow Chemicals ( DOW), Agrium ( AGU) and CF Industries ( CF).

Dow Chemicals continues to progress in delivering cost synergies from its latest acquisition of Rohm and Haas. Similarly, fertilizer manufacturer Agrium is growing through a combination of acquisitions and organic expansion. Agrium's acquisition of United Agri-Products is expected to drive growth through an expanded product line. The take-over of rival Terra Industries has made CF a global leader in the nitrogen fertilizer sector.

After a tough 2009, chemical makers would be careful in planning capital expenditures. Focus on aggressive cost reduction and improving yield from better technology have been a key technique for chemical manufacturers. DuPont ( DD), for instance, plans to capture $1 billion each in the years between 2010 and 2012 by way of reducing fixed costs and working capital productivity gains.

PPG Industries ( PPG), a major global supplier of protective and decorative coatings, responded to the economic turmoil with aggressive restructuring and cost reduction measures, while further increasing its focus on cash flows.

Additionally, leading chemical companies have been consolidating mature businesses and have started migrating to low-cost locations. Fertilizer companies such as Potash Corporation ( POT) benefits from geographic diversification as nearly 63% of its production is exported. Other chemical manufacturers such as Eastman Chemical Company ( EMN) are benefiting through diversification into downstream businesses that have helped boost revenue and margin growth.

Collectively, DuPont, PPG Industries and Eastman carry a short-term (1 to 3 months) Zacks #1 Rank (Strong Buy) and a longer-term Outperform recommendation. On the other hand, Dow Chemical, Valspar, Agrium and CF are a Zacks #3 Rank (Hold) and a long-term Neutral recommendation.

Weaknesses

The chemical industry as a whole remains heavily exposed to economic cycles and pretty much all of the industry's underperformance of the last two years can be put down to the economic turmoil. The global economic meltdown led to a weak industrial demand for chemicals, which led to significant regional and global production overcapacities, resulting in a dramatic fall in operating profits across the world. While the global economic recovery appears to be firmly in place, the recent turmoil in Europe and its impact on global growth remain sources of near-term uncertainty.

Weak residential and commercial construction demand especially affected companies into paint and coatings. Revenues and margins for Sherwin-Williams ( SHW), the largest US producer of paints and coatings, declined significantly in 2009. We do not foresee any significant momentum in earnings growth unless there is some substantial growth in macro trends.

Recently, we downgraded Valspar Corporation ( VAL), the sixth largest paint and coatings manufacturer globally, to Neutral from our previous Outperform recommendation. The downgrade was driven by concerns over the high raw material costs and pricing pressures taking toll on the company's paint business.

Recessionary trends coupled with inventory de-stocking resulted in sharp volume declines in the activated carbon sector last year, affecting Calgon Carbon Corporation ( CCC), a leader in the activated carbon sector, and Celanese Corporation ( CE), the global hybrid chemical company. A continuation of weak economic trends, particularly in the housing market, could hamper the growth of chemical makers. A further surge in raw material costs from persistently high oil prices could adversely impact margins.