Chemicals & The Economy

Germany is the powerhouse economy of Europe. Its also a late-cycle economy, relying more on engineering and equipment sales than consumer spending. So until recently, its growth has seemingly not been affected by the global slowdown. But Germany's Chancellor, Angela Merkel, indicated yesterday that a 'significant fall' was likely in economic growth next year.

Industrial production, a key indicator for the chemical industry, fell by 2.4% in May - the largest drop in a decade. And in a comment that will find echoes in many boardrooms, Merkel added that 'the economic context in which we are operating is certainly not getting any easier'. Her forecast that a 'clear economic slowdown appeared unavoidable' is rapidly becoming a consensus view.

Europe is the world's largest auto manufacturer, accounting for 32% of the global market. So news that European auto sales fell 8.3% last month, compared to 2007, is worrying. Italy's sales fell 20%, and were today described as 'disastrous' by CEO Sergio Marchionne, who announced that 4 of their 6 plants will shut for 3 weeks later this year. Fiat's truck plant will shut for 6 weeks, due to lack of demand. Spain was even worse, with sales down 31%. Whilst Irish sales halved.

The situation has echoes of how US auto sales began to fall away this time last year. Last August, I noted how the US majors were starting to report a fall in consumer confidence. Similarly ACEA, the European manufacturers association, is now warning of 'difficult economic circumstances' in its latest monthly report. The auto industry is a very important market for chemical sales. This new trend towards falling home market sales is therefore not good news for European chemical companies, already facing a difficult H2.

I suppose when an industry has lost $400bn in a year, some sacrifices have to be made. In May, I documented how Deutsche Bank was no longer approving expense claims for 'adult entertainment'. Well, things have got worse since then, as the losses have continued to mount:

• Goldman staff have to contribute to repair costs for their Blackberries, if the damage is their fault
• UBS bankers in the US now fly economy if the flight is less than 5 hours
• Several banks are asking staff to use taxis rather than limousines

And the C-suite are also setting an example. After a record 4 consecutive quarters of losses, Merrill Lynch executives now have to 'seek clearance from the global head of investment banking' before using private jets.

The current downturn is different from anything that has occurred in the last 15 years. Policy makers are clearly worried. The UK's Finance Minister, Alistair Darling, told Bloomberg today that 'the effect of what has happened is going to be far more profound than people predicted at the start of the year'. He added that 'conditions have become much worse across the world'.

Noting that banks have already had to raise $324bn in new capital, Darling warned that `I don't think anyone would be wise to start speculating on how long the present difficulties will last. We are dealing with them here (in the UK), and other countries are dealing them as well. If you look at the problems the banks have had, they have moved into a different phase and governments have to take account of that.'

A new debate about increasing US energy security, by reducing gasoline dependence, may be getting underway. Leading the move is Andy Grove, the man who made Intel into the leading global chip company. His key phrase, and the title for his 1996 book, was 'Only the paranoid survive'. Now he is taking this approach into the energy sphere, commenting that the US may end up 'starving to death economically', if nothing is done to reduce US gasoline consumption.

Grove's focus is on developing electric cars that can cover 40 miles (65km) before switching to gasoline. He is calling for 10 US million vehicles to be converted within 4 years. And he already has some powerful backers, in the shape of the big Silicon Valley venture capital firms who helped power Intel to its current $38bn of sales.

I suggested at the weekend that the Iran issue had the potential to move oil prices by $50/bbl either way. Since then, prices have fallen $20/bbl to $130/bbl, on news that the USA and Iran will meet tomorrow for the first time in nearly 30 years. If they reach agreement on the nuclear issue, oil prices will almost certainly fall further, as the threat to exports via the Strait of Hormuz is removed. Alternatively, if diplomacy fails, any bombing by Israel of Iran could easily cause prices to soar to $200/bbl.

Maintaining price hedges against both outcomes therefore seems the right strategy for chemical companies, given this uncertainty. If prices do fall further, working capital will take a major hit, as stocks are revalued downwards. Current price initiatives will probably also collapse. Equally, if bombing does take place, and oil prices jump in response, it is most unlikely that these higher costs will be quickly recovered in product prices.

Andrew Sentance of the Bank of England has issued a very clear analysis of current oil and commodity price movements. It rejects the view that these have been primarily caused by speculators. Instead, it points to increasing demand, and lack of supply, as the main causes of today's higher prices. The slide above sums up his case, showing recent increases in non-OECD oil demand in light blue, the OECD increase in dark blue, and supply increases in purple.

The diamond shape (◊) shows total demand, which has run well ahead of supply until this year. And today's supply/demand balance, is only due to the demand destruction caused by higher oil prices in OECD countries. Non-OECD demand continues at similar levels to 2005-7, due to subsidies. Sentance analyses the situation as follows:

• Investment in non-OECD countries tends to be in capital goods and new building work, 'which require large amounts of materials and energy'.
• Consumers in non-OECD countries spend more of their income on physical products, whereas OECD consumers purchase more services.
• The fall in energy prices between 1986-2003 discouraged producers from 'investing strongly in new capacity', or in developing alternatives.

Sentance concludes that it is essential to bring inflation back under control. He says central banks must now raise interest rates to 'squeeze spending and incomes', even though this will have adverse 'consequences for economic growth and employment in the short term'. Those preparing 2009 Budgets might want to include this Scenario in their planning.

Yesterday's US government data on gasoline consumption gives the clearest picture yet of what is happening to US demand. The data compares the 4 weeks covering the July 4 Independence Day weekend, with the same period last year. And it shows gasoline demand was down just 2.1%, even though oil prices have doubled since last year. Demand still averaged 9.3 mbd, about equal to Saudi Arabia's total oil exports. This tends to confirm the argument that US demand is relatively inelastic, in the absence of a major economic recession.

Last September, I wrote to the Financial Times on the subject of the US sub-prime disaster. At a time when many banking commentators were trying to minimise the problems, I suggested that 'a "buyer of last resort", such as the Federal government, would probably need to emerge if this situation is to be stabilised'.

Yesterday, 10 months later, the government took a major step in this direction with its emergency measures to support Fannie Mae and Freddie Mac. Between them, these two lenders guarantee 47% of all US mortgages, worth $4.8 trillion. That sum is equivalent to 10% of global GDP, or more than the combined size of the French and UK economies.

This lending is supported by just $70bn in core capital. And according to Barrons, the leading US investment magazine, their total borrowings are leveraged 68-to-1. With US house prices already down 16%, its no wonder Bill Poole, a Fed Governor till last March, has said they may already be 'technically insolvent'.

At the moment, Congress is still balking at the size of the bailout underway. But I think Poole was right to say yesterday that Fannie and Freddie will be 'de facto nationalised'. They really are 'too big to fail'. But this process will take a long time, probably till after November's elections. In the meantime, chemical demand will suffer as US housing remains weak, and financial markets fragile.

Oil price movements are now dominated by the Iranian nuclear issue.

Last month, they jumped $10/bbl to $146/bbl as news leaked of Israel's training exercise against Iran's nuclear sites. I've since talked to someone who was on holiday in Southern Greece at the time, and he says it was an amazing sight - the sky was apparently filled with planes.

Early last week, prices fell $10/bbl as news agencies headlined Iran's leader saying 'There won't be war'. But his actual comments made it clear that he wasn't backing down. Rather, he was arguing that the US/Israel were bluffing, and calling the threat of an attack a 'joke'.

And then prices rose $10/bbl again. First, Iran fired missiles which it claimed could reach Israel. Then the Jerusalem Post carried reports from the Iraqi Defense Ministry that the Israeli air force had been using US bases in Iraq in further training exercises.

Continue reading "Oil prices - the Iran factor" »