Chemicals & The Economy

The King of Saudi Arabia is the most important person in the oil industry. He controls the largest oil reserves, and is the largest single producer. Previous Kings have let their Oil Ministers do the talking at OPEC meetings, and to the world's press. But King Abdullah, who succeeded in 2005, has recently become more public with his own thoughts.

In April, with oil at $100/bbl, he rebuffed appeals to pump more oil, saying "when there were some new finds, I told them 'No, leave it in the ground, with grace from God, our children need it'." But then in June, as prices made their final ascent towards $147/bbl, he called an emergency Energy Summit in Jeddah, and said he thought $100/bbl was "too high". Now, he has told a Kuwaiti newspaper that he thinks $75/bbl is a "fair price".

The blog therefore deduces that the King's 'target range' is currently $75 - 100/bbl. This is also the level required to attract the investment necessary to maintain current levels of oil supplies. Without new investment, supplies will decline, as depletion rates are now 9.1% per annum on existing fields. Yet in the short-term, it is hard to see the chemical industry being able to afford such prices, as recession continues to bite.

Last March, the blog supported Warren Buffett's statement that "by any commonsense definition, the US is in recession". I also wrote an article for ICB in April, "Building your defences", to suggest how companies could develop contingency plans to deal with the "real threat" of recession.

At the time, government figures did not support Buffett's claim. But today, the official US body responsible for dating recessions has formally declared that the US entered recession last December.

As the blog expected back in May, when quoting Mark Twain's famous line "Lies, damned lies and statistics", Buffett's call has turned out "to have been right, after all".

The chart presents a sobering view of recent stock market performance. It shows (courtesy of chartoftheday.com) the Dow's performance in the first year of all bear markets since 1900. Since its 2007 peak, the Dow has fallen more than in any other bear market, even more than in 1929.

Foresight, and long-term relationships, have paid off for Dow.

Yesterday, CEO Andrew Liveris announced that a binding agreement has now been signed with Kuwait's PIC to form K-Dow Petrochemicals. PIC will pay $2bn less for their stake than originally agreed a year ago. This represents an exceptionally good outcome for Dow, given what has happened in world financial and petchem markets since then. It is also a major success for PIC, who now become a leading industry player. As the blog forecast last year, MEGlobal and Equipolymers will become part of K-Dow, taking its sales to $15bn.

Liveris and the Dow Board showed great foresight in creating the deal whilst the industry was still enjoying reasonable times. Equally, they would never have been able to conclude it, during the current meltdown, without the high level of trust developed between PIC and Dow, since the latter inherited the original Equate JV in 2001.

The blog congratulates those concerned for their ability to remain focused on the bigger picture, through all that has gone on in recent months.

INEOS is the world's 3rd largest chemicals company. Its €7.29bn debt burden ($9.2bn) means that it is also Europe's largest issuer of high yield debt. This is an unfortunate combination, given today's chemical markets.

Last month, INEOS was forced to ask its lenders for a waiver on its debt covenants. It offered to pay a 0.5% upfront fee for the waiver, plus an ongoing fee of up to 1.25%. Its lead bankers, Barclays and Merrill Lynch, offered their support immediately, but other investors have been cautious.

Bloomberg reports that INEOS has a number of US lenders, and says these are used to receiving much higher fees in return for covenant waivers. S&P data shows US companies paid an average 2.40% so far this year. And according to Reuters, "the markets' reaction shows that investors remain unconvinced that the company will be able to solve its problems by the end of May and avoid a full balance sheet restructuring".

Reuters adds that investors' concerns are also shown by the fact that insurers have recently required payments of "€7m upfront to protect €10m of the company's debt against default". INEOS senior debt has been trading around 50% of face value, whilst its junior debt has traded below 20% of face value.

INEOS has warned of an expected €400m loss on inventory write-down, if oil is $60/bbl at year-end. It announced a management restructuring of its European Olefins and Polymers businesses, and is taking a number of measures to reduce costs and improve working capital. John Reece, INEOS CFO, has also reassured investors that "the Group as a whole can produce significant profits and cash flows even at the bottom of the cycle".

Decision-time for the 233 members of INEOS's banking syndicate is 9 December, when the waiver request is likely to receive majority approval. Reports suggest, however, that the company may well have to pay an extra 0.5% in fees.

US auto makers today told Congress their "rescue plan" now needs $34bn in support, whilst GM and Chrysler said they need an $11bn loan "just to survive the year". US sales were down 37% in November, and are at their lowest annual rate since 1982:

• GM were down 41% versus 2008
• Ford were the best performer, but still down 30%
• Toyota were down 34%
• Chrysler were down 47%

In terms of overall demand, GM noted that "the annual volume of 2 production plants had simply evaporated in a single month". Whilst Ford said they plan to produce only 62% of Q1 2008 volume in Q1 2009 - 430k vehicles compared to 692k - in order to align supply with demand.

European volumes are also continuing to decline, with October data showing a 15% fall versus last year. ACEA, the industry association, notes that "new car registrations have now decreased for 6 consecutive months". New figures from the German association show that November sales were down 18%, double October's fall.

In September, the blog wondered whether "China's interest in remaining the manufacturing capital of the world may be starting to wane". Yesterday, Lou Jiwei, the chairman of China's sovereign wealth fund (China Investment Corporation) confirmed the new focus on domestic growth. He suggested that "if China can do a good job domestically, that is the best thing it can do for the world".

Lou's statement echoed last week's comments from President Hu Jintao that "difficulties in the global economy threaten to undermine growth in China". Lou also added that major losses in their western financial investments (for example, Blackstone down 82% since they bought at $29.60/share), meant they "do not have the courage to invest in financial institutions because we do not know what problems they may have".

Asian chemical demand is tied to GDP/capita growth in the West, not to domestic needs. So China's new focus means much slower growth in local chemical demand. As the blog warned a year ago ,"decoupling (of the Asia economy from the West) is a good story, but its not going to work going forward".

Sometimes a headline says it all. Today's in the Financial Times, "Markets braced for big European rate cuts", showed just how far we have travelled since the first signs of global financial crisis in August last year. Then, a co-ordinated round of interest rate cuts would have sent stock markets soaring. Now, they are taken as a sign of underlying weakness. Deflation, as the blog discussed in October, is now the real concern.

The downturn is starting to impact politics all over the world. As an example, take the recent sequence of events in Canada:

• In October, Prime Minister Harper increased his vote, but still ended 12 seats short of a majority, after calling an early General Election
• Last week, the opposition parties united against his economic policy, and called for a confidence vote in Parliament.
• In response, and for the first time in Canada's history, Harper won the Governor-General's approval to suspend Parliament for 7 weeks.

A month ago, with WTI at $70/bbl, the blog suggested that:

"If refiners are forced to cut runs for December, then it would be hard for OPEC to cut its own production quickly enough to compensate. In that case, a $20 - $30/bbl range for crude, albeit temporarily, would not be impossible."

During November, prices then slipped to $50/bbl. And since OPEC's failure last weekend to announce any production cuts, WTI has fallen to $40/bbl.

Saudi Arabia clearly played hard-ball at the OPEC meeting. Whilst highlighting their desire for $75/bbl, they did nothing to make it happen. Instead, as the perceptive Petro-Matrix has noted, they were "almost inviting market participants to push prices lower to pressure better OPEC compliance and some non-OPEC participation in the next round of cuts".

The Saudi position is entirely logical. They knew perfectly well that with oil at $50/bbl, many OPEC members would have signed up for production cutbacks, but then cheated on their quota. Saudi would then have been forced to make up the difference, at a huge cost to its revenue. But now prices have come closer to $30/bbl, compliance should be better. Fear of complete disaster is a great motivator.

Oil markets are not for the faint-hearted. OPEC now needs to make large, credible, cutbacks at their next meeting on 17 December. Otherwise the price fall could easily become self-perpetuating. After all, this week's $200/t benzene prices imply an oil price of $12/bbl on normal price and cost relationships.

Two months ago, the blog noted that the credit crunch was starting to impact sport. Then the issue was high leverage, with the UK's Football Association warning that the $5bn debts of the Premier League clubs were "high-risk".

Now, its the turn of Formula One racing. Yesterday, Honda pulled out of the 2009 competition on cost grounds. And the head of its governing body, Max Mosley, said the sport was in a "desperate situation".

With auto sales collapsing round the world, manufacturers can no longer afford the curent $220m a year cost of a F1 car. Maybe they could instead race versions of Nissan's Pivo 2 car, recently highlighted by my blogging colleague Barbara? She says it even comes with a tax break in Japan.

London's largely-male banking community has a new way to pass its time, now financial markets have collapsed. According to Lucy Kellaway at the Financial Times, many are prospecting for adulterous affairs on a website called Illicit Encounters.

Lucy says she has "picked up 247 men" since joining - including "a formerly powerful hedge fund manager, scores of newly idle bankers, a few entrepreneurs, various company directors, a well-known musician, some corporate lawyers, a couple of barristers and a rather dishy builder". One of her girlfriends gained 295 new "boyfriends" after just one week.

Its good business for the website's owners, who charge men £119/month ($175), whilst women join for free. Common sense would surely tell these men that the odds are against them? But, as we all know to our cost, common sense is exactly what many bankers seem to lack.

It all reminds the blog of the hedge fund manager it reported on last year. His £80k (then $160k) Maserati was about to be crushed because he'd been "too busy" to remember he'd parked it illegally.

The end of a major trend is usually marked by a significant increase in volatility. This seems to be what is happening to the equity bull market that began back in 1982. It has weathered a number of storms over the years, as traders kept faith with the underlying trend. But this week's Barrons, the US investment magazine, notes that the recent collapse has been marked by unprecedented volatility.

It points out that that there have been nearly 15000 trading days on Wall Street since 1950. And in all this time, there have only been 68 days when the Dow Jones has gained or lost more than 4% in a day (33 down, 35 up). Apparently, 28 of those days have occurred in the last 3 months. It seems that the Wall Street bull market may be joining the baby-boom generation, which sponsored it, in retirement.

Yesterday, Dow announced its new structure post the K-Dow JV and the planned acquisition of Rohm & Haas. This covered two main elements:

• Implementation of November's cost reduction announcement
• Dow's new organisation (the chart above)

The cost reductions were severe, with a headline 11% of staff facing redundancy. 20 plants in "high-cost areas" will close. 2000 of the 5000 jobs lost are in businesses targeted for divestment, and this process will now be "accelerated". Another 6000 contractor jobs will also go. Research spending is being reduced by $600m, and working capital by $2bn.

"New Dow" contains "feedstock-driven" and "market-driven" businesses:
Feedstock-driven includes those areas where Dow has been pursuing its "asset-light" strategy for some years. It consists of the various JV's, including Dow's share of K-Dow, plus the remaining associated petchem and basic chemical businesses. The focus will be to maximise upstream integration and become/remain lowest cost producers.
Market-driven will be solution-orientated, aiming to anticipate and meet market needs in forecast future growth areas.

The new organisation pursues the concepts first announced back in July, at the time of the R&H deal. At that time, Dow had indicated it was expecting the industry trough to last until 2011/12, with the next peak not till 2015. This led many analysts to fear a dividend cut, for the first time since 1912. In response, Dow's CEO Andrew Liveris has had to put his job on the line, saying it would not happen "on my watch".

"New Dow" is being born at a difficult time. Global markets are in recession, causing profits to weaken. But "new Dow" cannot just cut costs, as "old Dow" would have done, pay the dividend and wait for the recession to pass. It will now have to also find a way of continuing to invest in new product development within its market-focused businesses, in order to sustain their current revenue streams.

A long-standing industry friend sent me an email overnight about ethylene derivative margins. Only after sending it, did he realise that spell-check had decided to change the word "derivative" to "debilitative". But as he noted in a follow-up email, "amazing the insights of a spellchecker - I meant 'derivative' but maybe 'debilitative' is more of a commentary on the current situation..."

Having no risk management systems in place may be better than having the wrong systems in place. That seems to be one of the lessons from the recent financial meltdown.

The reason for this apparent paradox is that awareness of risk makes people cautious. But if they wrongly believe that all risk has been removed, then this can lead to over-confidence and potential disaster. Two recent articles highlight this issue:

• Paul Ray of ICIS kindly sent me The risks of risk management.pdf" by an expert in quantitative finance, which shows why banks failed to anticipate the credit crunch, despite employing thousands of highly qualified mathematicians to quantify risk for them.
• Prof Nassim Taleb (author of 'The Black Swan'), calls on companies and investors to boycott banks and business schools that employ the widely-used "value at risk" methodology, which he believes is fatally flawed.

Both authors believe that managing risk is not just a financial exercise, but also requires an understanding of human nature. It is well-known, for example that an unfortunate side-effect of building safer cars is that people feel more confident, and some may drive too fast as a result. This is bad news if you happen to be a pedestrian, and the driver fails to spot you crossing the road. Unfortunately, this has been the outcome in the financial world, as a result of flawed thinking on risk.

China has just reported its first fall in exports for 7 years. These were still growing at 19.1% in October, but fell 2.2% in November. The suddenness of the downturn is also shown in the import figures, which were down 17.9% versus 2007.

The numbers confirm the blog's long-expressed fear that China, and the Asian region, will suffer badly from the global downturn. Their relatively low levels of GDP/capita means that domestic growth rates immediately stall, as soon as exports dry up.

Several European chemical companies have been undertaking surveys of likely near-term demand from the auto sector, and have been kind enough to share their conclusions with the blog.

The results are not encouraging. It appears that every European car producer has announced plans for an extended Christmas shutdown of at least 2 weeks, compared to the usual 1 week. Some will shut for up to a month.

The issue is that European car sales are now starting to collapse, as they did 6 months ago in the US. As recently as July, when US sales were already down c22%, European sales were "only" down 7% versus 2007. But now JD Power say European sales were down 25% in November, a clear sign that a major downturn is underway. And as the blog first noted back in February, this also means increased credit risk for chemical suppliers with OEMs in the auto market.

INEOS has now confirmed that it has obtained the required covenant waivers from its banks. They had little choice, as pushing INEOS into bankruptcy would have destroyed value on a massive scale for everyone concerned. But as the blog expected, lenders successfully demanded an increased interest charge in exchange for their consent.

Investors' attention will now turn to the new business plan that the company has promised to present in Q2. Petchem and polymer markets will hopefully improve in Q1, after Q4's fire-sales. But INEOS knows its real challenge will be to demonstrate its robustness in "normal" industry bottom-of-the-cycle conditions, such as the extended downturns of the early 1980's and 1990's. The waiver request has clearly dealt a serious blow to investors' confidence. INEOS will have to work hard to regain it.

The world's major retailers, particularly Wal-Mart and Tesco, keep a very close finger on the global economic pulse.

They spotted looming recession 18 months ago - long before it became more widely apparent this year.

Yesterday, Wal-Mart's UK head went further, referring to "the dawning of the age of austerity". He added that "this won't be a recession where it is a blip, and then we are back to where things were". Instead, he forecast that "the era of conspicuous consumption is over. Saving money by cutting out waste of all kinds will be the priority".

Wal-Mart's view is echoed by Tesco CEO, Sir Terry Leahy, who noted that "the main thing is that we have to reshape the business". Customers have "less money to spend" and "you can't just buck a downturn".

Wal-Mart President, Lee Scott, also told analysts last week that there was "very little visibility as to what the economy's going to do". Scott's view is that it is now critical to "position yourself as a company that saves people money so they can live better".

Chemical companies largely ignored last year's early warning from the retailers. They have paid for this oversight in Q4, as they have had to dump inventory at firesale prices. It is vital for the future health of the industry that companies now respond quickly to the emerging new trends being highlighted by Wal-Mart and Tesco.

George Soros is one of the most successful investors in recent decades. The blog came across today a report of Soros' graphic description of the dangers of having too much debt in a business, or personally:

"Leverage was like driving along a straight, clear freeway with a sharp spike pointing from the centre of the steering wheel to an inch or two above your chest. All would be fine if the road and the traffic continued as they were, but any sudden application of the brakes would stab you through the heart."

The current credit crunch is, of course, equivalent to the "sudden application of the brakes" to which Soros referred.

The excellent Gretchen Morgenson makes a good point in her New York Times column today. As she puts it, "here in Bailout Nation, you'll be surprised to learn, some of us are more equal than others".

Her argument is that Congress is operating to double standards. Last week, it refused to support $14bn of lending to the auto industry, on the basis that "we cannot ask the American taxpayer to subsidise failure". Yet in October, it allocated $700bn to rescue the banks, where "taxpayers are financing not only failure, but also outright recklessness and greed".

Equally, she notes, that before even considering the automakers rescue, Congress required them to submit detailed business plans, sell their private jets, and negotiate pay-cuts for the workers. Yet the banks have not been required to produce business plans, stop paying excessive bonuses, or sell their jets.

The blog takes no position on the merits of the proposed automakers bailout itself. But it does remain very concerned that the banks' $700bn bailout is still being run by a 35 year old ex-Goldman Sachs banker with just 5 permanent staffers.

There is now general agreement that we are in a global recession. The World Bank's new 'Global Economic Prospects' report expects global GDP growth of only 2.5% this year, and just 0.9% growth for 2009.

This is well below the 3% level that signals recession. And the Bank also forecasts that world trade will contract in 2009, for the first time since 1982.

The key question is therefore how long this recession will last? The blog's research has highlighted 4 main scenarios:

V-shaped. The optimistic view is that recovery is just round the corner. But this seems unlikely, given the headwinds of the credit crunch and looming over-capacity in many key chemical products.

U-shaped. This is the blog's base case. It implies the recession bottoms in 2010/11, and then begins to recover. Early decisions to close high-cost plants, and cancel unnecessary new capacities, would also be required.

W-shaped. This is often seen in serious recessions. Severe destocking leads to an apparent early recovery, as the value chain restocks. But demand then slips back again, before properly recovering.

L-shaped. This is the worst case scenario, as it implies demand could fail to recover by 2011, and might instead remain at a low level. This would mirror Japan's experience post-1990.

The blog's view is that it would be very optimistic for companies to plan on the basis that this recession will be V-shaped, as in 2002/3 and 1997/8.

Instead, it shares the view of a senior BASF executive, who has reportedly said he had "hoped it would be a U-shaped recovery (as in the early 1980's and 1990's), but now thinks it could become L-shaped".

Japan went through its "bubble years" in the 1980's, with the Nikkei index peaking at 39000 (versus 8664 today). The blog well remembers standing in front of Tokyo's Imperial Palace in Tokyo in 1988, when its land was said to be worth more than all of California.

Since then, housing and stock market bubbles have occured in many other countries. Whilst Japan was picking up the pieces, after its bubble burst in 1990.

In his first interview today, the new Bank of Japan Governor says they found no "magic formula" that could "spare economies the pain of dealing with the excesses that led to the bubble in the first place". He adds that "alarm bells should have gone off when the global economy was growing at an unsustainable 5% from 2003-7".

The result, he warns, is that "the economic cost is so huge", fiscal stimulus or low interest rates will make little difference. In Japan, for example, "the cumulative drop in property prices was 60-80%". The uncomfortable lesson from Japan, he says, is that "the economy will have to grind out the excesses - high house prices and unsustainable household debt - that inflated the bubble in the first place".

The UK is expected to build just 135,000 houses this year, compared to 203,500 in 2007. This is the lowest level since 1924, when 87.000 houses were being built (excluding the war period). The outlook for 2009 is also poor, as many current projects date from before the start of the financial crisis. In turn, this suggests that chemical demand will remain at low levels into this important sector.

Yesterday the US Fed cut interest rates to an all-time low of 0% - 0.25%. Once again, Wall Street celebrated with a major rally, even though the move had more symbolic than practical purpose. It made it appear that the authorities were "doing something", even though the evidence of previous rate cuts indicates they have had absolutely zero effect. The reason is two-fold:

• Back in January, the blog quoted Merrill Lynch's Richard Bernstein, who argued that "the Fed can lower interest rates quite a lot, but they will likely have minimal impact on the economy unless credit creation grows".
• Even earlier, in September last year, the blog quoted Rodrigo Rato, then head of the IMF, who argued presciently there was a real risk that "systemically important banks may face constraints in extending credit". This is exactly what has happened, as banks continue to deleverage.

The only encouraging element in the Fed's statement yesterday was the implicit recognition that its policy of focusing on massive interest rate reductions has been equivalent to pushing on a piece of string. There is no other way to interpret its conclusion that, after 5.25% of cuts, "financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further."

In admitting it had been wrong, the Fed did leave the door open for a more useful policy to emerge, when adding that it "will continue to consider ways of using its balance sheet to further support credit markets and economic activity". But "to consider" is not the same as "to act". There is still no sign that the authorities have yet developed a clear and workable plan for resolving today's crisis.

The blog warmly welcomes the move by players in the European olefins market to re-engage with monthly pricing. The rationale for its support is based upon the conclusion of the major report that International eChem produced 3 years ago, Pricing for Profit:

"The cumulative impact of the current pricing mechanisms has caused the wider marketplace to become increasingly inefficient at balancing supply with demand, particularly over the short term, with an adverse effect on total industry profitability".

This conclusion has been confirmed, once again, by the disasters that have taken place this quarter. Quarterly price mechanisms are not efficient, and they cause major value-leakage by encouraging consumers to speculate on likely movements in feedstock prices.

The recession will have a major impact on M&A activity next year, according to a new analysis by Pilko & Co. Their key conclusions are:

• Increasingly,deals will be the result of financial restructurings, workouts or bankruptcies.
• Buyers with cash and debt capacity will be able to dictate terms.
• Asian/Middle East buyers will dominate, as they can still obtain funding, and have a longer-term approach.

In the boom years, too many deals were based on a view that any purchase price was acceptable, as long as sufficient debt could be found to leverage the earnings of the acquired company. 2009 will see the painful process of unwinding this fallacy get underway.

The chart, taken from the weekly ACC report, shows just how badly chemical production has been hit in recent months:

N America. This region has been worst affected, with volumes down 12% in November versus 2007.
W Europe/CEE. Both regions were down 3% in October versus 2007
Asia/Latin America. These regions are just positive, with 1% growth.
Middle East. This region remains strong, with 14% growth, as new production based on advantaged feedstock comes online.

Overall, world growth is now a negative 1.9%, confirming that we are in a global recession. And core sectors for chemical demand such as housing and autos are still in decline. The blog therefore fears that the news on production will get worse, probably a lot worse, before it gets better.

Prof Nouriel Roubini has long been correctly bearish about the economy, and was one of the first to highlight the deflation risk. In a new interview, he sets out his thoughts for 2009, and concludes:

"I don't believe we are going to be in a depression - but we could end up like Japan that had essentially economic stagnation for a decade with deflation. You know, the "L"-shaped recession.

"At this point, the "U"-shaped recession could turn into an "L"-shaped recession if we don't fix the financial system, and the credit crisis becomes worse and if we don't get a massive fiscal stimulus. So, a lot depends on our policy reaction. If our policy reaction is appropriate, by 2010 there will be some recovery of growth.

"The only risk is that the recovery of growth could be so weak that it feels like a recession even though we are technically out of it. So there is a risk of something like a Japanese-style, multiyear economic stagnation. I would not rule it out, but it is not my benchmark scenario.

"I think there is a one-third probability it will end up that way, but a two-thirds probability that we will end up in a severe, two-year-long recession. And that would be by any standard the worst recession that the U.S. has experienced in the last 60 years."

The blog's oil price forecasts have had a stellar record this year. Last month, with its $70/bbl forecast having been realised, the blog continued to worry about downside risk:

"If refiners are forced to cut runs for December, then it would be hard for OPEC to cut its own production quickly enough to compensate. In that case, a $20 - $30/bbl range for crude, albeit temporarily, would not be impossible."

Since then, refiners have indeed been cutting runs very hard. Equally, OPEC's secretary-general has confirmed that the cartel's November cuts have only achieved c60% compliance. As a result, the January WTI contract hit $33.87/bbl last week.

The expected temporary nature of the fall has led to massive forward purchases, causing June prices to be $10/bbl higher than today's. In turn, this offers guaranteed profits for those able to find storage. 50 million barrels have so far been added to stocks as a result. And official OECD stocks have risen by 5 days, to 57 days.

This supply overhang will make it hard for prices to rally quickly from today's depressed levels. Yet an eventual supply crunch is growing ever more likely. Today's prices are a long way from the $75/bbl that is needed to make most proposed new investment viable.

The blog has been searching the websites of the major central banks, such as the IMF, World Bank, Federal Reserve and Bank of England, for research on the history of credit crises. Several readers, including Paul Noble of Parsons Brinckerhoff, have also kindly forwarded helpful studies.

The most comprehensive study that it has found analysed 33 banking crises between 1977-2002 and concluded:

• The average length of each crisis was 4.3 years
• The median loss of GDP was 7.1%
• Major crises (such as today's) caused GDP losses of at least 10%.
• GDP losses can double if the banking crisis leads to a currency crisis

The studies also suggest that lack of effective government action (eg depositor guarantees and liquidity support) causes even greater GDP losses. The US Depression led to 30% of GDP being lost.

Another key message from the research is that even "successful" government intervention comes at a high price. This is because it causes banks to lower their risk profile in two key ways:

• They prefer to hold government debt rather than make corporate loans
• They only lend to the very safest borrowers

This change in risk profile means that government intervention has the side-effect of breaking the process by which banks provide credit for the real economy. Inevitably, therefore, credit crunches are deflationary.

History's lessons on the likely course of today's crisis are thus not encouraging. Governments will initially find it easy to borrow, but face the risk of a currency crisis if foreign lenders begin to suspect they will never be able to repay the money borrowed. Companies however, will find it more difficult to borrow, as banks "de-risk" their balance sheets.

Consumers therefore face an increased risk of unemployment, and so will tend to save more, rather than spend money. In turn, this will reduce demand - further pressuring companies, and government's ability to provide fiscal stimulus.

2008 has not been a good year for M&A in the chemical sector. First, there was the collapse of Hexion's Huntsman acquisition. Today, the Kuwait government has signalled its intention to "scrap" its $17.4bn deal with Dow to form K-Dow.

This is a quite extraordinary decision by a major Middle East government, especially as it comes just 2 days before the JV was due to begin operations. Citing "major changes in the world economy, the serious impact of the global financial crisis on the assets of companies and the sharp slide in oil prices", the government says it has decided that "going ahead with this deal involved big risks".

But none of these risks are new. And none of them have suddenly appeared in the last few weeks, since the K-Dow JV was finalised earlier in December. The real reason, as the Kuwait Times notes, is undoubtedly that pressure on the deal has since been mounting in the National Assembly, with opposition MPs threatening to "grill the prime minister (in the Assembly) if the government did not cancel the deal".

The cancellation of the deal at this late stage is clearly a lose-lose for both parties. It is clearly very damaging to Kuwait's reputation in world markets. Kuwait also loses its chance to further develop a leading global position in petchems, whilst Dow loses the support it would have found from allying its petchems business with a strong upstream partner.

But Dow is still the world's No 2 chemical company. And it will no doubt have developed a contingency plan, in case the K-Dow venture did fall through. It could, for example, step-up the current relationship with Saudi Aramco, its partner in the $20bn Ras Tanura project. And nobody would be very surprised if it also now sought to renegotiate the proposed Rohm & Haas acquisition.

2008 has not ended well for the chemical industry. First there was the collapse in demand, as the various value chains destocked in response to slowing consumer demand and lower oil prices. Then INEOS, the world's 3rd largest chemical company, had to seek covenant waivers from its lenders. Now, according to the Wall Street Journal, LyondellBasell, the 4th largest chemical company, may be about to file for bankruptcy.

The underlying issue is that petrochemicals has always been a highly cyclical industry. A typical 7 year cycle involves 2 years of stunning profitability as demand recovers after a downturn, 3 years of average returns as supply and demand rebalance, and then 2 years of horrendous losses as new supply comes online just as demand slows.

We are now 5 years into the current cycle, which started in 2003. So a downturn should not therefore come as a surprise. And, of course, it follows a lengthy period when central bankers had completely failed to do their job, and had allowed personal and corporate debt to reach record levels. As I noted in a letter to the Financial Times back in March 2007, they had proved totally:

"unwilling to implement the famous dictum of William McChesney, the long-serving Fed chairman in the 1960s, that "the job of the Federal Reserve is to take away the punch bowl just when the party starts getting interesting". Instead, they seem to confuse being market-friendly with being friendly to markets."

Thus they allowed demand to continue accelerating between 2005-7, by actively promoting ever-higher levels of leverage. This benefited housing and auto demand - prime markets for petchems - whilst also encouraging companies to increase their own levels of debt. But as the blog has warned many times:

"The seeming genius of many private equity funds in recent years has been due to nothing more than the application of high leverage during the 'up' part of the business cycle. As and when we go into the 'down' cycle, leverage will exert its same impact on the downside."