Chemicals & The Economy

The blog is now 18 months old. It has a truly global readership, and as shown in the above map, is now read in 1244 cities and 89 countries.

Its aim has always been to identify 'the influences that may shape the chemical industry over the next 12 - 18 months', and to 'develop useful insights into the key factors that will drive the industry's future performance'. So today is a suitable moment to review its development:

Economic events. The blog has been widely recognised for its success in forewarning readers of the global financial crisis. This was most obvious in its posting of 7 September, titled "The price of all assets will go down", which was written 2 weeks before the Dow Jones began its fall from 11,200 to a low of 7500. Its insight does not depend on economic models, but on its willingness to identify the key facts and let them speak for themselves.

Chemical industry growth and margins. The blog's prime interest is in understanding the trends that will drive chemical demand and profitability. Thus it follows developments in housing, autos, oil prices and the financial markets on a daily basis. Over time, this enables it to identify patterns of cause and effect. Thus its 2008 Outlook was titled 'Budgeting for a Downturn', and warned that "the consensus forecast for 2008 is very optimistic". Its more recent posting on 19 October, giving its 2009 Outlook, was titled 'Budgeting for Survival'.

Oil and feedstock prices. The blog's prime focus has been to stress the likely volatility of oil prices. This is due to tight supply/demand balances, which mean that small fluctuations around the core 85mbd level can lead to large changes in prices. This insight enabled the bog to forecast ever-high oil prices until July, when it was virtually alone is suggesting that oil prices "could easily fall $50/bbl to $100/bbl" in the absence of any military action on Iran. It then built on this success by forecasting that a further fall to $70/bbl was likely, followed by a warning on 4 November that "a $20-$30/bbl range for crude, albeit temporarily, would not be impossible". WTI's $33.87/bbl mid-December low justified this caution.

Summary. The aim of the blog is to identify key changes in the wider landscape, as early as possible. As a natural optimist, I would prefer these to be positive changes. Unfortunately, however, the last 18 months have instead proved to be full of warning signs. I hope that reading the blog has provided you with valuable insights into the underlying issues. And I will do my best to ensure that it continues to helps you prepare for the problems that we now face.

Q4 was never going to be good for US housing markets. The financial crash of September/October not only terrified potential buyers, but also meant they found it increasingly difficult to secure loans.

As the chart shows, this lethal combination hit house prices hard. The latest S&P/Case-Shiller figures show prices down 24% in October from the mid-2006 peak. 14 of the 20 metro areas saw record levels of decline, whilst S&P comment that the Pacific Northwest and Mid-Atlantic South regions joined the Sunbelt in experiencing a "severe contraction".

The East Coast is still seeing "only" single digit declines, but San Francisco saw a 31% decline versus 2007, whilst Miami was down 29%. And 6 cities, including Atlanta and Detroit, posted a record monthly decline. As S&P comment, "the bear market continues", with average prices now back to March 2004 levels.

Manufacturing output is contracting around the world. JP Morgan's global index sank 15% in December, and they expect "an intense contraction phase" to continue "for some months to come". The G7 and BRIC countries are all seeing a decline, as Nouriel Roubini notes:

• The US ISM manufacturing index hit a record low of 32.2 in December
• Eurozone manufacturing hit a record low of 33.9
• Japan suffered its worst-ever fall in November, plunging 8.1%
• Brazil's index is at 41.6, well below the neutral 50 level
• Russia's index fell to 33.8 in December, lower than in the 1998 crisis.
• India's production fell in October for the first time in 15 years
• China's December index remained close to November's record low

Meanwhile, Nobel laureate Paul Krugman points out that despite recent government moves to provide banks with more liquidity, "credit remains scarce, and the economy is still in freefall".

He warns that "this looks an awful lot like the beginning of a second Great Depression". And he worries that the fiscal stimulus planned by President-elect Obama may take months to pass Congress, and end up being too little, too late.

The past few weeks have not been good for the chemical industry, with 4 major companies suffering significant problems:

BASF warned that "customer demand in key markets has declined significantly" since October, and have temporarily shutdown 80 plants worldwide, whilst reducing production at another 100 plants.
Dow suffered a major reverse with the last minute collapse of the K-Dow venture, and had previously announced a restructuring programme.
Ineos had to seek covenant waivers from their banks.
LyondellBasell entered discussions to avert a bankruptcy filing.

This week's ICIS Chemical Business carries my forecast for 2009, which focuses on what CEO's can do, immediately, to ensure the survival of their business. Please click here if you would like to read it.

December was another bad month for US auto sales, with volumes down 36% versus 2007. Total 2008 sales of 13.2 million were the lowest since 1992, when the economy bottomed in the 1990-4 recession.

As the chart shows, sales volumes dropped continuously during 2008. They were down 10% in Q1, and then Chrysler and Ford's weakness dragged Q2 volumes lower. Q3 saw no recovery. GM then suffered a terrible October, with sales down 45%. Chrysler won the 'wooden spoon' award, however, with sales down 53% in December.

Overall, Chrysler's total volumes were down 30% in 2008 versus 2007; GM were down 23%; Ford down 21% and Toyota down 16%. And for the moment, there appears no sign of recovery. In fact, weakness continues to spread around the world, with Japanese sales down 22% in December, and both Toyota and Nissan today announcing Q1 output cuts.

LyondellBasell has become the largest-ever chemical company bankruptcy, just 12 months after its formation. Its US operations (Lyondell Chemical Co), and Basell Germany Holdings GmbH, filed for Chapter 11 protection in New York tonight. The company expects its other non-US operating entities to continue to function independently of the Chapter 11 process.

The blog is saddened by the news, particularly by the effect it will have on employees and business partners. But it will come as no surprise to blog readers. On 20 July 2007, just after the deal was announced, the blog commented as follows:

Those who liked the blog's earlier satirical postings on the banking crisis and subprime disaster, may enjoy this video from the Canadian show "This hour has 22 minutes", kindly sent to me by a US reader.

The sketch's punchline - "The money you give won't just save a life, it'll save a lifestyle" - says it all.

The fallout from the Lyondell bankruptcy continues to grow. One analyst has suggested Swiss bank UBS has exposure of $500m - $1.5bn. Other banks, including Citi and the UK's RBS, also have large exposures. Writing-off these debts will in turn reduce the banks' own capital. And so it will further reduce overall credit availability.

Meanwhile yesterday's bankruptcy court hearings in New York ran until after midnight, as creditors, lenders and the company negotiated on funding needs. Eventually an interim $2bn interim loan was approved, plus a $100m "super emergency loan" which will be used to fund Lyondell for the next 2 days.

Lyondell's next objective is to finalise an $8bn 'debtor in possession' loan, which would enable it to keep operating in the medium term. But for the moment, it is very hand-to-mouth. Thus it also had to obtain the court's approval to pay $8.1m of overdue wages to employees - Lyondell Chemical has 17000 employees worldwide, of whom 8000 are in the USA.

The US suffered 2.589 million job losses in 2008, making it the worst year since 1945. December's 524k losses caused the jobless rate to rise to 7.2%, the highest since 1993. Equally, the average work week fell to a record low of 33.3 hours.

Stock markets are still forecasting a V-shaped recession, but as the blog discussed last month, an extended U-shape is the most likely outcome, given the scale of the downturn. The current rally is based on the expected $750bn Obama stimulus programme, which is the latest in a long line of government initiatives since the recession started ($168bn of tax rebates, the $700bn TARP etc). This is said to be a Keynesian policy, akin to the New Deal.

But as Prof Peter Clarke of Cambridge University has pointed out, Keynes was never in favour of artificially boosting "demand by stimulating consumption". He regarded this as doomed to failure. Instead, his 'General Theory' was based on the idea of government-led investment during recessions, as "it was common sense to put idle resources to work. Savings otherwise not invested and workers otherwise left unemployed, could create valuable public assets if government took the initiative".

The new ACC weekly report rightly notes that "any economic recovery will likely begin with a turnaround in the residential housing situation". This is also the critical issue for the chemical industry, still reeling from last week's Lyondell bankruptcy filing. Yet as the ACC's chart shows above, no improvement is yet in sight. New home inventory is now 11.5 months, compared to just over 9 months in the early 1990's recession.

Stock markets have been hopeful that the new 'American Recovery and Reinvestment Plan', being proposed by President-elect Obama, will mark a turning point. But a new analysis by the incoming Administration of its own Plan does not build confidence.

One can certainly praise the authors for their honesty, but it is disturbing to find them emphasising that "all of the estimates presented are subject to significant margins of error". In fact, the blog counted 9 uses of the word "uncertainty". And the conclusion of the Executive Summary is that "uncertainty is surely higher than normal now".

The blog will judge the Plan, when it is finally published, on the same basis as it judged the earlier $700bn TARP plan. Will it "do anything about the excess supply of homes and the large number of mortgage borrowers in dire straits"? For the moment, the signs are not hopeful.

Dominique Strauss-Kahn, MD of the International Monetary Fund (IMF), has a surprisingly hard-hitting interview today in Bloomberg.

Casting aside normal central bank reticence he warns:

• Their current $1.4 trillion forecast of global financial losses will soon be increased by a "significant" amount.
• They will have to further reduce their November GDP forecast, which was already at a recession-level 2.2%.
• US tax cuts might have "very little impact on growth" unless targeted only at "the most vulnerable," who are likely to spend the extra cash.
• W European governments are "behind the curve" in implementing stimulus packages and are "still underestimating the needs."
• "Rates in Europe will probably go down in coming months. A decrease in interest rates is welcome but the impact will not be very important."
• "If in six months from now the crisis has worsened and many other of our members need our help, the demand may be above what we have."

As a former French Finance Minister, his final warning on the European outlook has psrticular resonance. He worries that "a rate of growth between -1% and -2% may have some really strong social consequences".

European auto sales fell 8.4% in 2008, versus 2007. Sales of 13.56m autos were just ahead of the USA's 13.2m. European volumes continue on a worsening trend, with December down 19% versus last year:

• Spanish sales were down 50%
• Sweden was down 45%
• The UK was down 21%
• The Netherlands were down 19%
• France was down 16%
• Italy was down 12%
• Germany was down 6%

Against the pace of the current decline, JD Power's forecast (above) of just a 16% sales decline in 2009 looks optimistic. Chemical companies will be hoping it is right.

The ever-interesting PetroMatrix report notes that 2008 saw record volumes of crude oil trading. As their chart shows (above), the volume of trading on futures markets in 1995 was equal to daily oil production volumes. By 2000, the ratio had reached 2 : 1, and by 2005 it was 3 : 1. The ratio then jumped to 7 : 1 in 2007, and was nearly 8 : 1 last year.

Olivier Jacob rightly notes that "this jump in volume has also brought a jump in volatility, and is an input that needs to be taken in consideration when making a price forecast".

Over the last few weeks, INEOS had to scramble to get a covenant waiver from its lenders, and Lyondell went into Chapter 11. Now Dow's debt is facing a potential cut to junk status from the main ratings agencies.

Dow's rating has already been cut, following the collapse of the K-Dow deal with Kuwait. And the agencies are worried by the lack of a convincing contingency plan to cover the lost cash. The blog suggested this would be required last month. The need is now urgent, due to the perceived lack of long-term financing for the proposed Rohm & Haas acquisition.

Moody's for example, have said they "would not assign an investment grade rating to this company if it had short-term debt of $11 billion to $12 billion". Similarly, S&P have said they want "proof of $15bn in financing to maintain the investment-grade rating". A junk rating would mean tens of millions in dollars in extra financing costs - not something that could be easily absorbed in today's difficult markets.

Early last year, the blog flagged up a warning from Gillian Tett in the Financial Times that Iceland could go bankrupt, as its banks were "too big to rescue". Yet at the time, the United Nations had listed it as having "the highest standard of living of any country" in the world. Unfortunately, however, Iceland's 'wealth' was all based on leverage, and in October the banks failed, causing the Icelandic currency to become virtually worthless.

Readers will also, of course, remember that last autumn's financial crisis originally started with a few, seemingly isolated, banking problems over subprime. So they will understand why the blog is taking recent concerns over the future stability of the eurozone quite seriously. Nobody is suggesting that Germany, for example, is at risk. But two developments signal that the situation could become serious:

• Yesterday, S&P downgraded Greece's credit rating, due to its high debt levels, and may downgrade Portugal, Spain and Ireland
• Bonds issued by Greece, Spain, Portugal, Ireland and Italy are now yielding record amounts versus the German benchmark

The core of the issue is whether any of these countries may be forced either to devalue against the euro, or to leave the eurozone entirely. The implications for the chemical industry would, of course, be enormous if this happened. After Iceland, however, it is clear that nothing can be ruled out, if the 5 governments do not quickly start to put their house in order.

Moody's, the global ratings agency, is today forecasting a 70% chance of a U-shaped recession, and a 15% chance of either a V or L-shaped downturn. This broadly agrees with the blog's own view, set out a month ago. Moody's also singles out the chemical industry as being one of those most at risk from a lengthy downturn. It highlights 2 key risks as being higher crude oil prices, and a major downturn in commodity margins.

It also worries about the impact of the "weak credit environment" on "financially stressed companies". It points out this will make it difficult for them to "sell assets and generate liquidity", and could force them "to sell their best businesses". Moody's worries that this "would greatly impair their ability to recover in a weak operating market". CFOs will also be be worried when they read the report (Moody's credit risks Jan09.pdf).

In the soccer world, the UAE has been making headlines this week. It is proposing to fund the first-ever £100m ($150m) transfer - of the Brazilian player, Kaka, to Manchester City. But behind the scenes, the collapse of the oil price has been playing havoc with the economies of the Gulf countries (GCC).

HSBC, for example, is warning that the region faces its most severe downturn in 20 years. It expects only the UAE and Kuwait to balance their budgets this year. Other countries will have to use their reserves to finance spending plans. And even the UAE is exposed to the major downturn now underway in Dubai.

Patrick Townsend of Instrata Capital tells the blog that "the mood in the GCC has become more despondent and redundancies are a fact of life - but not much reported. There are not many banks in the Middle East that have any lending appetite, and there is a large overhang of projects (especially power projects) waiting to get financed."

Current petchem projects in the Region are already financed, but as Patrick notes, future projects will only go ahead once the lending backlog has cleared. He also adds that clients now expect "to achieve meaningful cost savings" from their engineering contractors, and "are delaying orders" until these have been achieved.

The International Energy Agency (IEA) has cut its estimate of expected global GDP growth in 2009 to just 1.2%. It therefore expects the world to record its first back-to-back annual decline in oil demand since 1982/3.

It says oil production last month was unchanged at 86.2mbd, despite OPEC cutbacks and the first fall in Russian supply since 1996. It estimates OPEC pumped 30.9mbd in December, down 300kbd from November. Saudi Arabia cut 450kbd, so some other OPEC countries continued to cheat on their quotas.

Looking ahead to 2009, the IEA expects average consumption to be 85.3mbd, down 0.6% from 2008. China's demand is expected to grow just 1.3% to 8mbd, as lower exports slow the economy. So OPEC will only need to produce 29.9mbd - 1mbd less than in December.

For the moment, oil markets remain in contango, as players buy oil today and store it in the expectation of higher prices by the summer. But with 80mbd now in storage as a result, in addition to normal stocks, prompt prices will remain under pressure in the short-term.

The Yangtze River Delta region (which includes Shanghai, Jiangsu and Zhejiang) accounted for 22% of China's GDP in 2007. It is focused on exports to the USA and EU, and is a major centre for chemicals production. But now, like the Pearl River Delta, its economy is slowing fast. According to the China Daily, an increasing number of companies have ceased production, and some have gone bankrupt.

Shanghai's Mayor, Han Zheng, says "We are seeing negative growth in fiscal revenue, industrial output and exports, and there is increasing pressure on employment". And there are reports that industrial sector profits in the region fell 44% between January - September 2008. The main problem is the global recession, which has reduced demand for China's exports. In turn, of course, this will reduce China's import needs, so slowing the rest of Asia's economy.

Bond markets are a good place to look if you want to understand the outlook for major companies in the chemical industry. A key market is in 'credit default swaps' (CDS), which offer insurance against the possibility that a company might default.

The way they work is that the owner of a bond, or a speculator, can buy a CDS to insure against the possibility that a company might default over the next 5 years. Today, Bloomberg is suggesting that "trading in their bonds shows" that "Ineos Group Holdings, Georgia Gulf Corp. and Chemtura Corp. are crashing on a mountain of takeover debt and may follow Lyondell Chemical Co. into bankruptcy".

Bloomberg reports that "credit-default swap traders are demanding €8.2m upfront plus €500k a year to protect against default on €10m of Ineos bonds for five years". It adds that "the upfront cost soared from €4.8m two months ago. A year ago, it was €716,000 a year with no upfront payment". Bloomberg's conclusion is that this latest trading in INEOS "credit derivatives priced in almost certain odds the company will default".

Bloomberg also notes that Georgia Gulf's 9.5% bonds due in 2014 were trading at 28c on the dollar, to yield 45.8%. It says CDS buyers for Chemtura are having to pay $5m upfront and $500k a year to protect $10m of debt for 5 years. Whilst online news service 'Capital Structures' (CS) says INEOS reported an operating loss of €301.6m for November, and an operating profit year to date of €361.5m versus a budget of €1.35bn.

CS also says INEOS is seeking "new equity from 3rd party investors", and that an "asset sale process is ongoing". They add that "senior management has visited the Middle East as part of this process and has plans to return there". CS claims trade sales had earlier been discussed for two businesses at prices of c$1.5bn and c$1bn, but that "deteriorating conditions in the chemical sector made achieving fair value even harder".

Asia is hard-hit by the downturn in the Western economy. Today, China said its Q4 GDP had grown just 6.8%, the slowest level since 2001. This led premier Wen Jiabao to say the outlook for jobs was "very grim". It also increased speculation that China will devalue the renmimbi, which would increase trade tensions within Asia and with the USA.

The root cause is a decline in exports, which account for 37% of China's GDP. Japan's exports are also suffering, down 35% in December. Taiwan saw a 40% drop, whilst S Korea's industrial production is now declining at the fastest rate since 1975. In turn, this has very worrying implications for petchem producers. Many Asian countries send 50% of their production to China, to be re-exported as manufactured goods to the West.

Meanwhile, the outlook in the West is still getting worse. Housing is a key driver for chemical demand, and today the US government announced that total 2008 housing starts were just 904,000, down 33% from 2007 levels, and the lowest annual rate since records began in 1959. December housing starts were even lower, at only 550,000 on an annualised rate.

In early October, I forecast that we were about to revisit "the scariest moment of my 30 year chemical career", adding that:

"The moment the blog has long feared, and warned about, may be about to arrive. It appears that we may be about to revisit 1980, when for some weeks it seemed that demand for many petchem products had simply stopped."

I also repeated this forecast in an EPCA interview with ICIS radio.

Sadly, the coming results season is likely to demonstrate that my forecast was all too prescient. INEOS have already announced inventory holding losses of €1bn ($1.3bn) in Q4.

As I wrote in October, "If your Board would like to talk about the current situation, and to discuss how to manage it, please contact me. I will be happy to use my experience to try and help."

Global chemical production is now falling at an alarming rate, down over 4% in November, as core demand from housing/construction and auto markets collapses. Only the Middle East is now seeing positive growth year-on-year. As the chart shows (using ACC data):

• N America is now down 12%
• W Europe/C&E Europe are down over 6%
• Asia-Pacific is down 1.6%
• Latin America is down 0.1%

Meanwhile, the Middle East continues to show strong growth of 14%, as new advantaged-cost production comes on line. These volumes will increase the pain of falling demand, especially for those producers who depend on exports to maintain their operating rates.

Saudi Arabia, the world's largest oil producer, now seems to be moving to Phase 2 of its efforts to achieve a $75 - $100bbl price range. As the blog noted in early December, the Saudis' initial tactic was to play 'hardball' within OPEC. The aim was to ensure that other countries did not try to get a free ride, by forcing Saudi to make most of the cuts needed to bring supply back in line with slowing demand (as happened in the early 1980s).

Thus prices were allowed to slip to a low of $32/bbl, in line with the blog's forecast of a temporary $20 - $30bbl floor (made when oil was $70bbl). And the Saudi tactic has led to high levels of OPEC compliance, as members recognised the dire consequences of indiscipline. Compliance with OPEC quotas is now around 75%, with output cut by over 3mbd versus the 4.2mbd target. Current OPEC production is just 26.15mbd according to PetroLogistics, who track tanker movements.

Now, the Saudis are signalling a more aggressive approach. Oil Minister Ali al-Naimi has suggested that Saudi will now reduce production by a further 300kbd, below their OPEC quota, and commented that "we are working hard to bring the market in balance". Their first aim is clearly to stabilise the market around the $35 - $45 range. This looks achievable, especially with the USA's summer driving season just about to start.

A month ago, after the collapse of the K-Dow deal, the blog suggested that Dow would need to move quickly to a Plan B. It added that "nobody would be very surprised if it now sought to renegotiate the proposed Rohm & Haas acquisition". This now seems to be underway, judging by two pieces of evidence:

• An interview with Dow's CEO, Andrew Liveris, in the Wall Street Journal (WSJ) where he says that Dow are "unable to complete the deal without stable financing".
• An analysis by the New York Times' (NYT) legal expert that suggests "Dow is worried about compliance with its $13bn bridge facility (and)...is using this worry to attempt to force Rohm to the table".

The issue is one of leverage. The Bridge facility has a covenant that requires Dow to maintain its Total Leverage Ratio below 4.25: 1.00, if Dow's debt ratings reduce to a certain level (BBB- from S&P, for example). At the moment, S&P rates Dow just one notch above this at BBB, but the NYT notes that "more downgrades" are possible.

At this point, the NYT suggests Dow "conceivably gains a solvency argument" to use in any negotiations with R&H. Was Liveris preparing the ground for this, when he told the WSJ, "Why would you put two more American companies at risk in this most horrible of markets?"

A year ago, the International Monetary Fund rightly warned that the world was facing a "serious economic slowdown". This week, it has updated its forecasts, and now "expects the global economy to come to a virtual standstill in 2009". This will be "the lowest rate of global GDP growth since World War II". As the chart shows, the IMF expects all countries and regions to suffer:

• USA growth will be -1.5%, Eurozone -2%, UK -2.8%
• Japan growth will be -2.6%, China just +6.7%, Middle East +3.9%

The IMF has reduced its global growth figure by 1.75% since November, because of the global financial crisis. It says this "has weakened consumer and business confidence, raised uncertainty and destroyed wealth, leading to much lower consumption and much lower investment". Emerging economies have been hit by 3 extra factors:

• A collapse in exports
• An inability to borrow overseas
• A decline in commodity prices

The IMF is, however, still forecasting a V-shaped recovery at the end of 2009. It argues that this could occur if a "comprehensive framework for restoring financial health" is put in place, including liquidity provision, capital injections, and the disposal of bad assets". It also advocates large fiscal stimulus by governments to promote spending.

Clearly the IMF has to remain optimistic, as it attempts to persuade governments to adopt its policies. And the blog hopes the IMF is right. But it would be unrealistic for chemical companies to plan on this basis. Today's demand slump, plus the growing risk of deflation, means that a U-shaped recession, lasting till 2011/12, is a more sensible Base Case.

The blog hopes that its recently published "CEO's Survival Guide" will be useful, as companies start to update their 2009 forecasts.

The credibility of some chemical industry CEO's seems to be under increasing attack, due to their apparent failure to develop proper contingency plans in advance of the current recession.

One example this week comes from the USA, where Jim Cramer is one of the most well-known business TV commentators. He suggests that Dow's CEO, Andrew Liveris, "may be the single worst CEO ever to run a major company". You can see the full version by clicking on the picture, and then scrolling down to start the video (it begins with an advert).

Prof David Blanchflower, of the Bank of England, is not optimistic that the current recession will end soon. He notes that "few macro-economists actually spotted the greatest financial crisis in a hundred years". And in the chart above, showing OECD forecasts for the UK economy during the last recession, he demonstrates that forecasters kept predicting a "V-shaped recovery" for the whole 3 years of the downturn.