Capacity utilization for processors continues to slip

The capacity utilization rate for plastics and rubber processors in the United States slipped to 75 percent in January from 75.3 percent in December, according to the latest data from the Federal Reserve Board. This marked the fifth consecutive monthly decrease in this data. By comparison, one year ago the utilization rate stood at 79.1 percent.

As the chart shows, the decline in January is a continuation of a longer-term trend that has prevailed for the past two years. The last peak in the capacity utilization rate occurred in late 2014 at 81.6 percent. Clearly this is not the direction we want to go — processors typically make more money when operating rates are high and rising.

So the question now before us is, “When does this trend reverse and start to head back up?”

Before I go into the particulars about what this two-year decline means for the outlook for our industry in 2017 and beyond, it is useful to look at the trend in the Fed's corresponding data on monthly output for the plastics industry. These two data series are closely connected, and when analyzed together they provide insight about trends in investment, pricing and profit levels.

As the chart for industrial production of plastics products illustrates, the plastics industry enjoyed a six-year trend of steady improvement after it rebounded off of a major cyclical bottom in the first half of 2009. This string of six straight years of annual increases in total output ended last year when the overall production for the industry declined by a modest 0.6 percent.

These data also exhibit an interesting stair-step pattern in which periods of above average growth rates are interspersed with periods of flat growth. The average annual rate of growth during the period from 2010 through 2015 was almost 4 percent per year. There was one year in which the pace of growth accelerated to 8.3 percent, but that was followed the next year by a gain of only 0.3 percent. Overall, the plastics industry had it pretty good — we were growing by 4 percent per year while the whole U.S. economy was expanding at an average rate of right about 2 percent. During this time, the plastics industry was one of the fastest-growing segments of the entire manufacturing sector.

A comparison of these two charts shows that for the first six years after the data hit bottom in early-2009, the steady increase in the output of plastics products was matched by a rise in the capacity utilization rate. The trend in the capacity utilization also exhibits a stair-step pattern, so the relationship between these two data series was consistent.

But then starting in the second half of 2015, the close relationship between these two indicators became unhitched. Over the next five quarters, output levels were mostly flat while the utilization rate data steadily declined.

This divergence was due to the rising levels of capital investment in this industry since the recovery started. Expenditures on both new equipment and employees plummeted during the Great Recession, but as the plastics industry and the overall economy began to recover, so did investment in new machinery. The rate of investment in new equipment really perked up as the utilization rate got close to the 80 percent level.

The time since the recession ended has been an auspicious time to invest in this country. Interest rates were low, resins prices were relatively low, and overall demand was steadily expanding. Thanks to advances in digital technology, new equipment is more energy efficient and also more productive. Processors can produce more goods with fewer inputs. Over the past five years, the decision to invest in new equipment has not been difficult for many processors.

My research indicates that over the long term, productivity in the U.S. plastics industry improves at a rate of 3 to 4 percent each year. This is due to the steady improvements in efficiency that the machinery suppliers achieve with each new generation of machines.

This explains why the utilization rate declined significantly in 2016 while output level registered only a modest decrease. Processors who recently invested in new equipment are able to manufacture the same amount of product with less capacity. This means that processors can meet current levels of demand with 75 percent of capacity being utilized where as it would have taken 80 percent of the capacity to meet this level of demand two years ago.

It takes sustained growth of about 4 percent per year to push operating rates higher. We were getting this kind of growth for a while, but the pace fell off during the past two years. That allowed operating rates to steadily decline in 2016.

My forecast calls for growth in the output of plastics products to get back up to 4 percent in 2017. Aggregate demand for plastics products will increase due to stronger spending on residential housing and consumer products. The packaging sector is also expected to see an incremental increase due to a rebound in growth for retail sales in the United States.

If this forecast holds, then the capacity utilization data will hit a cyclical low point in the first half of 2017 and it will then start to rise. This means that processors will not have many opportunities to raise prices this year, but profits should be solid due to firm demand and relatively low resin prices.

Machinery suppliers will see demand for new equipment sag through at least the first half of this year as it will take a couple of quarters for demand growth to catch up to the new capacity that has been installed during the past couple of years. Orders of new machinery should pick up again in 2018.

If this were the stock market, then the analysts would describe the recent soft period in the data for both production levels and capacity utilization rates as a “healthy correction.” The expansion in the plastics industry got a little ahead of the increase in aggregate demand. But the good news is that we did not suffer a recession. After a sluggish year in 2016, the conditions that enable faster growth in both the U.S. manufacturing sector and the plastics industry are starting to emerge.