Chemicals & The Economy

The irresponsibility of some parts of the global banking system continues to upset the blog.

First, there was news that several banks are planning to award themselves huge 'bonuses', based largely on their trading success.

Yet the money they are using for this trading has mostly been provided by central banks and governments. And it was supposed to have instead been used to support lending to companies and individuals.

The blog completely fails to see the social value in what has been achieved as a result. This trading may have been profitable for a few banks, but it has created increased volatility in currency and commodity markets, and higher prices for key products such as crude oil.

And now comes news in today's Financial Times that US Treasury bills are now paying negative rates of interest. The FT says this is because banks are wanting "to polish their balance sheets for the year end". Once again, the cash being lent out by central banks is instead being used for selfish purposes by the recipient commercial banks.

How can it be sensible for governments to allow this type of activity to continue? The chemical industry is a $3trn business worldwide. Maybe it is time for its leading CFOs to express themselves more publicly on the problems being created by some banks, and set out what needs to be done to solve them?

IPIC, Abu Dhabi's International Petroleum Investment Company, made a very shrewd acquisition of Nova at the bottom of the market, earlier this year. And now they are apparently in talks with a number of major chemicals companies about joint ventures and possibly acquisitions.

The key for IPIC is to obtain technology, with which they can go further downstream. At the moment, their focus is on the ethylene/propylene chain via Borouge, the JV with Borealis (36% owned by OMV). The driver is the IPIC decision to develop the enormous Chemaweyaat project, scheduled to start coming online in 2014.

This will be based on liquid feeds, rather than ethane. It will therefore allow Abu Dhabi to grow their propylene position, and to move into the other 'building block' products, such as butadiene, benzene and paraxylene for the first time. In turn, this drives a need for derivative technology, such as polycarbonates, where they are reportedly talking to leading player, Bayer MaterialScience about a JV.

Abu Dhabi has the world 5th largest oil and gas reserves. Its increasing interest in petchems is another sign of the Middle East's growing role in the chemical industry.

The Q3 company results season is now almost complete. It suggests that:

• Companies still find it difficult to forecast revenue increases
• Earnings are instead being boosted by cost cutting eg jobs

In the US, the average workweek is now at a record low of 33 hours. Whilst EU companies are worrying whether today's short-time working arrangements can continue into 2010 if demand does not start to recover.

The above chart, from S&P, shows that analysts' expectations still diverge for reported and operating earnings. Forecasts for operating earnings remain very bullish (blue line), but reported earnings (which meet accounting standards) are still showing a flat outcome, once last year's destocking falls out of the picture.

In February, the blog worried that we were at the start of a cycle of deflation, as depicted in the above chart from Comstock Partners.

The warning signs were that major excess capacity was developing in many industries, and some major countries were devaluing. Since then, the US and China have both undertaken competitive devaluations versus the euro, following the lead of the UK and other countries.

Now Nobel Prize-winning economist Paul Krugman raises the same issues in the New York Times. He believes that "in recent months China has carried out what amounts to a beggar-thy-neighbor devaluation". And he worries that this is happening as US unemployment is getting worse.

Equally, China has not yet come close to replacing its 23 million job losses in Q4 last year. And the risk is that both China and the US will want to devalue against each other. As Krugman suggests, this could easily lead to "month after month of headlines juxtaposing soaring U.S. trade deficits and Chinese trade surpluses with the suffering of unemployed American workers".

Without capacity reductions, industries such as chemicals will not be able to restore their pricing power. The risk is that we will then see increased calls for protectionism in many countries. The cycle of deflation will then become unstoppable.

Leading indicators are useful reference tools, but sometimes they can also mislead. The chart above, from the ACC's excellent weekly report, seems to provide a good example of this problem.

The blue line shows the official Leading Indicator for the OECD area plus the 6 major non-OECD countries. It suggests that a strong recovery is underway. Yet actual global industrial production (the red line) is only showing a very weak recovery.

The problem is that the OECD Indicator has to use "expectation-dependent" indicators such as share and commodity prices. These have been on a roll recently, as financial investors bet on a V-shaped recovery. But as the blog has noted, at today's levels, factors such as higher crude oil prices can actually slow down recovery, rather than support it.

The new World Energy Outlook from the International Energy Agency (IEA) spells out two major challenges. It:

• "Identifies higher oil prices, coupled with the downturn in oil sector investment, as a serious threat to the world economy, just as it is beginning to recover".
• Suggests that "a profound transformation of the energy sector" is required, to achieve the Copenhagen goal of restricting greenhouse gases to 450ppm of CO2 equivalent.

OPEC is also now concerned about potential demand destruction at today's high oil prices. A year ago it cut output dramatically, as the financial crisis hit. But it is now tacitly encouraging more production. Quota adherence is just 61% today, versus 89% in March.

Most significantly, Saudi Arabia allocated increased supplies to Asian refiners this week. And Oil Minister al-Naimi "maintained that price extremes in the low and high ends are not sustainable", and made clear that he favours increased control of commodity exchanges to reduce today's, trader-inspired, high levels of volatility.

On the Copenhagen agenda, the IEA noted that "energy efficiency is the largest contributor, accounting for over half of total abatement by 2030 (whilst) low-carbon energy technologies also play a crucial role." This represents both a problem and an opportunity for the chemical industry.

Increased energy efficiency will require increased investment, which will not be easy in today's financial climate. But it will also drive increased use of chemicals and polymers in key industries such as housing and autos. Similarly, the process engineering skills that support the chemical industry will be vital for successful development of low carbon technologies.

The blog regards Wal-Mart and other major retailers as excellent leading indicators of trends in the wider economy.

It was therefore concerned to see CFO Tom Schoewe reporting today that Wal-Mart continues to "operate in a very challenging economy", where the key driver is to provide "the lowest prices to our customers around the world."

US CEO, Eduardo Castro-Wright, added that US same-store sales were actually down 0.4% versus 2008. He said the decline was "driven by price deflation that was well beyond what we had expected, across many food categories, as well as electronics."

This deflation is occurring at a time when oil prices have doubled since the start of the year. It suggests that chemical companies and polymer convertors will have a tough task pushing through price increases, especially as Wal-Mart expect price deflation to continue into Q1.

A key driver for the rally in crude oil markets has been the increase in China's demand. The assumption has been that this confirms economic growth is recovering strongly.

Crude oil imports have certainly been rising since Q1, and have recently averaged 500kbpd more than 2008. Refinery runs have also been higher.

However, new analysis by Petromatrix shows that much of this increase is flowing into oil product exports, not domestic demand. As the chart illustrates, China was importing large quantities of diesel/gasoline in the run-up to the Olympics. Now, as the new refining capacity starts up, it has become a major exporter of both diesel and gasoline.

Petromatrix conclude that China's increased refining capacity has effectively therefore "shut down refining capacity in OECD Asia", rather than feeding domestic demand. It also worries that as more refineries come online in both China and India, their output will also be exported and compete with existing "refining capacity in the Atlantic Basin".

Many US policymakers are still in denial about the underlying causes of the downturn. They argue it is due to a lack of liquidity, and are thus encouraging 'hot money' to flood into financial markets.

But the new 'bubbles' created by this wishful thinking, such as today's $80/bbl oil prices, are making the underlying problem worse, not better.

As the blog noted last March, the real problem is that too many US banks are actually insolvent. Many loans made during the 2003-7 Boom to property developers and homeowners will never be fully repaid. Already 120 US banks have gone bust this year, and the Federal regulator has another 416 on its watchlist.

Insolvent banks can't lend, which is why lending to businesses and individuals remains so weak. Until policymakers start to tackle the solvency problem, the blog fears that we are unlikely to see any major recovery in the US jobs market, or in chemical sales.

The US accounts for 23% of global GDP. Its economy is 3 times larger than the No 2 country, Japan. And most critically for the chemical industry, 70% of US GDP is consumer-based.

Developments in US housing/construction, auto and electronics industries are therefore the biggest single influence on global chemical sales.

In turn, the level of unemployment is a critical influence on consumer spending. Sadly, especially for those who have lost their jobs, it rose to 10.2% in October. The broader measure, including those who have given up looking for work, or have taken part-time work, reached 17.5%, or 1 in 6 of the total workforce.