Chemicals & The Economy

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'A vicious circle now seems to be in place again, where a lower dollar inspires raw material prices to rally, which in turn increases worries about inflation’. This was how strategists at BNP Paribas summed up the US Fed Chairman’s two days of testimony to Congress last week.

For the last 20 years, every Chairman and US Treasury Secretary has paid at least lip service to the concept of ‘the strong dollar’. Hank Paulson repeated the mantra on Thursday. But Bernanke did not once mention the phrase to Congress. Currency and commodity traders were quick to take the hint. The $ dived to new lows against both the euro and yen. Oil prices also jumped to new record highs.

A 2nd stage of the financial crisis that began last August now seems to threaten. The 1st stage was the discovery that US houses (and those in several other western countries) were no longer worth the price that had been paid for them. This led to a collapse in house-building, and a general tightening of global credit markets.

Now, the Fed sems to be encouraging the $ to fall, with Bernanke commenting that this would have ‘the benefit of stimulating exports’. But as Barrons, the influential US investment magazine noted, this policy carries the risk of creating an ‘inflationary maelstrom’. Just as in 1973, they added, oil producers may get ‘tired of parting with their precious petroleum for depreciated dollars’.

The combination of lower economic growth, tighter credit conditions, and commodity/feedstock price inflation is potentially a toxic cocktail. Some companies selling into buoyant agchem markets will have no problem overcoming it. But others face a more uncertain future.

Anthony Bolton of Fidelity has been the UK’s premier stock picker for 30 years. His learnings from his ‘worst disasters’ provide an insider's perspective on how to spot a company that’s about to fail. He revealed his top 3 warning signs in the Financial Times this weekend:

‘If it walks like a duck, and quacks like a duck, then its a duck’. This simple logic probably best sums up Warren Buffett’s position on the current state of the US economy. ‘By any commonsense definition’, said Buffett yesterday, ‘the US is in recession’.

Buffett is the world’s leading investor. And key evidence from a chemical industry perspective supports his conclusion. US vehicle sales fell 10% in January, after a terrible 2007. Housing starts are 50% down on earlier peaks, and US house prices are falling nationally for the first time since the Depression. As Buffett added, ‘most people (are) experiencing recession’, and ‘their net worth (is) heading south’.

Buffett’s warning about the US$ was also worrying, with his belief that it ‘is going to get weaker over time’. Last year, the lower $ allowed US chemical companies to compensate via increased exports for slow domestic markets. But the $'s latest fall means that it is now challenging the ¥102 level, which has held for over a decade.

Equally, investors search for a reliable ‘store of value’ is causing them to chase commodity prices higher. Speculative long positions on NYMEX crude oil rose 50.4% last week, as financial players rushed to exit the US$. Many expect crude to hit the $110-$115/bbl level shortly.

OPEC today decided to hold oil production at current levels, even though prices are at a level which clearly threaten economic growth. They even recognised this risk in their statement, ‘highlighting the economic slowdown in the USA, which together with the deepening credit crisis in financial markets, is increasing the downside risks for world economic growth and, consequently, demand for crude oil’.

Normally, faced with this outlook, OPEC would have flooded the market with crude, in order to bring prices down and help support the world economy. Clearly their priorities have changed, and we appear to be back to the difficult times of 1973/4 and 1979/80, when OPEC similarly held production whilst the world economy went into a downturn.

OPEC’s statement seems to reflect a growing hostility towards the US over a number of issues, including the weak US$ (as noted by the New York Times). Saudi Arabia, the leading OPEC moderate, clearly feels let down by the lack of progress in the Middle East peace talks. And OPEC also decided to support Venezuela’s ‘sovereign rights over its natural resources’ in its dispute with ExxonMobil, calling on EM to hold back from further legal actions to support its claims.

Faced with this background, chemical company planners need to rethink their crude oil scenarios for the year. I argued back in October that the consensus $70/bbl forecast looked too optimistic. Now, with OPEC taking a hard line, and western investors starting to panic over the value of the US$, we are in uncharted and potentially dangerous territory.

Central bankers are slowly recognising that inflation is becoming a serious problem. But their responses differ. So chemical companies will find it harder to predict interest and exchange rate policies.

China announced yesterday that inflation had soared again last month, reaching 8.7%, versus the government target of 4.8%. Part of the increase is clearly due to the effects of recent major storms. But with the US Fed likely to cut rates soon, China remains in a difficult position. If it increases interest rates, then the currency will rise further, making it a target for ‘hot money’. If it doesn’t, then inflation (particularly in food and energy) will continue to rise.

Meanwhile, Bloomberg has analysed developments in US fixed income markets and suggests that bond traders now believe that the US Fed is about to ‘lose control of inflation’. Since 29 February, the yields on US Treasury Inflation-Protected Securities (TIPS) have been negative. Buyers are apparently prepared to give up ‘real yield today’ for the security of inflation-proofing in the future.

Against this background, it is perhaps not surprising that traders pushed up crude prices yesterday to a new record of $107.91/bbl, as they continued to search for a ‘store of value’. US natural gas prices have also strengthened recently, and are now over $10/MBTU.

India is apparently facing its own subprime crisis. Banks have cut back on lending, as the Bank of India has caused real interest rates to rise to around 7%. Loan growth is already down 20% this year, with personal unsecured loans facing the greatest cutbacks.

ICICI, India’s largest bank, has withdrawn entirely from this sector, which was formerly growing at 40% a year. V Vaidyanathan, executive director at ICICI, said ‘we have tightened credit norms across all elements of the credit portfolio. Though the existing book is performing well, its better to be conservative’.

As a result, India’s GDP is now expected to be around 8 – 9% this year. Earlier optimistic expectations of 10% growth now look unrealistic.

The US$ had now fallen through the ¥102 level, which has held since 1995, and went straight to the psychologically important ¥100 level. The dollar peaked 9 months ago at ¥124, and so it has now fallen 19%. This is dramatic by any standards. I forecast back in November that an ‘old-fashioned currency crisis’ could be just around the corner. With the dollar falling against both the yen and the euro, I think this crisis has probably now arrived.

My other recent forecast, that crude would hit $110/bbl, has taken only a week to occur. Yet a month ago, crude was 'only' $90/bbl. Part of the rise was caused by speculators having to unwind short positions, but there is also increasing interest in call options at $150/bbl. I have even heard people talking seriously about the chance that $200/bbl could be seen before the end of the year. As I commented after the OPEC meeting, we are now ‘in uncharted and potentially dangerous territory’.

The Financial Times this morning reports that the US Fed fears that ‘the economic downturn in the US could turn into a deep and protracted recession of the kind that plagued Japan’. Clearly based on interviews with senior Fed officials and other policymakers, the two articles (one for the European edition, and one for the US) provide a remarkable insight into the Fed’s current thinking:

I am indebted to Paul Krugman for passing on this piece of black humour, now going the rounds in financial markets.

Unfortunately, these problems are getting closer to home. Carlyle, who have a number of private equity investments in chemical companies, defaulted on a $16.6bn bond fund today.

We have now seen 3 financial disasters in a matter of days:

• Northern Rock, the UK’s 5th largest mortgage lender, was nationalised last month, after failing to secure sufficient funds to continue lending.
• Carlyle, one of the world’s largest private equity firms, saw their $16.6bn mortgage fund default on Thursday, due to its excess leverage.
• Bear Stearns, the 5th largest US investment bank, had to be rescued by the US Fed/JP Morgan over the weekend, as it too hit a liquidity crisis.

Bear were the subject of one of my first postings in the blog, last July, when I commented that its hedge fund troubles sent ‘a chill down my spine’. My fears have been amply justified by subsequent events. As the BBC’s business editor, Robert Peston, said on Friday, "the rescue of Bear Stearns demonstrates that the worst of the global credit crunch is not yet behind us." He added ‘that if Bear Stearns had been allowed to collapse, it could have put the whole financial system at risk’.

And although stocks rallied globally on Thursday, after S&P were reported as saying the end of subprime writedowns was ‘now in sight’, it is clear from reading the full S&P statement that their real views are quite different:

‘We believe that any near-term positive impact of reducing subprime risk in the financial system via increased disclosure and write-downs will be offset by worsening problems in the broader U.S. real estate market and in other segments of the credit markets. A major repricing of credit risk is taking place across the debt markets, with credit spreads having further widened in most segments since the beginning of 2008’

As I have noted since September, the whole zeitgeist is changing in financial markets, with lenders now focused on ‘return of capital’, rather than ‘return on capital’. Clearly, they don’t like the prospects they see ahead, and who can blame them? But with housing markets so important to the chemical industry, it is hard to believe that we will avoid major impact from the financial disasters now taking place.

The US$ took a major tumble yesterday, as traders decided the Bear Stearns news meant there was little risk of central bank intervention. Against the Japanese yen it fell almost 2.5% during the day, closing at ¥97.35, as shown on the chart. It also fell 2% against the Swiss Franc to SwFr 0.98, and continues to hit new lows against the euro.

The $ is now at its weakest since 1971 on a trade-weighted basis. This will have a major impact on chemical company results:

Winners will be those who buy feedstocks in dollars, and sell in hard currencies such as the euro, yen or SwFr.
Losers will be those who buy in hard currencies, and sell in dollars

US exporters are likely to do well as a result. But one should expect to hear cries of real pain from the losers as Quarter 1 results are reported.

Benzene prices may be about to tell us something quite important about future profitability trends for the chemical industry. As the chart shows, benzene has hit a price ceiling at around $1200/t over the past 4 years in European markets. Yet crude has been climbing, from an average $38/bbl in 2004 to average $95/bbl so far this year.

Equally benzene prices, normally the most volatile of all the petchems, have suddenly become quite ‘normal’. Volatility was typically above 100% between 2001 – 2004, using average European monthly spot prices reported by ICIS pricing. But so far this year, they have moved within just a 12% range, after a range of only 27% in 2007.

The $1200/t price ceiling suggests that it has now become very difficult to pass on today’s higher crude/feedstock prices. Equally, it seems unlikely that benzene prices will remain unnaturally stable for very much longer. If they start to slip, whilst naphtha stays strong, then we will know that the outlook for commodity petchem profitability itself has also weakened.

The New York Times has an excellent feature today that aims to explain how ‘US sub-prime mortgages could take out the whole global financial system’. I know that many readers found the Bird/Fortune video on the subject very useful last December. So I thought you might like to know about this new analysis.

The Times reporter called a number of senior figures on Wall Street, asking them the simple question ‘Can you explain this to me?’ After they had finished, he often then asked ‘Can you try again?’ He concludes:

• The US had a housing ‘bubble’, which is now going ‘bust’
• Massive leverage meant that even small losses led to equity wipe-outs
• All ‘busts lead to panics’, which can cause ‘long, deep, economic downturns’
• ‘Unprecedented’ actions are now being used to try and restore confidence

The above chart comes from Kevin Swift’s weekly report for the American Chemistry Council. Sadly, it paints a downbeat picture for the near-term outlook for the US chemical industry. It shows that US housing starts fell a further 0.6% in February, whilst building permits fell 7.8%.

Housing starts are now down 28% versus a year ago, and building permits are down 37%. In absolute terms, they are back to 1990 levels, and still falling. This is very bad news, as housing is a key market for the chemical industry, with each new home requiring $16k of chemicals.

The only bright spot for US producers is that they have been able to compensate for this domestic decline via increased exports. As I noted last week, the US $ is now back at 1971 levels on a trade-weighted basis. The report shows rail car loadings are now up 3.4% versus last year as a result. But I doubt that these levels of exports are sustainable. Asian and European markets are probably already slowing themselves, now the US has moved into recession.

Volatility has been rising in the crude oil and feedstocks markets. This is because individual players have completely different strategies. In turn, this makes it difficult for chemical companies to forecast short-term feedstock costs. It also makes it difficult to maintain margins.

Last Monday, crude reached a new high of $111/bbl. Then, as the scale of the Bear Stearns collapse became apparent, it fell over $10/bbl. Currently, it is trading around $100/bbl. A number of different rationales have been put forward to explain this sudden fall:

• Many commentators have taken it as a sign that the US recession will reduce demand, causing prices to weaken. Latest EIA figures show a rare, if minor, 0.1% decline in gasoline demand over the past month.
• Other analysts have pointed out that last week’s wild swings in equity markets caused major losses for many investors, requiring them to meet margin calls by selling out their positions in commodities.
• They have also added that Bear Stearns’ Proprietary Trading Group had been very active in crude oil futures, and it was likely that its positions had been sold quickly once its collapse had been confirmed.
• Equally, others have argued that crude’s recent strength was due to US $ weakness, as investors used commodities as a ‘store of value’. They now expect the US $ to strengthen, reducing their attractiveness.

All of these analyses probably have some element of truth in them. Over the longer-term, prices will be set by the fundamentals of supply and demand, which in turn will be influenced by geo-politics. But last week’s ‘perfect storm’ of events illustrates just how complex it has become to forecast day-to-day market action in crude oil markets.

Those who liked my earlier posting about Margin calling, might like to look at the new online Financial Times page devoted to subprime jokes. For example, 'What's the definition of an optimistic investment banker?' 'Someone who irons 5 business shirts on a Sunday night.'

It also mentions the prospect of a new breakfast cereal being launched, ‘Credit Crunch’. One hopes this won’t be served along the RiverWalk at San Antonio during next week’s NPRA meeting.

After 5 months, ExxonMobil is once again the world’s largest company by market capitalisation. PetroChina had overtaken it last November, but has since lost half its value in China’s stock market decline. Today, PC is worth $453bn, versus EM’s $455bn.

China’s stock market has lost 25% so far this year. But PC has been particularly badly hit by its inability to raise product prices to compensate for higher oil costs. Its refineries are losing $54m a week as a result. With inflation at a record high of 8.7%, the government is determined to insulate Chinese consumers from the impact of $100/bbl oil.

In turn, this means demand is not being restrained by higher market prices, with all oil product prices frozen last January. The same is true in many other emerging countries, and in the OPEC countries. This means the West is facing the bulk of the adjustment process, which is bad news for those petchem producers without access to advantaged feedstocks.

Readers will know that I am a great admirer of Gillian Tett’s analyses of banking issues in the Financial Times. Today, she has another thought-provoking article, this time on the emergence of Iceland as ‘the world’s first country run like a hedge fund’. The article is worth reading in itself, but also for the question that it raises in conclusion. This is whether the leverage used in recent years by some banks now means that they are ‘not just too big to fail, but also too big to rescue’?

China is well worth watching at the moment. Quietly, away from the headlines, the Shanghai stock exchange has been collapsing. It is now down 44% since its October peak, and fell over 5% on Wednesday.

This matters to the chemical industry for two reasons:

• The immediate cause of Wednesday’s fall was news that Sinopec and PetroChina lost money in January and February. Their shares fell over 8% as a result. This shows the level of ‘subsidy’ now being offered to Chinese consumers following the government’s decision to freeze oil product prices in January. It turn, this subsidy delays any rebalancing of demand (as I noted on Wednesday), putting more pressure on western consumers.

• The collapse itself indicates that the Chinese ‘growth story’ may be about to take a break. The government has been raising interest rates very steadily, because of worries about ‘over-heating’ in the economy, and rising inflation. The stock market is forecasting that these measures will work, and that we may well see a major slowdown after the Olympics. This would be extremely serious as China was the powerhouse behind the recent boom in global chemical demand.

Of course, stock market collapses do not always lead to economic downturns. But they are often linked. The establishment of contingency plans for dealing with a global slowdown is fast becoming an urgent priority for chemical industry managements.

The US Fed’s decision to keep cutting interest rates is causing a major change in Asian investment behaviour. This will slow world economic growth quite significantly, and is bad news for chemical industry sales. It also means that the informal Bretton Woods II system of currency management has broken down.