The Chemicals “Recovery”: Seeing Through The Flawed Logic

PEAsia27April

By John Richardson

AROUND 90% or more of the price movements in most chemicals and polymers are tied to crude oil.

Add to that the pick-ups in buying than can occur from time to time, based on supply and demand factors specific to particular chemicals markets, and you end up with a devilishly difficult job in trying to assess what “real demand” is at any particular point.

The problem is that, of course, end-users stock up on their raw materials, sometimes well beyond their immediate needs, when they think that oil prices will go higher. They can equally be tempted to build-up their inventories if they see further tightness in the chemicals market or markets from which they source their raw materials.

Meanwhile, as these short term rallies take place, it is very easy to lose sight of the longer term fundamentals that can present major risks to the durability of any particular rally. The danger is that as a producer you run your plants too hard or as a buyer you overstock, only to then see oil prices suddenly retreat. This leads to losses on inventories.

“Tell me something new,” you might well say. But there is something new and very important here that you cannot, and, in fact must not, lose sight out and it is this.

  • Making mistakes on inventories for most of the time between 2010 and H2 2014 didn’t really matter that much because oil prices and so chemicals prices moved together, up and down, in fairly narrow bands. So you never lost that much if you either over or under-stocked.
  • This meant that you didn’t have to lose that much sleep over getting “real demand” wrong.
  • But as the events since the second half of last year have illustrated, we are now in an altogether different world.
  • In such a world, it is therefore absolutely vital that today you see through all the flawed logic that is sometimes used to overcomplicate any particular price rally that, in the end, is mainly down to crude. If you do not, you might end up incurring heavy inventory losses, either through running your chemicals plant too hard or by buying too many chemicals because of much-greater volatility in oil.

Here is a great example of flawed logic, which I heard from a polyolefins trader last week: “China’s decision to lower its bank reserve requirement again, for the second time in just a few months, is fantastic news. It means that there will be a flood of new bank lending available for end-users in China.”

What you must do is ignore this kind of flawed logic and assume big risks ahead and build a business plan around these risks, which means a razor-like focus on inventory management.

All the evidence from China points in exactly the opposite direction to what the trader told me. We know that the reduction in the reserve requirement was a defensive move in an attempt to alleviate some of the further pain of economic reforms. An “industrial shakeout” in the second half of this year remains very much on the cards.

And returning to the subject of crude oil, data from the US Energy Information Administration last week showed that crude oil inventories once again rose to at least an 80-year high. Total US oil in storage is now at over 480 million barrels.

But we know that oil markets have ignored this kind of data for the last few weeks. Why? Because the majority of traders in crude are betting that the fall in the US rig count will soon result in a sharp decline in US production. This has driven oil prices higher rather than lower.

The speculators can easily move in the opposite direction, however, and so take note of today’s Wall Street Journal, which wrote the following:

Money is pouring out of a popular investment tied to the oil market, a sign that a month-long crude-price rally may be running out of gas.

Exchange-traded funds (ETFs) that invest in US oil futures, including the $3.1 billion United States Oil Fund LP, have registered about $2.7 billion of investor outflows this month, according to investment bank Macquarie Group Ltd.

That reverses an inflow that started in January as oil prices tumbled. These ETFs took in roughly $6 billion this year through mid-March, when the U.S. oil benchmark hit a six-year low, according to Macquarie.

Traders and analysts are closely watching weekly production and demand data for signs that the global glut of crude oil that sent prices swooning last year may be shrinking. They are also watching the ETF trends closely, because they say crude prices are vulnerable to a pullback following a 32% run-up since March 17.

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We also know that yesterday’s wisdom about “fracking economics” is completely wrong. The breakeven prices for US shale oil producers is getting lower and lower as the pace of innovation accelerates. This could well result in US production being a lot higher for a lot longer than some people expect.

None of this extra supply would matter if global demand for oil was robust. But why is global demand for oil not robust? Because of China.

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