2008 Market Outlook: Another Good Year

A Recession is Coming

Alan Beaulieu, economist for the Institute for Trend Research, had some disquieting news for Outlook attendees: This nation will see a recession in the year 2010.

However, he insisted the news was not necessarily all bad.

The good news is, we have a couple more quarters of prosperity,” he said.

Beaulieu said the economy is running just about where he predicted it would go at last year’s workshop, though he’s lowered the figures somewhat for the rest of 2007 and 2008. By 2009, the economy will start to go weak and by 2010, it will take a dip, he said.

“We have no empirical indications yet, but home prices are just the tip of the iceberg,” Beaulieu said. He expects to see oil prices heating up this winter, edging up above $80/barrel in the first half of next year. He also said wage inflation in many sectors has already started.

And he said the Fed will raise rates by 50 to 75 basis points in early 2008, “which doesn’t sound like much,” but, as a nation that carries a lot of debt, the extra $400 a month per household that would result, for instance, could have a chilling effect.

Also, by 2010 there will be a new president who will be facing a number of problems, many of which are tied to the aging Boomer generation. “Whoever is president will be dealing with Social Security, Medicare, drug programs, all of which are budget busters,” he said.

The need to pay for these and other entitlement programs will mean the U.S. will need to borrow money, which puts the country at a global disadvantage, Beaulieu added.

One advantage this nation does have is its demographics, he said. Unlike some countries, “we’re having kids,” at a rate of about 2.1, which is balancing out retirees. In comparison, Russia, where male life expectancy is only 57, is shrinking and will lose 50 million by 2050, “which is the equivalent of the Bubonic Plague,” Beaulieu pointed out. And India, though it will grow almost as much as the U.S., is dealing with a land mass one-third the size.

The U.S. also has industrial advantages. For example, when comparing U.S. Industrial Production to its Gross Domestic Product, “we spend most of our time in a positive track, and we have been for a long time,” Beaulieu said. Currently, goods and services as a percent of GDP is the highest it’s been since World War II.

“We are a profitable nation and prosperous. We are first in technological readiness, quality of research, productivity, profits,” Beaulieu said.

The U.S. is also first in percentage of total world exports of goods and services with Germany, China and then Japan following next. And though many fear China’s growing strength, Beaulieu noted the country has significant demographic problems because of an aging population and restrictions on family size. It also has 125 million more men than women, which raises fears about violence, and significant pollution problems that are killing hundreds of thousands of people.

“China has been on steroids,” Beaulieu said, “but you don’t fix problems like these overnight.”

Beaulieu had these tidbits of advice:

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• Be cautious about doing business in China.
• Get out of the stock market before the end of the year, or 30% of your wealth could disappear by the end of 2008.
• Get into any line of business having to do with elder care: medicines, living facilities, vacations.
• Get into higher education. People go back to school when they lose their jobs.
• Get into any line of business that has to do with energy: “It’s going to be largely bullet proof; coal will remain popular, nuclear will get more popular,” he said.

FORECAST: A couple of more quarters of prosperity in the U.S., then the economy will falter; it will weaken measurably in 2009 and be in recession by 2010.

The Wall Street Perspective: Most End Markets Shining

Right now, the nation is looking at “very healthy industrial capacity,” and most end markets are doing well, according to Scott Graham, managing director, Bear Stearns, Inc.

Spending in this nation is up, with industrial production and capacity utilization close to cycle highs, but spending is moderating, Graham said. Capital expenditures and maintenance, repair and operating (capex/MRO) together stand at about 3 to 4%, which is part of a three-year trend (beginning in 2007) that Graham doesn’t expect to change until after 2009.

Capital expenditures alone count for about 1%, which Graham said he found “a little troubling,” but MRO stands at a healthy 5%. Capital spending is positively affected by the chemical, power, water, commercial construction, metals machinery and other industries, but negatively affected by residential construction and auto-related industries, as well as coal, paper and textiles.

In Europe, industrial production and capacity utilization is improving with capex/MRO spending currently at about 6 to 7% compared to 5% a year ago. There, the market is currently driven by heavy industry (capital goods, machinery, metal, construction, rubber, etc.) and negatively affected by the power and energy industries and textiles, a condition he expects to continue through the rest of this year.

As far as specific markets, Graham says a favorable place to be right now is the oil and gas industry. “Since 2004, this is the market you want to be in. Dollars spent annually are about $200 to $300 billion a year, and it’s spent everywhere: upstream/downstream/ midstream.” He believes this market represents “huge opportunities” for valve makers.

Although there is still opportunity abroad, the U.S. is where a good deal of the money in the market is being spent, he said. “The U.S. is in the fifth inning, while Europe would be about in the second,” he said.

The chemical market, which suffered great decreases in capex spending several years ago, “is back with a vengeance,” Graham said. “Seven years ago, chemical was just awful, declining by about 40% in the late 90s,” Graham said. But both MRO/capex and pricing are positive currently and should remain that way.

Every aspect of power in the world right now is “going forward,” which has created “very favorable” market conditions, Graham says. Spending domestically is running about 15-20%, while in Europe it’s running about 10%. And China, which is expected to invest about $800 billion on shoring up its power grid in the coming years, presents a great opportunity.

There are also many opportunities in water spending both here and abroad, Graham said. In the U.S., there is a great need for infrastructure upgrades and retrofittings made even more critical by new, clean water regulations. Abroad, there are the opportunities presented by the many places in the world that don’t have adequate water supplies, and the World Bank is really stepping up efforts to help less fortunate areas of the world, he said.

Overall, Graham said the best opportunities today lie in petroleum, power and water. And while the residential market has “very long arms” that could potentially hurt the domestic situation, “I’m less worried about a credit crunch than the “r” word (recession).” Still, he predicted “because we’ve been so productive as a market in the U.S., I don’t think the market downturn will be severe.”

FORECAST: Globally, spending on oil and gas will increase by at least 10% upstream (and more likely 15%); up 5% midstream; and up 5 to 10% downstream in 2008. Domestic spending on chemicals should be up 5 to 10%, while European spending will increase about 5% and in the rest of the world will be up 5 to 10%. Power spending will increase again at about 15% domestically, 5 to 10% in Europe and about 10% in the rest of the world. Domestic spending on water, along with foreign opportunities, should increase about 10%.

The Global Economy: A Bright Picture

The world economy is “growing at about its speed limit,” according to Sara Johnson, managing director of Global Insight, Inc. Still, the outlook is “very bright” with growth continuing at a fairly rapid clip, especially outside North America. Overall, the global economy will grow about 3.6% this year, down from 3.9% last year.

The world is near full employment potential and the output gaps (the difference between potential and real GDP) show little spare capacity. Once an economy reaches past its potential, inflation comes into play, Johnson explained. In the U.S., the economy reached past its potential just this year, but good employment rates have kept inflation mostly out of the picture here, she said.

The major risk around the world is corrections in equity and property values, Johnson said. Regionally:

U.S. growth has picked up, but housing is still declining. Johnson said the economy will slow to a growth of about 2 to 3% mostly because of housing markets. Although U.S. housing prices rose rapidly over the last 10 years, they rose much more in many other counties, including South Africa, Ireland, the United Kingdom, Spain, Australia and France. Johnson also said “the worst is over” for real GDP growth in the U.S., business investments are back on track, inventory corrections have been completed, and the export markets looks bright.

In Canada, the economy is operating near full capacity with about 2.4% growth this year, which will pick up next year. Exports have been hurt by the rise of the Canadian dollar (about 40% since 2002). Business investments are decelerating, and core inflation has risen to 2.5%. The western provinces will be strengthened by the oil shale industry.

In Mexico, the economy is slowing down to about 4.3% this year from 4.8% last year, oil production is declining, inflation is rising from record lows in 2006, and the country is competing against China and India.

In the Eurozone, unemployment stands at 6.9% but that situation will improve, boosting consumer spending. Consumer confidence there is high. Rising interest rates and the euro will slow growth momentum. Overheated housing markets pose risks in Spain, Ireland and France.

In India, foreign investments have nearly tripled. Overheating is a risk because inflation is at 6 to 7%, but the country is helped by its demographics: the working-age population is rising sharply.

Western Europe, which has seen better performance in the last few years, will be more sluggish going forward, as will Japan.

Japan is shifting from an export-led economy to a domestic economy. Deflation of early 2007 will soon be reversed.

Other than in Japan, Asia is seeing the fastest growing markets, followed by emerging Europe. Emerging Asia is powering much of the global growth. Emerging Europe is attracting investments from around the world.

China’s investment is overheating: the stock market saw a 140% growth last year, which will drop to about 42% this year. China’s huge trade surplus has created financial and political pressures.

Latin America, Africa and the Middle East are experiencing strong growth in trade and high commodity growth rates.

In South America, Brazil’s economy is improving as interest rates fall from 20% to about 11%; Argentina and Venezuela, which have high double-digit inflation, are suffering as nationalization discourages investments, as are Bolivia, Ecuador and Venezuela. Chile, Peru and Columbia are the star performers of that area.

FORECAST: In the U.S., the housing recovery will start in spring 2008, and the worst is over for the U.S. economy. Around the globe, inflationary pressures will lead to higher interest rates; emerging markets in Asia and Europe will experience the fastest growth; and the major risk is a boom-bust cycle. The outlook for the services, manufacturing and real estate finance markets is “quite bright.”

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Water/Wastewater:The Race Is On

As the first speaker at this year’s Market Outlook Workshop, Tom Decker started off with an appropriate symbol, a green racing flag. As Decker, vice president with CH2M Hill, who addressed the water/wastewater situation, explained, the green flag is symbolic of where the water market is today—still in the “go forward” mode.

For example, while materials price growth eased downward in the last year, the numbers went up by about 12% overall for the water market this year, which was higher than predictions made at the 2006 workshop.

“Last year we said it would nudge in at about 10%, but it came in at 12%—so how did YOU finish the year? If you were significantly lower, you might want to look for a new pit crew,” Decker joked.

He cautioned, however, that there are several yellow “caution” flags that need to be watched. For example:

The first caution flag involves the real estate market’s pain: Decker pointed out that new home sales fell 4% in June in the U.S. and new home construction was down 29% for the year. What that does to the water/wastewater community is slow down the rate of growth because it means less new customers and new service connections. He predicted the real estate situation will not cause major problems in the water/wastewater industry right away, but that “it’s something to keep an eye on.”

Decker also described an interesting dilemma for some communities regarding water conservation: “While everyone agrees conservation is a good thing,” it has actually meant decreased flows to some communities, such as Las Vegas, which paid customers recently to replace green lawns with desert scapes. The city’s water consumption has remained the same for the last few years, while the population growth has grown by about 65,000 per year. What that means for the city and for other cities with progressive programs is that a way must be found to replace revenue so the governments can keep up with infrastructure needs, he said.

The second caution flag Decker pointed to also means less money for infrastructure buildup: the “decidedly mixed and unclear financial picture” for state and local governments, as he put it. One factor contributing to that situation is the $1.5 trillion in pension liabilities those governments face, which he says “will come home to roost by the end of this decade going into the next.”

That money has to come from somewhere and Decker expressed concern that the somewhere might be infrastructure, including the water and wastewater industries.

At the same time, he also noted that governments around the world are spending less on water: from about 2% of GDP average per nation to about 1% currently.

The third caution flag Decker brought up was the decreasing supply of skilled staff and engineers.

“What if you pulled into the pit, and there was no pit crew,” Decker said. The lack of talent due to less engineers graduating, as well as a “brain drain” as older engineers retire, combined with falling unemployment rates in the construction industry, mean labor is scarcer and labor costs are rising. As a result, Decker said contractors are becoming pickier in what jobs they’ll bid in the first place.

Going forward, Decker says that in the longer term, what will drive the water race is its “fans”—the people in need of water.

For example, in many countries now being developed there is a growing middle class who expect good water/wastewater services. “They are the little nugget that will drive the marketplace most solidly as we go forward,” Decker said.

At the same time, there are many undeveloped countries badly in need of water services. A United Nations report last year said water is now a global crisis around the world, Decker pointed out.

He said the “pace car” to watch around the world today—the trend that will affect the world going forward—is desalination: There were 7,500 plants in 1993; 17,300 by 2004; and 21,000 plants today.

FORECAST: Water/wastewater market growth will be about 9 to 10% through the remainder of 2007 and into 2008.

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Power Generation: Much Potential Business for Valves

As with so many of the industries that rely on equipment and manufacturing, the main issue in power generation is “the increases in cost and prices for everything we deal with,” according to Howard A. Russell, vice president and regional general manager for the Power Business of Black and Veatch Corporation.

The communities that need that power are facing more choices as well as changing ideas about what is safe and what is practical. But they are also facing the realities of what it costs to build the plants needed to take advantage of the choices.

“As I talk to communities, I tell them they have a choice—they can generate power through natural gas [as the state of California has announced it will do] and pay generally about $10 per million btus (mbtus); or you can use coal at about $1/mbtu [with most of that cost coming from transportation]; or the ultimate, which is nuclear at about 10 cents /mbtu,” Russell explains.

Certainly, the coal industry is abounding as oil and gas prices climb and cleaner ways to use coal are created. In fact, a recent MIT study that looked at coal said the nation will burn more coal, not less, as security of the oil industry and fuel prices for oil and gas become more of a concern, Russell pointed out.

That’s positive news for the valve industry, he said.

“Obviously the coal market is huge for those in the valve industry. They use big pumps and high-pressure valves—high-dollar value items,” he said.

At the same time, there are other industries projected to do as much, if not more, business. Capital investments planned for coal from 2008 to 2015 are projected to be $25 billion. However, the combustion turbine industry is expected to generate $63 billion worth of investments, and the air quality control industry will be as big as the coal industry at $26 billion, Russell said. Meanwhile, the nuclear industry will see expenditures of $48 million during that period.

“Growth in the nuclear industry is twice what it is in coal. That’s $100 billion to be invested in the infrastructure of the country in the next 10 years,” Russell said.

The push behind nuclear will be its promise to create less CO2 emissions, and the industry has an advantage over some other power industries: it’s not allowed by regulation to age, he said.

“Nuclear plants are not like autos. Today’s plants have to be as good as, or in better shape, than when they first opened,” Russell explained.

Still, all the power industries face the pressures that most of industry faces: scarcity of skilled labor to build and run plants, construction cost increases because of the shortage of labor, and material increases and rising commodity pricing.

Russell gave the example of a bid his company put out for chimneys. The cost estimate was for $12 million. “But when we booked the order, we got one bid for $22 million. That’s what’s happening in the market,” he explained.

Russell also gave the example of skilled labor needed for retrofitting and new construction in the power industry. Last year, the need went from about 4,000 jobs to almost 8,000. However, by 2010, the skilled craft market is going to need 45,000 people to fill those jobs, he said.

FORECAST: Driven partly by higher natural gas prices, the total market investment for coal over the next 10 years will be closer to $30 billion than the projected $25 billion. The combustion turbine industry will reach $40 billion by 2008 with about a quarter-million dollars in valve business in the next six to seven years. The air quality control business may see a downturn in 2009 in new business because compliance dates focus on mercury after 2010.

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Nuclear: Get Ready to ‘Ride the Wave’

The market for nuclear used to consist mostly of decontamination and deconstruction efforts, but the situation has greatly changed, and “it’s amazing who has come over to the ‘dark side,’” joked Gary Wolski of Curtiss-Wright Flow Controls’ Commercial & Power Services Division.

Operating a nuclear facility is not that much different than operating a fossil fuel plant, and even the environmentalists and politicians have gotten behind nuclear because of its carbon-free operation and because the nation truly needs a source for sustainable energy, he said.

Put simply: the nuclear renaissance has arrived, pushed along by many years of successful operation and safety, and the world is about to “ride the wave” of the movement into the next generation of nuclear plants, he said.

Already, 60 plants are in the planning stages in the world, 31 are under construction, and 150 are under consideration, he pointed out.

Some of the initiatives that affect that growth include:

The U.S. Energy Policy Act of 2005, which was designed as a tool to encourage (not pay for) nuclear growth – The act created new programs such as loan guarantees, risk assurance, production tax credits and more, and created research and development sources for looking at the fourth generation of power plants, a “phenomenal technology” that actually will burn the nuclear waste, Wolski explained.

The Nuclear Power 2010 program, a joint government/industry cost-sharing effort that allows companies to go through an approval process before the plant is built—Although the program has stretched out how long it takes before a plant is built (from five to six years to about 10 to 12), “you take care of all the political issues beforehand,” instead of investing before the process begins, he added.

The next step is the Global Nuclear Energy Partnership, an international joining of companies for the purpose of finding ways to reprocess spent nuclear fuel. The U.S., France and Japan (the three countries with the most plants currently) signed an agreement in February 2006 to work together to develop reactors that will reuse nuclear fuel.

And while the U.S. has the most plants currently with 104, there are now 438 operating reactors worldwide, and in 20 years, the market will be much different, Wolski said. Russia has a nuclear renaissance rivaling ours, and China is also looking to increase its participation.

One challenge of the U.S. renaissance will be consolidation. Currently, seven utilities own 52 of the 104 reactors and this consolidation will grow as the industry gets stronger. Also, as with other types of manufacturing, one of the main problems domestically will be finding adequate staff to help with new builds, as well as supporting the existing 104 facilities.

FOR MORE ON NUCLEAR POWER: See the article on page 38 of this issue, “The Rise, Fall and Renaissance of Nuclear Power.”

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The LNG Market: Think Globally

The major difference in the LNG industry today over what it was a decade ago is that the market has become global, according to Kenneth Medlock III, a Fellow in Energy Studies at the James A. Baker Institute for Public Policy and an adjunct assistant professor at Rice University.

“You have to think about it the same way you think about crude,” in that what happens above the ground dictates what happens in the market, he said.

Ten years ago, most natural gas was traded in distinct, segmented markets, but this situation has changed as prices have climbed, supplies in mature markets have declined, transportation costs have been reduced and demand around the world has increased, Medlock explained.

That demand has risen because of environmental pressures, combined-cycle technologies, and technologies that allow gas use for power generation. But at the same time, supplies in markets like Europe and North America have matured so these markets are reaching out to nontraditional sources.

Most of the growth in European and Asian markets has come from the power generation sector, he said. And while he does not think that demand will sustain itself because of higher efficiency methods of generating power, he thinks a growing demand for gas as a clean-burning fossil fuel will prompt further development of LNG regasification capacities.

One of the main issues going forth will be access to resources. In the U.S., the Rocky Mountain area holds possibilities, but a major constraint is lack of infrastructure to get the gas to regions east of the mountains. If federally protected lands remain off limits, the country will need to find supplies elsewhere, which includes looking outside the U.S., he said. This situation also bodes well for the LNG market. Three terminals will come online worldwide in the next two to three years, which will double U.S. import capacities, he said.

Meanwhile, gas prices, which were fairly stable through 2002, when prices ran about $2.50 to $3, have risen to a level closer to $6.50 to $7.

“Economic drivers support an expectation (over the long term) of $5.50 to $6.00/mbtus, but political forces and random shocks can cause temporary dislocation,” he said.

And while prices are regional based on how far the gas has to travel and what storage capabilities each country has, “the key point is that over time, every market in the world will be connected” (much as it’s connected with crude today), he said.

Like crude, LNG and gas also will be affected by geopolitics. Some of the developments to watch include:

• If war breaks out in Iran, it could create choke points for the flow of oil and gas. Iran holds the second largest natural gas resource potential in the world.
• Chinese, Indian and Pakistanian demand is growing, which means more competition for resources.
• Disputes within Russia threaten pipeline flows to Europe and financial arrangements with Western countries.
• Civil strike in West Africa has disrupted supplies from there.
• Several countries in South America have supplies, but nationalism threatens capital flows.
• Environmental objections in North America keep some supplies from being tapped.

One of the other factors to keep in mind when it comes to LNG as well as gas and oil supplies is that: “Security is not specific to one region, which is increasingly important because the world is becoming global. Coordinated actions are likely to be much more effective than policies adopted in a vacuum,” Medlock concluded.

FORECAST: LNG will comprise 40% of all gas supplies by 2040. Price differentials between different countries will be driven by transportation factors.

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The Oil & Gas Market: A Slower Pace, But Plenty of Demand

For the first time in about five years, the year-to-year changes in prices for oil and gas will be less than 10% and rig activity will grow only about 8% for the year, John Spears, president of Spears and Associates, told workshop attendees.

Crude oil prices stand at about $68.50/barrel, which is only about a 3% gain for the year, while average gas prices appear stable at about $6.50/ million btus, he said, which compares to about $4 three to four years ago.

What these figures show is that prices have slowed down a lot in the last 12 months. As a result, he said, U.S. drilling activity has slowed sharply.

Meanwhile, the global numbers look robust, Spears said, with world oil demand growing about 1 to 2% a year, up to about 86 million barrels per day (bpd). China accounts for about a third of that demand while the U.S. accounts for 15%.

Spare production capacity over the past few years has improved somewhat, starting at about 1 million bpd three years ago to today’s figure of about 2.5 to 3 million bpd. Still, the world is operating at about 97% utilization of its productive capacity, which is historically very low. In the past, it has operated at roughly twice what it’s operating at today.

“This is one reason the market is considered tight,” Spears said. Still, operators continue to moderate their expectations for future oil prices. In 2003, oil companies were looking at $25 to $26 per barrel, whereas two years later, it had more than doubled to $50 to $60.

“That kind of change will cause companies to look at candidate wells as extremely profitable. This explains why operators have massively increased their reinvestment ratios,” Spears explained. While they used to spend 20% of revenue on new drilling in the 90s, today they spend almost 50%.

The gas market has swung back and forth for most of this decade, but shown very little change overall in demand, Spears said. “All that says is weather plays a vital role.” Low points are late spring and early autumn when it bottoms out at 50 billion cubic feet. Then winter depends on weather.

Still, summer gas consumption has begun to creep up, which reflects back to the power generation market: gas-fired generators have been put in place, so there is now a major summer load for cooling purposes.

“How much gas is going into storage plays a huge role in support of the swings. Last year, August was very hot. By the middle of the summer, there was very little put in storage. That hasn’t been the case this year, which will leave a lot of gas around for the rest of this year,” Spears said.

He predicted that prices, because of that development, would weaken in the short term carrying into next year.

Meanwhile, rig activity, which has been robust the last few years, should flatten in 2008.

“Last year we built about 20 years worth of rigs for the U.S. market,” Spears said. Because lead times are about 12 months, those numbers reflected orders from 2005. By 2008, “we might be lucky to see 100 new rigs.” At the same time, however, drilling costs should drop by about 10 to 15%.

Another development with rig activity has to do with the types of wells being drilled. While all wells used to be vertical, about 45% of today’s rigs are directional—wells drilled horizontally from existing sites. Because of the success of such wells in several major U.S. sites, operators are now looking at similar formations on sites that have been ignored for years but may prove to be fruitful going forward.

FORECAST: Prices for oil will go up about 10% to $75 per barrel next year. U.S. gas demand is projected to surge this year by about 4% to $22.8 per trillion cubic feet. Spot natural gas prices will average $6.50/mtmbtu in 2008, which is unchanged from last year.

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Chemical: An Increasingly Positive Mood

Chemical manufacturers are getting more positive, according to the most recent survey by the Synthetic Organic Chemical Manufacturers Association. Speaker Diane McMahon, a vice president with SOCMA, reported that an annual survey taken of the organization’s members found that 53% said the state of the industry was “excellent/very good.” That compares to 41% in 2005 and just 35% in 2004.

“Almost half of our members also said they expected sales increases this year of 20% or more,” McMahon reported.

One thing that has bothered chemical professionals, however, is increased competition from global players. In 2003, 22.4% of members said the U.S. market had disadvantages over other locations in the world. By 2006, that gap had spread to 31.7%.

The player with the most potential is China, McMahon said, while India has fallen to the No. 2 spot mostly because it cannot keep up with infrastructure needs.

“In China, when they see a need for a road, they build a road; they are proactive,” she says, which she compared to India, where she recently was four hours late for a meeting because of a 90-mile drive.

Still, McMahon predicted the lower quality coming out of China may cause problems down the road and pointed out that members who felt products from emerging market suppliers were “not as good as” U.S. products has risen from 52% in 2004 to 60% in 2006.

Other positive indicators included:

• 95% of respondents felt the number of leads would stay the same or increase.
• 70% anticipated a greater number of outsourcing projects over the next three years.
• The average length of time that respondents felt new business would continue has reached 5.5 years (compared to 2005 when that figure was 4.8 years).

One of the areas that many chemical companies, especially in the pharmaceutical industry, are focusing on is increased reliance on outsourcing. For example, Pfizer recently announced it is prepared to commercialize at least two new products per year brought in from outside smaller research and development companies from now until 2010. Some pharmaceuticals are also looking to close expensive manufacturing sites so they can focus efforts on R&D, she said. Almost 73% of respondents to the SOCMA survey said they will look for profit growth by introducing new products.

Meanwhile, the likelihood these companies will invest in capital projects is increasing. McMahon said American Chemistry Council figures show the chemical industry invested $25.72 billion in plant and equipment for 2006, which is 9.4% over 2005.

FORECAST: The U.S. fine/specialty and batch chemical industry expects to increase sales, outsourcing and spending on capital projects.

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Hydrocarbon Processing: Facing the World’s Needs

Gas production today is at the highest level ever “contrary to what the general press and Congress would have us believe,” reported Mark Peters, publisher of Hydrocarbon Processing magazine.

According to Peters, the U.S. refines 17.5 million bpd of crude to produce gasoline, while it needs about 21 million.

“Fortunately for us, Europe is primarily diesel,” so we import much of our gasoline from there, he said.

The biggest challenge going forward will come, however, from global needs, not domestic, Peters pointed out.

“An awful lot of the world doesn’t have access to energy and clean water,” he said. “We’re already straining production capacity—and the rest of the world is starting to participate, which is keeping prices high,” he said. Almost every country in the world is now growing in use of hydrocarbon and other fuels, and those that are fairly new to the picture are usually high-energy users until they can build efficiencies into their processes.

These developments mean that a lot of oil-producing companies are negotiating or renegotiating contracts, and in some cases, major oil companies have left foreign countries because they could not reach mutual agreements with those countries (e.g., BP is pulling out of Russia, Exxon-Mobil and Conoco are pulling out of Venezuela).

Meanwhile, new sources are in the works in much of the world, including the tar sands in Canada and in southeast Texas, Peters said.

What all of this means is that the world of energy sourcing will look a lot different by the year 2030, he added. However, as with much of industry, a main constraint will be engineering capacity, Peters said.

“Most of the engineering graduates from universities today don’t want to go into the smokestack industries,” Peters said, so the world will need to look elsewhere for skills and support. Ten years ago, Peters visited China for an industry conference and about 90% of attendees were Western while 10% were Chinese. On a return trip this year to Beijing, the numbers were more like 50/50.

It also means that more valves will be coming out of China, which could be problematic for U.S. manufacturers, he said.

And it means that biofuels will receive more serious consideration. Though the industry has a long way to go, Peters said, there are enough ethanol facilities planned in the future to double capacity to 15 billion gallons by 2012. However, he also pointed out that to go over that amount would require finding new sources of base fuel such as sugar cane.

FORECAST: Process industries are doing extremely well and will continue to do so for at least four or five years. U.S. refining capacity, which currently sits at about 17.5 million bpd, will grow to over 19 million bpd by 2011 mainly due to announced and estimated refining additions. HPI spending in 2008 is projected to be $95.9 billion globally for equipment and materials. In the U.S., $9.6 billion will be spent on capital; $13.7 billion on maintenance; and $28.5 billion will be spent on operations.

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Pulp & Paper: Industry Evolution Continues

Cost increases, driven in part by increased energy costs, continue to be the biggest influence on the North American pulp and paper industry, according to Peter Frandina, senior manager, Accenture Forest Products.

The main question pulp and paper companies have had to ask themselves in the last few years is “how do I stay competitive and reduce my costs when I can’t push the cost increases onto

the market,” Frandina pointed out. “When you can’t pass it on, you have to look at internal efficiencies and profits,” he said.

The answer in part lies with capital expenditures, which Frandina said the industry continues to cut and peg to depreciation. A decade ago, the ratio of expenditures to depreciation was about 1 to 1.5, but that number today stands at about 1:1 as the industry continues to find ways to use “internal financial levers to balance performance.”

However, the industry is headed toward “hitting the wall,” Frandina said, which will happen in the near future. At that point, companies will need to begin spending to replace aged equipment or face taking equipment off-line.

The answer to cost problems also lies with changing strategies, Frandina said. For example, diversification is no longer a hot strategy.

“The model where you have 10 to 15 companies or divisions doing different things in paper and pulp is no longer with us,” Frandina pointed out. Instead, market concentration, specialization into one or two core segments and shedding of assets that don’t fit into those segments has become the norm in the market.

Meanwhile, capacity rationalization, which has been aggressive in the last couple of years, is “still not keeping up with the demands,” and private equity is playing a short-term role in the industry. Private equity’s share of paper and board capacity within North America, for example, has grown from about 4% in 2000 to about 25% in 2006, he said.

“The bad news is, PE keeps some bad assets on the books,” Frandina said. The good news with private equity, however, is that PE owners that keep in the market look less at quarterly earnings and more at sustainable capabilities—what will be profitable over the long run.

One development that the paper and pulp industry, which relies heavily on equipment and transportation, is paying strict attention to is energy management—facilities are looking at better ways to predict what energy will cost as it is being used instead of waiting until the end of the month to pay utility bills. What they hope to do is be able to slow production or even shut off parts of operations when prices get to a certain point. They are also looking at alternative fuels for running some equipment, and at the capacity for switching fuels when one type gets too expensive.

“Real-time costing [for energy costs] is a very hot topic right now,” Frandina said.

The biggest drivers going forward will be changes in who buys the paper and pulp and how they use it, Frandina said. For example, print advertising is flat and even declining slightly in some areas helped along by electronic technologies as well as lower publication volumes. At the same time, magazines and book publishers are pushing for lighter-weight paper to save on postage and lower-quality coatings, and high-end brochures and annual reports are starting to go electronic. Meanwhile, smaller niche printing companies are springing up, producing quick turnaround, small-volume jobs.

Internationally, Frandina called China “the big gorilla” and reported that three out of the top five machines in the world for printing have been put in place in that country in recent years, so capacity there is definitely exceeding demand. There are also other places that have an advantage, such as Brazil, where trees are easy to grow. While U.S. producers are getting nervous about foreign competition, “there is fortunately a very small light at the end of the tunnel” in the form of anti-dumping legislation, which the U.S. government is now taking seriously, at least for the coated and sheeted sectors, Frandina said.

FORECAST: The ratio of capital expenditures to depreciation will stay about the same in the short term, flattening out in the next three to five years and not seeing an uptick until after that. The U.S. will look for more ways to keep global competition out or go overseas for supplies and business. Short-lived private equity investment will fizzle out and investors will look more at the long term.

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Construction: Commercial Helps Balance Out Residential

The outlook for construction for the next 12 months is positive with nonresidential expansions making up for the downturn of the residential market, according to Sue Schwartz, director of the Construction Services Group of Aon Risk Services. While the residential market is suffering and hiring has turned to layoffs, many aspects of noncommercial markets, especially in the area of heavy construction, have seen double-digit expansion, she added.

This is due to increased funding that resulted from the 2005 transportation and energy bills, more private sector spending, more state and local government spending, increases in power generation construction projects, new defense and homeland security spending, the buildup of infrastructure along the Gulf Coast, and demand increases for projects in petroleum, pharmaceutical, biotechnology and chemical sectors, she said.

Overall, residential building is down by about 29% from a year ago and nonresidential is down 1%; however, non-building construction such as highways, bridges and sewers is up 7%.

At the same time, price increases for building supplies are seeing double-digit increases, a scenario contractors and building owners should get used to, according to Schwartz. Most of the increases are tied to world demands, but that situation isn’t about to change, she pointed out. For example, contractor clients have told Schwartz that China’s need for infrastructure construction is consuming 30% of the world’s steel supply.

Finding skilled labor is a problem, she said, and while some people have indicated they thought workers who were in residential could move to commercial, “my clients are saying that the skills aren’t really transferable,” she said.

There is more state and local construction spending occurring, but it’s happening to shore up current investments rather than building new plants, she said. She’s also seen an increase in power generation projects, but the emphasis is now on projects built to reduce consumption rather than bring in more energy.

She’s also seen a lot of projects whose schedules have been slowed or postponed because of higher-than-expected project costs. This has caused some problems with insurers who are unwilling to extend the insurance on a project, she said.

FORECAST: The commercial construction industry will grow 5% in 2007, which was the same as 2006.

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China: The Giant is Awake and Hungry

One of the great myths about business with China is that the country is responsible for the increased trade deficit in the U.S., but that is simply not true, stated George Koo, director of the U.S. Chinese Services Group for Deloitte.

China’s portion of the deficit was 27% in 1997 compared to 28% in 2006, he said. Meanwhile, the rest of East Asia made up 17% of the 2006 deficit but 43% of 1997’s; and the rest of the world accounted for 55% in 2006 and 30% in 1997.

“Politicians have demonized the country for unfair trade, but it’s our own national policy that is responsible,” he said.

A second great myth is that U.S. companies can’t make money in China. From 1995 to 2005, U.S. companies reported income (returns on capital) of $15.8 billion from their operations in China, and of that amount, 42% was repatriated earnings.

Koo said companies are proportionately repatriating less and less in China and reinvesting more in the country as opposed to taking the money out.

“GM made more money selling Buicks in absolute dollars last year than they made in the rest of the world because they were getting such a large margin compared to margins in the U.S.,” Koo said.

China, which is slightly smaller in area than the U.S. and has four times the population, is a country in the middle of many engineering marvels—projects that will take much less time to become reality than they would in the Western world. For example, Shanghai’s port, which is already the third most-used port in the world, is shallow and runs into the city through a river, so the country converted an island into a massive container port for offloading big ships—and built a 20-mile bridge to shore. Three Gorges Dam, which is a 15-year project nearing completion, will be the largest hydroelectric and flood control project on Earth at 1.3 miles wide and 610 feet high. It’s projected to decrease shipping costs by 20 to 40% by 2010.

What all that means is that an infrastructure is being put in place for further growth in status among the world’s economies. China is transforming the global economy today with the fourth largest economy, Koo said. The GDP has doubled every seven years since 1987.

One of the main questions is whether the country can maintain the kind of growth it’s experiencing, he added. And one of the unfortunate results is that the country adopted the Western development mentality—polluting for the sake of development, a problem that will need to be solved if the country’s growth rate is to continue, he added.

Koo had this advice to give:

• Besides the regular justifications for going into China—which include sourcing, manufacturing and selling—there is a fourth reason: “If you’re not there and you wait, they are going to be in your back yard,” Koo said.
• One of the biggest problems in dealing with China is trademark infringement; Koo suggested any company wanting to do business needs to have its trademark registered there. He also cautioned that enforcement is sketchy and dependent on local officials in many cases, so companies need to get to know those officials.
• When operating in China, a company needs to realize that local employees do not have the same awareness of the need to protect intellectual property so those companies should make educating employees and suppliers part of the process.
• The legal and regulatory system presents many opportunities but imposes real constraints because some areas don’t publish laws like they do in the Western world and sometimes “you don’t know you’re not in compliance until they are knocking at your door.”
• It’s important to remember that China is not one homogeneous market: it’s a thousand different markets.

FORECAST: China’s GDP as a percent of global GDP will continue to rise. By the year 2025, it will reach 20%.