Chemicals & The Economy

Last month, I noted the suggestion by leading bankers that interest rates would probably rise by the end of May. The rationale for this view was that the bigger, stronger banks seemed to have got fed up with subsidising the rates being charged via LIBOR (London Inter-Bank Offer Rate) to weaker banks. And sure enough, LIBOR closed on Friday at 2.68%, well above the 2.0% rate set by the US Federal Reserve.

LIBOR may sound like an obscure part of the banking system, but it is the main benchmark for $347 trillion of global borrowing. So its rise will affect borrowers all around the world - both companies and individuals. Equally, government bond rates have risen between 0.2% and 0.5% during May in all the main financial centres, as investors worry about the impact of higher energy and food prices on inflation.

These higher interest rates are bound to slow demand for many chemical products. They will also make life more difficult for highly-leveraged companies.

Some minor relief may be at hand for hard-pressed cracker operators, particularly those in Asia. Sinopec announced today that it will reduce ethylene output by 65 KT in June (the equivalent of 1 cracker's output), in order to allow it to boost fuel production by 200 KT. This will be done by bringing forward planned cracker maintenance at Zhongyuan, Dongfang and Shanghai. The aim is to respond to government directives to ensure fuel supplies after last month's earthquake.

Balancing petchem and fuel needs seems to be becoming a recurring factor in China. I noted back in January that olefin imports had surged in late 2007, as the government stockpiled fuel in advance of the Olympics. 1 tonne of ethylene production equates to an extra 5 tonnes of diesel. But before we get too cheerful, we have to remember that there is a cloud to this particular silver lining. The International Energy Agency is now forecasting that China's 2008 oil demand may rise 4.7 percent to 7.9 mbd, which will help support today's already high energy prices.

Fuel subsidies are set to double this year to at least $100bn, according to the head of the International Energy Agency (IEA), Nobuo Tanaka. This is in spite of the fact that some countries such as Taiwan have recently abolished subsidies, whilst others such as Indonesia have reduced them significantly. But for every subsidy withdrawn, a new one seems to appear. Yesterday Chile, which imports almost all its oil, announced that it would start to subsidise. Equally, some Western governments are toying with the idea of reducing existing fuel taxes. This has already become an issue in the US Presidential campaign, as well as in many European countries. And of course, it amounts to the same thing as an outright subsidy, as it means today's higher prices are not being passed on.

The problem is one of 'chicken and egg'. Once some governments start to subsidise, prices get out of line with costs. So demand increases. In turn, with supply tight, world market prices increase for everyone else, and so the pressure for more or new subsidies increases. The ironic thing is that energy subsidies themselves, whether direct or indirect, benefit the rich and not the poor. The International Monetary Fund has recently calculated that the top 20% of households receive 42% of a country's total subsidy. This is because wealthy people consume more energy. The poorest people only receive 10% of the benefit.

Subsidies are therefore a very wasteful use of resources. But I doubt that will stop governments from using them. And energy-intensive industries such as chemicals will end up paying the bill.

The blog doesn't often comment on management issues. But one interesting article has caught my eye today. A major study reported in the Financial Times suggests that 'leadership teams were four times as important as leaders in the process of developing strategy'. And it quotes Lee Scott, Wal-Mart's CEO as saying that 'I don't run the company...as CEO, if you have to get up every morning and tell people what to do, then you've got the wrong people in the jobs'.

I think the chemical industry may soon find itself putting this insight to the test. As the economic downturn worsens, so it will show up those companies and Boards that are essentially 'one man bands'. Recent boom conditions have rewarded risk-taking, and it is no surprise that the idea of the 'CEO as hero' has developed in response. But in today's more uncertain world, the study suggests that leadership should be considered 'a team sport', where tasks are distributed 'far and wide' to the most appropriate people.

Yesterday's action in financial markets reminded me of the Bird/Fortune video (noted here in December), where they took a satirical look at the causes of the sub-prime debacle. Specifically, the question in the interview where Fortune describes Bird as a 'sophisticated investment banker, with his fingers right on the pulse'.

The moment that recalled this was after the opening bell on Wall Street, when the Dow was trading happily, so it seemed, above 12500. Then General Motors released its auto sales figures for May, and the market promptly collapsed nearly 200 points. One wondered why? I can't believe any chemical industry executive was surprised to see that GM sales were down 16% YTD, given that April had been down 17%, and that all the major companies had said the industry's slide was continuing.

It seems that all these 'sophisticated' investors had assumed that Father Christmas had been going to appear (presumably in the shape of the US Treasury tax rebates that were mailed in April), to single-handedly rescue the US auto industry? This would indeed have been a triumph of wish-fulfilment. For as every Western child knows, Father Christmas visits in December, and only if you've been good during the year.

In the meantime, the bad news for chemical sales is that the 2 key US market sectors, housing and autos, are continuing to get worse, not better. The second half of the year is shaping up to be very difficult indeed.

US economic conditions are 'ominous", and may worsen into 2009, according to Dow CEO, Andrew Liveris. "A month ago we might have said ... the US slowdown could be bottoming, but I don't think it is bottoming," Liveris said in response to analysts' questions at an investor conference in New York. He added that "I think we are in for a tough 2008 and maybe even a tougher 2009."

Central bankers had it easy over the past decade. Now they are going to have to earn their money. Inflation is rising rapidly, and growth rates are falling. But unfortunately, as I first noted back in March, they still seem to have differing ideas about what policies will best counter these twin challenges.

The US price for natural gas has risen faster than crude so far this year. It is already up almost 65%. Rising coal and oil prices have encouraged power generators to switch to gas, whilst lower Canadian exports and a tight global LNG market have helped to push prices higher. Increasing demand for ethanol will also require 1bn cu ft of extra gas supply, between 2008/9, according to Merrill Lynch. US producers can be forgiven for feeling battered, with their costs rising and the domestic market hit by lack of demand from the housing and auto sectors.

Every now and then, a few interesting quotes come along, which seem to recent summarise developments, and set the tone for the next few months. Recent days have been a good example of this process at work:

'The era of cheap energy is over, as oil production isn't rising fast enough to meet demand amid a lack of spending'. Tony Hayward, CEO, BP

'A public backlash against high (oil) prices in China could have an adverse impact throughout the world'. Zhang Guabao, China's delegate to the G8 Energy Ministers' meeting

'It is not clear if the rest of the world is going to continue to fund the US current account deficit at current levels of exchange rates'. Malcolm Knight GM, Bank of International Settlements (the central bankers bank)

'The banking system might simply revert to the role of a utility, which is the way things were before the great deregulatory tide began in the 1970's'. John Plender, senior financial columnist, Financial Times.

The blog usually focuses on news items and analysis. But just occasionally, anecdotal evidence seems worth reporting. My colleague, John Keeley, is well known to many readers from his days at Shell Chemicals, as well as more recently with IeC. Just back from chairing the ICIS Phenol and Acetone Conference in Budapest, he reports that he 'had never seen American colleagues so downbeat in his 40 years in the industry'. John is by nature one of the world's great optimists, so his concern is particularly powerful.

The latest leading indicators from the OECD (shown in red above) are now diverging quite strongly from actual Industrial Production performance (shown in blue). The chart is taken for the latest American Chemistry Council (ACC) weekly report, and the ACC comment that the indicators should anticipate changes in 'global industrial activity' and 'provide early signals of turning points (peaks and troughs)'. The ACC adds that they are also 'good indicators for basic and specialty chemicals, 85% of which are sold to the industrial sector'.

The puzzle is the divergence that seems to have opened up since 2005. Before then, actual industrial production seemed to track the indicators very well, with a suitable lag. Perhaps the availability of cheap credit between 2005-7 allowed a higher level of production than normal? Whatever the cause, the ACC is not optimistic that this divergence will continue, commenting that 'the data suggests that global industrial production will further slow'.

I noted earlier this year that China was now exporting inflation, rather than the deflation of the past decade. Working in Asia again this week, one can see a major change in attitudes is now underway. Rising food and energy prices are having an enormous impact, and Asian governments are clearly nervous about the potential for greater political unrest.

Therefore many have instead introduced subsidies of one type or another. In addition, central banks have allowed real interest rates in every major country to turn negative. For example, China's real borrowing rate is now -1.03%, as inflation is higher than the benchmark interest rate. Across the region, rates average 6.75%, well below average inflation of 7.5%.

Governments fear that raising benchmark interest rates would push up currency values, and damage exports. But many are still keen to cool their domestic economies. So they use other levers instead. This week, for example, China raised the deposit rates for banks to 17.5%, forcing banks to cut back on loans to companies and individuals. India followed, raising its rate to 8%, and Vietnam, Indonesia, Philippines and Pakistan also raised rates.

The result was a major fall in stock markets. China's benchmark index, the CSI, plunged 15%, the biggest fall on record, and is now down 44% for the year. Benchmark Asian indexes also fell around 7% on the week. And the Chairman of Morgan Stanley Asia, Stephen Roach, warned that the world was 'in denial' about the likelihood that Asia would now start to export 'stagflation' (stagnant growth, plus inflation). Stagflation last occured in the 1970's. This time, he argued, 'it will be made in Asia'.

Chemical companies, faced with rising feedstock costs and the prospect of lower volumes, might well argue that it has already happened.

There seems to be remarkably little information about Saudi Arabia's planned oil 'summit' next Sunday in Jeddah. The first news of it seemed to be released rather informally, via a 'junior official' at the Oil Ministry. Since then, various rumours have been reported, but nothing very substantive. All we seem to know for certain at the moment is that King Abdullah told the UN Secretary General over the weekend that he thinks oil prices are 'abnormally high'.

In the past, a clear Saudi view such as this would be a prelude to a major decrease in price. But at the moment, there seems little clarity as to what, if anything, the King might be planning. And the main media have differing views on the key short-term issue - the potential for extra Saudi production:

• Bloomberg reports that Saudi Aramco will start pumping an extra 500kbpd from the new Khursaniyah field 'next month'
• The Financial Times, however, only suggests this will start 'soon'.
• The Wall Street Journal takes a different line altogether, suggesting there might not be any additional net production increase at all, as 'the plan for that field was to ramp up its production slowly, while using the new stream to allow some of the country's older fields to rest'.

It looks as though we may have to wait till next weekend to find out what King Abdullah is really hoping to achieve from his summit.

Monday, Monday, can't trust that day
Monday, Monday, sometimes it just turns out that way
Oh Monday morning, you gave me no warning of what was to be

These 'Mamas and Papas' lyrics certainly sum up Monday this week:

• Oil prices went to another record high, just under $140/bbl, as traders worried about the falling US$ and the risk that an attack on Iran might not be far away
• A leading US economist suggested that the next 18 months might parallel the 1988-92 US real estate crisis, 'when more than 1000 banks and 1000 thrifts failed'.
• ICIS' Nigel Davis highlighted the suggestion from Citigroup analysts that the chemicals industry was also'heading for crisis' due to its inability to pass through recent feedstock cost increases

Linda Naylor, ICIS's polymers guru, has just written a market analysis that took me straight back to 1980. She described how current feedstock prices meant that 'many of Europe's cracker operators were losing money', and noted that Dow was being 'very firm' in trying to recoup these losses via higher polymer prices. However, her research suggested that other sellers were showing more 'flexibility' in their negotiations. And she quoted one buyer who forecast that 'Dow will lose an awful lot of volume'.

In 1980, I was a young sales rep, working for one of the then world majors (ICI). And I went through the same experience that Dow is now suffering. At the start of Q2, we were told to 'hold the line' on pricing, in order to recapture margin caused by rising crude prices. (Does this begin to sound familiar?). Oil prices had moved above $30/bbl, or to around $95/bbl in today's money. Competitors, of course, undercut us. By the end of the quarter, we had lost around 20% of our volume - which we had to reclaim in Q3 by lowering prices still further.

John McCain, Republican Presidential candidate, is making waves in the US political scene with his suggestion that the ban on offshore drilling for oil might need to be lifted. Barron's, however, notes rather ironically that in fact, drilling is already underway off the Florida coast. It points out that 'Cuba is allowing Chinese energy companies to drill for oil and gas in the Gulf, less than 90 miles (145km) from Florida'.

A first visit to Cambodia. I'm here en route to our Asian Conference in Bangkok, and the picture shows the famous line of Buddhas at Angkor Wat. But the main topic of conversation when talking to local people is the high cost of food and energy. With wages averaging $30 - $35 a week, these costs now account for up to 65% of income. Other expenses, such as schooling and healthcare, have to be cut back if people are to survive. This is not good for the future of the country, which risks slipping backwards in the development stakes as a result.

I've read several reports on the outcome of the Jeddah oil 'summit', and still feel no wiser than last week:

The US has now confirmed what oil traders have been suspecting - that Israel is preparing for a bombing raid on Iran's alleged nuclear facilities. According to Bloomberg and the New York Times, around 100 Israeli aircraft took part in a full-scale training exercise in early June. The distance it involved, 900 miles, is apparently 'about the same distance between Israel and Iran's uranium enrichment plant at Natanz'.

Higher oil prices will change the way that Procter & Gamble operates its supply chain. The world's largest consumer products company describes its current operations as being 'upside down'. 'They were implemented in the 1980s and 1990s, when oil was 10 bucks a barrel', according to Keith Harrison, P&G's head of global supply.

Oil prices at $140/bbl caused plenty of debate in Bangkok this week at our Asian conference (jointly organised with ICIS). Delegates also heard from Reliance's President of Fibre Intermediates, Rajen Udeshi, on the potential for a new commodities 'Super Cycle' to be underway.

Discussing the above chart, he pointed out that the industrialisation of China and India might well cause the same disruption as the industrialisation of Europe and the USA in previous centuries. 'China and India have a combined population of 2.1bn, which is one third of the world population', he added. 'That is a lot of buying power'.

Alexei Miller, CEO of Gazprom, believes 'that OPEC doesn't have any real influence on the global oil market nowadays'. Interviewed by the Financial Times, he claimed that 'not a single decision has been passed of late that would really influence the global oil market'. And he repeated his suggestion that oil could reach $250/bbl, noting that 'the last 10 years saw Chinese energy consumption almost double and India's grow over 1.5-fold'.

Three major themes (ICIS Jun08.pdf) emerged from our Asian Conference last week, co-organised with ICIS:

• Change. The world is clearly changing very rapidly. Feedstock prices are rising. At the same time, major new capacity is starting to come on-stream in the Middle East, and in Asia.
• Complexity. There are many more issues to understand. Feedstock costs are being affected by geo-politics, gasoline and biofuels. Whilst economic growth is also looking much weaker.
• Challenge. Over the past decade, companies have focused on optimisation within their own chosen 'silos'. This has been a very successful strategy, but it may not be sufficient for the future.