Chemicals & The Economy

The US Congress is currently close to finalising a Bill that would aim to tackle climate change. This follows the EU model by establishing a carbon price via a cap-and-trade system, and is very welcome news.

However, there is a sting in the tail, as currently drafted. For it also calls for a border tax on carbon-intensive goods. Chemicals would inevitably be a prime target for such a tax, and ‘The Economist’ rightly devotes an editorial to attacking this concept.

Proponents of the border tax argue that it would encourage other countries to reduce their carbon footprint. It would also stop American producers being disadvantaged by the higher costs imposed by the new higher US standard. But its costs could be huge.

As ‘The Economist’ comments, not only would a ‘massive bureaucracy be needed to certify the carbon content of different goods imported from different factories in different countries.’ But the indirect cost could be even higher, as ‘such a tax would be a dangerous weapon in the hands of America’s growing gang of protectionists’.

‘The Economist’ is not prone to exaggeration. It says that if these measures are passed, America risks starting ‘a global trade war’. Chemical industry executives need urgently to get themselves up to speed on this issue. And the trade associations need to monitor developments very carefully.

Its 2 months since I was last in Asia. It is clear that earlier optimism about the region’s resilience in the face of a possible US recession in 2008 has begun to disappear.

Typical is the comment by Kanit Saengsubhan of the Thai Fiscal Policy Institute. He sees Thai growth in 2008 falling below earlier 5% government projections ‘if the US sub-prime mortgage crisis deteriorates further’. And he voiced uncertainty over just how severely Thailand might be hit. ‘In a moderate case, economic growth in the next year could stand at 4.5%, he commented. ‘If the situation becomes more severe, chances are that growth will be less than 4.5%.’

Asian chemical demand is critically dependent on the West. The Asian Wall Street Journal pointed out on Friday that ‘Chinese “exports” often aren’t very “Chinese” at all. The mainland is still largely an assembly point for other countries’ parts’. Thus the current boom in Asian chemical demand is underpinned by an expected 30% increase in this year’s EU-China trade deficit to $253bn (€170bn), and a further rise in the US-China deficit above last year’s $232bn.

As I wrote post-EPCA, we may well be about to discover that ‘when America catches a cold, the rest of the world sneezes’.

Are we seeing just a dip in economic growth? Or are we at the start of a downturn that may run for months, or even years? The answer to this question lies in the US, which still accounts for 25% of global GDP, and where US consumer spending is 70% of US GDP.

Optimists maintain that central bankers have the power to stimulate the economy via interest rate cuts. And certainly, as we saw again last week, the merest hint of further US reductions is enough to send stocks soaring worldwide.

But from a chemical industry viewpoint, the answer is not so simple. Kevin Swift’s excellent weekly report for the American Chemistry Council (ACC), gives a mixed picture. November’s US railcar loadings remained strong, as export activity continued to compensate for weakness in the housing and auto sectors.

But as the chart shows, global chemical industry production growth (ex-pharma) has slowed significantly since the summer in all regions. And the ACC notes that US leading indicators are now negative, and at a level usually associated with recession.

US housing data is very worrying from a chemical industry viewpoint. Each US housing start generates an average $16k of chemical demand, according to ACC calculations. And the massive fall in building permits does not bode well for H1 demand next year

November’s figures for new and existing US home sales are just awful, compared to 2006:

• New home sales are down 24%; median prices down 13%; housing starts down 16%; building permits down 25%. Inventory is 8.5 months sales.
• Existing home sales are down 21%, median prices down 5%. Inventory is 10.8 months sales.

A further worrying sign is that in the wider economy, US inventories are increasing rapidly, adding a full 1% to US GDP growth in Q3. This is perhaps not surprising, given the recent rapid rise in oil prices. Crude was only $71/bbl in early July, when I first suggested it could reach $100/bbl, and it would not be surprising if chemical/polymer buyers have been building even more stock in recent weeks as prices rose.

The optimists may still be right, and central bankers may be able to wave the magic wand that restores us to a growth path. But with US housing/auto sales so critical for the global economy as well as for chemical demand, and with feedstocks remaining tight, it is hard to imagine that the chemical industry can now avoid a serious downturn.

There’s a very interesting article in Barrons (the premier US investment magazine) today. It compares current efforts by Treasury Secretary Paulson in trying to cap US mortgage rates with President Nixon’s ill-fated introduction of a US wage/prices freeze in 1971.

Barrons points out that non-US buyers are already being hit by major write-downs in the value of their US subprime holdings, and adds that ‘now, the interest may be less than promised’.

It is concerned that this weakening of creditors’ rights will discourage global investors from sending their savings to the USA. And it wonders ‘what impact will that have on the current credit crisis? On the dollar? And the status of the US as financial capital of the world?’

US housing conditions are bad enough already. If Barrons is right, the proposed ‘cure’ may end up by making the situation worse, not better. This would not be good news for chemical sales into this important market.

The UK has a proverb about how stable doors only get shut after the horse has run away. We can see this happening in the UK housing market.

The main regulator (the FSA) failed to spot the Northern Rock problem before it led to the UK’s first bank run in 140 years. Only now has it woken up, telling mortgage lenders yesterday to expect ‘market conditions to remain very difficult for a sustained period’.

It also warned that 1.4m UK borrowers face higher interest charges next year ‘which may prove too much for many of them to afford’. In other words, only now has the FSA realised that the US subprime disaster may be just about to hit the UK market, where house prices are even higher as a multiple of earnings. Apparently, they are already having to pay ‘weekly visits’ to some lenders where ‘liquidity levels’ seem too low.

The only problem with this warning is that it comes far too late. The time to stop the unsafe lending practices was when they started. Already the main UK lender (Halifax) has announced a 1.1% fall in UK house prices last month. This makes 3 months in a row that prices have fallen – and one has to go back to 1995 (when the UK was emerging from the last housing crash) for the last time this happened.

The European chemical industry will be badly hit if the UK follows the US housing decline. UK housing has been a major source of demand. And indirect demand will also decline, as UK homeowners will no longer be able to borrow against the rising value of their homes, in order to purchase autos and other consumer goods.

The risk of a global downturn is clearly increasing, as the credit crunch intensifies.

Central banks seem to have their work cut out if they are to restore normality to global credit markets. The famed head of Legg Mason, Chip Mason, who manages over $100 billion of assets, and is one of the world’s largest money managers, said yesterday that ‘credit markets are in the worst state he has seen them in his 47 years in the business’. ‘I have not seen anything like this’, added Mr Mason.

As I discussed back in August, when the current crisis began, companies with high leverage are obviously at great risk if current credit markets conditions continue. By now, many Finance Directors will have already completed their own in-depth assessments of credit risks. Sales people should therefore not be surprised if ‘cash before delivery’ soon becomes the norm for some companies. This may seem a harsh requirement, and may lose some sales in the short-term, but it is far better than standing in line for repayment after the worst has happened.

There is some interesting material on the OPEC website, following this week's Summit, which clarifies their current strategy. The key points are:

• OPEC is currently targeting inventories, not prices. Their policy is to keep OECD crude stocks within the 5 year average. OPEC says its previous production cutbacks ‘minimised the excessive overhangs that existed at the beginning of the year'. Saudi Oil Minister, Ali Naimi, added that ‘inventories (are now) at a healthy level within the 5 year average’.
• In keeping with this approach, OPEC made no comment on current prices. Instead, it focused on the issue of volatility, blaming this on ‘fear of future shortages’, ‘increasing speculation in the futures market’, ‘continuing geopolitical tensions in some oil-producing regions’ and ‘downstream bottlenecks’. This is quite different from September's meeting, when they tried to talk prices down.
• Naimi reiterated OPEC’s commitment to ‘stability and reliability of supply in oil markets’. But he also raised a warning flag over the negative impact of any Western initiatives to move away from fossil fuels, commenting that OPEC’s investment in future production increases will be ‘assuming in good faith that the demand will be there’.

OPEC, in public at least, thesefore seems much more relaxed about the impact of today’s high prices on economic growth than it was in September. Then, the IEA had suggested that OPEC was targeting a minimum $70/bbl price, compared to today’s level near $90/bbl. Or maybe, with a mild winter forecast for the US as a result of the La Nina effect, they are just hedging their bets until they next meet in February.

The major investment banks have changed their minds about the potential for Asia to ‘decouple’ from any credit-crunch induced downturn in the West.

Originally, they had believed that domestic demand in China and elsewhere would enable the Asian economy to sail ahead, no matter what happened elsewhere. I was a bit sceptical of this hypothesis, after my recent visit to the region. And now Bloomberg reports that both Goldman Sachs and Morgan Stanley have changed their minds.

Typical of the new realism is the comment from Morgan Stanley’s Chairman in Asia, Stephen Roach that ‘decoupling is a good story, but it's not going to work going forward’. He sees the region’s economy being badly affected ‘as the US slowdown goes from housing to consumption’. Whilst Goldman also now believe that ‘what began as a US-specific shock is morphing into a global shock’.

China's global manufacturing lead is focused on housing-related products such as refrigerators, microwaves and DVDs, as well as textiles and related products. These are also all areas of strong demand for chemicals/polymers.

And as I noted recently in ‘A dip or a downturn?’, it looks as though the pace of Asian growth is already slackening, as a result of the downturn is western housing markets. 2008 could well be a difficult year in Asia, as elsewhere.

A reader has kindly sent me a YouTube link to a recent British television sketch featuring two masters of satire, John Bird and John Fortune. It takes the form of a mock-interview, with Bird playing the all-wise investment banker, and explaining to Fortune how subprime happened, and what a SIV might be. Not only is it very funny, but also (as always with their work), well researched. It lasts around 9 minutes.

CFOs are paid to worry, but their worries seem to be increasing quite rapidly, according to the results of the quarterly CFO survey by Duke University/The Economist. This showed:

• Record pessimism about the US economy, with US CFOs worrying about ‘weak consumer demand, high fuel costs, rising labor costs and credit markets’.
• European CFOs are ‘dramatically more pessimistic’, and expect employment to fall 0.6%
• Asian CFOs are still optimistic about growth, but almost all CFO’s with Western multinationals said they were being told to increase revenue growth to compensate for slower Western growth.
• A third of Asian CFOs see Chinese growth as likely to slow, whilst 61% of Chinese CFOs expect a US recession to hurt their firms.

Credit market worries are particularly painful for US CFOs, with around half saying that credit has become less available, and that they have experienced an increase in the cost of credit. A third of European CFOs have seen the same impact. US CFOs also noted an increase in ‘hardship withdrawals’ by employees from their 401K savings account, as a result of a need to make mortgage payments or avoid personal bankruptcy.

News that UBS, the major investment bank, has had to follow Citigroup in raising new capital in a hurry, will have added to the CFO concerns I describe below. Massive subprime losses have forced both banks to raise a combined $24.5bn in the past fortnight. Both had previously said that their losses would only be modest.

According to the Financial Times, ‘strong forces are pushing up banks’ demand for capital’. It suggests they are no longer being able to ‘sit on’ bad debts, and that as a result, ‘pressure on bank capital is starting earlier than in previous downturns’. As a result, it believes that Citi and UBS rushed ‘to get in first’, before market conditions become more difficult next year.

Tonight the Fed will have another attempt at waving a magic wand to make these mounting worries go away. To judge by the Duke University survey, chemical industry CFOs, and their professional colleagues, are obviously not over-impressed with the success record so far.

In recent days, 3 respected commentators on oil markets have raised concerns about the near and medium-term prospects for oil supplies:

• Goldman Sachs has raised their 2008 WTI price forecast to $95/bbl from $85/bbl. This is driven by their expectation that cost inflation, plus continuing technological and political uncertainty, will ‘increase the price required to motivate capacity investment’. They point out that there has recently been a ‘large rise in long-dated prices to the $80-85/bbl range’.
• CIBC have pointed out that ‘soaring rates of consumption’ in Russia, Mexico and the OPEC countries will reduce their exports by 3.5mb/day by 2010. This equates to 3% of world demand. High oil prices are stimulating rapid growth in car ownership in many of these countries, whilst subsidised gasoline prices make driving cheap.
• The International Energy Agency (IEA) said yesterday that ‘we are on the eve of a new world order’ in energy, where China and India ‘now drive global energy demand’. The IEA chief economist, Faith Birol, projects 35mb/day of new demand by 2015, but worried that only 25 mb/day is currently being planned. Equally, the IEA says major energy consumers, including the USA, are doing very little to restrain demand growth.

My reading of all this is that dialogue between oil producers and consumers is starting to break down. As I noted after the OPEC meeting, even the Saudis are questioning whether they should invest the billions of dollars needed to bring major new fields on stream.

The price and availability of oil is absolutely critical to the chemical industry. Growing uncertainty around these key issues is already leading to increased price volatility, which in turn will reduce margins and profitability.

It is now almost 6 months since I started writing this blog. And I thought you might like some feedback on how it is developing.

As you can see from the green-shading on the map, it is now read in almost all of the major chemical producing/consuming areas. A high proportion of readers bookmark the site, and return to it regularly. You are also spending more time on the site, as the amount of content builds.

Certainly, there has been no shortage of issues to cover:

• Oil prices. The blog was amongst the first to suggest, on July 5, that crude prices might reach $100/bbl over the winter. At that time, the price was $71/bbl, and most forecasters were expecting a decline. The recent peak was $99.26/bbl, and the winter is not yet over.
• Credit crunch. The blog covered this from the start, just as the US subprime crisis began. And many people have kindly commented that they first became aware of its implications for the chemical industry via the blog’s commentary.
• Chemical markets have been covered extensively, with a focus on key areas such as housing and autos. These are clearly leading indicators for chemical demand, and the blog has been able to highlight potential problems before they became widely recognised.
• Regional developments. Chemicals is a global industry, and the blog has kept readers up to date on developments in all the major areas – Asia, the Americas, Europe and the Middle East.

Re-reading the blog’s Mission statement (at the top of the main page), it therefore seems to be fulfilling its role of ‘sharing ideas that may shape the chemical industry over the next 12-18 months’. We have certainly ‘looked behind the headlines’, and I have tried to provide as many links as possible to original source material elsewhere on the web.

We have also had our moments of ‘fun’ - commenting on the hedge fund trader who ‘forgot’ he owned a £80k Maserati, and on the Brazilian super-model who sparked a mini-currency crisis by revealing she preferred to be paid in euros, not dollar.

One recent change is that I am often now writing shorter summaries of issues as they develop. With 82 postings already on the site, readers can then link to more detailed background, as required. Hopefully, this makes it quicker for you to find the topics of most interest.

Thank you very much for your support and comments over the past 6 months. I’m looking forward to covering whatever 2008 may bring.

Dow has been unique amongst the world’s largest petchem companies in not being integrated upstream into oil and refining. This position will change dramatically at the end of 2008, when its newly-announced JV with the PIC subsidiary of Kuwait Petroleum opens for business.

Not only will Dow then integrate its ethylene/PE business, but it will be do so with a non-western oil company. As Dow’s CEO, Andrew Liveris, describes it, ‘the day of the NOC (National Oil Company) dominance has arrived’. The new JV will be responsible for pursuing ethylene/PE projects on its own, and will be the prime focus for Dow's Asian ambitions. Some/all of the existing PE-based JVs may also be linked to it in the future. Liveris explained that the aim is ‘to bring each one of those relationships to the table in due course’.

This deal continues Dow’s strategy of JVing its Basics business, whilst growing its technology-led performance businesses. In Basics, the aim is to anchor Dow’s technology and market knowledge with locally sourced advantaged feedstocks. Whilst the Performance businesses focus on 4 key areas – Human health, Energy, Infrastructure & Transportation, Electronics & Communication.

The deal creates a $19.1bn global JV that (if combined in due course with the existing Equate, MEGlobal and Equipolymers JVs) will create the world’s No1 polyolefins company. It will focus on plastics (PE/PP/PC/PET), and will also create the world’s largest EO/EG & derivatives company. It will have supply agreements with 3 of Dow’s crackers at Fort Saskatchewan (Canada), Bahia Blanca (Argentina), Tarragona (Spain). If combined with the existing JVs, it would have $14bn in revenue, and be largely focused on ethylene, with some aromatics involvement via polycarbonate. Dow’s other US/European crackers will remain wholly-owned.

The partners have so far concluded a non-binding MOU. Closure of the deal is expected at the end of 2008, at which point PIC will pay $9.5bn for its share of the businesses that Dow is contributing. This will provide Dow with the flexibility to move forward on the next stage of its push into a more market-facing portfolio.

Dow now plans a ‘more aggressive approach to M&A’. It will certainly have the flexibility to do this, having successfully reduced its ‘debt to total capital ratio’ in recent years from over 50% to today’s low 30%. But any prospective acquisitions will need to be aligned with the market-facing businesses, and to also meet Dow’s DCF, IRR financial metrics, as well as having a short payback period, and adding more value to earnings than a simple share buyback.

For Dow, the deal aims to preserve integration whilst mitigating cyclicality via JVs. Transfer pricing downstream will continue as today, as if they were Dow businesses. And Dow will aim to put the income from the deal ‘to better use’ in new business development. Whilst for PIC, the deal will provide 50% of the businesses that Dow is contributing, and the basis to contribute Kuwait feedstocks (eg crude/gas) to future integrated refinery/petchem projects in China and elsewhere.

Dow’s other potential JVs with Saudi Aramco, Egypt, Libya, Oman and Gazprom are all outside the new JV ‘for the moment’. And its multi-product JVs such as with Saudi Aramco will likely remain separate. Equally, the existing PS JV with CPChem will remain separate, as Dow do not see the PS/ABS area as capable of much growth, by comparison with the other polymers. Dow did however hint that they do have further plans around their existing VCM business with Shintech, but did not elaborate further.

Yesterday the European Central Bank opened its doors and lent €349bn to 390 banks seeking to shore up their reserves position for year-end. Will this help solve the credit crunch? Writing today in the Financial Times, their excellent banking editor (Gillian Tett) is doubtful. She worries that ‘the banks know something nasty that we don’t’, and that this is causing them to hoard ‘cash to an extraordinary degree’.

What does this mean for the chemical industry? Firstly, of course, it will add to CFO concerns about their ability to obtain reasonably priced loans, as I discussed last week. There are already reports of major M&A deals in the chemical sector being unable to raise long-term debt due to current market conditions.

Secondly, it seems to add to the uncertainty over the outlook for 2008. As one banker told me recently, the worry about Q1 is that auditors will not only find further problems in the lending books of some banks, but also find holes in the balance sheets of some companies, who had put subprime investments (knowingly, or unknowingly) into their reserves.

Helpfully, Gillian Tett has separately summarised the 3 major scenarios that describe how the current crisis might play out next year:

Consensus. The US narrowly escapes recession. US housing and banking markets stabilise in Q1, and there is little spillover into the rest of the economy, although auto sales growth and jobs growth decline. Emerging markets continue to boom, helping to balance slower Western growth.
Muddle through. The credit crunch slows global growth. Western economies come under pressure, and high levels of debt reduce corporate and individual flexibility. The US$ remains under pressure, as investors reallocate portfolios to other currencies.
Downturn. Today’s credit worries spread. Banks severely restrict lending as their current business model of securitising loans to 3rd parties stops working. They also suffer losses in other consumer areas (eg credit cards). A US recession leads to a second wave of financial turmoil, as highly indebted companies go bust.

What worries me about the consensus view, as with the consensus on oil prices that I discussed in October in ‘Budgeting for a downturn’, is that it is not a true base case. It is easily the most optimistic scenario. The other outcomes are both downside cases in terms of the 2008 outlook for the ‘real world’ in which the chemical industry operates.

The need for chemical companies to develop robust contingency plans, in case the consensus is wrong, is looking ever stronger.

Bloomberg reports today that China’s yuan has now risen 12% against the US$, since the dollar peg was scrapped in July 2005. And the rise is accelerating, with the currency up 6% so far this year.

Significantly, China’s Commerce Minister Chen Deming said that the yuan’s rise ‘fits China’s economic needs’. A strong exchange rate will help to keep China’s inflation in check. This is now at 6.9%, an 11 year high. But it is a mixed blessing for Asian chemical companies, as although they (and other regional exporters) will obtain higher netbacks for their exports to China, they may also find themselves having to compete harder against domestic suppliers.

The dollar has rallied a bit in December to around 113 yen. US corporate buying traditionally supports the dollar in December, as companies finalise their accounts for year-end. But this is still a 9% fall versus its June high of 124 yen. As I noted last month, there is still a worrying potential for a dollar fall below 100 yen in the New Year, once these seasonal influences are out of the way.

Housing, as we know, is an absolutely key market for the chemical industry, both directly and indirectly. Directly, each new house accounts for $16k of chemical demand, whilst indirectly, years of rising western house prices has allowed consumers to cash out their gains to spend on Asian imports.

Now this virtuous circle has turned with a vengeance. And the subprime mortgage crisis is turning into a game of very big numbers. Earlier this week, the European Central Bank handed over €349bn, not too many questions asked, to 390 banks. It was also revealed that the Bank of England was now liable for around £50bn in respect of the continuing Northern Rock debacle.

Now the Financial Times reveals that the US is ahead of them both, handing out $746bn in Q3, on an annualised basis. Apparently the reason the US hasn’t (yet?) suffered a major bank run is that an obscure body called the Federal Home Loan Bank (FHLB) system has stepped in to replace the lack of liquidity in mortgage-backed loans.

The sums lent by now may be even higher, because like all government bodies, data releases tend to be delayed. But we do know it raised $210bn in November alone, presumably to fund loan commitments already made, on top of the Q3 lending. Its top 3 borrowers have been Citigroup. Countrywide and Washington Mutual – and one wonders what would have happened to their balance sheets without this infusion of federal money?

The Chairman of the FHLB, Ronald Rosenfeld, summed up the dilemma facing central banks and governments across the Western world. Asked by the Financial Times what would happen to the FHLB portfolios if house prices fell by 20 or 30 per cent, he replied: "I do not know the answer, but I can tell you I do not want to hear the news’.

But, he added, if the loans weren’t being made, and ‘if house prices were to depreciate 20% to 30%, you would simply have enormous problems in this country.’

Right at the start of the crisis on 2 August, I noted that Jochen Sanio, head of Germany’s financial regulator, had warned that we were facing ‘the worst banking crisis since 1931’. Since then, public statements from the world’s central bankers have remained calm. But actions speak louder than words. And it is clear from their actions that they too must share Herr Sanio’s fears.