Asian Chemical Connections

As flagged up on this blog last week, ICIS news has confirmed that the US-Asia propylene arbitrage has shut following a rise in US domestic refinery-grade C3 prices.

This could be good news if West-East arbitrage in general becomes more difficult.

During Q1 and the first few weeks of the second quarter, big quantities of US and European aromatics, olefins and derivatives were shipped to Asia as a result of much-stronger prices in this region compared with the West.

The Western producers (and, of course, the traders who seem to have done very well) benefited greatly from being able to relieve inventory pressures.

Volumes would have been even greater if it hadn't been for vessel re-positioning issues and delays caused by increased piracy off the coast of Somalia.

But now the risk is that further big West-East volumes are fixed for arrival after May.

June-July will see cheaper naphtha and increased petrochemical supply, creating the potential for across-the-board price corrections that could be made a lot worse by continued high levels of deep-sea cargoes.

Any excuse to make a reference to the late, great and wonderful Ian Dury.

I sent the following email to my friend in response to the stock market rallies and the green shoots of optimism seemingly turning into beautiful May flowers:

"I take it nothing can has fundamentally changed? The confidence couldn't possibly be so self-fulfilling that all the consumer and corporate debt somehow vanishes into a great big black hole?"

His response, justifiably caustic, was:

"Of course, that's the answer. We wake up on May 1, and its all been a nightmare.

"Suddenly houses are still worth what they were there years ago, and are still increasing in price on a monthly basis.

"None of the banks have been nationalised, and the shadow banking systems is still the same size as the normal banking system.

All is fine with the world, and neither Chrysler nor GM are close to bankruptcy."

Quite. Enjoy it while it lasts.

"Nobody can see until the end of the month - never mind into the third quarter," commented an olefins trader recently.

"The reason is that very senior managers are too busy micro-managing everything, from getting involved in trying to track commodity chemical price direction to insisting on signing off every expenditure over a few hundred dollars.

"The problem with these senior guys when they track markets is that they are so out-of-the-loop - assuming that they have ever actually been in the loop - that they don't know what they are doing."

I heard of one big company where the CEO has even insisted on signing off travel authorisation to next week's APIC conference in South Korea.

In these days of tight credit and collapsed sales, it's understandable that much tighter control on spending is essential.

And during the boom years, can we all honestly say that every single trip we made was entirely commercially justified - and that we were always sufficiently foused on the bottom line to get maximum value out of each trip? Look back at your old expenses forms and count up the number of genuine "drinks with Mr Kim" entries.

It will be interesting to see how the lessons being learnt today will be remembered when the economy has fully recovered.

But from a HR perspective, a tough sign-off regime needs to be well-communicated.

So does the senior guys tracking shifts in chemicals pricing - whether competently or incompetently - otherwise the workers on the ground are likely to become demoralised.

They are unlikely to be able to leave in this current climate, but will surely perform far worse if they feel their opinions are being ignored for no good and well-explained reasons.

Off-the-record, of course, how does your company measure up?

And did you fiddle your expenses during the good times?

The timing of when to strike the ball is everything in the wonderful sport of cricket - and also, apparently, in the American pastime of baseball.

An Australian banker is fond of reminding the English how much better his country is at playing cricket.

But his gloating doesn't extend to how well he's been timing dipping in and out of equity markets of late. Like a lot of other "cashed up" people he is suffering from the "if only" syndrome.

"A lot of money seems to be pouring into stock markets because it has nowhere else to go. I didn't expect this run to last as long," he said.

All the moving indicators are pointing upwards with crude above $55/bbl on Thursday where he thought there would be very tough resistance.

"There's so much crude in storage which has been acquired by the financial traders who perceive the economic recovery is just around the corner. This is a big risk.

"Equity markets are also responding as if a recovery is only three months away. They usually price in a recovery about a quarter ahead of when it actually happens, but I believe that the recovery - or rather the bottom of the market - is at least six months away."

And in his view, you have to be very careful how you measure "recovery" in the context of the worst economic downturn since possibly the Great Depression.

The first important measure is the effect of inventory adjustments on GDP (gross domestic product) growth.

In the US, for example, total inventory reductions subtracted $50bn from growth in the fourth quarter of last year, he said.

The first quarter adjustments will see a further $100bn or so of production cuts and the second quarter possibly in excess of $150bn.

The collapse of liquidity in Q4 2008 forced companies across all sectors to make much quicker operating-rate cuts and plant closures than occurred at the start of previous recessions.

"There was simply no re-financing available so the companies had no choice."

BASF has reduced is global production by 25%, Bayer Material Science has taken 300,000 tonne/year of polycarbonate (PC) capacity temporarily off-line and Dow Chemical's average operating in the fourth quarter was just 64%.

"I expect some inventory replenishment down many of the production chains in Q3 in the US, and probably elsewhere," he added.

"This could give the false impression that we have reached the bottom of this crisis and recovery has begun."

Inventory building in Q3 would need to be measured against consumer spending, he said.

Retail sales on big-ticket durable items such as autos and homes might take longer to bounce back in the West than in Asia. Cost consciousness could also extend for some time to clothing, food and tourism.

Individual wealth has been badly dented by the fall in stock markets relative to their peak and the collapse in housing.

"Savings rates are likely to continue increasing as a result of this loss in wealth - even more so if unemployment keeps on rising."

Recoveries in GDP growth in the third quarter of this year would also need to be measured against the same period in 2007 rather than 2008, he added.

"This will give us a measure of how far we are away from returning to the boom conditions of 2004-07."

The crisis began in the third quarter of 2008.

Any comparison between Q4 2009 and Q4 2008 would be even more misleading as the global economy ground to a virtual halt during the last quarter of last year.

Comparing 2007 with 2009 is crucial for the chemicals industry as new capacity was planned on the belief that growth would continue at levels close to the great boom years.

"Even if were still in a global boom we would still need capacity to shut down," said Paul Hodges, chairman of UK consultancy International eChem.

"In most building block products we are now faced with 20% oversupply."

It could be a very long time before the world economy enjoys another period like 2004-07.

Consumer and corporate credit is likely to remain much more restricted because of financial-sector reforms.

"You also have to look at the potential for credit-card debt going bad to undermine consumer spending and the stability of the banks," the banker added.

"The first quarter results of the Western banks were very misleading. They looked good because of a reduction in competition due to consolidations and bank failures.

(Also, the banks could hardly fail to make money as governments were practically giving money away)

"But behind the numbers you could see warnings over just how much bad debt could result from credit-card defaults.

"As much as 25% of the revenues of some commercial banks come from credit-card transactions."

Consumers who are not in danger of default will be eager to pay off their plastic debts rather than incur 20% interest charges, he said.

The other big risk is the rate of recovery on corporate debt that's gone bad. Optimists think it could be as high as 40%, whereas others are warning of returns of as low as just a few cents on the dollar.

There appears to be the risk of a least a double-dip recession - perhaps even three dips.

Commodity chemicals prices started going up before the current equity-market rally.

This followed the deep global production cuts in aromatics, olefins and derivatives and a rebound in feedstock costs.

It's a moot point whether the cuts, combined with delayed start-ups in the Middle East, created genuinely tight markets or just the perception that they were tight.

In the end, though, the result was the same - raising the age-old conundrum of whether sentiment or fundamentals are driving markets.

A danger is that rising crude prices and the stock-market rally could lead to chemicals production being ramped up (if it hasn't happened already), despite the uncertain outlook for consumption.

Confidence can be a dangerous thing.

It's a great deal easier to off-load shares when you think the market has turned than a warehouse full of polyolefins.

The current run-up in equities might go on and on - perhaps even for several years, according to economist Russell Napier.

But he warns, in this excellent video interview with FT journalist John Authers, that an extended boom in equities doesn't necessarily mean the economic fundamentals are sound.

For example,the stock market rally after the dot com bubble burst was fuelled by too-lax lending. Was this in effect a bear-market boom?

Now governments are pouring money into economies the world over to stimulate consumption.

This will lead in perhaps as long as 2-3 years time to a big inflation problem, the Chinese losing their appetite for US Treasuries, Treasury yields doubling and a cataclysmic bear market with the S&P falling to 400.

Until then, S&P could easily double from its March low, predicts Napier

Do you have the courage to stick your money in and wait?

It still feels counter-intuitive that the current run-up will last a few years given the scale of consumer and corporate debt.

But since when has logic had anything to do with anything?

This very interesting note from Jun Ma, chief economist for Greater China at Deutsche Bank (see the end of this post) offers evidence to support what this blog has been worried about for some time - the quality of China's economic rebound.

The government would presumably be less concerned about the sharp increase in loan growth if the extra money had substantially boosted domestic consumption.

Instead, a large portion of the new loans could well have ended up in the hands of speculators (helping to drive chemicals prices up), Factories also seem to have been encouraged to keep operating rates high for social reasons - and state-owned enterprises area wash with cash for industriall investments. This is crowding out borrowing by private companies.

My fellow, Paul Hodges, points out that Wal-Mart is actually reporting a decline in consumer spending at its stores in China.

Net lending falls 70%mom to RMB592bn in April

RMB net lending fell sharply to RMB592bn in April from RMB1.9tn in March, broadly consistent with our expectation. We believe this reflects the success of the window guidance (about 3 weeks ago) by PBOC and CBRC that advised banks to "appropriately control loan growth"; the decline in new project approvals; as well as the slower pace of equity capital injections from the central government budget.

Going forward, the continuation of these factors will likely lead to a further decline in net lending to about RMB300-400bn per month in the remainder of this year.

As lagging indicators, the yoy growth in outstanding loans remained at 29.7% in April and M2 growth accelerated a little to 26%. Within a few months, we expect these yoy rates will begin to moderate following the decline in monthly net lending.

We see two main implications from the slowdown in net lending. First, net lending is a good leading indicator for QoQ GDP growth in China, with a lead time of about one quarter. The 70-80% fall in QoQ net lending in Q2 implies that QoQ GDP growth will likely moderate in Q3, following its peak in Q2 (at an annualized rate of 12-14%). Together with other factors such as a more visible corporate capex slowdown and a less supportive inventory cycle, it will likely result in a second phase of economic deceleration (measured on a QoQ basis) from Q3. On a YoY basis, the second down-leg of the economic cycle will likely begin in Q1 next year, as YoY growth lags QoQ growth by about two quarters. Second, net lending has a high correlation with market turnover in the A share market. The decline in net lending growth will therefore likely be associated with reduced liquidity for the A share market going forward.

Yoy inflation falls further in April

CPI inflation declined to -1.5% yoy in April, down from -1.2% in March. Producer prices are also declining, falling 6.6% yoy in April, vs a fall of 6.0% in March. Both figures are identical to our forecasts. In the CPI index, a 0.8%mom decline in food prices led the index down. Other commodity prices were essentially unchanged on the month according to the Ministry of Commerce. We expect yoy CPI inflation to remain in negative territory for another three or four months and PPI inflation to remain negative for six months. Upside risks to inflation stem from the possibility of higher wheat prices after a drought earlier in the year and the possibility of higher pork prices as farmers have slaughtered pigs in recent weeks due to the 10% drop in pork prices amid the Swine Flu outbreak (note that mainland China reported its first confirmed swine flu case today). Month-on-month PPI inflation - much more influenced by non-food raw materials prices - should recover on stronger demand due to rising gov't-led capex and inventory restocking in coming months, but these price increases may not be sustained beyond mid-Q3 when we think the QoQ increase in the number of new projects starts to fall and the inventory cycle turns less favorable.

One of the new skills being learnt in this current crisis is how to run plants efficiently at low operating rates.

"It's funny that for years now, we've worried about how to scale up profitably. Now industry is faced with just the opposite, how to scale down profitably," says Mark Matzopoulos, chief operating officer at UK-based Process Systems Enterprise in this article in ICIS Chemical Business.

A friend of mine has just graduated from university with a very good degree in chemicals engineering and has managed to land a job with an engineering company. His fellow graduates have not been as lucky in their search for jobs with chemical companies.

At least somebody is making money out of this crisis

Consensus opinion tends to swing firmly in one direction and then the other.

For example, in the good old days of 2007 you would have been pretty hard-pressed to find many in the chemicals industry who saw anything but a mildly cyclical downturn.

But the widely-held view now - that we are facing five years of incredibly tough times, the first period of this length in the history of the business - might also not come true.

"In 1992, the same was being said but then within 12 months the industry was in recovery," said an old industry hand.

"I don't know what the macroeconomic factors might be on this occasion. If I did I could make a fortune. In 1992, it was the unexpected emergence of very strong Asian demand.

"But even if the economic news keeps getting ever-gloomier, the industry itself might make yet more adjustments to bring supply much more in line with demand."

He cited the sweeping production cutbacks that have already taken place as evidence that the will to make the necessary changes exists.

"Leveraged and private-sector companies will just not sit on their hands. In the distant past, action was slow because the industry was mainly state-owned."

These included Dow Chemical reducing operating rates to a 63% average in Q4 last year, BASF shutting down 25% of capacity in Q1and Bayer Material Science idling 300,000 tonne/year of polycarbonate (PC) capacity - again in the first quarter.

The cutbacks seem to have been more extensive than in a recession of this comparable severity - the one which occurred in the early 1980s.

"Chemical companies had no choice because raising working capital through re-financing was simply impossible," says a Singapore-based banker.

Maybe if cash flow remains constrained by ever-weaker revenues - even if the financial system is repaired - companies will face no option but to permanently shut down capacity and definitively cancel projects.

The extent of the capacity closures to date suggests that markets being brought back into balance is possible far more quickly than the doom-mongers (including myself) expect.

A few major bankruptcies might make this process very rapid indeed through closure of a large amount of a capacity in one fell-sweep.

Apologies for letting this blog slip again, but have been busy trying to make a crust presenting ICIS training courses.

And so as a bonus for our army of avid readers, here are my extended thoughts on the above:

In the midst of the economic crisis it would be so easy to bury your head in the proverbial sand and forget that once the recovery does arrive, the same old feedstock-cost problems seem almost certain to re-emerge.

"The profitability of your average Asian naphtha cracker with the right level of investment in derivatives was extremely good throughout 2007. This was particularly the case if you were processing C4s into butadiene," said an industry observer.

"But in the first half of last year margins turned negative because of rising crude and naphtha costs. Every manufacturer down every product chain frantically built inventory because of the fear that oil would reach $200/bbl by the end of the year."

Of course we all know what really happened: Crude prices collapsed in Q4 resulting in the biggest inventory losses in the history of the chemicals industry. Stocks simply had to be liquidated due to the non-availability of working capital.

Governments are lavishing cash on stimulus packages in a desperate effort to return the world to business as usual.

This might on the surface seem the sensible thing to do, but unless that money is spent wisely in boosting energy conservation and renewable technologies, a return to strong growth could hasten the return of $100/bbl plus crude.

There's not much sign of smart investment in China. A surge in bank lending has been used to ramp up steel and aluminium production and provide the finance for manufacturers of finished goods to run their plants hard in order to limit job losses.

China announced a $586bn stimulus package last November and then in March disclosed plans for heavy investment in ten industrial sectors, including refining and petrochemicals.

"While the (investment) proposals may boost the economy, and thus energy demand in the short term, they could also lead to continued growth of energy-intensive industries in the medium to long term," writes the UK-based Cambridge Energy Consultants in an article on its website.

The Obama administration has also come in for some pretty fierce criticism over a cap-and-trade-bill before the House of Representatives. Lots of emissions permits would be given free under the bill, offering benefits to coal-based electricity generators and other energy-intensive industries.

Oil industry experts are queuing up to warn that the economic crisis has cut capital investment by the small independent oil companies in harder-to-get-at conventional crude reserves. The oil majors have slowed down development of unconventional sources of oil, such as the Alberta Tar Sands.

OPEC warned at its recent meeting that the fall in prices was resulting in lower investment, and the Paris-based International Energy Agency estimates that spending on oil and natural gas exploration will fall by 21% this year over 2008. This would represent $100bn less spending on building reserves.

The implications of a return of very expensive crude are obvious for Asia's petrochemical industry, which is largely naphtha-based.

The Middle East gas-based producers would once again stand to benefit due to another surge in margins as, of course, global petrochemical prices are oil-driven.

But what if everyone suffers? Could the return to crude in excess of $100/bbl re-awaken inflation, further stoked by excess liquidity resulting from government stimulus packages?

The danger is that we might repeatedly see nascent economic recoveries nipped in the bud by surging energy costs.

BASF announced last June that it was looking at making petrochemicals from biomass using its catalyst expertise, and said that it had made good progress at the laboratory stage.

Numerous companies were also looking at methanol-to-olefins technologies, including ExxonMobil and LyondellBasell.
China's coal reserves offer an opportunity to make methanol into large amounts of olefins and transportation fuels.

Let's hope that cutbacks forced on companies by the financial crisis have not included freezing research into attempting to break the crude-petrochemicals link.

Another concern is the long-term outlook for naphtha supply.

The US announced new car and truck fuel-efficiency regulations last week, which, in the short term could increase the availability of the feedstock.

By 2016, all new autos will have to meet a 39 miles per gallon standard (mpg) standard, up 42% from the current 27.5 mpg. Trucks will have to do 30 mpg versus 23 mpg today.

"Europe was already heading for an enormous gasoline surplus by 2015 even before this announcement," said Paul Hodges, chemicals consultant with the UK based International eChem.

Diesel demand in Europe has surged at the expensive of gasoline. However, the Europeans have been able to export their way out of gasoline surpluses due to shortages in the States.

But these exports were already under threat from increases in US refining capacity and the mandated steep rise in ethanol blending, added Hodges.

"The new fuel-efficiency standards will increase the pressure for European refinery closures, but in the interim there could be a disposal problem.

"This could create the opportunity for cost-advantaged naphtha supplies into the hard-pressed European and US petrochemical industries."

Eventually, though, refinery capacity will have to close because, as one Asian-based oil and gas consultant put it "there is going to be a worldwide glut of gasoline. Even on a straight-run basis before you look at more advanced processing, there will be a big surplus requiring rationalisation."

It is far too early to say whether refinery closures will lead to a net reduction in available naphtha.

Asia is adding capacity as Europe confronts the need to rationalise. In 2009-10 alone, 2.7m bbl/day of refining capacity is due to be come on stream in Asia Pacific, according to oil and gas consultancy FACTS Global Energy.

But naphtha exports from the Middle East could decline as the region looks to crack more naphtha in order to widen its petrochemical-product slate.

In Abu Dhabi, for example, a naphtha cracker complex is due to start-up by 2013.

Anyone with either access to advantaged ethane, propane and butane or with a proven technology that breaks the refinery/petrochemicals interface might be OK during the next oil shock.

The key for Asian liquids-based producers without either of the above must surely be maximising feedstock flexibility.

This flexibility could include cracking more liquefied petroleum gas (LPG).

LPG should be in abundant supply once liquefied natural gas (LNG) demand is booming again on higher oil costs and rising environmental concerns.

LNG producers either extract the gas during initial processing or leave it in the LNG to be taken out at re-gasification terminals.

Whatever are the solutions, they need to be found and found quickly if surging stock markets are proof of a quicker-than-expected economic recovery.

Source of picture: The Nymex

To continue the same theme of earlier this week, I agree with my fellow blogger Paul Hodges when he warns that OPEC's price target for $75-80/bbl could nip the nascent economic recovery in the bud.

As he quite rightly argues, inventory building ahead of further crude rises in 2007-08 occurred despite evidence of slowing end-use demand for chemicals.

A recent Lex piece in the Financial Times calculated that crude prices averaged around $100/bbl last year. With the world consuming a total of $88m bb/day this therefore cost the world economy $3.200bn.

When the article was written earlier this month, prices were averaging around $50/bbl which would for the whole of 2009 represent a saving of $1,600bn.

This is more than the total of all the government bailouts - $1,600bn - and the bailouts are one-offs rather than the constant savings resulting from cheaper crude.

This year's crude bill looks likely to be more expensive that had seem the case in early May, though, as a result of oil around $60/bbl, assuming it stays around this level (one hell of a big assumption but hey, why not, the rest of the media has become adept at turning a short-term trends into a long term outlook).

As the excellent Schork daily oil and gas report points out, oil and gas inventories remain at record highs.

But traders are ignoring the underlying long term trend in favour of putting a positive spin on recent relatively minor reductions in stock levels.

As the report points out, it's all about market psychology:

What started out as a bear market rally in equities
back in March is now in the process of morphing
into a full fledged rally. Sidelined money,
disgruntled and dismayed that it has missed the
bull's party of the last two months, is now
reluctantly piling back into the market. Some of
this money is finding its way onto the NYMEX.
The Street has convinced itself the recession is
over. Two months ago traders were buying
because they wanted to "participate" in the
equities rally before the bear market resumed.
Today these same traders are spinning a dubious
fundamental case because dour economic
headlines, which the market receives nearly daily,
are less bad. Thus, the crude oil bulls have
hitched their wagon to the equities. And, they are
going to continue to do so until it stops working
for them.

I remain convinced this is just about market psychology and the economic news is going to get worse before it gets better - so prepare for a lot more volatilty in energy pricing.

A sharp dip in crude would help inject some more much-needed cash into the world economy.

But - again as Paul Hodges points out - if crude does reach the OPEC target of $75-80/bbl this will at least encourage some of the investment necessary to lessen the supply crunch when the economic recovery has conclusively arrived.