Chemicals & The Economy

OPEC’s decision to hold its production quota at last Friday’s meeting came as no surprise to the markets, which were busy taking prices down $2/bbl on renewed fears of a US recession. But it did produce a warning from the International Energy Agency (IEA) that OPEC’s policies ‘threaten the strength of the global economy’.

The decision also tells us something very significant about current oil market politics. Because it was only last month that President Bush had made a direct appeal to the Saudis to lift oil production. And there have only been two previous occasions when a sitting US President has failed to influence OPEC discussions via the Saudis.

The first was in 1973-4, in the aftermath of the ‘Yom Kippur’ war, which resulted in OPEC oil embargoes. The second was in 1979-80, during the Iran hostages crisis. At all other times, the relationship between the US and the Saudis has been based on the close personal linkages established at the famous Valentine’s Day meeting 62 years ago between Saudi Arabia’s King Abdulaziz and then US President FD Roosevelt.

Saudi Oil Minister Naimi was typically Delphic in his comment after the OPEC meeting, commenting that ‘supply and demand are equal, and global reserves are fine’. And it is true that the Saudis have increased their own production to 9.2mbd in response to US requests. But probably two factors caused this historic rebuff to take place:

• Pragmatic. As noted at the time of the last OPEC meeting, the La Nina weather system generally produces mild winters on the US East coast. This has happened in 2008. Equally, the severe winter storms in China (attributed by government meteorologists to La Nina), will reduce demand still further, just as it normally takes a seasonal dip.
• Politics. It is probably hard for the Saudis to force through an OPEC increase with so much political tension around the Middle East. The US threat to bomb suspected Iranian nuclear facilities is clearly creating major tension in the region, and it would be difficult, if not impossible, for the Saudis to respond to a US appeal at the moment.

Quite why, in the light of these factors, President Bush chose to issue his personal appeal must be a matter of debate. History, as well as the IEA, is warning us that its rejection implies that oil markets are likely to stay difficult for some time.

Chemical companies tend to trade on ‘open book’ terms with long-established customers. They are also supportive when those customers are facing problems in their end-markets. In a recession, these admirable qualities can become expensive.

ICIS news reports tonight that the bankruptcy of Plastech Engineered Products in the US has led to debts of nearly $5m for 4 of the major US polymer producers. Plastech was a supplier of door panels and other items to Chrysler, and got into difficulty due to the alarming auto industry downturn chronicled here in recent months. Dow are apparently owed $1.57m, Basell $1.4m, BASF $1.02m and SABIC $970k, according to bankruptcy court documents.

CFOs and sales heads need to look urgently at their terms of trade with companies in recession affected industries such as housing and autos, as Plastech will probably not be the last company to fold. For example, as I commented 2 months ago:

“I would 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.”

These decisions are not taken lightly, but no chemical company can afford to take losses on this scale on a regular basis. I fear that a new generation is about to learn what some of us had the misfortune to go through in 1980-83 and 1990-2. If they can learn from our experience, and avoid some of the most extreme disasters, then everyone will benefit.

Very few non-OPEC oil projects have been financed in recent years, although market prices have risen from $20/bbl to $100/bbl. This is because oil companies and banks assumed that current prices would fall back to $40/bbl, or even lower, within 3 – 5 years.

But a new reality has been dawning, summed up by Total’s CEO last year, when he commented that major production increases from today’s $85mbd ‘would be difficult’ to achieve. Now BP have also reacted. Under new CEO Tony Hayward, they will now test projects against an assumption of $60/bbl. This 50% increase reflects a growing sense that the oil price will stay higher, and for longer, than oil companies had previously expected.

Futures markets still regard this price as too low. WTI for 2009 delivery is trading today at $85/bbl, and for 2016 delivery at $88/bbl. Buyers at these prices are aware that history would suggest oil prices should tumble in a US/western recession. But they also know that most demand growth is now taking place in Asia, and this is less price-sensitive due to subsidies.

Will the change in BP’s assumptions lead to more oil appearing? BP will certainly now invest more money, but construction costs have more than doubled in recent years. So the net effect will not be large. But at least they are investing. This was something that never appealed to Hayward’s predecessor, Lord Browne. His priority was always share buy-backs rather than investment.

‘‘I despair at times at why the equity markets can’t see how serious the credit crunch is’, said one senior credit analyst at an investment bank. ‘They just trade off the day-to-day newsflow’.

This interview from yesterday’s Financial Times reminds me of last July, when I noted how financial markets seemed to have become divorced from reality.

My musing then was prompted by the fact that Access had offered $12bn for the Lyondell business. This struck me as an extraordinary amount of money. Net debt was forecast at $22bn and 5.5 times current ebitda. And although the deal has now closed, I understand that the underwriting banks have still not been able to offload the debt into the market. This is a clear sign of the problems in credit markets to which the FT is referring.

Equally worrying is the fact that Wal-Mart, probably the best managed company in the world, yesterday reported that US sales were ‘below expectations’ during January. If Wal-Mart are now being surprised on the downside, then it is clear that things are really bad in US retail markets.

The FT goes on to warn that debt markets are growing ‘increasingly pessimistic about companies’ ability to withstand the bursting credit bubble and a possible recession’. Equally, the Wal-Mart warning means that US domestic chemical sales in the first half of the year will probably be much weaker than normal seasonal trends would suggest.

The prudent course for CEOs and CFOs must be to ignore the rose-tinted glasses still being worn in equity markets. They need to review January’s performance for early signs of weakness. They also need to test current budgets against an assumption that credit markets will get worse. Unfortunately, this week’s Plastech bankruptcy is probably not an isolated event, but just the first of many.

I noted last month that China seemed to have changed policy with regard to the renminbi. Since then, its rise versus the US$ has accelerated, as shown in the above chart from Merrill Lynch (ML). Since August, it has been rising at an annualised rate of 13%.

ML’s explanation is that the government is having to relax credit controls as the economy slows. The recent snowstorms have further loosened policy. Yet with wage inflation now at 18%, something needs to tighten and so the exchange rate is being allowed to rise. ML say 'it is possibly the fastest sustained appreciation' since the PRC was founded in 1949.

ML suggest that the increase will continue, and that it will cause Asian interest rates to rise in sympathy, as well as Asian exchange rates. Outside Asia, the impact will be to export inflation to N America and Europe, as China’s export prices rise in $, € and £ terms.

This is good news for chemical exporters to China. But at a macro level, it means that the ‘virtuous circle’ of the past decade, under which China exported deflation, is well on the way to reversing itself. In turn, this will eventually limit the ability of Western central banks to cut their interest rates to try and stave off recession.

The US Fed has dramatically cut interest rates by 1.25% recently. But as it eases, so US banks seem to be tightening their lending criteria for mortgages. Present standards are the tightest recorded

Since 1990, the Fed has asked banks about their lending standards. The chart above (by Merrill Lynch) shows the results. From 1992-2006, banks were relaxing standards most of the time. And even when they tightened, it was only by relatively small amounts, with no more than 20% of the US population being affected.

But over the past year, there has been a major, and unprecedented, change. As the above chart (complied by Merrill Lynch) shows, over 70% of Americans are now finding it harder to get a mortgage. 85% of banks have tightened their standards. And the change is not just affecting the subprime market. Over 50% of banks have tightened their standards for traditional prime mortgages.

The implications of this are enormous. It means that stimulating demand, whether by interest rate cuts or tax rebates, is unlikely to significantly reduce today’s inventory of new and existing US homes, which now stands at 9.6 months. Previous demand relied on lax lending standards – and today’s tighter policies mean that previously qualified buyers cannot now return to the market, even if interest rates go to zero percent.

So in reality, trying to stimulate demand is like pushing on a string. The only way to bring housing supply/demand back into balance is to reduce supply. And as anyone who has ever traded oil products or petchems knows, the only mechanism to achieve this is a sustained period of falling prices.

The banks have clearly recognised this new fact of life, which is why they are rushing (too late, of course) to try and reduce their exposure. Unfortunately, from a chemical industry standpoint, this could help to ensure that sales to the important housing market may take months, if not years, to properly recover.

Its not normally a good sign when chemical industry bosses feel the need to cheerlead on the outlook for the economy.

Dow’s CEO Andrew Liveris therefore caught my attention at Davos, when he told CNBC that talk of recession was ‘over-reaction’. Particularly when he then corrected himself, adding that what he had meant to say was ‘I won’t say there won’t be a recession – but there’s an over-reaction’.

This week, BASF Chairman Jürgen Hambrecht has taken up the role of cheerleader. Interviewed by the Financial Times, he revealed that he was ‘sleeping well at night.’ He conceded that in some industries related to housing and the consumer there was ‘a little bit of inflection’ from credit problems. But overall he was serenely confident, adding ‘why should there be a big, big crisis? I can’t see this happening’.

Unfortunately, his compatriot Peer Steinbrück, the German finance minister, was less upbeat over the weekend. Speaking after the G7 finance meeting in Tokyo, Steinbrück said the ‘G7 now thought subprime losses could reach $400bn’. This is quite an increase from the original $50bn estimate made by the US Fed. It also implies $280bn of write-offs are still to come, as total losses revealed to date are ‘only’ $120bn.

The Bank of England’s quarterly survey of corporate credit conditions, published today, shows that companies are finding it harder to get credit, and that rates are rising. This is in spite of the massive liquidity injections made by the Bank over the past 6 months, and its 0.5% interest rate cut.

The Bank says that ‘lenders reported a tightening of credit supply in Q4 and expect to tighten supply further in coming months’. Equally, as shown in the chart, the Bank says that ‘the effective rate of borrowing has remained elevated, despite falls in Bank Rate'. The Bank also worries that ‘although the effective rate on new business has fallen since its peak in August, this decline may be misleading, as it is likely to reflect the fact that as banks cut back on riskier higher-rate loans, the average rate on new lending falls'.

I noted 2 months ago that CFO pessimism was increasing in the chemical sector. This week’s reports from the Fed and Bank of England will do nothing to lighten their mood.

Ratings agencies Moody’s and S&P started taking a heavy line with Sabic in December over the supposed decline in the business environment at Sabic Innovative Plastics (the former GE Plastics business). This caused me to speculate that they were preparing the ground for a more wide-ranging move.

Today’s S&P report on private equity owned companies confirms my suspicions. S&P has looked at 36 European buyouts, including some major chemical names. It compares 2007 performance with the forecasts made when the deals were being done over the past 18 months.

S&P’s conclusion are worrying. Firstly, they report that the median company missed its first year forecast for EBITDA by 5%. And if this wasn’t bad enough (given that the period was a boom time in terms of margins and earnings), they add that net debt targets at many companies were only met by squeezing capex and working capital. And they add that 20% of the companies surveyed would breach loan covenants if their EBITDA fell by 10% or less.

The Lex column in the Financial Times sums up the report, with admirable restraint, by commenting that ‘if the corporate profit cycle turns, as seems inevitable, inappropriate capital structures will leave many buyouts in big trouble’. S&P’s report suggests that worried CFOs now have to wonder whether the risk of continuing to supply such companies on open book terms is one they should be taking.

China has been a major source of price deflation for the past decade. It is now the world’s leading manufacturer of a whole range of products from microwaves to DVDs. And the rest of the world has benefited from the lower prices that it has provided.

But not any more. The attached chart from the ACC’s weekly report shows that import prices from China into the USA increased by a record 3.3% in January. The trend is also worrying. For years, import prices were falling at around 1% a year. Now they are on a steep upward path.

I noted last week that the renminbi is now rising at an annualised 13% rate, whilst Chinese wage inflation is running at 18%. This implies that import prices from China could continue to rise over the next few months.

The UK government has today nationalised the country’s 8th largest bank, responsible for 18.9% of UK mortgage lending.

You may remember that Northern Rock was an immediate victim of the US subprime crisis. Its funding model, based on securitisation, failed to work once lenders became more concerned about return of capital than return on capital. Since September, the Bank of England has been forced to provide GBP 55 bn of emergency funding, following the UK’s first bank run in over 100 years.

The government even employed Goldman Sachs to scout the world and seek new investors. Sovereign Wealth Funds and others were approached, but none would agree to participate in a rescue. And so a bank which had an asset value of over GBP 100 billion in August, is now dependent on government for its survival.

The absence of Northern Rock will put further pressure on the UK housing market. Northern Rock had grown via aggressive lending, providing loans at multiples of 10 times salary, more than treble historical norms. In turn, this will reduce chemical industry sales to this important sector.

There’s an interesting article on Bloomberg, suggesting that the US Fed’s dramatic interest rates reductions are ‘driving Asia’s governments back to controlled economies’.

Its argument is that by cutting rates, Bernanke is ‘limiting his Asian counterparts’ ability to curb inflation'. It goes on to argue that Asian banks cannot now raise domestic interest rates to restrict demand, as a ‘widening spread between US and Asian borrowing costs draws more foreign money into the region’, causing asset bubbles to appear.

The same effect will occur if they allow their exchange rate to rise too quickly versus the dollar. And Asian central banks certainly don’t want to encourage a repeat of the US housing bubble in their own countries. So they are instead being forced to impose price controls on essential goods, in a bid to restrain inflation.

As I noted on 10 January, China froze the prices of oil products, natural gas and electricity, as well as public transportation. 5 days later, just as the Fed embarked on its 2nd round of interest rate cuts, it added price controls on grain, cooking oil, meat products, milk, eggs and LPG. The rationale can be seen in today’s announcement that inflation hit 7.1% in January, the highest for 11 years.

The problem, of course, is that domestic price controls (which also now apply in many other Asian countries for similar reasons), reduce the incentive to cut back on consumption as world prices move higher. The same is true for oil and gasoline prices, which are subsidised across Asia and also in many OPEC countries.

Thus the law of unintended consequences applies. These subsidies mean that supply and demand will be much slower to rebalance. So the net effect is that as the Fed reduces rates to try to avoid a severe US recession, it is indirectly causing global food and energy prices to rise. And in the end, if inflation starts to spiral out of control, rate increases may become essential, even in the US.

Quietly, oil has moved back to the $100/bbl level.

This is quite different from January, when it first hit the magic $100/bbl number. Financial players had jumped on the trend from November as crude rose above $80/bbl, and then wanted to ‘get out at the top’. Their thinking was that a US recession would reduce demand for oil, and so prices would fall. Now, however, more fundamental forces seem to be taking prices higher, and causing the 'shorts' to cover their positions.

The problem for the chemicals industry is that this purely speculative behaviour creates additional volatility. And with $120bn already ‘invested’ by financial players in commodities, much of it in oil, companies must assume that ‘speculative volatility’ will increase.

The behaviour of financial players is not the only uncertainty currently driving oil prices. Apart from the impact of geo-political issues such as Iran, Nigeria and Venezuela, four key questions will influence the direction of oil prices in 2008:

• Does OPEC care that higher oil prices will damage the western economy? In the past, the answer would have been ‘yes’, but recent signs (their decision to ignore President Bush’s plea for lower prices last month) imply their thinking may have changed.
• Can net non-OPEC supply increase as much as expected this year? Production from existing fields in Mexico and the N Sea has recently been decreasing faster than expected. This means more new oil has to be produced, to make up the difference.
• Will Asian and OPEC countries continue to subsidise oil products? If they do, then higher world prices will have no effect on the countries where fastest demand growth is taking place.
• Will financial players and pension funds see oil as a hedge against a falling US$? Some are already viewing the ‘US recession’ argument from a different angle, and believe it will force the Fed to cut interest rates back to 1%, causing the US$ to fall further.

The downturn in the global economy has been impacting chemical margins since the summer. Profits have been hit, as key customer industries such as housing, autos, and retail became more price conscious. Demand has also been slowing, as higher oil prices acted as a tax on Western consumption. Now feedstock volatility is likely to increase, due to the growing influence of financial players. CEOs and CFOs therefore need to ensure that proper risk management tools are in place to protect margins.

BASF Chairman Jürgen Hambrecht sounded confident last week, following their annual results.

2007 sales were €58bn (up 10% on 2006), and income from operations was €7.3bn (up 8%). However, Q4 saw sales up just 1.6% at €14.7bn, and income actually down 3.4% at €1.6bn.

The main culprit in Q4 was chemicals. Sales were marginally down on 2006 at €3.4bn (partly due to the impact of extended plant turnarounds), but income fell 50%. Unsurprisingly, N America was the problem region, with sales down 11% and income down 64%. BASF was clearly hit very hard, as one would expect, by higher feedstock costs and the downturn in housing and autos.

However, BASF was supported by a solid performance from its oil and gas business, where their main partner is Gazprom. The sector accounted for only 18% of 2007 sales, but contributed 41% of total profit. This was a very good performance given the strength of the euro, as the $7/bbl increase in the average price of Brent translated into just a €1/bbl increase for BASF.

The sector’s Q4 performance was excellent. BASF faces a headwind in its gas business when prices are rising, as it takes time to pass on these increases to customers. (Of course, it benefits from the same effect when prices fall). But although oil and gas sales were flat at €3.1bn, they still contributed €800m and represented 50% of total Group income.

BASF are continuing to reshape the portfolio, and hope to complete the styrenics sale within a few weeks. This would follow previous petchem divestments (eg Basell), and the acquisition of late-cycle businesses (eg Engelhard). BASF’s low debt ratio is also a strength as the credit crisis worsens. Whilst its Verbund strategy of highly integrated sites provides cost leadership, which is always critical during a downturn.

Chemicals and plastics will probably cause increased problems for BASF in 2008. But oil prices are already well above BASF’s budget figure of $78/bbl. So its perhaps understandable that Hambrecht felt able to tell the Financial Times he is currently still ‘sleeping well at night.’

Wheat prices rose 25% yesterday, the biggest one-day rise ever, as Kazakhstan imposed restrictions on wheat exports.

The rationale for today’s rising prices is three-fold:
• US farmers have shifted land over to corn, to meet increased ethanol demand, and US wheat inventories are forecast to hit 60 year lows
• Emerging countries are now eating more meat, because of growing prosperity, and so more grain is required to feed livestock
• Financial players see ‘soft commodities’ such as wheat as representing a store of value, versus weak currencies such as the US$

Inevitably increases of this magnitude will feed through into higher inflation. In turn, longer-term bond rates will increase. Chemical company CFOs were already facing problems from the credit crunch. Higher food and energy prices can only make these problems worse.

Its not often that one gets clear statements from central bankers. Today’s comment from the Bank of England’s Deputy Governor that the credit crunch was ‘an accident waiting to happen’ is truly remarkable for its clarity. She also gives the best one sentence summary that I have seen on the background to today’s credit crunch. :

‘The US housing crisis has acted as the trigger for an overdue correction in financial markets, after a long period of plentiful liquidity during which risk premia of all sorts had become unduly compressed, asset prices had become detached from reality, financial innovation had run ahead of risk management, and unsound business models had led to a deterioration in credit monitoring and, in some areas, underlying credit quality.’

She summarised it as ‘the largest ever peacetime liquidity crisis’.

US housing markets are getting worse. Today’s S&P/Case-Schiller index showed prices declined 8.9% in December. Moody’s said that 10% of homeowners (8.8 million people) had negative equity in their homes. And unsurprisingly, given this background, bank repossessions rose 90% versus January 2007 levels.

Price changes generally follow changes in volume, up or down. And so yesterday’s existing home data from the US Realtors Association indicates that we are still some distance from a price bottom. January’s sales were 23.4% below the level of January 2007. Inventory, the other major indicator, is also still moving in the wrong direction. It is now at 10.3 months, compared to 9.7 months in December.

The underlying problem is that credit availability continues to tighten. The Realtors say ‘subprime loans and other risky mortgage products have virtually disappeared from the market’. And the Fed’s interest rate cuts are having little impact on the price of credit for those able to get loans. The standard 30 year mortgage rate was 6.22% a year ago, and is now 5.76%. Had the rate followed the Fed’s cuts, it would be 3.97%.

The same reluctance to lend is now developing in the UK, following the Northern Rock nationalisation. ‘The Guardian’ reports today that lenders are focused on margin preservation as credit markets tighten, and are no longer ‘worried about market share and volume’. 125% mortgages are unavailable for new applicants, and many major lenders are now demanding 25% deposits for the first time in many years.

In the past, comments ‘The Guardian’, falls in house prices have normally been driven by rising unemployment. This time, however, the main factor is the ‘credit crunch’, which means there is a ‘lack of funds for lenders’. Until this can be resolved, chemical companies will continue to suffer from the double whammy of lower sales into the critical housing market, and higher borrowing costs.

The blog has been following the debate over ‘decoupling’ with some interest. With the US going into a downturn, it is critical to understand whether Asian chemical markets will follow. Until recently, they have been buoyant, allowing US companies to make up for some of the decline in their domestic markets via exports. But I suggested back in December that this would probably not last.

Today’s news from Japan tends to confirms my scepticism. Factory output fell 2% in January. Bloomberg reports this was because ‘a deepening US slump weakened demand for cars and electronics’. Even worse, companies expect output this month to slide a further 2.9%. March may be better, as inventories will have been worked off.

Japanese central bankers can do little to stimulate the economy, with interest rates near zero. Governor Fukui said last week that ‘a deeper slump in the world’s biggest economy (the US) would have adverse effects on the emerging markets that Japanese exporters depend on’. With the US$ weakening as well, markets seem likely to get increasingly tough for Asian chemical companies.

China’s move last month to charge for plastic bags has now been followed by the iconic UK retailer, Marks & Spencer.

Whilst the environmental angle is clearly important, the move also represents a reaction to higher oil prices. Plastic bags are not ‘free’ to retailers, and their cost is now escalating. Restricting this cost, whilst also gaining ‘green’ credentials, is a ‘win-win’ for them. Similarly, its a ‘lose-lose’ for polymer producers. They have to pay the higher feedstock cost, and will now have lower volumes, so unit costs will increase.

Even worse, it probably marks the start of a more general movement to restrict ‘non-essential’ uses of crude oil. Gordon Brown, UK premier, has now said the UK government will force all supermarkets to charge within a year. Other governments will no doubt follow. The benefits of plastics are not well understood by the general public, and represent a soft target. Operating rates for producers and converters will suffer as a result.