Chemicals & The Economy

It seems likely that this week’s European Petrochemical Association annual meeting in Berlin will mark a turning point in the petchem cycle.

Looking back over 2007, Boy Litjens, CEO of Sabic Europe, told ICIS@EPCA that performance this year had been ‘excellent’, and that they would ‘definitely report the best results ever’. He was also hopeful about the outlook for 2008, but thought that 2009 onwards might prove to be ‘difficult years’ for the industry.

Litjens went on to add, however, that ‘I am realistic enough to say that somewhere in 2008 and 2009 the economy is going to turn down’. But in his view, the pressure from new Middle Eastern and Asian capacity won’t really begin to be felt ‘until the fourth quarter’. So the key issue is whether demand begins to turn down before this.

The views that I picked up on this issue over the 4 days were mixed. The US market definitely seems to be weakening, and although European and Asian demand is still robust, industry margins are coming under pressure:

• There seemed no doubt in the minds of US delegates that the US housing market will get worse (some thought a lot worse) before it bottoms. This means there will be a lot less demand for chemicals/polymers in this important sector.
• However, US producers were encouraged by the decline in the US dollar, and hoped that this would enable them to compensate for lower domestic sales via increased exports to Asia, and Europe.
• European producers generally saw demand continuing to be strong, although many noted that the major downstream buyers were taking a more aggressive stance on pricing.
• Asian delegates, particularly those from China and India, remained very confident. They see strong demand in their domestic markets out till at least 2010.
• Feedstock pricing and availability was a major concern for everyone with whom we spoke. The volatility seen during 2007 is expected to continue, and this makes margin forecasting much more difficult.

It used to be said that ‘if America sneezes, the rest of the world catches a cold’. My sense from our EPCA meetings is that we may find ourselves needing to rewrite this phrase, if housing and subprime problems do tip the US economy into recession next year. This might cause us to discover instead that ‘when America catches a cold, the rest of the world sneezes’.

Its now 3 months since we first saw the impact of the subprime crisis. At that time, the main impact was on poor Americans, who were losing their homes. Then, in August, banks stopped lending to each other, causing credit conditions to tighten. By September, central banks were fighting fires on several fronts:

• Injecting billions into money markets to improve liquidity
• Bailing out major mortgage lenders such as Northern Rock in the UK
• Cutting interest rates in the US by 0.5% to help avert recession

Their activities continue to be the focus of attention, but at the same time the American Chemical Council (ACC) have performed a useful service in a recent weekly report by reminding us that the original problem in housing is still getting worse, not better.

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As their chart shows, new home sales are now down 21% on a year ago, and existing homes sales down 12%. The inventory of new homes is at its highest level for 16 years, whilst that for existing homes is at an all-time record high of 10 months. Equally, the ACC comments that ‘the pace of monthly (house) price declines is accelerating as tightening mortgage lending standards and a slowing economy suggest the housing downturn will last into 2008’.

This does not bode well for future chemical demand in this important sector.

Coal-to-chemicals just took a further step towards becoming a major source of chemical production once again.

Yesterday, major coal producer Shenhua Energy listed on the Shanghai stock exchange, and saw its shares jump 93% to value it at $173bn. Shenhua is the world’s second largest seller of coal, after the US’s Peabody Energy, and it now becomes the world’s largest IPO this year.

This is part of a process by which huge sums of money are now being raised in China to finance industrial development. As I noted on June 22, PetroChina started the trend by successfully raising $5.6bn, to help finance its proposed 6 new ethylene cracker projects, as well as to develop new oilfields and construct new refineries.

Shenhua Energy is going down the same expansionary route. Having consolidated many of China’s coal companies over the past decade, Shenhua is now looking to invest in a range of coal, power and transportation projects. It aims to produce 200 million tonnes of coal in 2010, compared to 137 million last year, as well as 20,000 megawatts of electricity.

In addition, and critically for the chemical industry, it plans to ramp up its activity in the coal-to-liquids and coal-to-chemicals sectors. It has already partnered with Dow Chemical in planning to build a world-scale coal-to-chemicals complex in Shaanxi province. This intends to use ‘clean coal’ technologies to produce ethylene and propylene, as well as a chlor-alkali unit and a wide range of derivatives.

The chemical business started life by adding value to coal, and the impact of higher oil prices seems to be re-opening this route as an economic source of feedstock for the future. With 66 billion yuan now in the bank post IPO, nobody should doubt Shenhua’s ability to finance its ambitious plans.

The price of a product is a key factor in determining the profitability of producing and using it. And a transparent pricing structure encourages liquidity, which enables price discovery to take place more easily between buyers and sellers. This is why I have long been a supporter of the London Metals Exchange (LME) initiative to trade futures contracts in PP and LLDPE.

At the moment, pricing in the cracker and thermoplastic sector involves a long chain of players, many of whom have differing agendas and priorities. The actual producers and users of the products rarely get to negotiate prices directly with each other. Instead, the main buy-sell relationship today is often with a converter. As a result, much pricing is done on a lagged basis, so the ultimate sales price is often not known until well after the product has left the factory gate.

This ‘lag’ also creates an opportunity for playing the market. Converters, for example, can build stock if they see feedstock prices rising, and reduce it when prices fall again. But this is not a zero-sum game, as cracker operators and polymer producers then have to respond by adjusting operating rates up or down (always very expensive). Equally, unnecessary polymer imports and exports take place, as players down the chain respond to confusing signals about demand trends.

This is why I was glad to see in the MF Global daily plastics report this week that some players, at least, are now starting to hedge LLDPE and PP by using a monthly average price based on the LME prices. This is only a small step forward, but anything that makes it easier for producers and consumers to better manage their business is to be warmly welcomed.

Hopefully it will also encourage others to experiment with LME trading. As the downturn edges ever nearer, it will become increasingly vital to have an accurate picture of underlying demand. Today’s lack of transparency and liquidity in pricing will otherwise extract a major cost in terms of lower profitability throughout the value chain.

BP and Reliance Industries are both powerhouses in their own fields. BP’s new CEO, Tony Hayward, has just given his first interview in the new job. Comparing, and contrasting, his comments with last week’s AGM statement by Reliance’s Chairman, Mukesh Ambani, is very revealing in terms of content as well as tone.

Hayward’s interview in the Financial Times showed him as making a decisive break with the Lord Browne era. He believes that the company had done a ‘fantastic job assembling a great set of assets, but a much poorer job in really making them run efficiently’. He also ‘admitted that morale at BP was poor, and that the company had been failing to recognise and reward excellence among its employees’.

Over the same period, of course, BP has divested much of their petchems business via the Innovene sale to INEOS. But according to Hayward, they have still managed to ‘increase the complexity of BP’s structure’, as a result of which ‘it is so tough to get things done’ within BP.

Ambani, of course, had no need to eat humble pie. He titled his talk ‘Towards a quantum leap’, and in it he set out the major changes now underway in Reliance’s portfolio. From small beginnings with a single polyester plant, Reliance is now the world leader. And Ambani announced a move from 1.9 MT to 4.5 MT of PX capacity, in association with the refinery expansion at Jamnagar.

The site will also feature 2 MT of new olefins capacity, with further expansion already planned. Ambani explained that the petchem business now aims to ‘follow the path to global leadership set by the polyester business’. Reliance has also become one of the top 20 private upstream companies in the world, and he revealed that they are now planning to invest a further $4bn to build on the success of the past 7 years.

But even Reliance now needs to make a number of major strategic shifts. Ambani accepts, for example, that although they have been able to focus on organic growth to date, ‘acquisition’ will have to become a more important part of their growth process. He also accepts this will require a shift in mind-set, towards ‘partnership’ and more JVs of the type carried out with Chevron in the Jamnagar refinery expansion.

What is interesting about both Hayward and Ambani’s viewpoints is the stress that they lay on operational expertise. Reliance’s success to date, like BP’s in the past, has been based upon their ability to deliver. To recapture excellence in this area must be Hayward’s objective for BP, if he is to achieve the turnaround he targets.

There has been a noted change of tone from leading policymakers in the past few days. Gone is the jaunty confidence that the world economy is ‘fundamentally sound’. This has been replaced by a sense that debt market problems may have a wider impact than first expected.

US Treasury Secretary, Hank Paulson, typified the new tone when warning this week that the US subprime problem will ‘continue to adversely impact our economy, our capital markets, and many homeowners for some time yet’. His downbeat assessment was all the more remarkable as it followed his success over the weekend in establishing a $75bn ‘superfund’ to help support the asset-backed commercial paper market.

Instead of spinning this fund as the answer to recent problems, Paulson seemed to be going out of his way to reduce expectations about a quick recovery. This also seems to be the approach being taken by the IMF, which has cut its forecast for world growth and warned that the US$ may still fall further.

The IMF is still forecasting a relatively strong year in 2008, with 4.75% GDP growth compared to 5.2% this year. But it commented that ‘the risks to the outlook look firmly on the downside, centring around the concern that financial market strains could continue and trigger a more pronounced global slowdown’.

Equally, its comment that ‘the weakening dollar was part of a normal process of economic rebalancing’ is likely to raise concerns in parts of Europe, and Asia, that the US is quietly pursuing a policy of ‘beggar my neighbour’ via currency devaluation.

The new note of realism by policymakers is very welcome if it leads them to debate robust solutions to the present crisis. But if frankness merely leads to argument, as we saw most notably in 1987, then those finalising the 2008 budget process in chemical companies may need to anticipate more turbulent times ahead.

I mentioned PetroChina in the very first blog entry, when the stock was trading at $155 in New York. It seemed to me to typify the new mood of confidence that I was finding as I travelled in Asia on the 10th anniversary of the Asian financial crisis. Little did I think that just 3 months later, it would be trading at $260.

This meteoric rise in the Chinese stock market has left me feeling more than a little uneasy, as to whether confidence has now turned into pure speculation. And this concern has been amplified by news this week that legendary investor Warren Buffett has sold his entire 11% holding in PetroChina, for a $3.5bn profit. Agreeing that, as usual, he sold ‘a little too soon’, he told Fox Business News yesterday that the sale was due to his concern over valuation.

Buffett clearly feels that the best of the China stock market run is behind us, at least for the moment. It will be interesting to see how much longer the present surge can last, and what the impact will be if (when?) it tumbles back to reality.

And in the meantime, it was also interesting to see that in the same interview Buffett denied that he had ever been interested in buying troubled investment bank, Bear Stearns. He added that he was still steering clear of the housing market and US housing stocks, as ‘prices still didn’t seem low enough’. As Buffett tends to buy and sell early, this is a salutary warning that there may well be more trouble ahead for this critical area of chemicals demand.

The ‘consensus forecast’ for 2008 is very optimistic, as I commented in my post-EPCA note. It says oil will remain at $70/bbl, that debt market problems will be contained, and that petchem margins will remain at 2007 levels. This is unusual, as the consensus is normally a base case scenario, with upside and downside variants.

And since EPCA, oil has already increased to around $90/bbl. Back in early July, when it was still ‘only’ $70/bbl, I noted that it had the potential to approach $100/bbl, and this still seems a real possibility. In these circumstances, it is perhaps no surprise that we are seeing an apparent ‘boom’ in demand, as downstream consumers rush to cover themselves before product prices move higher.

I first saw this effect happen in 1979, when the industry had a record year. It was only in 1980 that we discovered that the apparent ease with which the economy had weathered a rise in the oil price to $30/bbl (around $95/bbl in today’s money), was a mirage. Could the same be happening today? I think it is worth considering very carefully as a possibility.

After all, whilst history never repeats itself, the underlying position in financial markets is clearly deteriorating. Bank of America (the 2nd largest US bank), came out with truly shocking Q3 results on Thursday, whilst on Friday Caterpillar’s CEO Jim Owens said the US was already ‘near to, or even in, a recession’. And new housing starts and US house prices were already very weak, even before the recent credit crunch.

There must surely be a real possibility that this latest upward rush by the oil price will be the catalyst that finally causes the US consumer to cut back on non-essential spending. Equally, the continuing problems in the banking sector may well turn off the tap of consumer, and maybe even corporate, lending.

If I was drawing up budgets for 2008, I would be putting in place contingency plans for just such an outcome, even whilst crossing my fingers that I would not have to use them.

I recently had the opportunity to attend a workshop organised by Pilko & Associates with leading figures from the private equity (PE) industry. It was fascinating to hear their views on how the current credit crunch is affecting M&A activity. The days when some PE players were acclaimed as geniuses simply for loading up a company with debt are clearly gone. There is a growing consensus that we are moving into a tougher climate for deals, which will probably affect M&A activity and chemical company valuations quite significantly:

• PE had lost its cost of capital advantage in M&A, with a maximum of 4/5 times leverage now being available, compared to the 8/9 times that had been common.
• Investors have also become more cautious, wanting ‘simple stories’ to support a deal, and preferring to work with known people who have good track records.
• Deal size has dropped to around $3bn - $4bn, with larger deals only being done by strategic buyers (eg major companies) who can fund via their own cash-flow.
• Valuations are therefore reducing, but PE has not yet reduced its expectations for >20% return. Bolt-on acquisitions will therefore become more common.

I also got their inside view of the US subprime crisis, where caution seemed to be the order of the day. The expectation was that this would rollover into Q4, and that even then we might not be ‘out of the woods’.

There were also a number of specific issues which have recently appeared on the radar:

• H1 saw several major deals completed, and these will take time to be digested.
• PE buyers are more wary of above ground liabilities after the Texas City refinery explosion. Issues such as process safety/maintenance spend/training are now key.
• The ‘mood music’ of management presentations is seen as critical, as whilst governance policies/systems can change quickly, cultures change more slowly.
• There is probably less sharing of HSE/EHS experience going on, due to the more fragmented nature of the industry. This is a negative step, and needs addressing.
• The majors are now imposing their own standards very quickly on new acquisitions, and taking the costs up-front as part of the deal’s overall cost.

Of course, the current problems in financial markets may all blow over in the next 6 months. But it was interesting to hear the response given to a question as to whether it would be better to issue debt now, or wait 6 months. ‘Take the pain now, and pay the extra premium’ was the advice. ‘Risk is currently increasing in financial markets, not reducing’.

The Bank of England correctly predicted in April this year that the risks associated with US subprime lending had increased, that credit risk monitoring was poor, and that markets should be prepared for liquidity to dry up in parts of the financial sector.

It must therefore, as the Financial Times said, ‘have required some restraint not to write “we told you so” at the start of the Bank’s latest report this week on Financial Stability’. This report updates its analysis, and does not provide much comfort about the near-term outlook. It concludes that:

• Lenders will become even more nervous about asset valuations if any further problems emerge in the US subprime and housing markets
• Highly-leveraged companies, including those involved in recent buyouts, could suffer from a tightening in credit availability, as banks have to absorb formerly off-balance sheet loans back onto their books
• Equity markets (in both industrialised and emerging economies) are vulnerable to any downward revision in global growth prospects
• The US$ may also be vulnerable to a downwards correction if recent changes in investor sentiment to US securities persist

The Bank believes that the cause of the recent problems was ‘a long-standing “search for yield” in financial markets – a desire by investors to maintain high returns in a low interest rate environment’. Its view is that ‘a repricing of risk was long anticipated and necessary’.

But it goes on to add that ‘the scale and breadth of the transition have caught market participants and the authorities by surprise’. It also suggests that players have become complacent, and ‘afraid to stand against the tide for fear of losing market share’.

Its warnings echo those made in early summer by the central bankers’ bank, the BIS, which I covered on July 3 in ‘4 risks to the world economy’. And judging by the Bank's tone in this week’s Report, we should remain on our guard in the coming months for signs that further problems are developing in financial markets.

Oil prices last week rose to an all-time, inflation-adjusted, high in New York at over $92/bbl. Meanwhile food and commodity prices have continued their upward march. In China, the rate of consumer price inflation hit a decade-high of 6.5% in August. So why are we still seeing rates of around 2% reported in the USA and Europe?

Part of the answer is that China, like other developing countries is less energy-efficient than the West. Equally, as the world’s leading manufacturer, it is first in line to suffer higher prices for metals (the steel industry is expecting a 50% increase in the iron price next year, on top of 145% increases this year). But freight costs get passed straight on to buyers, and the Baltic Index for dry goods such as iron, coal and grains has risen 135% this year alone.

Yet current official Western inflation figures still appear benign. As I commented back in July, central banks such as the US Fed conveniently focus on ‘core’ inflation, that excludes food and energy costs. Similarly, the Bank of England now focuses on consumer price inflation (CPI) instead of retail prices (RPI). What’s in a name, you might ask? 2.1% is the answer. The new CPI registered just 1.8% in September, but the older and more comprehensive RPI clocked in at 3.9%, and is clearly on an upward trend.

Central banks also use ‘hedonics’ as a way of avoiding the hard decisions to raise interest rates when economies are over-heating. But one can’t eat or drive a mobile phone or a laptop, so although these are more powerful today than earlier models, this may not impress union negotiators when they plan tactics for next year’s wage round.

Thus there is a strong argument that investors may have been lulled into a dangerous sense of complacency. A double whammy may be just around the corner. Not only may ‘official’ inflation rates finally start to rise, just as the housing-dominated economies are slowing sharply. But chemical companies’ earnings may also suffer from margin compression if, as seems very possible, consumers prove less willing to accept the latest round of price increases.

Since posting yesterday, oil prices have moved further ahead, with WTI closing at $93.53.

I have also had an interesting dialogue with Paul Satchell of ING Bank, one of the leading chemical analysts, who has kindly allowed me to summarise his comments. Paul believes that investors have become 'dangerously complacent' about the industry's ability to cope with increases in oil prices, following the success of companies such as BASF at passing-through input cost rises since 2004.

He sees a growing danger that commodity chemical producers may suffer the same fate as specialties companies such as Ciba and Clariant, who 'seem to have suffered a major loss of pricing power'.