Chemicals & The Economy

'When I use a word,' Humpty Dumpty said, in rather a scornful tone, 'it means just what I choose it to mean -- neither more nor less.'

This quotation from Lewis Carroll's great novel 'Through the Looking-Glass' rather seems to sum up policymakers' current approach to financial markets. Two recent examples highlight the issue:

• Cyprus. Last month, we were assured that the capital controls introduced in Cyprus were only 'temporary' and would be lifted within days, or maybe a few weeks. But last week, the Governor of the central bank changed his mind. Instead, they will be lifted "as soon as possible". And the criteria for lifting is he needs to "make sure that trust in the banks has recovered sufficiently". That rather sounds, to the blog at least, as though it could be a decade or more before people are allowed to move their euros around freely again. As Reuters notes, the 'temporary' controls imposed by Argentina and Iceland are still in place years later.
• Japan. Also last month, the G20 Finance ministers issued a statement noting that "Japan's recent policy actions are intended to stop deflation and support domestic demand". Nothing about devaluation in order to boost exports. But after pausing in its downward spiral whilst the meeting took place, the currency has resumed its fall and has now passed the $1: ¥100 level. This is already a 27% devaluation since the Abe government arrived.

The blog will continue to keep a close eye on developments, particularly with regard to the Japanese yen. Its link to a potential bursting of the oil price bubble is too important to ignore.

Sometimes a picture really is worth 1000 words. This is certainly true with the above chart, showing China's producer price index since 2008:

• It highlights prices up 10% at the peak of the export boom, before the H2 2008 crash
• Then it shows the short-lived recovery after China's massive lending boom
• Finally, we see how over-capacity is now leading to consistent deflation
• Even the pre-Party Congress lending boom of May-October 2012 has now lost its effect

This is the problem with economies built on liquidity and external stimulus. When these supports finally end, domestic consumption is unable to fill the gap. As the Wall Street Journal notes:

"Producer prices--a measure of prices of goods before they reach consumers--dropped 2.4% in April, the sharpest decline since October, paced by particularly steep falls in the metals and chemicals sectors. That could add to concerns about slowing Chinese economic growth, say economists, because falling producer prices makes it tougher for producers of industrial goods and commodities to make profits, pay off their debts and pay their suppliers on time."

Japan has faced the same problem for 20 years. It has tried to maintain economic growth via exports and its own lending/stimulus programmes. But they have failed, just as China's have failed. And just as those of the West's are also failing.

A much better route is to accept that the world has changed, and instead develop the economy in a new direction. This policy avoids the wasted investment in capacity that will never be used. And it avoids piling a burden of debt on younger generations, which they will never be able to repay.

The same point is made in a different way by Prof Stéphane Garelli, the head of the World Competitiveness Centre at Swiss business school IMD as follows:

"Today very few countries are still closed to world competitiveness. There are some obvious candidates such as North Korea, Myanmar, Cuba and Iran. But even if they do open up fully, none of them will reshape global competitiveness like the post-1989 generation did. As the global market increasingly shifts from being a "first buy" economy to a "replacement" economy, competitiveness will develop more slowly.

Growth will depend more on technological innovation and better skills than on accessing cheap factors of production in uncharted lands. This will imply more time to see results, and a new mindset. As the French writer Paul Valery put it, "the problem with our times is that the future is not what it used to be..." The last 25 years of competitiveness were exceptional, even epic. But now we should turn the page, and work on a 'new normal'."

The 25 years of the BabyBoomer demand supercycle between 1983-2007 cover the careers of most people in the industry. Over this quarter-century, we all grew to accept that low-cost and reliable supply was key to success. Demand would always take care of itself.

Today's world is the opposite. Low-cost supply is no longer enough on its own, as growth has become hard to find. Instead, focusing on demand is now critical for success. And understandably, companies find it very difficult to adjust to this quite different world.

Developments in US shale gas provide the best example of the mindset change that is required:

• The US now has some of the lowest-cost ethylene supply in the world
• It also has all the necessary expertise and infrastructure to monetise this
• The problem is that it needs demand to increase
• And in today's low-growth world, this is very hard to achieve

The chart of US polyethylene (PE) exports highlights this core issue. It is the largest ethylene derivative, yet Q1 net trade data from Global Trade Information Services shows export growth is very slow:

• 2013 exports (blue) have recovered from 2012's slowdown (when outages reduced capacity)
• But they were up just 5% versus 2011 (red)
• The important Asian export market is also now much reduced
• China continues to invest in new capacity, as does SEA
• Latin America is the only real growth area, up 34%, but the outlook is uncertain
• It is building new capacity, whilst its growth is slowing in line with China's slowdown

Of course, some argue that producers in high-cost regions such as China and Europe will shutdown and import product instead. But the blog has written many expenditure proposals in its time, and none have ever been dependent on competitor closures for success.

The reason is that experience shows existing capacity has a tendency to survive for much longer than anyone expects. Thus payback periods can become very hard to predict. And in the case of China, profit has never been the key driver for its own capacity expansions. As the blog's study of Sinopec's accounts since 1998 highlights:

• Its EBIT earnings have never covered its capital expenditure costs for chemicals
• Its role, being 76% state-owned, is instead to be a reliable supplier of raw materials to the factories to keep people employed
• In turn, this enables the communist party to ensure people's living standards increase
• This then enables the party to remain in power

PE thus highlights the key issue as we transition to the New Normal. Ageing western populations cannot maintain the steady demand growth of the SuperCycle, when they were younger.

Of course, low-cost supply will always be important for profit. But as PE shows, the real key to success in the future will be understanding demand patterns.

Q1 data from Global Trade Information Services provides further evidence of the slowdown underway in China. As the chart shows, the dramatic drop in net PVC imports suggests the new leadership are determined to burst the house price bubble they inherited:

• Imports (red column) were down a startling 98% versus Q1 2011 (blue)
• NEA imports were down 29%, NAFTA down 24% and Europe down 63%
• SEA saw its net export position replaced by imports
• The FSU also saw imports from China up 97%

Similarly US exports dropped 31% versus 2012, reversing the previous trend of volume gains due to shale gas cost advantage.

PVC is thus reinforcing the message given by the head of China's central bank, Zhou Xiaochuan, who emphasised last month that:

"China is undergoing economic restructuring, which sometimes is not in lockstep with growth. We need to sacrifice short-term growth for the purposes of reforms and structural adjustments."

It is giving a clear warning that China's economy may well be following the pattern of 1993, as its leaders crack down on corruption and housing markets.

Friday provided a good test of the blog's analysis that Japan's aggressive policy of devaluing the yen could result in major downward pressure on crude oil prices:

• The yen crashed through the $1: ¥100 level, ending at a 4-year low of $1: ¥101.6
• Brent sold off by $2.80/bbl, only recovering after Asian markets closed for the weekend

Hedge funds have already woken up to the new profit potential that is developing. Thus Bloomberg reported the head of one large New York fund commenting "the inverse correlation between the dollar and the commodities is alive and well".

The chart shows the 180 degree change that has taken place since March:

• Until then, all the main financial markets had continued to move together, in the 'correlation trade' financed by western central bank liquidity
• But then the potential impact of Japan's devaluation policy became obvious to major players
• A lower yen means a stronger US$ - hence no need to buy commodities as a 'store of value'
• Today Brent (blue line) and naphtha (black) are both down over 5%, whilst the dollar/yen (orange) and S&P 500 (purple) have risen over 10%

As Mizuho Securities noted, "commodities are taking a hit because the dollar is rising".

Of course, it is still too early to be sure that crude will indeed crash out of its current trading range and revert to historical price levels below $30/bbl. Equally, markets never move in straight lines, downwards or upwards. But if one waits for proof, it could well be too late to do anything about it, as the blog warns in its new Research Note.

Critically, however, in terms of the fundamentals, US oil inventories remain at 82-year highs and supply is at 21-year highs: whilst forecast global demand growth this year is just 800kbpd.

Two other highly relevant points have also surfaced in recent days:

• Prof Martin Feldstein, President Reagan's economics head, has called the Federal Reserve's liquidity programme "a dead end". He calculates its $2tn of new debt has raised consumer spending by less than 0.3% of GDP per year, adding that "the evidence suggests that the QE programme hasn't worked"
• At the same time, the IMF has warned that US pension funds have piled into commodities and other risky assets in a desperate "gamble for resurrection". It estimates their current shortfall at 28% - meaning they do not have enough reserves to pay current pension obligations. And it adds their issue is "solvency not liquidity"

Naïve pension fund trustees have thought 'investments' in crude oil and other commodities would enable them to avoid raising contribution rates or restructuring benefits. If prices now start to fall, they will have no alternative but to sell quickly, at whatever price is available in the market, in order to salvage what they can.

Meanwhile in Europe, further evidence of the impact of today's failed policies in the real world emerged with the announcement of a proposed merger by INEOS and Solvay, Europe's two largest PVC producers. This follows a 30% fall in PVC demand, and Kem One's entry into administration in March. When first-class management teams like these are struggling, markets are clearly in very bad shape.

Benchmark price movements since the IeC Downturn Monitor's April 2011 launch, and latest ICIS pricing comments are below:
Naphtha Europe, down 25%. "The prompt naphtha market has become balanced as a result of the 1 million tonne movement to Asia"
PTA China, down 21%. "Market outlook remains uncertain because of the volatility in crude futures and uncertainties over China's manufacturing sector"
Brent crude oil, down 18%
HDPE USA export, down 17%. "Global export demand remained somewhat soft"
Benzene NWE, up 6%. "Prices ebbed and flowed alongside crude and benzene values in Asia and the US"
S&P 500 stock market index, up 20%

The importance of demographics in driving demand is clearly becoming more widely understood.

This week, the blog was interviewed by the editors of MoneyWeek (the UK's leading investment magazine) in the implications of today's ageing western population for investors.

The interview covered a wide range of subjects:

• The importance of 2013 as the year that the average BabyBoomer turns 55
• The outlook for economic growth and interest rates
• How major companies such as Unilever and P&G have adapted to today's New Normal world

Please click here if you would like to see the interview (which starts at 7 minutes).

Blog readers read it here first. Last month the blog did some simple sums to show that US auto sales were unlikely to continue to grow at the 8.6% reported rate of Q1. The reason was that sales had been increased by the need to replace the 250k autos destroyed during Hurricane Sandy in November.

As the chart shows, April's figures confirm the blog's analysis:

• 2012 sales (red square) failed to maintain Q1's momentum
• The seasonally adjusted annual sales rate fell below 15m for the first time since October
• As analysts Ward's note, "April's 4.1% rise in daily sales was the smallest year-over-year gain since August 2011", and they add
• "It marked the fifth consecutive month that year-over-year sales growth has declined"

Equally, as the Wall Street Journal notes, "nearly four years since the recession ended, the pace of expansion remains grindingly slow". And whilst last week's US jobs report was viewed as positive by financial markets, it was of course taken before the impact of the sequester began.

The blog thinks it unlikely that the $1.2tn sequester-based cuts now underway in Federal spending will support increased consumer spending over the rest of the year. It is far more likely that households will spend less, and save more, in case their own jobs become threatened.

Q1 auto sales growth, assisted by the after-effect of Sandy, may well therefore turn out to have been the strongest of the year.

As the blog discussed yesterday, central banks have now kept oil prices above the historical $10-30/bbl range for 10 years.

But can they remain there forever?

What might bring them back in line with the fundamentals of supply/demand? And what would be the risks if this happened?

The background can be simply stated:

• Investors have bought crude oil futures and other assets on a 'buy and hold' basis
• Some, according to the IMF, have up to 25% of their assets invested in this way
• So normal supply/demand fundamentals have become irrelevant
• Thus oil markets have lost their price discovery role

Logic therefore suggests that repricing will most likely occur when investors decide they no longer need a 'store of value'. And this may be about to happen:

• The Bank of Japan's (BoJ) new policies have begun to reassure investors on this critical point
• It clearly aims to devalue the yen, which would boost the US$ again
• The US$ has already risen from its low of $1: ¥77 to $1: ¥100
• Many expect it to rise further to $1: ¥120 or more, as Japan tries to kick-start economic growth

It was therefore not coincidence that prices of oil, copper and gold all fell by 10% following the BoJ's announcement last month. The risk is that more falls may now be on the way. Investors never knew, or cared, about their impact on the real economy when they bought their 'stores of value'. They will also not care about their impact when they sell these positions.

Even more importantly, there will be no warning in terms of the fundamentals. These are already signalling lower prices and a return to historical levels. Therefore prudent companies need to take time now to review how they would manage this critical risk, if serious disinvestment by the investment funds does begin to occur

The problem is that investors can simply sell their futures contracts at the press of a button. But companies cannot do this with their inventories and work-in-progress. Equally, if prices did start to fall during a period of weak demand - say over the summer months - it could become very difficult to avoid a panic.

Boards may understandably feel that there is no more than a 10% risk of this situation developing. But seemingly low probability risks can happen, as we saw in Q4 2008. And unprepared companies can, as then, easily go bankrupt as a result.

We are in very dangerous times. Prudent executives will therefore want to spend time today planning in advance how they would cope with such a crisis.

ADDITIONAL FREE RESOURCES
The blog's new Research Note focuses on this critical question. Please click here to download it. A video interview with Will Beacham, deputy editor of ICIS Chemical Business, is also available by clicking here.

Since 1900, as the chart shows, oil prices have never been so high for so long as now. Until 2003, they had only been above $30/bbl for 4 years between 1979-1982, during the OPEC production cuts in the Iran crisis. But since 2004, they have been continuously above this level.

The reason is the misguided stimulus policies of western central banks, which aimed:

• Firstly to support US/European housing markets until the sub-prime lending crisis of 2008
• Secondly to enable a speedy return to full economic recovery since then

The 2004-8 period boosted consumer demand well beyond sustainable levels, causing inflation to rise quite dramatically. Thus when the second stimulus programme began in March 2009, investors were well prepared. They rushed to buy 'stores of value' - commodities such as oil, copper and gold, all priced in US$ - as well as equities. They also worried that the US Federal Reserve aimed to devalue the US$ to boost US exports and economic gtrowth.

Unfortunately for all of us, this pushed oil prices back up to unsustainable levels again. But this time, due to the financial crisis, there was no demand surge. Instead, as credit was no longer easily available, people had to cut back spending. They had to heat their homes and fuel their cars, so they had less to spend on the areas that would drive demand growth.

The result has been two-fold:

• Supply has leapt. 10 years is long enough for most oil companies to 'forget' previous history, and to invest in new output on the basis that $100/bbl prices are now 'normal'
• Thus US oil production has reached 7mbd, a 20-year high, and is still increasing. Other sources are also booming, whilst shale gas is gaining major market share
• Demand growth has been weak. Prices in US$ were at record annual levels in 2011-12. In other major regions such as Europe and China they have been at all-time record levels
• Inventories are at record levels in many parts of the world. In the US, for example, they reached an 82-year high last week

Normally high inventories, increasing supply and low demand growth would not lead to record high price levels. But these have not been 'normal' times. Tomorrow, the blog will discuss the risk that oil prices might now fall rapidly back to historical levels below $30/bbl.

ADDITIONAL FREE RESOURCES
The blog is today publishing a Research Note on this critical question. Please click here to download it. A video interview with Will Beacham, deputy editor of ICIS Chemical Business, is also available by clicking here.

Central bankers mean well. But, of course, good intentions do not guarantee good results.

Their intention since the start of the 2008 crisis has been to boost financial markets. They have therefore provided $tns of liquidity, which has indeed produced record highs in major stock market indices such as the S&P 500 and Dow Jones Industrials. As Ben Bernanke, Chairman of the US Federal Reserve said in January 2011:

"Policies have contributed to a stronger stock market just as they did in March 2009, when we did the last iteration of this. The S&P 500 is up 20%-plus and the Russell 2000, which is about small cap stocks, is up 30%-plus."

The problem is that there is no clear link between developments in financial markets and the real economy. As the Washington Post notes, only the wealthiest 10% of the population own large amounts of stocks. Their retirement accounts are worth an average $277k. But middle income families have just $23k in their accounts, and poorer people nothing at all.

So record highs in stock markets do nothing to boost consumer spending for the vast majority of people. Whilst on the negative side, of course, record high oil prices actually reduce their spending. People have no choice about paying higher prices to heat their home and fuel their cars. So they have less to spend on everything else.

The chart of benchmark prices shows the result since the start of 2013:

• The Fed's QE3 liquidity programme has taken the S&P 500 (purple line) up 10%
• But European prices for naphtha (black) and benzene (green) are lower
• China's prices for PTA (red) are also lower
• And Brent oil prices (blue) are down 8%, as consumers reduce spending
• Only US polyethylene export prices (orange) are up, and by just 2.5%

The break in the correlation between Brent and other financial markets could well prove highly important, and dangerous to company finances, as the blog will discuss tomorrow.

But this is not something that will worry the central banks until it is too late. For the moment, they are popping the champagne corks as their stock market bubble continues to inflate.

Benchmark price movements since the IeC Downturn Monitor's April 2011 launch, and latest ICIS pricing comments are below:
Naphtha Europe, black, down 26%. "Oversupplied market is finding some relief in what industry players described as a surprising appetite for naphtha in the Asian export market"
PTA China, red, down 23%. "Polyester demand slowed slightly this week because of the 3 day Labour Day holiday"
Brent crude oil, blue, down 18%
HDPE USA export, orange, down 18%. "Traders still waiting for producers to offer lower prices for May."
Benzene NWE, green, up 4%. "Output had been curtailed throughout Q1 owing to low prices amid weak end user demand."
S&P 500 stock market index, purple, up 18%