Chemicals & The Economy

The good news from the latest reports on US house prices and auto sales was simple - things have stopped getting worse. US house prices saw "some stabilisation in some regions" according to the S&P/Case Shiller Index for April. Whilst auto sales are clearly bouncing along the bottom, down "only" 29% in June versus May's 35% decline.

The bad news in terms of house prices was that the decline is really only just getting underway in some key markets. Chicago and New York, for example, "posted record annual declines in April", and are now down 19% and 13% respectively. By comparison, Phoenix, the worst market, was down 35% versus last April, and 54% from the 2006 peak.

Anecdotal evidence from the blog's recent New York visit certainly suggested that the city's bankers are only now beginning to sell up. Initially, those newly unemployed in Q4 had held on to property, believing that they would quickly find new employment. But now cash is getting tighter, and H2 may well see more homes up for sale.

The auto market is also showing diverging trends. Ford seems to be on a bit of a roll, as the chart shows, even though its sales were down 11%, and it claims to be reducing price incentives. Other producers fared less well, with Chrysler having to increase its incentives by up to $750.

The other good news is that auto inventories are also coming down, due to the recent plant closures. Ford is actually increasing Q3 production by 25k vehicles, having dropped inventory by 214k since last June. GM has also reduced stocks by 206k over the same period. This should certainly help hard-pressed chemical and polymer suppliers.

Capacity closures are always hard to achieve in the petchem industry:

• First, these are a 'zero sum game' - if I shut my plant, then other producers gain in terms of overall operating rates and margins, at my expense
• Secondly, there is the integration issue. Closing a consuming plant also impacts output from an upstream plant, and may make it unviable

Dow Chemical's announcement of US capacity closures reflects this underlying logic. By shutting downstream consuming plants, and an ageing cracker, Dow will align its overall US ethylene balance. It will no longer purchase ethylene in the merchant market. Dow is therefore passing on the pain of any necessary upstream closures to its suppliers.

But Dow also added a wholly new dimension to the debate, when Brian Ames, Global Hydrocarbons Business director, spoke to ICIS' Nigel Davis. His comment, no doubt carefully prepared, was that US capacity had to shut because "demand overall is lower than it used to be".

The blog shares Ames' view. US exports must suffer, in spite of the Gulf Coast's ethane advantage, as major new capacity arrives in the Middle East and Asia. Equally, there must be doubts about underlying US demand, unless housing and autos recover quickly to their former levels.

Dow's moves are therefore likely to prompt further debate about how to best manage capacity closures during depressed market conditions.

Last month, the blog introduced its new Boom/Gloom Index, designed to track sentiment in financial markets. The chart above now updates it to reflect the whole of June.

The Index has continued to move up, and is close to the levels last seen in October 2007. Equally remarkable is the performance of the Green Shoots Index, which has hit another all-time high. There is little doubt that the performance of the two indices is related. Investors clearly want to believe that recovery is 'just around the corner', even though there is little hard evidence to support this belief.

Chemical companies have done well in exploiting this improved sentiment. Dow managed to raise nearly $10bn to repair its balance sheet, via asset sales and equity/debt issues. Ineos are well on the way to agreeing new covenants with their lenders. Neither looked easy to achieve before the market began its March rally.

Now, of course, comes the hard part. Will the current restocking process turn into a real recovery? The blog maintains its doubts, and fears the green shoots may wither to become yellow weeds.

Germany and China have benefited massively from the growth in world trade since 1980. As the Wall Street Journal chart shows, 47% of Germany's GDP comes from exports. And China has a 37% dependence. US exports are just 13% of GDP, so it is more self-sufficient.

Both countries have punched above their weight in terms of chemical demand as a result. Germany has been a major auto exporter, a key use for all types of chemicals. Whilst China, as the manufacturing capital of the world, has become a major chemical importer and producer.

But now, with world trade likely "to record its largest decline in 80 years" according to the World Bank, the economies of both countries are struggling. However, their policy responses have been quite different:

• The German government, faced with a 17% drop in exports, has decided to sit out the storm. It is subsidising payrolls, as companies move to short-time working, and supported auto sales, but has refused to introduce more general stimulus programmes to boost the economy.
• China has instead pumped enormous sums of money into its economy, to support GDP. But with exports down 26%, much of this stimulus has gone into building inventories and to finance stock market speculation.

Now China's Banking Regulatory Commission has called for this "explosive lending" to stop, and called on banks to "make sure that loans flow into the real economy".

Unrestrained lending got the world into the current crisis, when Western banks lent recklessly to borrowers who could never repay. Now China is at risk of repeating the same mistake. It creates a real danger, as the Commission states, of a sudden slowdown when bank lending is cut back.

If firms then liquidate their inventory, this could have a major deflationary impact on chemical demand worldwide, particularly if it happens to coincide with a slide in crude oil prices from today's peaks.

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Economic recovery can't come soon enough for Ineos. After 7 months of negotiation, it has finally agreed new covenants for its €7.3bn of debt with its major lenders. These will now be put to all 230 lenders for approval by 17 July. But the price is high:

• Initially, Ineos was paying c2.5% over euro base rates (Euribor)
• Now this premium is to rise to 6.50% on €5bn of loans

The Financial Times estimates that this will cost Ineos €260m a year, as well as €82m in one-off fees.

And in spite of the agreement, bond markets remain nervous about the company's ability to eventually repay its debt. According to Bloomberg, it now costs €6.16m to insure €10m of Ineos debt against default, plus €0.5m a year. In January 2008, the upfront cost was just €716k, with no annual payment.

Yesterday's financial market action was very revealing. As Olivier Jakob of Petromatrix perceptively describes it, "liquidation on gasoline led to a correction in crude oil, which in turn pressured equity markets".

The problem is that financial markets now seem to be in circular mode:

• Speculation about tighter oil markets has led to a belief in 'green shoots'
• In turn, this has led a stunning global equity market rally since March

Yet the "real economy" still seems to be stuck in recession.

President Obama acknowledged today that a second "stimulus programme" may become necessary, as the first has failed to prevent US unemployment rising above the 8% level he had expected. Equally, in a major negative for chemical sales, it was revealed that foreclosures now account for 1 in 3 of every US home sold.

The bulls still insist that oil can reach $80/bbl, and that stock markets are not in just another bear market rally. But yesterday's gasoline weakness is a clear sign that doubts are beginning to appear.

The chemical industry is always a leading indicator of the global economy. One of the blog's oldest friends used to be a central banker, and he made no secret of the fact that our discussions about demand levels were often an important factor in his overall analysis.

So it is no great surprise that the World Bank has issued a rather gloomy new forecast for the world economy. It is now predicting a 2.9% decline in 2009, compared to a 1.7% fall in March. And it is only expecting a modest 2% rebound in 2010.

The Bank also warns that "developing countries are expected to grow by only 1.2% this year, after 8.1% growth in 2007 and 5.9% growth in 2008. When China and India are excluded, GDP in the remaining developing countries is projected to fall by 1.6%, causing continued job losses and throwing more people into poverty."

The great wave of destocking is finally coming to an end. And it is clear that underlying global demand is well below previous "normal" levels.

The evidence for this can be seen in the above chart, based on American Chemistry Council data, which shows global chemical production down 12.8% in April versus 2008. And as Nigel Davis noted in ICIS Insight last week, BASF (the world's largest chemical company), has said that it is "operating worldwide at less than 75% of operating capacity".

The ACC's data covers 33 key countries, who probably have slightly better competitive positions that other producers. Thus a decline of 15 - 20% is probably a reasonable estimate, and would also correlate with the BASF data (as effective maximum operating rates are c95%).

This is not a good starting point as we enter H2. Not only will more capacity be starting up for many products in the Middle East and Asia (particularly China). But also Q3 is normally seasonally slow, whilst year-end cash management is likely to mean December demand will be weak.

The blog's close eye on Scotland's media has again been rewarded this morning, as 'The Scotsman' reveals that Ineos have appointed Morgan Stanley, the investment bank, to advise on the sale of Grangemouth.

It suggests that a company such as "PetroChina could buy the refinery, while Ineos would retain the polymer and petro-chemical processing plants located on the same site". But worryingly from Ineos' point of view, it quotes a PetroChina official as saying that "downstream business has a poor margin nowadays and talks can take a really long time".