Chemicals & The Economy

The moment the blog has long feared, and warned about, may be about to arrive. It appears that we may be about to revisit 1980, when for some weeks it seemed that demand for many petchem products had simply stopped. As Nigel Davis notes in an excellent ICIS insight article, we are not there yet. But the warning signs are building.

As he observes, 'the slowdown in demand growth has until now been masked by supply chain inventories, but those clouds are drawing back to reveal the true situation. Producer stocks are building as the situation deteriorates. Polymer prices have fallen sharply over the past two weeks.'

The causes are the same as in 1980:

• End user demand for polymers is focused on housing/construction and autos. As the blog has chronicled over the past year, this demand has collapsed by 20 - 60%, depending on country.
• The petchem industry, however, has been living in a 'parallel universe'. All down the value chain, buyers were instead focused on buying ahead of likely oil price rises.

As I noted in my radio interview last week, the 1980 experience tells us what to expect. First, buyers have to reduce their stocks to more 'normal' levels. This probably took place in Q3. Now, they have to adjust stocks to today's actual level of demand, which is a lot lower than 'normal'. This process will probably take most of Q4.

I remember 1980 as the scariest moment of my 30 year chemical career. We simply had no idea what was happening to us. If your Board would like to talk about the current situation, and to discuss how to manage it, please contact me. I will be happy to use my experience to try and help.

The blog has given up counting the number of US banks that have failed in recent weeks, away from the headlnes. Ken Lewis, CEO of Bank of America, predicted last month that half of all US banks would fail, and he is well placed to know.

Bank rescues are also rising across Europe. The German government last night supported a €50bn ($68bn) rescue for Hypo Real Estate, the country's 2nd largest real estate lender. Whilst France's biggest bank, BNP Paribas, took control of Fortis Bank in Belgium and Luxembourg for €14.5bn after a government rescue failed. Germany also followed Ireland's example in guaranteeing bank deposits, to avoid further bank runs this morning.

Against this dreadful trans-Atlantic background, the UK government is moving to address one of the fundamental issues. The Financial Times reports today that Finance Minister, Alastair Darling, is considering a taxpayer-funded 'recapitalisation of Britain's banks' as part of 'some pretty big steps which we would not take in ordinary times'.

Darling impressed the blog in August with his realisation that the 'global economy is at a 60-year low'. His move mirrors the successful Swedish response to a similar banking crisis in the early 1990's, which was also caused by a bursting property bubble.

This model only allowed the strongest banks to survive, and GDP still fell by 5% over 3 years. But its use of government money for selective recapitalisation is now viewed 'as one of history's most successful financial system bailouts'.

A year ago, the blog was in a minority of one, with its forecast for 2008. Its heading was 'Budgeting for a Downturn'. By contrast, the consensus post-EPCA was for $70bbl oil, debt market problems to be contained, and for chemical margins to remain at 2007 levels.

This year's EPCA mood was different. There was an acceptance that a downturn was now underway. The only question was whether this would be short, or lengthy. The blog believes it will be multi-year, on the basis that not only are we entering a global economic downturn, but we are doing this at a time when the oil price is high, and when over-capacity is developing in almost every major product area.

As discussed in my ICIS radio interview, it is also clear that a financial crisis is already well-advanced, even before the economic downturn has really taken hold. What will happen if/when major industrial companies crash over the next few years? Experience from the multi-year recessions of the early 1980's and 1990's suggests that this is probably inevitable. We do not know how this will play out, but it is unlikely to be pleasant.

However, experience from previous recessions also shows that 'self-help' is a better policy than simply waiting for 'something to turn up'. The former allows companies to become 'players', and to retain some control over their own fate. The latter leads to the development of a 'victim' mentality, in which apathy develops and critical issues are left undecided.

It is also important to remember that economic cycles have always been a part of life in the chemical industry. The last 4 years have been amongst the best in our history, and we have enjoyed blue skies. So whilst there are now storm clouds ahead, a 3 - 4 year downturn does not mean that the industry will never recover.

Photo courtesy of www.freefoto.com

September was another difficult month for the cornerstones of US chemical demand, autos and housing:

• GM cut prices dramatically via its 'Employee discount for everyone' programme. But even so, sales fell 16% versus last year (blue column)
• Toyota (red column), fell 30%
• Ford (green column) fell 34%
• Chrysler (purple column) fell 33%

Auto sales were down 27% overall, and Ford CEO Alan Mulally said he didn't expect any recovery before 2010. Chrysler's President, Jim Press, added that 'its hand-to-hand combat' in the auto market at the moment.

Meanwhile house prices continued their 'record decline' according to the S&P/Case-Shiller index, and are now down 17%. S&P noted that, by comnparison, the 'record low was -6.3%' during 1990-2.

In today's difficult times, everyone looks to the majors for guidance on what is happening, and what it all means for the industry. So the blog welcomes the advice given by Graham van' t Hoff, newly appointed VP for base chemicals at Shell, when he spoke to ICIS news at EPCA.

He emphasised 3 areas:

• Cost competitiveness 'in the right place'
• A strong balance sheet, to avoid having to 'run very short term'
• Investment in 'advantaged cracker feeds globally and in closer refinery integration'

The blog has long worried about the high levels of debt that have been incurred by some companies in recent years. So it applauds Akzo's decision to halt its planned €3bn share back at the half-way stage. As Nigel Davis notes in ICIS insight, Akzo has a very strong balance sheet, and its 'gearing is only 10%'. But even so, Akzo apparently cannot currently 're-finance short-term bonds'.

'Buy on the rumour, sell on the news' is the classic definition of a weak market. So the US stock market's reaction to the passing of the US bailout is a worrying indication that further problems may lie ahead. On 19 September, the Dow rocketed to 11388 as the bailout was confirmed. Last night, as the bailout passed into law, it closed 9% lower at 10325.

Nor do we yet know all the answers to the 5 key questions that worried the blog when the proposal was first announced last month:

What is the likely total cost? We know the cost has risen by $150bn plus from the original $700bn requested, in order to gain support from the House of Representatives. But as the New York Times points out, the bailout still has to 'put a dollar value on mortgage related assets that nobody wants'. And previous bailouts in the 1930s and 1990s ended up costing at least twice the number originally proposed.
Is it a done deal? The blog was clearly right to suggest that the bill might well not pass in its original form. And even now it has passed into law, there are serious questions over how it will operate. Will Congress allow tens of $bns to be siphoned off by Wall Street in fees, as apparently proposed by Treasury Secretary Paulson? And will he really be allowed to recruit former colleagues from Goldman Sachs 'to advise him'?
How will the money be spent? It is being suggested that it will take at least 6 weeks to put the necessary systems in place. But already people such as Alan Blinder, former vice chairman of the Federal Reserve, are warning that 'you need to worry about conflicts of interest' when it comes to 'determining the bailout's winners and losers'.
Who will pay the bill? As expected, there are no tax increases planned. So the Treasury will have to borrow from domestic and overseas markets instead. With credit already tight, this may well 'crowd out' borrowing by companies and individuals, as happened in the 1970s.
Will it solve the crisis? The final package is clearly an effort to re-start interbank borrowing. But as the blog noted originally, nothing is being done about the underlying cause of today's crisis, namely 'the excess supply of homes and the large number of mortgage borrowers in dire straights'. Until this is addressed, it is hard to see how markets, and the 'real economy' in which the chemical industry operates, can truly recover.

Against this background, 'buy on the rumour, sell on the news' seems an entirely logical reaction.

Last March, the blog noted an excellent article on Iceland by Gillian Tett of the Financial Times. She argued that Iceland was 'the first country run like a hedge fund'. And she worried that its banks might prove not 'too big to fail', but 'too big to rescue'? Now, it looks as though we are close to finding out the answer.

In 2007, according to Bloomberg, the assets belonging to Iceland's 3 biggest banks were 9 times the country's GDP. But on Monday, the government had to bail out the 3rd largest bank, Glitnir, to save it from bankruptcy. And now the Wall Street Journal reports growing doubt about the government's ability to rescue any other large banks.

After months of denial, Iceland's government has finally begun to face facts. On Thursday, the Prime Minister, Geir Haarde, warned that 'Government, companies, households and people have seldom faced such great difficulties'. But it may already be too late, as there are suggestions that the country will soon require a rescue package from the International Monetary Fund.

Will Beacham of ICIS radio did a 6 minute interview with the blog this week at EPCA. It focuses on the impact of the credit crunch and the high oil price, and provides advice on how to prepare for the downturn.

If you would like to hear it, please click here.

Warren Buffett, the world's leading investor, was quite candid yesterday in his views on the US economy. `In my adult lifetime, I don't think I've ever seen people as fearful, economically, as they are right now,' Buffett, 78, told PBS. 'They are not wrong to be worried'. He added that a lack of short-term credit is `sucking the blood out of the economic body of the United States.'

Buffett is a long-term investor, who says his favoured holding period for stocks is 'forever'. But even he added that, whilst he assumes a bailout bill will soon pass Congress, he doesn't expect much improvement in the economy over the next 6 months.