By John Richardson
HOW long a recovery lasts is always relative to your investment horizons.
For example, if you are a day trader in the Dalian Commodity Exchange’s futures contract in linear low-density polyethylene (LLDPE), a rebound might only need to last 24 hours for you to make money.
And if you are trading in the physical PE market in China right now – where import prices rose by $10-20/tonne for the week ending 10 February according to ICIS assessments – all seems good compared with a very-weak Q4 2011. This marked the fourth week in a row during which pricing has edged up.
But for producers, who of course have a longer-term time frame, it is far too early to say with any degree of certainty that this recovery is going to last long enough to make up for ground lost in the fourth quarter of last year.
Chemicals analysts are notably bullish. Take BNP Paribas, in a report released last month, in which the bank saw margins for the ethylene chain, and petrochemicals in general, bottoming-out in Q1.
“Since April 2011, chemical margins have declined, further falling in November and December 2011 to levels last seen in early 2009 as apparent demand fell sharply on tight monetary conditions in China, “wrote the analysts.
They attributed this decline to the bursting of the underground banking bubble, a slowdown in the Chinese property sector and growing uncertainty over global economic growth prospects.
“We believe that product spreads are likely to bottom in Q4 2011 and Q1 2012 and could stage a gradual recovery from Q2 2012, although a meaningful margin recovery is only likely in H2 2012. Our reasons for this moderately bullish view are:
*Chinese policymakers are likely to return their attention to growth now that inflation is no longer the overwhelming concern. BNP is forecasting 15% lending growth and a 150 basis point reduction in bank-reserve requirements in 2012.
*Chinese apparent consumption could rebound strongly, with apparent demand of ethylene having grown just 0.5% in 2011, indicating a large degree of destocking as historical demand growth has closely matched GDP (gross domestic product) growth.”
And Morgan Stanley, the investment bank, famous for coming up with the SuperCycle theory for petrochemicals in November 2010, has once again turned bullish.
The underlying growth of Chinese PE demand has been hugely underestimated because the distorting effects of inventory build-ups have not been taken to account, writes Morgan Stanley analyst, Vincent Andrews.
For example, China Petroleum and Chemical Industry Association (CPIA) data for January-November 2011 shows a 2% fall in demand when, in fact, it increased by 15% in the same timeframe, he adds.
Both banks are equally upbeat over the longer-term prospects for growth in China. For instance, to again quote BNP, the same report says: “Over the medium to long term, we remain positive on the sector due to limited capacity additions and the structural growth story in China, making chemicals a play into the Chinese consumer.
“Our analysis of 24 major chemicals indicates a tightening supply/demand balance for the majority of products over the next three years, provided that global economic growth remains on track at 3-4% per annum.”
Sometimes, those who trade in chemicals shares can also have a short investment horizon – meaning that they buy and then sell before growth patterns, beyond, say, a month or a quarter, become apparent. This makes longer-term forecasts, such as the one above, irrelevant to them.
But as we said, producers have to worry about the longer-term. The crux of their problem is that while what the chemicals analysts say about the rest of 2012 – and the next 2-3 years – has strong historical logic, there are no guarantees that history will repeat itself.
Everybody seems to agree that new global supply additions are few and far between.
For instance, BNP adds: “In terms of supply, we believe that we have passed the peak of new cracker additions in 2010 and 2011, where we estimate that 15.4m tonne/year of new ethylene capacity was added, equivalent to average supply growth of 6% per annum in those two years.”
“Over the next four years, we estimate average annual ethylene capacity additions of 3.5m tonne/year, less than our estimated demand growth of 4.9m tonne/year, allowing for a gradual improvement in cracker margins.”
But the more you think about the Chinese economy, the more the future becomes as murky as the air in Beijing during a day of bad particulate pollution.
Michael Pettis, a finance professor at Peking University’s Guanghua School of Management, has long-argued that eventually China’s investment growth model will have to change if the country is to avoid a bust.
That is fine, not a problem, if you believe that China’s 12th Five-Year-Plan (2011-2015), the biggest set of economic reforms in at least a generation, will effectively be put into place: The plan involves major structural changes to achieve a big rise in consumer spending.
But will the Five-Year-Plan, in its current form, survive the leadership transition? All of China’s top leaders are due to be replaced in a process that begins in November this year and concludes in 2013.
And what about resistance from vested interests who want to maintain the current growth model?
These include local government officials, who have reportedly made vast sums of money from acquiring agricultural land at knock-down prices and selling the land on to developers.
Local government land sales are also vital for the revenues of the provinces and cities. So, if China does stick with its policy of reducing new investments in real estate and export-based industrial capacity, a new source of revenue will need to be found for the local authorities.
Incredibly, 16,000 to 18,000 government officials and executives from state-owned enterprises (SOEs) stole $123bn of public funds between the mid 1990s and 2008, says The Economist, quoting data from the People’s Bank of China.
This gives statistical weight to the argument that the well-connected have strong motives to resist change.
But the longer the current system stays in place, the more the threat from social unrest – and from bad debts, which are already a challenge to China’s continued economic success.
Economists have a terrible record in predicting recessions, as their models are often based on the future being the same as the past. In 1929, for instance, the Harvard Economic Society declared that a depression was “outside the range of probability”.
Has China reached one of those economic tipping points where long-term growth could easily decline as much as maintain its historic strength?
Chemicals producers can only be sure about new supply additions, and not that the answer to the above question is, without doubt, a “No”.