Asian Chemical Connections

By John Richardson

ETHYLENE spot prices rose by $20-50/tonne in Asia last week on the back of stronger derivatives pricing, including a $5-25/tonne increase in polyethylene (PE), according to ICIS.

However, nobody is cracking open the champagne. As the chart above shows, despite a $51/tonne improvement in Northeast Asia's variable cost integrated margins for the week ending 17 May, the region continues to struggle.

To a large extent, the recovery is said to have been driven by the rebound in crude prices last week as PE buyers in China, as usual, irrationally slightly increased their buying on the theory that the "real" cost of resin was higher. There was also a slight uptick in the number of intra-trade deals.

But after four consecutive days of gains, oil prices declined yesterday.

"The danger is that we will attempt to push PE prices up too quickly over the next few weeks, causing another big retreat by the processors. The absolute maximum that I think the converters can take is an increase of $100/tonne," said a source with a major producer.

"The mood in Shanghai remains incredibly cautious because everyone thinks that Xi and Li really mean business and, therefore, there isn't going to be any big economic stimulus later this year.

"Labour cost pressures in Northeast China are also increasing and the gap with South China, which still remains more expensive, is narrowing and thus forcing an increasing number of processors to migrate to Bangladesh, Sri Lanka and Myanmar. In a couple of years' time, people think that Northeast China will be as expensive as South China.

"The lower value processors in China, who have had lots of easy access to financing over the years and have had enjoyed guaranteed strong demand growth, are really struggling. During the boom years, they didn't have to develop particularly strong skills and dabbled in too many diverse business sectors to be able to develop any such skills."

Several sources are now looking back on the boom years and, for the first time, are seriously worrying about what really drove the huge increase in processing capacity.

Some of the extraordinary growth is now being attributed to corruption, as the disbursement of bank loans provided big opportunities for back-handers.

China has changed for good. Get used to it.

By John Richardson

Quite often, a chart is worth many thousands of words. The above chart, from Bloomberg, shows the divergence between the soaring S&P 500 index and US macro-economic indicators.

The theory is that soaring equity values will be the tide that lifts all boats. Even America's hard-pressed middle classes will benefit, not just the Wall Street elite, is the argument as 401 funds are boosted.

But isn't there a danger, just as was the case towards the end of the sub-prime bubble, that towards the end of this particular bubble, those who don't understand financial markets will be sucked-in to risky investments and will thus lose their shirts?

And, according to fellow blogger Paul Hodges, the strength of the S&P 500 is out-of-kilter not only with the real US economy, but also with many other asset prices.

"What we are witnessing is the final 'melt-up' phase of the $7tn [central bank] liquidity programmes. Originally, this pushed up all asset prices, but reality has since begun to set in," he wrote in this blog post.

"Four years ago, most investors assumed stimulus would quickly lead to recovery.

"But since then, they have gradually become wiser, if poorer.

"Cotton, for example, jumped from 46c/lb to 227c/lb, but is now back at 86c/lb.

"Copper jumped from $3330/t to $9880/t, but is now $7330/t.

"Gold went from $880/oz to $1920/oz, but is now $1360/oz.

"Brent went from $44/bbl to $123/bbl, but is now $105/bbl today."

As we keep saying, please be careful out there.

By John Richardson

THE blog is often accused of being pessimistic. We are not. We are just realistic.

It was realistic last November to anticipate that China's new leaders would be dedicated to major economic reform. In fact, this was clear even earlier than that - back in February 2012 when the World Bank produced its landmark report on China - that a fundamental shift in economic policy was taking place.

This excellent article from Reuters highlights, as we have thought for a long time, that Xi Jinping and Li Keqiang, are firmly committed to a major overhaul of China's economy. They have cemented their power base and will present more details on a radical reform programme at the crucial third plenum of the 18th Central Committee of the Communist Party of China, which is expected to take place in October, adds Reuters.

Quick fixes are no longer possible. Chemicals traders and company executives expecting a return to the type of stimulus-fuelled growth we saw in 2009 are going to be disappointed.

But this should not be a reason for pessimism for anybody who is looking beyond the immediate value of their share options, or the money to be made on the next chemicals shipment to China.

If Xi and LI are successful the opportunities are enormous, as The Economist points out in this article.

These opportunities include a huge surge in the spending power of low-income workers, thanks to successful reform of the Hukou system that at present denies hundreds of millions of workers access to basic social services.

A surge in investment by innovative private firms, if bureaucratic hurdles can be reduced and the allocation of capital improved, is another great opportunity for the chemicals industry.

But, as the chart above illustrates, some essential reforms, such as higher utilities charges and a liberalised interest-rate regime designed to improve the allocation of capital, will have a negative short term effect on demand. Nobody should be surprised, therefore, if real GDP growth in China over the next few years falls to 4% or even lower.

Meanwhile, as this painful shift takes place, the mood music needs to change. Rather than asking China to "save the world" through returning to an economic model that no longer works, chemicals company CEOs and Western politicians and central bankers need to all get behind this make or break effort to transform China.

We worry right now, though, that the huge quantitative easing programmes unleashed first by the Federal Reserve and more recently by the Bank of Japan, will not be supportive of China's efforts.

There could instead be a "race to the bottom" as currencies are competitively devalued, including the Yuan. China might end up boxed into a corner and thus forced to export deflation.

By John Richardson

LABOUR markets are tight in China and so on the surface there appears to be no great pressure on Beijing to attempt to export its way out of an unemployment crisis.

But what happens if, as we suspect, real GDP growth has fallen to 4% or even lower? The government, despite its firm commitment to economic rebalancing, might be forced to once again boost export competitiveness.

A hint that this might be on the cards appeared in the state-run Global Times newspaper earlier this week.

"The Chinese Yuan has limited room to appreciate further and may be depreciated to foster the country's struggling exports and the broader economy, according to experts and insiders," wrote the newspaper.

Aggressive monetary easing by the Federal Reserve and, more recently, the Bank of Japan, were cited as reasons why the appreciation of the Yuan might be reversed.

The massive stimulus programmes of both central banks have depreciated the values of the Dollar and Yen, and, as the Global Times also points out, have also caused capital inflows into China, thus pushing up the value of the Yuan.

The approach of Western central banks looks set to continue, even though there is no prospect of it reviving demand.

And so China, boxed into a corner, could be forced to respond, resulting in a global trade war as it exports deflation via its many heavily oversupplied industrial sectors, including chemicals.

By John Richardson

TEN trillion dollars doesn't buy what it used to do, according to The Wall Street Journal.

The reason is that despite central banks across the world aggressively expanding their balance sheets, there is no inflation.

"My customers in China are worried about the opposite - global deflation because demand everywhere is so weak," a polyethylene (PE) industry source told the blog recently.

Supply across many industries is exceeding demand because demographics drive demand in the West, and demographics in the West tell us that demand in the long term will be weaker.

China can longer export its way to economic security because of problems in the West, as China struggles with economic rebalancing.  

By John Richardson

China's factory-gate prices have fallen for 14 months in a row because of huge overcapacity in many industries, said the Wall Street Journal in this article.

"Producer prices - a measure of prices of goods before they reach consumers - dropped 2.4% in April, the sharpest decline since October, paced by particularly steep falls in the metals and chemicals sectors," wrote the WSJ.

"That could add to concerns about China's slowdown in growth, say economists, because falling producer prices make it tougher for makers of industrial goods and commodities to make profits, pay off their debts and pay their suppliers on time."

The ICIS Petrochemical Index (IPEX) Northeast Asia sub-index for May (see the above chart), reflects the WSJ analysis. Prices in the region fell by 5.6% over April due to weaker olefins and butadiene markets.

Falling producer prices might well undermine the argument that the surge in bank lending during Q1 will result in stronger economic growth in H2. If companies are too busy paying off debts, and dealing with falling prices caused by overcapacity, a loans-fuelled rise in output seems unlikely.

And Barclays, in the same WSJ article, said that some of the first-quarter lending was used to serve existing debt, as we have discussed before.

"The deflation in the industrial sector reflects overcapacity in a number of major Chinese industries including steel, coal, glass, aluminium, solar panels and cement," continues the WSJ.

The problem is so great in solar panels that higher-quality solar grade ethylene vinyl chloride acetate (EVA), used to make the encapsulants for the panels, is being sold at discounted prices for training-shoe and other lower-value applications, said an industry consultant on the sidelines of last week's Asia Petrochemical Industry Conference (APIC).

And last week, The European Commission decided to impose preliminary antidumping duties of 47% on Chinese solar panel imports. Last year, the US imposed antidumping tariffs of more than 30% on Chinese shipments.

We worry that trade protectionism will in general be on the rise as China's economic weakness continues. 

Overcapacity is a problem across many petrochemicals, said several delegates at last week's APIC.

Purified terephthalic acid (PTA) is a good example of oversupply. Asian operating rates have fallen below 70% as a result of demand growth of 5-6% in 2013 versus capacity growth of 21%, said Becky Zhang, the ICIS fibre intermediates pricing editor for Asia.

Despite their concerns about oversupply, APIC delegates, as we said on Monday, believed that surpluses would be absorbed as a result of China returning to strong growth by 2015.

Reasons to doubt this theory include:

*China's inability to export its way out oversupply, as it has done in the past, because of weak Western economies.

*The inability of the government to launch a stimulus package on the scale of 2009 because of bad debt problems and diminishing returns from the investment growth model.

A further negative for growth is that painful restructuring across many industries seems likely, including in aluminium where 90% of producers are said to be loss making.

Previously, the government was reluctant to streamline inefficient industries because of the danger of a sharp rise in unemployment.

But now the job market is tight, giving the government freedom to close down loss-making manufacturers.

Industrial restrucutring will likely also take place as part of China''s attempt to to avoid the middle-income trap.

Low-value, loss-making companies will be strategically shut down as iinnovative, higher-value companies are encouraged to start-up.

By John Richardson

CHINA'S petrochemical prices might rally in the second half of this year, along with local stock markets, in response to the delayed impact of the big surge in bank lending that took place in Q1.

James Gruber, author of the Asia Confidential newsletter, argues that a mild H2 recovery is possible because:

*Property investments have rebounded and infrastructure spending is still growing by around 20% - the same rate as most of the last 12 months.

*Monthly social financing (total financing including formal and informal lending) in the first quarter of 2013 was Rmb2.1 trillion, higher than the monthly average of any single quarter since the introduction of the data in 2002, as the chart below illustrates.
 

*Although this absolute number is high, it is nowhere near the rise in lending during 2009. As a result, there is no big risk inflation risk.

*Because China is a command economy, when the government increases lending it is able to make sure that the money ends up the hands of companies. But there is usually a six-month lag between higher lending and an improvement in growth. In 2009, for instance, as the second chart below shows, the huge stimulus package introduced early that year did not result in a surge in growth until the third quarter.

*The anti-corruption campaign, which is widely believed to be the reason for weaker retail sales growth, will be relaxed. Retail sales grew 12.6% year-on-year in March, down from the 15% recorded in the fourth quarter on last year.

* The latest export data have been quite encouraging, even if you strip out distortions. The biggest discrepancy appears to be the Hong Kong export data. Growth in Chinese exports to Hong Kong was 57% year-on-year in April and 93% in March. This is likely due to over-invoicing in order to circumvent capital controls and bring foreign capital into China. "The key point is, though, that if you strip out the Hong Kong figures, Chinese exports still grew 9% in the first quarter of 2013, up from 4% and 0% in the previous two quarters," writes Gruber.

Gruber goes on to warn that nobody should assume that any rebound in growth will be sustainable. He is with us in believing that China faces a long-term struggle against bad debts and an over-inflated property bubble, as it also confronts the challenges of economic rebalancing.

But if  you believe Gruber, and you are a chemicals producer or trader, this is an opportunity.

But be careful out there. Against this recovery theory is the notion that most of the extraordinarily high Q1 bank lending went to service bad loans and so much of the extra money will not end up boosting industrial output. This article from the China Daily, if you read between the lines, seems to support this view.

China's cracker operators would surely, also, have ramped-up production by now if they felt that the first-quarter loan surge was going to deliver a big benefit to the economy. But Q1 ethylene production was up by just 2.9%.

Just an anomaly?

Source: American Chemistry Council

By John Richardson

FEEDSTOCK advantage is, of course, crucially important, but so is demand.

And yet the only subject that most people wanted to talk about in any depth at last week's Asia Petrochemical Industry Conference (APIC) appeared to be how to achieve feedstock advantage.

Why? Probably because discussing the shale gas revolution in the US, how to transfer that revolution to Asia and other means of gaining competitive advantage, such as perhaps coal-to-chemicals in China and better refinery/petrochemicals integration, lie within the industry's comfort zone.

Just because a subject is difficult shouldn't lead to it being almost entirely sidelined - especially, of course, the subject of demand! Sadly, though, this is what it felt like was happening last week.

What worried the blog was that instead of in-depth discussions about scenarios for growth, delegates appeared to assume that while operating rates would be low this year and in 2014, everything would be back to normal by 2015. We have been waiting for everything to return to normal ever since 2008, but it hasn't happened yet.

The idea that China might suffer an economic collapse wasn't contemplated, or even that the headline 7.7% growth in Q1 might be a misleadingly bullish indicator of real economic activity.

Delegates also seemed to assume that Europe would somehow muddle through and that, obviously, it was Morning in America again.

By John Richardson

A MAJOR Southeast Asian polyethylene (PE) producer has reduced its percentage of exports to China from 30-40% in 2012 to just 10% so far this year, a source with the producer told the blog on the sidelines of the Asia Petrochemical Industry Conference (APIC) in Taipei.

This is further confirmation of the huge long-term changes taking place in China's economy as its government forges ahead with rebalancing.

"We have managed to compensate for the drop in business to China by raising our intra-ASEAN [Association of Southeast Asian Nations] exports," said the source.

Demand growth in the ASEAN region remains strong. For example, PE consumption in Thailand is expected to expand by around 5% this year, in line with the growth in overall GDP. In Indonesia, demand is expected to increase by more than the anticipated 6% rise in the country's GDP.

But the question on the minds of several delegates at the event was to what the extent the ASEAN economies would be impacted by the slowdown in China, particularly heavily trade-exposed Singapore.

By John Richardson

ASIAN higher cost polyvinyl chloride (PVC) producers are facing the twin squeeze of increased electricity costs and very competitive exports from the US, according to an industry source the blog met with in Taipei, ahead of tomorrow and Friday's 2013 Asia Petrochemical Industry Conference (APIC).

Such is the pressure on the Japanese, and perhaps even the South Koreans, that rationalisation of capacity might have to take place, he added.

"Electricity costs are 3 cents a kilowatt in the US because of shale gas, making chlor-alkali units there exceptionally efficient. And, of course, the US has very cheap ethylene, thanks again to shale gas, for ethylene dichloride (EDC) production," said the source.

"This compares with 10-12 cents a kilowatt power costs in Japan - much higher than used to be the case before the 2011 tsunami forced Japan to import much more liquefied natural gas (LNG) to meet its electricity generation needs."

This is illustrates why three major themes look set to dominate this year's APIC conference: US shale gas, US shale gas and more US shale gas.

"A couple of years ago, coal-to-olefins (CTO) in China were heavily featured in the discussions at APIC, but now people seem to recognise that CTO will have a limited impact," said a petrochemicals consultant, again in Taipei ahead of APIC.

Returning to the subject of PVC, we might perhaps see a great deal of overseas interest in investing in the US chlor-alkali and vinyls sector, which again of course would be linked to the foreign interest in building steam crackers in the States.