Asian Chemical Connections

To quote Woody Allen, "More than any time in history mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray that we have the wisdom to choose correctly."

It's refreshing that this was written by an American, given the widely held perception that most of the nation's citizens lack a sense of irony.

As we enter the New Year, gallows humour seems very appropriate as the bad news multiplies from the cancellation of the K-Dow deal to the possibility of LyondellBasell filing for Chapter 11.

My good friend and colleague Paul Hodges makes the following comment on his blog, Chemicals & the Economy: "Petrochemicals has always been a highly cyclical industry. A typical seven-year cycle involves two years of stunning profitability as demand recovers after a downturn, three years of average returns as supply and demand rebalance and two years of horrendous losses."

If you take the start of the upswing as 2003 therefore, the Lyondell and Basell merger in December 2007 was a big risk. Perhaps those who negotiated the $20bn deal believed that cyclicality was dead.

What has, of course, made highly leveraged companies very vulnerable in this downturn is the severity of the credit crisis.

The way forward? Bring in the restructuring consultants, cut, cut and make more cuts and focus on making chemicals as cheaply as possible. The difficulty will be balancing this need with retaining sufficient R&D investment to cope with the inevitable increase in environmental legislation.

It's all about hoarding cash over the next few years, but survival might not even be possible for even the best managed of companies if Martin Wolf's worst-case scenario comes true. The Financial Times columnist writes of the unravelling of globalisation into the protectionism that characterised the Great Depression years if the Obama stimulus package fails.

There is a good chance it will fail, fears the Federal Reserve in the notes released from its December meeting.

At a chemicals company level, leverage is obviously out and the private equity model thoroughly discredited - perhaps for good.

You can argue that the biggest mistake of the biggest casualty so far, LyondellBasell, was timing as the acquisition of Lyondell Chemicals took place in December 2007. Asset prices were then at their peak with many believing that the boom would continue forever, despite the already rapidly deflating US housing bubble. As recently as March last year, The Economist was talking of Asia's decoupling as the potential saviour of the global economy.

But leverage is itself the problem because of how the extraordinary multiples over tangibe, realisable assets were generated through the shadow banking system, creating the climate for deals such as the Basell takeover of Lyondell to occur. It is this badly regulated, free-for-all system that's brought the global economy down.

Maybe we will never again see the break up chemical companies for sale to private, or public, companies burdened by enormous amounts of debt.

Perhaps the well-integrated chemicals company with sufficient diversification to provide compensating cash flows when a particular subsidiary is struggling is the way forward. Is this yet another case of back to the future?

In an even better position are the state-owned giants in the Middle East and China. They are in the enviable position of cash in hand, and government ownership structures that guarantee funding if that cash was to ever run scarce. These are the only companies I can see able to make the acquisitions the industry now needs.

I am reading Charles R Morris's The Triillion Dollar Meltdown at the moment, having also recently cheered myself up with Paul Krugman's update of his classic, The Return Of Depression Economics.

As the private equity model implodes, Morris's following words ring so wonderfully true:

"The leveraged-buyout business, after a highbrow restyling as private equity, came roaring back. A typical deal: Put up $1 billion, borrow $4 billiion more, snap up a healthy company for $5 billion (after making a rich deal with its executives), vote yourselves a "special dividend" of $1 billion, all the while taking no risk. 'People talk about a wall of money,' one banker said. Private equity funds didn't have to raise capital; it was chasing them."

I am sure, of course, that such unscrupulous and whollly dishonourable practices have never, ever applied to any private equity deal involving our great and wonderful, wise and so superbly well-run chemicals industry that has always taken a long term and measured view of how to run its operations in the most financially-optimal way and for the benefit of humanity as a whole in its caring and compassionate pursuit of higher and principled ideas for a sustainable, warm and cuddly future where everyone sits around the campfire and sings "Well be coming round the mountain" (enough waffle, stop - please!).

As a very wise man once said, everything goes in and out of fashion like long skirts and short skirts.

Hence, my very capable colleague Malini Hariharan has offered some analysis of South Korea. Its companies, having being brutally hammered by the West post Asian Financial Crisis (which I had pointed out at the time ignored their strengths) are now at the front of the proverbial cat walk because they have low levels of debt.

Of course they have significant competitive disadvantages, but they might at least survive the crisis.

OK, this blog is supposed to focus on the long term, but in line with just about everybody else, all I can think about is the immediate and my collapsing share portfolio and the value of my home.

As a bit of light relief (and also, by the way, because it's my job) I've been taking a close look at polyoefins markets over the past week. More to follow on aromatics later.

It does appear as if current price levels are unsustainable, that buyers know it and that some modest further price gains are possible.

Some modest re-stocking was inevitable after the inventory-loss disaster of H2.

And the world economy hasn't completely stopped. Maybe we are only (?!) talking about 10-20% of lost demand into mainly consumer durables.

Perhaps also crude can't fall that much further, providing a floor for polyolefin pricing.

But the question now is how long pricing will remain around this new level, fluctuating by small increments with buyers maintaining an incredibly cautious approach.

If quarters turn into years, who will be left to pick up the pieces when the economy finally recovers?

At the moment, a shell-shocked chemicals industry is still recovering from the impact of destocking following the huge inventory write downs in Q4.

The next step will be to measure the state of genuine, end-user demand and how this compares with the fantastic growth we saw in 2003 right through until the end of H1 2008.

Comparisons will inevitably look bad, even if, as some hope, recovery arrives in the second half of this year. This is bound to have a pyschologically dampening effect on markets.

Plus, chemicals and plastics markets are about to be roiled by large amounts of new capacity.

Recent price rises in the aromatics and olefins chains might, therefore, be reversed.

And so cost will remain King in the second of 2009, and perhaps for several more years.

The rise of private equity in chemicals, which I examined in a previous post, resulted in claims that the sector's more efficient management techniques would result in money being made "even at the bottom of the cycle".

But key to survival may no be longer innovative financial engineering and cutting costs social and bureaucracy costs incurred by previously much bigger, listed companies.

It might instead be all about chemical engineers getting every last cent of value out of production processes through optimising "every pipe and every valve," says my colleague Nigel Davis - editor of the Insight section of ICIS news.

It will be fascinating to watch how this plays out - and what becomes of chief financial officers.