Chemicals & The Economy

Kevin Swift at the American Chemistry Council issued a new 2009 Outlook this week. His analysis suggests that we will see a V-shaped recession, as the "massive stimulus being injected into the US and other world economies will foster demand and a virtuous cycle of recovery will engage". His optimism is very welcome, given the dire news this week from US housing markets, which are so critical to chemical sales.

The chart above, from the excellent weekly ACC report, shows that new home sales in January were down 48% versus 2008. New home inventories also rose to 13.3 months, which will no doubt lead to further cutbacks in housing starts. Meanwhile the S&P Case-Shiller house price index fell for the 29th successive month, with "all 20 metro areas reporting annual declines".

Propylene prices have been relatively strong in recent years, compared to ethylene. As the chart shows, they averaged 90% of the ethylene price between 2003-8. Now, however, they have returned to the historical 70% - 85% range. Propylene's recent strength was well founded:

• Benzene prices rose in 2004, making PP more attractive versus PS
• Ethylene then became tight, helping PP to gain volume
• Automakers favoured PP as they sought to reduce auto weight

Now, however, these factors are reversing. Benzene is in surplus, whilst major new ethylene capacities are starting to come online. Equally, auto sales have slumped. As a result, the ratio has fallen back to the long-term average of 78% (based on European monthly prices for Q1).

Producers will hope that it stays above the 70% level, which has held since 1981. But as I warned in the December 2006 issue of ICIS Insight Middle East (Insight.pdf), major new on-purpose C3 production is now coming onstream in the Middle East. In addition, refiners are set to produce more propylene (and benzene) from their planned expansions, whilst the outlook for the auto market is not encouraging.

BASF's reported results for 2008 show that its profits are increasingly coming from the oil and gas sector. Geographically, it is becoming similarly dependent on its German operations.

Agricultural and performance products put in a strong performance during the year, with their combined EBIT rising €300m to €1.5bn. But the chemicals, plastics and functional businesses, which accounted for 47% of total sales, saw EBIT fall €1.5bn to €2.1bn

A year ago, the blog noted that the oil and gas "sector accounted for only 18% of 2007 sales, but contributed 41% of total profit (EBIT). In 2008, it accounted for 23% of total sales, whilst profit reached an astonishing 59% of total EBIT. Of course, higher taxes on the sector meant that its net income was 'only' €951m, up 20% on 2007. But even so, this meant that oil & gas accounted for 33% of total BASF net income of €2.9bn, versus 19% in 2007.

Similarly, BASF became even more dependent on its German operations in 2008. These accounted for a similar proportion of sales (44%) as in 2007. But their share of BASF's total €6.5bn EBIT rose to 73% from 58% in 2007. If the downturn continues for the next few years, as the blog expects, BASF may become increasingly dependent on the resilience of the oil and gas sector, and its core German manufacturing sites.

James Baker was Treasury Secretary to President Reagan. When he says that the US is "repeating Japan's mistake by viewing our banking crisis as one of liquidity and not solvency", the blog listens.

His prescription is stark: "we should divide the banks into 3 groups - the healthy, the hopeless and the needy". And he suggests policymakers should "leave the healthy alone, and quickly close the hopeless. The needy should be re-organised."

Baker also argues in today's Financial Times that "this crisis demands a pragmatic, comprehensive plan. We simply cannot continue to muddle through it with a Band-Aid approach." And he goes on to echo former Treasury Secretary Brady's concern that policymakers have not yet realised "the true scope of the problem".

Q. How do you know your bank is in trouble? A. When its share price is less than the cost of taking money out of one of its ATMs.
The blog is indebted to Thomas Friedman for this gem.

Thanks also to a blog reader for these 2 jokes from the Jay Leno show:

'The US has made a new weapon that destroys people but keeps the building standing. It's called the stock market.'

'I want to warn people from Nigeria who might be watching our show. If you get any emails from Washington asking for money, it's a scam. Don't fall for it.'

Newer readers of the blog may also like to refer back to an earlier joke page, linked to the Financial Times' collection of sub-prime jokes,

February brought no relief for the troubled US auto industry, so critical to chemical sales. Sales were down 41% versus 2008. Even more worryingly, sales over the past quarter, and last 6 months, averaged under 10 million/year. Chrysler's results also show the severe cost of gaining market share. It gained 1.4% in the retail market, but only by increasing its discounts by c$2000, to $5566 per vehicle.

Inventories have been reduced due to lower production, but still remain high. Ford, for example, had 405000 vehicles in stock - equivalent to 4 months supply. GM were worse, with 781000 vehicles in stock, equal to 6 months supply. A sign of the times is that Chrysler boast on their website of having only 100 days of inventory.

The decline in auto sales is now threatening many industry suppliers around the world:

• Today, the main Japanese car parts group has warned that "Toyota's production cuts will cause bankruptcies among suppliers if the government restricts aid to large manufacturers".
• Last month, the main US associations requested $18.5bn in support from the Obama administration, and met Treasury officials this week to press their case.
• Similarly, Bosch's CEO, Franz Fehrenbach, has warned that in Europe, "A slew of suppliers will no longer be able to finance themselves and stay solvent in the first quarter."

The chart above, from Paul Ray's excellent 'ICIS Weekly Margin Report', clearly shows the level of pain currently being suffered by naphtha-based cracker operators. Based on European pricing, it also demonstrates the great difference between today's recession versus the 'dip' of 2002/3:

• Margins based on contract prices fell to €151/t in January
• They then fell further to €117/t in February

By comparison, they averaged €239/t in 2002, and were back to €272/t in 2003. And today's margins are, of course, being 'supported' by the significant number of crackers that have been offline in recent months.

The blog's worry is that it is hard to be very optimistic over the near-term outlook for margins. Demand will hopefully improve at some point, even if this is just due to destocking coming to an end. But equally, one has to expect that the offline crackers will restart at some point. This will not only help to balance out any increase in ethylene demand, but may also put further pressure on co-product margins for propylene and benzene.

The chart above represents a sad story, with all major stock markets now down at least 48% since their peaks in 2007/8. When the blog last reviewed performance in September, Shanghai had been the worst performer, down 69% from its October 2007 peak. Since then, it seems to have stabilised, with the market down 64% yesterday.

The other BRIC markets (Brazil, Russia, India) have continued their decline, and are now down 49%, 77% and 60% respectively, as exports collapse. Industrialised country markets have also seen further major declines, with the US S&P 500 now down 56%, similar to the loss on Germany's DAX. Japan is down 61%, whilst the UK emerges as the 'best' performer, down 'only' 48%.

This confirms the blog's fear, back in September, that we would see a second round of declines as the financial crisis evolved into a severe economic downturn. We will, no doubt, continue to see major bear market rallies as, for example, followed the Obama victory. But a sustained recovery will probably have to wait until earnings show signs of stabilising,

The world's major financial institutions become more pessimistic each time they report on the economic outlook. 6 weeks ago, the blog noted that the IMF expected "the global economy to come to a virtual standstill in 2009".

Today, the World Bank is forecasting that "the global economy is likely to shrink this year for the first time since World War 2". Equally worrying is its forecast that "world trade is on track in 2009 to record its largest decline in 80 years, with the sharpest losses in East Asia".

Yet many policy-makers still seem to underestimate the problems. As Nobel Prize-winning economist Paul Krugman wrote last week, "the reality is that when it comes to dealing with the banks, the Obama administration is dithering. Policy is stuck in a holding pattern."

Several European policymakers also seem stuck in denial mode. In January, for example, the IMF warned of "deflation risk" if the current policy approach failed. Yet Sunday's central bank meeting didn't even discuss the issue. European Central Bank President, Claude Trichet, said "It's not something we consider a high probability at all at a global level."

As economic risks rise, the blog hopes policymakers will quickly turn their attention to contingency planning, in case their expectations for a V-shaped recovery prove illusory.

The blog has always had enormous respect for Dow. This was due to their ability to manage unconventional risks, in a way that other chemical companies (such as the blog's former employer, ICI), found impossible. Even when things went wrong, they always had a Plan B, which allowed them to exit on a sensible basis.

This time, however, there was clearly no Plan B with regard to the K-Dow JV and R&H purchase. This seems very strange, given that it was increasingly obvious through H2 that the value of chemical assets was declining very fast. Equally, there was always the awful warning of ICI's attempted transition from petchems into downstream businesses in the 1990's. This became a classic example of how to "buy high, sell low".

Now Dow is faced with making the best of a very bad job. As ICIS news notes, it is paying $78.97/share versus the original $78/share. Plus, there is always the worry that, like ICI, an 'efficiency-driven' Dow may not really understand that R&H's innovation-driven businesses rely on R&D for their long-term profits. Dow's announcement of the "additional consolidation of 6 R&D facilities" is a very worrying sign.

The blog wishes 'new Dow' well, but its confidence has been badly shaken by the events of the last few months. Restoring it will take time.

The UK's most senior civil servant, Sir Gus O'Donnell said yesterday that the UK government was struggling to organise next month's G-20 meeting because of the "absolute madness" of the US system, whereby "a new administration had to hire new officials from scratch, leaving a decision-making vacuum".

O'Donnell added that "there is nobody there. You cannot believe how difficult it is".

Last month, in discussing the 'Cycle of Deflation', the blog worried that "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".

On Thursday, the Swiss National Bank announced that the Swiss franc's strength was "inappropriate" and said it would intervene in currency markets.

Now it is not just the blog that is worried. The Financial Times comments today that, "a Swiss National Bank decision this week to weaken the Swiss franc has raised fears that other central banks will follow suit in a wave of currency devaluations".

It is still not too late for protectionism to be avoided. The chemical industry has been a major beneficiary of globalisation and lower trade barriers over the past thirty years. Its leaders now need to speak out strongly, and in a co-coordinated way, on the subject. The upcoming NPRA meeting in San Antonio would be a good place to start.

OPEC Oil Ministers, meeting today, have achieved 80% compliance with their announced production quotas. This is much higher than normal, and owes a lot to the hard-ball tactics played by Saudi Arabia, the world's leading oil producer, in initially allowing prices to slip to a $32/bbl low.

The blog forecast in January that OPEC would be successful in stabilising prices "around the $35 - $45 range". And as the Barrons chart shows, this range has since held, in spite of major speculative attacks from financial players trying to push prices either below $30, or above $50/bbl.

Saudi has also made no secret of its desire to push prices back to a $75 - $100/bbl range in due course. But as OPEC noted last week, the global economy is in a "terrible situation". OPEC expects a 1mbd fall in demand during 2009, whilst it and the International Energy Association expect consumption to average only around 84.5mbd.

Uncertainty over OPEC's ability to maintain the current range is therefore likely to continue, especially as quota compliance from Iran, Nigeria and Angola is only at 51%, 54% and 15%. Equally, this means that prices are likely to remain highly volatile. Even the core $35 - $45 range implies nearly 30% swings, whilst over 50% is entirely possible if prices overshoot on the downside towards $30 and then recover towards $50.

The G20 represents over 85% of the world's economy. And there is certainly no shortage of major issues for government leaders to discuss when the G20 meets next month in London.

But the blog is not over-hopeful about their ability to make things happen. In November, the G20 promised "concrete policy outcomes" from its meetings. But the rather bland weekend communiqué from the preparatory meeting of finance ministers suggests there is still little of substance behind the words.

Its not just the World Bank that is concerned about the outlook for East Asia. Today, Moody's (the ratings agency) says it has a negative outlook for the petrochemical sector over the next 12-18 months. It concludes:

• "In response to weakening global demand, Asia Pacific's petrochemical companies are rapidly shedding inventory and delaying their procurement of feedstock, which has amplified the sector's current down-cycle.
• "The negative outlook in the Asia-Pacific petrochemical sector reflects petrochemical manufacturers' deteriorating margins, which in turn result from weak demand, a slowing economic environment, and new capacity coming online in the Middle East and China in 2009 and beyond."

Human beings go through a number of stages when confronted by major change. As first described by Elisabeth Kübler Ross, the process starts with:

• Denial that any change is taking place
• Then anger at the implications of the change
• Bargaining to reduce its magnitude
• Depression as reality begins to be confronted
• Finally acceptance of what has happened.

John Authers notes perceptively in today's Financial Times that Kübler Ross' model is likely to be a good guide to the evolution of the financial crisis. He suggests that the world is now moving on from Denial, into the Anger stage. Some still deny we are facing a major downturn. But public anger over the bonus payments issue is now on the rise around the world.

Authers suggests that Bargaining will be the next stage, as players try to develop a solution to the crisis. Then we will go through a stage of Depression, at what has been lost, before reaching the Acceptance stage, and moving on. Moving through the Denial stage has taken almost 2 years. So the blog fears we may still have a long journey ahead.

The IMF and World Bank continue to play leap-frog in reducing their global growth forecasts.

In January, the IMF forecast growth would come to a "virtual standstill". Then, two weeks ago, the World Bank said the economy would "shrink" for the first time since World War 2.

Today, the IMF joins the Bank in suggesting growth will contract by 0.5% - 1% in 2009. It has also cut its regional forecasts very sharply:

USA growth will be -2.6%, down from -1.5%
Euro area growth will be -3.2%, down from -2%
Japanese growth will be -5.8%, down from -2.6%
Emerging economy growth will be just 1.5%-2.5%, versus 5% plus

The Fund pessimistically now expects the world's advanced economies to "contract sharply in 2009". It adds that: "Turning around global growth will depend critically on more concerted policy actions to stabilize financial conditions as well as sustained strong policy support to bolster demand."

Benzene is one of the most widely used, and widely traded, chemicals. It is therefore an excellent leading indicator of chemical industry supply/demand balances, and profitability.

• A year ago, the blog noted that benzene prices had "hit a ceiling", suggesting that industry profitability was close to a peak.
• Then in October, when they fell to naphtha levels, benzene provided a first indication of "just how dire market conditions" were to become.
• By November, benzene prices were anticipating crude prices of $16/bbl, indicating that producers were "selling on a firesale base" and that profitability was "getting close to the floor".

Since then, benzene prices have indeed risen from December's $258/t low. But, as the chart shows (based on ICIS pricing), benzene has still not recovered its normal premium versus naphtha. Prices have averaged just $332/t so far in 2009, versus an average naphtha price of $378/t. Such an extended period of discount has never happened before.

Unfortunately, this suggests that, unless Q2 brings a swift improvement, the outlook for 2009 industry profitability remains fairly dire.

ICIS Chemical Business has just published my article, 'Low-cost operation key to survival', which discusses business strategies for surviving the downturn. Please click here if you would like a copy.

You can also hear a radio interview with ICB Deputy Editor, Will Beacham, by clicking here, or read Will's summary of the interview in ICIS news.

Japan's auto exports tumbled 71% in February, and its US exports fell 58%, causing total exports to decline 49%. Imports also fell 43%.

Exports to China, however, were 'only' down 40%. And other NEA exporters, more dependent on Chinese markets, showed an improving position. S Korea's exports were only down 17%, versus -34% in January. Taiwan was down 29%, versus -44% in January.

Yet China's own exports fell 26%, versus an 18% fall in January. So why should China be buying more from its NEA neighbours? Clearly the end of Lunar New Year could have helped revive trade. But an interesting analysis by my fellow blogger, John Richardson, suggests that much of China's recent demand may be going straight into inventory.

He notes that the government's easy money policies are allowing firms to operate at a loss. Equally, traders can easily fund speculative purchases. This all boosts activity in the short-term, and helps to keep GDP near the government's 8.5% target. But whilst China can stockpile goods for a while, in advance of any recovery, this cannot continue forever.

China's current policies are creating a major risk of "traditional supply-induced deflation" for the world's chemical industry. If demand does not recover during H1, then China may well end up having to dump this inventory on world markets, at whatever price they will fetch.

Oil prices have been rising steadily over the past few weeks, and are up 20% since the start of the year. Yet US oil inventories have also been rising, and are now at their highest level since July 1993. Stocks have risen in 22 of the last 26 weeks.

Whilst OPEC production cuts have certainly helped to stabilise the market, demand is continuing to fall, and is now down 3.2% from 2008 levels. In response, Total is taking the extreme measure of temporarily shutting its 240 kpd Port Arthur refinery.

The rationale for the disconnect between weak oil market fundamentals, and higher prices, lies in financial market sentiment. Traders continue to believe, as they have all year, that demand is just about to recover. A clear sign of this is the forward premium in futures markets, where the March 2010 WTI futures contract is $10/bbl above today's high price.

Sentiment can, and often does, take prices out of line with the fundamentals - on both the upside and downside. But in the end, fundamentals will again set the price, as they reflect the underlying physical supply/demand balance.

Last month, the blog supported former US Treasury Secretary Brady's argument that 'mark to market' accounting rules were helping to worsen the current financial crisis. It therefore welcomes the decision by the US Financial Accounting Standards Board to revise its rules with effect from April 2. It applauds Paul Kanjorski, chair of the relevant House sub-committee, for forcing this change through so quickly.

It is less optimistic that current Treasury Secretary Geithner's new plans for dealing with 'toxic assets' will work. These seem to be based on the belief that people want to buy these 'toxic assets', but can't find the cash. The blog fears they are 'toxic', simply because they will never be repaid.

US new home sales began falling in 2005, when they peaked at 1.4 million a month. Last month, as the above chart from the ACC weekly report shows, they were down to just 337,000. Similarly, new home inventory has risen to 12 months. Each new home uses over $16k of chemicals, so this decline has had a major impact on industry sales.

But, at last, there are signs that the decline may be slowing:
• Existing home sales have been stable at c4.6 million since November
• Foreclosures have accounted for c40% of this volume
• Foreclosure prices are c20% below market, encouraging buyers
• The US Fed aims to cap interest rates via its 'quantitative easing' policy

Equally, spring is normally the peak time for sales. And after 4 years of constant decline, any relief, even temporary, would certainly be welcome.

There had been speculation that President Obama's mid-West background might tempt him to take a soft line on the troubled automotive industry. But his comments on Thursday that there has been "a lot of mismanagement of the auto industry over the past several years", suggested this was unlikely. Today's news confirms it:

• GM's CEO has been fired, along with some other Board members
• GM has to provide another business plan within 60 days as a pre-condition for further funding
• Chrysler have been told to finalise the merger with Fiat within 30 days, if they wish to receive further funding
• The threat of bankruptcy still hangs over both companies

The core issue is summarised in the above chart from TheChartStore. US auto sales are currently at an annualised rate of just 9 million units. During the 2003-7 boom period, they averaged almost double this amount. Even in the 1991 recession, they only dropped to 12m units.

The new President's tough line suggests that he, like the blog, does not expect a quick, V-shaped, recovery back to 2007 levels.

Source: Chartoftheday.comUS house prices remain on a "downward path" according to today's latest S&P Case-Shiller house price index. S&P report that in terms of nominal prices (including inflation), "average home prices across the US are now at similar levels to late 2003". In 'real terms' (after excluding inflation), the picture is even worse.

According to the above chart from ChartOfTheDay, "a home buyer who bought the median priced single-family home at the 1979 peak has actually seen that home lose value (1.6% loss)". COTD adds that "the median priced home has moved back to the top of a trading range that existed from the late 1970s into the mid-1990s".