Chemicals & The Economy

China faces a difficult outlook, after the collapse of its main export markets in the West.

Interviewed by the Financial Times today, China's premier, Wen Jiabao, sets out a pragmatic list of "forceful" actions that are now underway. Most are Keynesian measures, aimed at putting money in the pockets of those who are most likely to spend it quickly:

• 74m low-income people have received spending subsidies
• Pensioners of state-owned companies have been given supplements
• 12m teachers have been given salary increases

In addition, Wen is planning to introduce a "fairly comprehensive social safety net", with further money being spent on medical care. Subsidies for small-engine cars are being introduced, and technology spending is being increased. Plus, of course, $400bn has already been allocated to increased infrastructure spending.

Wen was also relatively outspoken, for a top Chinese official, about the causes of the downturn. Dismissing suggestions that China's savings had caused the current recession, he noted that "it is completely confusing right and wrong, when those countries that have been overspending, then blame those that lent them money for their spending".

The scale of the crisis in Asian economies becomes clearer, month by month.

Exports account for nearly half of S Korea's GDP. In January, these dropped 33%. Of course, January is always a slow month, due to the Lunar New Year, but these figures followed earlier falls of 19% in November and 18% in December.

S Korea's chemical industry is heavily dependent on exports to China, from where they are manufactured into finished goods for the West. With China slowing fast, and domestic GDP dropping 5.6% in Q4, survival is definitely the key priority for the industry in 2009.

One can still rely on ExxonMobil to deliver positive results, even whilst the world is collapsing around them. Friday's report showed Q4 chemical volumes down 20%, as a result of hurricane effects and destocking. But although earnings tumbled from $1.1bn in 2007, they were still in the black at $0.2bn.

January's US auto sales figures gave no hope that demand is yet bottoming out. Volumes were down 41% versus 2008. As the chart shows, the main pain was felt by GM and Chrysler, who saw sales down 49% and 55% respectively. A key factor in the downturn for both companies was a collapse in fleet sales - which were down 80%.

The only bright spot, if a 30% year-on-year decline can be considered "bright", is that Ford suggested "retail demand appears to have stabilised", around this level. But as GM noted, the overall market is now down 6m in terms of vehicle sales versus 2007. A real recovery in this important end-market for chemicals seems as far off as ever.

The emerging economies, which built their growth on exports to the West, are being badly hit by the global recession. Brazil, where poverty levels were at their lowest level for 30 years, is now seeing recent gains unwind. Its exports fell 29% in January, the biggest drop since 1991. This followed a terrible December, when industrial output fell 14%.

Now President Lula has warned "we might have a contraction in the Brazilian economy". He plans to build 500,000 homes as part of a new Growth Acceleration Programme. This will provide some support for chemical sales, but the outlook is clearly very difficult.

Restructuring will become an important issue for the chemical industry, according to John Verity, ExxonMobil's polyolefins head. Speaking to ICIS news, he was downbeat about short-term prospects, noting that whilst some restocking is currently underway, "we are not likely to see any real demand until the end of the quarter".

Earlier, in his speech to PlastIndia, Verity warned that "there has been a significant collapse in demand", at a time when supply is increasing rapidly. He noted that "this will force older plants to shutdown, and drive restructuring in the industry".

There is little justice in today's recession. Countries that saved hard, and avoided reckless lending, are seeing their economies collapse as fast as those that spent as if there was no tomorrow. Thus Germany is now following the path already trodden by other export-oriented economies, such as Japan and most of the emerging economies. As the chart shows, based on new figures from the German central bank, the Bundesbank, industry's export orders in December were down 32% from a year ago. Overall, orders were down 29%.

Orders hit an all-time peak as recently as last February. This led many to hope that prudence would have its reward. But unfortunately, the decline was only deferred, not avoided. As a late-cycle economy, Germany is now suffering from the lack of demand in its formerly profligate trading partners. In turn, this will encourage its own population to save even more. This is bad news for the chemical industry, which depends on consumer spending for most of its sales.

The financial fallout from the Lyondell (LBI) bankruptcy continues, as the banks slowly begin to acknowledge their losses.

According to Bloomberg, RBS has taken a $1.47bn hit, Citigroup $1.4bn, and Goldman Sachs $850m. UBS are also believed to have lost at least $500m. But like Bank of America (new owners of Merrill Lynch), they have yet to reveal any details. Nor have hedge fund Apollo, who are believed to have bought $1.9bn of senior debt from Citi last April.

The final losses could be much larger. LBI's net debt at the time of the deal was reportedly around $22bn. And whilst investors comfort themselves with the hope that LBI's senior debt (first lien) will eventually be worth over 70c on the $, the current market value is reportedly just 22.6c. In addition, $8bn of more junior debt could well end up worthless.

Update 10 February. UBS disclosed a loss close to $1.2bn.

European auto sales fell 25% in January, according to JD Power. This equals an annualised rate of just 11m cars, the lowest since the early 1990's. 13.6m were sold in 2008. And although the forecaster hopes for some improvement later in the year, it suggests that "a late 2010 recovery is the most likely timing". It notes that major markets, such as Spain, Italy and the UK, continue to struggle. France also weakened, in spite of the sales incentives on offer.

The blog found some optimism on a recent German visit about the impact of the government's "new for old" deal. The aim is to boost consumption by encouraging older, more polluting cars, to be scrapped. But JD Power say that its introduction "was less than convincing", with German sales down 15% in January.

Last August, the blog noted that politicians were beginning to wake up to the scale of the current crisis. There are still many politicians (and businessmen) who still hope we are facing just a 'normal recession'. But last week, IMF head Dominique Strauss-Kahn told a Malaysian audience that "advanced economies are already in a depression".

Now a senior UK politician, Ed Balls, formerly an economic adviser to the Prime Minister, has warned that "the reality is that this is becoming the most serious global recession for, I'm sure, over 100 years as it will turn out." He added that "we now are seeing the realities of globalisation, though at a speed, pace and ferocity which none of us have seen before".

Yet again, as in October, 'buy on the rumour, sell on the news' has been the financial markets' reaction to the latest efforts to solve the financial crisis. A 5% fall on Wall Street last night, in response to the Geithner plan, tells its own story. The blog is also unconvinced that this further $2.5 trillion will solve the problem.

Back in September/October, it raised 5 questions about the spending plans. None have yet been properly answered. And crucially, for the chemical industry as well as for the economy, nothing has yet been done to solve the root cause of today's problems, namely "the excess supply of homes and the large number of mortgage borrowers in dire straits".

Today, however, former Treasury Secretary Brady has put forward a plan to address this issue. Brady was the man who gave his name to the Brady bonds, issued during the first Bush administration to resolve Latin American banking problems. He has a good track record, and the blog agrees with his diagnosis and proposed solution. His plan focuses on the two key issues that are currently depressing the US economy:

Deleveraging. Brady argues that this process has to be eased. One key step would be to abandon 'mark to market' accounting. This creates a vicious circle, whereby today's low value becomes the norm tomorrow. In turn, this destroys the banks' capital base, forcing them to further reduce lending, and causing more bankruptcies.

Foreclosure. As Brady notes, you can't begin to rescue the US financial system without first confronting the mortgage problem. His first step would be to make a realistic calculation of the "true scope of the problem". At the moment, neither the public nor the financial markets believe that this has been done.

The essence of Brady's plan is that the authorities need to get a handle on the amount of money that needs to be written off, as a result of the reckless lending that took place in the housing sector. People then need to be given support to help them stay in their homes, rather than being pushed onto the street, leaving their property to become derelict.

At the same time, the financial system needs to be given time to begin to repair itself. The US Treasury will need to pick up the tab, and the US taxpayer will end up paying the bill. But as Brady says, quoting General George Patton, " a good plan, violently executed now, is better than a perfect plan executed next week".

China plans to increase petchem production as a way of stimulating its economy. According to the China Daily, the government intends to allocate 400bn yuan ($58bn) from its fiscal stimulus to accelerate the implementation of petchem expansion plans. Bloomberg adds that the givernment could approve plans next week to increase "tax rebates for the exports of some petrochemical products". In addition, refiners will gain increased subsidies, allowing them to support downstream pricing.

This news is a disaster for other Asian petchem producers. China has been the main export market for NEA/SEA countries in recent years, accounting for up to 50% of output. This demand has already been reduced by the West's recession, as production has slowed in China's manufactured goods sector. Now, the use of subsidies will make China's own production even more competitive in the short-term. Whilst the decision to accelerate capacity increases will increase regional and global over-capacity in the medium term.

Last week, the blog spent 2 days at Wilton in the UK, one of the world's largest and most integrated chemical manufacturing sites. It also contains some of the world's major companies, including SABIC, Dow, INEOS, Huntsman and Lucite. The mood was downbeat, as one would expect with operating rates at historically low levels.

Critically, however, people were looking forward. Nobody expected that today's problems would soon be over. In fact, many thought a real improvement was some way off. But this was not plunging them into despair. Instead, they were focused on reducing costs, and managing their business for survival.

This may not be as much fun as planning for growth. But it is definitely as important. And from the blog's observation during its visit, it is also very motivating. Nobody was talking about giving up, in the face of the most adverse circumstances seen for at least 25 years. Instead, they were working on the basis that a chain is only as strong as its weakest link. The power of the teams now being created at Wilton could be immense.

In December, the blog noted that Japanese policymakers saw clear parallels between the mistakes they made during the 'lost decade' of the 1990's, and those being made today in the USA and other Western countries. The New York Times now has a fascinating article on this subject, which notes that:

"The Japanese crisis of the 1990s and early 2000s had roots similar to the American crisis: a real estate bubble that collapsed, leaving banks holding trillions of yen in loans that were virtually worthless. Initially, Japan's leaders underestimated how badly the real estate collapse would hurt the country's banks. As in the United States, a policy of easy money had fuelled both stock and real estate speculation, as well as reckless lending by banks.

"Many in Japan thought that low interest rates and economic stimulus measures would help banks recover on their own. In late 1997, however, a string of bank failures set off a crippling credit crisis. Prodded into action, the government injected 1.8 trillion yen into Japan's main banks. But the injections -- too small, poorly planned and based on little understanding of the extent of the banking sector's woes -- failed to stem the growing crisis."

It adds that "One reason Japan's leaders were so ineffectual for so long was their fear of stoking public outrage. With each act of the bailout, anger grew, making politicians more reluctant to force real reform, which only delayed the day of reckoning and increased the ultimate price tag."

Depressingly, the NYT concludes that, "so far, the Obama administration's plan avoids the hardest decisions, like nationalizing banks, wiping out shareholders or allowing banks to collapse under the weight of their own bad debts." Denial, however, is not a viable policy, and the NYT notes that "in the end, Japan had to do all those things".

The blog has noticed a major change in dress code over the last few months. The concept of 'Dress Down Friday' has begun to disappear in both the chemical industry, and the financial world.

Apparently this experience is not unique to the blog. Writing in the Financial Times today, Lucy Kellaway observes that "the casual look, which we used to regard as a sign of egalitarianism and unstuffiness, now looks sloppy".

She notes that when the economy is bad, "we need to dress up to cheer up". And she also mentions that a female friend of hers, recently promoted, is about to launch 'High Heels Friday" as a way of boosting the morale of her female staff. I wonder whether my blogging colleague, Barbara, will help to lead this trend?

Speaking today, Federal Reserve Governor Elizabeth Duke produced some doleful figures about the current state of the US housing market. She noted that 25% of sub-prime loans, and 13% of near-prime loans, are now "seriously delinquent" - either 90 days overdue, or in foreclosure. The serious delinquency rate for prime mortgages is now over 3%, having doubled during the past year.

As a result, foreclosures have also doubled since 2006, to 2.25m. Last week's sales even included the boyhood home of Fed Chairman, Ben Bernanke, sold for just $83k. This sombre background make it clear why chemicals demand into the important housing market remains so slow.

TOTAL's CEO, Christophe de Margerie, has become even more pessimistic on the future of oil supplies. In 2007, when prices were rising, he suggested it would be very difficult for production to reach even 100mbd, versus the 130 mbd or more assumed by the IEA and the US government.

Now, he is warning that the limit may be 89mbd, only 4mbd above recent production levels, due to 3 main factors:

• Project delays/cancellations as oil prices weaken
• Faster output decline in older fields, such as the N Sea
• Political constraints in Iran and Iraq

This forecast highlights a key dilemma for the oil-dependent chemical industry. Oil prices are currently too low to encourage necessary investment for the future, even if there were no political obstacles. But as and when oil supply and demand do begin to rebalance, it will be too late to bring on new supply quickly. At that point, oil prices of $100/bbl might not be just the temporary phenomenon that we saw last year.

Vita Group has chemical sales of €1.5bn, 5000 employees, and manufactures in 20 countries. In December it announced that it was in talks over restructuring, to avoid breaching covenants on the €663m of debt taken on in 2005, when it was bought by private equity group, Texas Pacific (TPG).

It now looks set to emerge with a new structure. This provides an important first example of what may happen to other over-leveraged chemical companies, as the recession intensifies.

The basic principle in restructuring is that debt gets exchanged for equity. The 'class' of debt is critical, and in Vita's case it seems that the debt-equity swap may end up as follows:

• 'Junior' debt of €200m will be exchanged for 2% of the equity
• 'Senior' debt of €300m will be exchanged for 32.5% equity

In addition, a further €95m of working capital is being provided by senior and junior debt holders, in exchange for further equity.

Vita's restructuring was relatively simple from a legal point of view, as it just involved European rules. But Lyondell Chemical's bankruptcy filing last month under the US Chapter 11 process seems to have thrown up some very complex legal issues. This is because it involves two different sets of bond-holders - those who bought the European debt issued to fund the original Basell purchase from Shell/BASF in 2005, and those who bought LyondellBasell debt in 2007 to fund the Lyondell purchase.

The Lyondell Chemical Chapter 11 filing had also included 1 German subsidiary. According to today's Financial Times, this was to enable the new 'Debtor in Possession' funding (raised as part of the US process) to be used to "service the European debt while the restructuring took place". However, the rules governing European and US restructurings are quite different, and the FT quotes one lawyer who argues that some European creditors do not want companies to "stretch the reach of Chapter 11 to European companies".

The FT says the issue could lead to a battle over jurisdiction between US and European courts. At the moment, Lyondell has "secured a temporary injunction against a group of European creditors to prevent them from enforcing their claims, as it feared this could push the European business into insolvency". But the creditors are contesting the injunction, on the grounds that "the Chapter 11 filing is an event of default under the terms of the bonds in question".

Now the US courts will have to decide on Monday whether to make the injunction more long-lasting. The legal wrangling is potentially very serious, as Lyondell has also told the court that "the potential loss of control to a foreign liquidator would be disastrous to the debtors' reorganisation efforts".

Update 27 February. Al Greenwood reported last night for ICIS news that the temporary injunction has been extended by the bankruptcy court to give 60 days protection to LBI.

The current recession is the blog's fourth, after those of the mid-1970s, and early 1980's and 1990's. It is, however, already different from these, as it is the only one which has led to comparisons being made with the 1930's Great Depression. As Harvard's Prof Shiller has noted, "Depression fear did not take off" in these earlier recessions.

The leading retailers are also flagging up major change in consumer values. Last year, they suggested we are now in an "Age of Austerity". Further evidence of this is becoming clear. Wal-Mart's US CEO, Eduardo Castro-Wright, noted on Tuesday that a "major consumer pullback on discretionary spending was now underway". Wal-Mart also said their "every day low cost model (now) works around the world".

Equally, as shown by the above chart of US auto sales, something quite different is happening in durable goods markets. The current fall in sales is far worse than anything seen since records began in 1967, in terms of absolute volumes and the 6 monthly average. Clearly, if this continues, it will be very bad news for chemical demand into this important sector.

The blog worries that this trend might become permanent. We might see an L-shaped recession, whereby an aging Western/Japanese population leads to an aging global economy. The New York Times reports today, that even after Japan's 'Lost Decade' ended, consumers have continued to hold back on spending, with car sales now 50% below 1990 levels.

The key issue may be one of "needs" versus "wants". Savings are being badly hit during this recession, with stock markets down c50% in many countries, and many corporate pension schemes in trouble. In this environment, consumers will focus on absolute "needs", such as food, housing and transport. And with most durable goods now lasting longer, they can make their money go further by cutting out the "wants", such as new cars and new kitchens.

As the blog argued in December, CEO's should encourage their Boards to seriously consider the potential impact of an L-shaped recession on their business. A U-shape is still the sensible Base Case. And we all hope the Upside Case of a quick V-shaped recovery may occur. But it would certainly be prudent to consider what might happen if the world now follows the example of Japan post-1990.

Nova's CEO, Jeffrey Lipton, has always been the great optimist of the petrochemical industry. As recently as December, he was arguing at the GPCA meeting that "demand forecasts will prove to be too low", and forecasting a shortage of ethylene and polyethylene in 2012.

However, optimism isn't a business strategy, particularly when it leads to over-leveraging the business. As the chart shows, Nova's shares had fallen 95% since September. According to Bloomberg, Nova needed "to secure $100 million in additional financing by Feb. 28 and $100 million more by June 1". So yesterday, Nova was instead forced to accept a $2bn offer from Abu Dhabi's IPIC. Lipton himself acknowledged that "it was pretty clear that this was the best alternative, you have to deal with today".

Nova's strategic mis-step is Abu Dhabi's gain. Nova benefits from advantaged feedstocks in the shape of Albertan ethane, has several excellent facilities and a highly professional workforce. With a sensible debt structure, it should now survive the present downturn. It should also be complementary to IPIC's existing investments in Borealis and OMV. The blog wishes Nova well under its new owner.

Destocking is currently a key issue for the chemical industry. The above chart, from Andrew Sentance of the Bank of England, provides some useful clues as to where we are in the cycle. It shows current performance (the green line) versus the history of stock levels in the recessions of the early 1980's (blue) and 1990's (red). It is based on UK industry, but should be reasonably representative of global conditions.

Each line begins 5 quarters before the start of the recession. They show that the onset of recession typically causes a period of "aggressive destocking". History would therefore suggest that we are now past this point. However, they also indicate it will be some time before demand picks up sufficiently for inventories to return to pre-recession levels.

At a time of uncertainty, its sometimes helpful just to frame the questions that need to be answered about the future. Pimco, the world's largest bond fund managers, have done just this in two separate analyses. Their answers mirror those advanced by former Treasury Secretary Nicholas Brady, and make good sense to the blog:

Q1. How bad could this get?
Answer: "No one knows for sure, but common sense would provide a good guess. If the government cannot substitute credit to the same extent that it is disappearing from the private system, then the U.S. and global economies will retreat. If the economy is viewed as a bathtub filled with water (credit), then draining it back down might reduce economic activity proportionately. Liquidate credit to 2003 totals and you just might reduce economic activity (GDP) to 2003 numbers as well. Whoops! That would mean a 10%+ contraction in the US economy with unemployment approaching the teens."

Q2. What can be done?
Answer: "Keeping the tub sufficiently full means advancing policies in content and magnitude never contemplated since the days of FDR. The U.S. and global financial systems require credit creation and foreclosure prevention, not bank nationalization as currently contemplated by some. Trillions will be required in the U.S. alone and it is critical that there be a high degree of policy coordination among all nations, which avoids protectionist measures reflective of failed policies in the 1930s."

Q3. What is the new credit paradigm?
Answer: "Expect to see lower levels of liquidity (making price discovery harder), more corporate defaults (and restructurings), and lower recovery values. You can no longer assume a 40% recovery rate as a bond investor. Government bailouts will likely be based on political parameters, rather than commercial reasoning."

Apparently its not just Jim Cramer who is less than happy with the current performance of Dow CEO, Andrew Liveris. The New York Times notes that merger arbitrageurs on Wall Street have started to spell his surname backwards, and re-christened him accordingly.

Japan's exports fell 46% in January, after a 35% fall in December. Exports to the US fell 53%, and to China fell 45%. This makes it likely that Japan's economy will shrink further, after the 3.3% decline in 2008. It could soon become the first G-7 economy to fall into depression - defined as a 10% fall in GDP.

Asia's economy has become heavily export-dependent in recent years. The chart above, from today's Financial Times, illustrates this by individual country. This dependence will make it very hard for most Asian countries to maintain domestic GDP growth, if their export sales to N America and W Europe are falling rapidly.

The implications for chemical demand are worrying. Asia's exports of manufactured goods to the West have been the driving force for chemical growth in recent years. Now, the trend is reversing rapidly. Japan's export fall included a 52% decline in car parts, for example - a key demand sector for many chemical producers.

US fund managers Comstock Partners reported a 50+% gain on their flagship Capital Value Fund in 2008. The logic behind their out- performance is summarised in the chart, which depicts their belief that we are now in a global cycle of deflation. Their analysis is that this cycle:

• Began with a rise in savings in emerging countries such as China, which then funded over-investment locally whilst also supporting excess consumption in the West.
• In turn saw twin excesses appear, of debt, and manufacturing capacity. These then led to the generalised weakness in pricing power now impacting chemicals and other major industries.

Some countries, such as the UK, have already responded to recent developments by devaluing. The pound is down 23% versus the US$ since September, and 13% versus the €. The risk is that we now see a round of competitive devaluations, as other countries also try to support their exports, and reduce import penetration.

Logically, countries should instead be focused on closing capacity as fast as possible, to avoid the menace of deflation. This would, of course, be very painful in terms of immediate job losses. But the risk, as Comstock suggest, is that we may end up seeing a rise in protectionism to protect employment, with governments imitating the 1930s by introducing tariffs and other beggar-my-neighbour trade policies.

Past performance, as we all know, is no guarantee of future performance. But there seems to be sufficient evidence for Comstock's analysis to make the blog concerned that they may just be right.