Chemicals & The Economy

Leaders of the G-20 represent 85% of the global economy, and 65% of world population. Set up by Finance Ministers after the Asian crisis in 1997/8, they first met at Heads of Government level in the USA last November. Sadly, although their communiqué was filled with earnest promises, few of these have since been enacted.

Most critical for the chemical industry is the outlook for global trade. This is now seriously threatened. The above chart from the OECD shows trade fell 24% in Q4, more than in 1975, and is forecast to fall at similar levels for Q1 2009. And as the World Bank has already documented, protectionism is on the rise - with 17 of the G-20 countries having introduced new measures since the November meeting.

The blog is always optimistic, and so it hopes that the meeting will provide an opportunity for world leaders to put aside the rhetoric and focus on the real issues. These are:

• Is fiscal stimulus the way to go? If so, how should it be done? The US has already committed $12.8 trillion (versus total GDP of $14.2 trn). Is this money well spent, or simply storing up more debt for the future?
• How far should governments go in combating the downturn? Are we, as the blog speculated in October, getting to the point where the principle becomes "markets where possible, governments where necessary"?
• What should be the future role of regulation and central banks? What changes need to be made to the global financial system? How should they be implemented?
• What happens if things get worse, not better? The consensus view is that the economy will 'naturally' recover at some point. But as the blog discussed in December, an L-shaped downturn is certainly possible.

These are big issues, and the blog does not expect immediate answers. But much time has already been lost, as politicians (and some industry leaders), denied that a crisis was underway. Hopefully, tomorrow's discussions will finally start to move policy in the right direction.

The blog still finds it hard to adjust to Dow Chemical's current financial status, following the K-Dow/Rohm & Haas episode. But facts speak for themselves. Earlier this week, S&P lowered Dow's debt rating to just above junk grade, on completion of the R&H deal.

However, news that Dow has sold R&H's Morton Salt to Germany's K&S, for a cash payment of $1.675bn, shows that the company hasn't forgotten all its negotiation skills. K&S are paying 6.2 times 2008 EBITDA of $270m, a reasonable multiple. And whilst salt is less cyclical business than polymers, Morton's 2006 EBITDA was only $138m.

The blog has been reading the G-20 communiqué, and various news reports, to understand whether the London summit answered the 5 key questions it raised in advance of the meeting.

Reuters provides a good summary of the outcome in terms of 3 blog questions:

• Global trade. "The Summit 'reaffirmed' commitment from previous summit last year to refrain from raising new barriers to investment and trade. In practice, however, many of the G20 countries have adopted protectionist measures since the Washington summit in November to defend domestic companies." On the positive side, the Summit also provided $250bn to support new credit lines for international trade.
Blog conclusion: more talk than action.

• Fiscal stimulus. "The United States, Britain and Japan had been strong proponents of concerted action around the world to pump more government funds into stimulus packages; France and Germany led calls to hold off, preferring to wait for results from funds already committed. The Summit set no obligation for further fiscal measures."
Blog conclusion: talk, but no new action.

• Regulation. "Clear Summit commitment to extend regulation and oversight to all systemically important financial institutions, instruments and markets. Credit rating agencies will also be covered."
Blog conclusion: clear action plan.

The summit communiqué covers another question:
• Role of Governments: Leaders have "committed ourselves to work together with urgency and determination to translate these words into action. We agreed to meet again before the end of this year to review progress on our commitments."
Blog conclusion: much talk, no clear action plan.

• Plan B: The final question, of a contingency plan in case the global economy does not begin to recover, seems not to have been addressed.
Blog conclusion: No sign of a 'Plan B' being developed.

The blog may be over-optimistic, but as with US house markets, it is hopeful that US auto market may have hit at least a temporary bottom. Spring should be a good period for sales, and March saw auto volumes down 37% versus 2008. This was a relatively good performance after February's 41% decline, but still remained under the 10 million/year level.

Housing and autos are leading indicators for the economy, whilst unemployment is a lagging indicator. Firms usually only fire people after sales have declined, not before. Sadly, it is therefore not surprising that the US economy lost 663,000 jobs in March. 5 million jobs have now been lost due to the recession.

Hopefully the US economy will not get much worse short-term. But it is hard to see it recovering quickly with so many people out of work, and many others worried about their job security.

The blog is delighted that the Financial Times' Gillian Tett has been named Journalist of the Year, in the annual UK awards. She was the first journalist to call attention to the dangers developing in financial markets, and has been an invaluable source of information.

Two postings, from March 2008 and December 2007, illustrate her ability to spot potential problems long before they became major issues: 

Too big to rescue

Posted by Paul Hodges on March 28, 2008 1:39 PM

Readers will know that I am a great admirer of Gillian Tett's analyses of banking issues in the Financial Times. Today, she has another thought-provoking article, this time on the emergence of Iceland as 'the world's first country run like a hedge fund'. The article is worth reading in itself, but also for the question that it raises in conclusion. This is whether the leverage used in recent years by some banks now means that they are 'not just too big to fail, but also too big to rescue'?

2008 economic outlook

Helpfully, Gillian Tett has separately summarised the 3 major scenarios that describe how the current crisis might play out next year:

Consensus. The US narrowly escapes recession. US housing and banking markets stabilise in Q1, and there is little spillover into the rest of the economy, although auto sales growth and jobs growth decline. Emerging markets continue to boom, helping to balance slower Western growth.
Muddle through. The credit crunch slows global growth. Western economies come under pressure, and high levels of debt reduce corporate and individual flexibility. The US$ remains under pressure, as investors reallocate portfolios to other currencies.
Downturn. Today's credit worries spread. Banks severely restrict lending as their current business model of securitising loans to 3rd parties stops working. They also suffer losses in other consumer areas (eg credit cards). A US recession leads to a second wave of financial turmoil, as highly indebted companies go bust.

What worries me about the consensus view, as with the consensus on oil prices that I discussed in October 2007 in 'Budgeting for a Downturn', is that it is not a true base case. It is easily the most optimistic scenario. The other outcomes are both downside cases in terms of the 2008 outlook for the 'real world' in which the chemical industry operates.

The need for chemical companies to develop robust contingency plans, in case the consensus is wrong, is looking ever stronger 

Tom Hicks was a major player in private equity, but then moved on to sports investment via his Hicks Sports Group (HSG). He owns the US Texas Rangers baseball and Dallas Stars ice hockey franchises, as well as a 50% stake in the UK Premier League's Liverpool FC.

Now The Guardian reports that HSG has missed $525m of payments on 3 separate loans, and soon needs to refinance a £350.5m Liverpool loan. Hicks has also confirmed he is searching for "partners that share my long-term vision".

The blog noted in October that many major Premier League teams were loss-making due to excess leverage. Even Manchester United may be impacted. Its US owners seem set on selling Cristiano Ronaldo to Spain's Real Madrid next month for £75m, to help pay their debts.

Benzene is the blog's favourite leading indicator of chemical industry demand. It is one of the most widely used products and, as a liquid, it is also widely traded.

Its recent successes as an indicator include calling a peak on industry profitability, when its prices peaked a year ago. And then it provided early confirmation in October of the downturn, since when it has been at a sustained, and unprecedented, discount to naphtha.

But very recently, prices have begun to recover, with European benzene now trading around $575/t according to ICIS pricing, versus naphtha at $450/t. US benzene prices are at similar levels, around $1.85/gal. Asian levels are over $630/t. Thus benzene is once again trading at a healthy 'spread' to naphtha around the world.

This suggests that, finally, destocking down the value chains may be coming to an end. But the blog remains very cautious about whether this will then lead to a full-scale V-shaped recovery by the end of the year. The prudent policy is still to hope for recovery, but to plan for an extended downturn.

To misquote the famous HL Mencken phrase, "nobody ever went broke under-estimating the losses caused by the credit crisis".

Initially, Fed chairman Ben Bernanke estimated the losses at just $100bn.

Then, a year ago, the IMF said its estimate was $1 trillion. Now, the IMF is raising its estimate even higher, this time to $4 trillion.

According to The Times, the Fund expects $3.1trn of these losses from US-originated assets, and $900bn from EU lending. Even more worryingly, as Nouriel Roubini points out, these estimates do not include prospective losses from corporate loans to highly-indebted companies. According to respected analyst Mike Mayo, the banks are still carrying these loans at close to face value.

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Recently the blog has identified a number of signs that US housing and auto markets are stabilising, at least temporarily. This should feed through into chemical demand during Q2, and enable production volumes to show some improvement.

What happens next? In order to answer this critical question, we have to understand where we are today, and where we have been:

Downturns are difficult times. There is always the hope that markets might improve, and this can delay the implementation of tough decisions on plant closures. Nobody wants to shut down, and then see a competitor benefit from an improving market.

But if markets do stay depressed, then precious cash is being wasted whilst plants operate at a loss. This can put other businesses at risk. So it is important to get the balance right. There are no easy options.

The position of LyondellBasell is particularly difficult. It became the largest-ever chemical company bankruptcy in January (with $26bn of debt), and Lyondell Chemical is now operating under Chapter 11 rules. This has already given rise to major legal issues, as different sets of creditors fight for their position.

This led to a worry that financial and legal issues might over-shadow the equally essential need for major business restructuring. Therefore it was very positive when the company announced it was appointing a COO to consolidate management of the worldwide businesses, including its manufacturing divisions.

Ed Dineen was also an excellent choice for the role, given his extensive industry experience and understanding of the LBI businesses. Since October, when the blog published its 2009 Outlook, 'Budgeting for Survival', it has been clear that we were facing one of the worst crises in the industry's history. It is important in these conditions for management to lead from the front, and be open and honest about the problems.

It is also critical that implementation is effective. Since Dineen's appointment was announced, the company has confirmed a target of 4800 job losses amongst employees and contractors, plus the closure of 14 plants, with around half of these already underway. The aim is to achieve $700m fixed cost savings by year-end 2010, with a further $600m of savings targeted by other business improvement measures.

The blog knows and respects many LBI employees, and is saddened by these job losses. But as Dineen noted yesterday, "March and April have not given indications of any significant change in market conditions." In these circumstances, delaying the inevitable would be an abdication of responsibility.

US consumer prices fell for the first time since 1955 last month. Deflation was more common before 1955, and in the 1929-33 period prices fell by c10% a year.

The danger of deflation is that it changes the entire psychology of purchasing. With inflation, it is better to buy today, because the product/service will be more expensive tomorrow. But with deflation, one can postpone the purchase as it will become cheaper with time. Thus demand slows, and profits come under major pressure.

Today's news provides further support for the blog's October suggestion that "Prudent CEOs and CFOs will need to develop contingency plans for this depressing prospect".

As the blog had hoped, US housing starts have stabilised in recent weeks. As the chart from Wall Street Journal shows, single-family home starts in March remained at c360,000 for the 3rd month running.

Equally, the National Association of Home Builders' index improved slightly from 9 in March to 14 in April.

But starts are still 80% off their March 2006 peak, and just 50% of the March 2008 level. Meanwhile, foreclosures continue to rise, whilst average prices are down 29% since their 2006 peak.

It would therefore be very optimistic to believe that the current period of stability might be any more than the start of a bottoming process. The chances of it leading to a full-strength V-shaped recovery by H2 look remote.

The last 6 months have been traumatic for many parts of the chemical industry. The next 2 or 3 years may well continue to be very difficult.

How should your company best position itself to survive?

That is the key question I will discuss on Thursday 14 May in my Webinar, 'A Checklist for Survival'. Please click here for details, and to register.

The above chart is a real 'labour of love' by the American Chemistry Council. It represents their best statistical effort to model:
• Change in inventories for the major thermoplastics
• Change in underlying demand for them, down the value chain

This is critically important for the chemical industry, as it shows what is really happening in the US economy in terms of demand for the major volume products - polyethylene, polypropylene, polystyrene and PVC.

The conclusions are sobering. Inventories fell 31% from 2008 to trough. Actual demand fell 17% from the same 2008 peak, and is not showing any signs of being about to recover in a major way.

The blog was never convinced by US Treasury Secretary Paulson's efforts to manage the financial crisis. Its view was that Paulson avoided the real issues, and focused instead on trying to boost market sentiment. Worryingly his successor, Tim Geithner, seems to have inherited the same mindset.

2 months ago, Geithner announced that 19 major US banks would be subjected to a 'stress test'. The idea was to check whether their balance sheets were strong enough to withstand more losses on their loans, if the economy continued in recession.

Soon afterwards, global stock markets took off on a major rally. Clearly some people believed that the tests would encourage investors to turn positive on financial companies again. This theory was confirmed when news 'leaked' that all 19 banks would, indeed, pass the test.

However, party-pooper Prof Nouriel Roubini now points out the test is "meaningless". He says this is because actual data for the 3 variables being tested (GDP, unemployment and house prices), "are already running worse than the (so-called) 'worst case scenario'".

You can read the full details on Roubini's blog. But it poses an interesting question. Will the Administration still have the nerve to suggest that all 19 banks are in the clear? Or will it, as the Financial Times suggests, now have to revise the tests to make them more credible?

Either way, the banks will still be in trouble. Their problems now include not just dodgy sub-prime housing mortgages, but also credit card debt and corporate loans. Rising unemployment means consumers will increasingly default on their credit cards, whilst continuing recession will force more companies into bankruptcy.

Parts of Europe are now following the US lead and seeing deflation.

Spain saw prices fell 0.1% last month, for the first time since records began in 1961.

In the UK, the retail prices index fell 0.4%, to register the first decline since 1959. Prices have also fallen in Portugal, Ireland and Luxembourg

Economists have been queuing up to explain that this is only temporary. But the blog is not an economist, just a practical business-person. And it remembers many of the same economists telling us last year that a financial crisis was impossible.

The blog's concern is simple. It believes that inflation and deflation depend on the balance of supply and demand. If demand is greater than supply, then prices and inflation will rise. But if supply is greater than demand, then deflation is a serious possibility.

This seems to be the situation today. Major over-capacity exists in many parts of the global economy, with petrochemicals being just one example. At the same time, demand is low, as consumers prefer to save instead of spend. So prices are falling.

The risk is that this downward spiral might become self-reinforcing. Consumers might come to believe it is better to delay purchases, because they will then be cheaper. This has not happened in the West for a sustained period since the depression. But it did happen in Japan during the 1990's, and may well now be returning there as well.

The prospect of bankruptcy is finally sharpening the knife at GM. As the blog noted last month, inventories are at astronomical levels.

781000 vehicles were in stock at the end of February, and this figure had only dropped by 15000 vehicles during March to 765000 vehicles. This equates to around 6 months supply.

Now the inevitable is finally under discussion.

According to the Wall Street Journal, GM will shut most of its plants for 2 months over the summer, instead of its normal 2 week break. Chemical companies will also take a big hit, with lost sales of c$2500 per auto.

The blog's chemical career began with selling raw materials to the paint industry during the recession of the early 1980's.

Since then, it has always regarded the decorative paint sector as an excellent real-time indicator of underlying economic conditions.

Today's results from Akzo, one of the global leaders, confirms the sector's reputation. Akzo said decorative paint volume was down 16% during Q1. EBITDA was down 41% in constant currencies.

Stock markets may have rallied over the past month. But the International Monetary Fund (IMF) sees no cause for optimism. In March, it thought the economy would contract by 0.5% - 1.0%. Now, it is forecasting a contraction of -1.3% in 2009.

The chart, from the Wall Street Journal, compares the current downturn to the average of the 1975, 1982 and 1992 recessions. It is worse, by every measure.

Yet many investors are still more worried about missing the recovery - hence the bear market rallies continue. We have seen such disconnects before, and the fall-out can be very painful when reality dawns.

The blog is particularly worried about the impact of this speculation on crude oil prices. Not only do these remain in contango, with prices for future delivery being higher than today's. But all the while, oil product demand is slowing, with US demand down 4.3% in 2009 versus 2008. The result is that oil stocks are building:

• Total US inventories are at their highest level since 1990
• PetroMatrix estimate US Gulf stocks are only 3mb off all-time highs
• Commerzbank suggest oil in floating storage now totals 100mb

There is therefore a growing risk that the speculative bubble will eventually burst. This could take prices back towards January's $32/bbl low. In turn, this would destabilise chemical prices and margins, and lead to another wave of destocking down the value chain.

It seems highly likely that GM, the largest US car manufacturer, will enter Chapter 11 bankruptcy proceedings in the next few weeks. Chrysler, the 4th largest US company, may well follow them.

Even if it avoids bankruptcy, GM's own restructuring plan has the potential to be equally traumatic. It is based on a forecast US market of just 10 million vehicles/year - compared to the 15-17 million/year sales seen between 1995-2007.

This raises a number of serious issues for chemical companies supplying into the auto industry value chain:

• Bankruptcies are nearly always messy affairs. It is therefore very hard to forecast just how they will develop. A judge will most likely be in charge of the process, and whilst they will be aware of commercial issues, their first priority is to follow the law.
• A bankruptcy of this scale will be unprecedented. It is also important to remember that a key aim of the process, as the Wall Street Journal notes today, would be to help GM "outmanoeuvre uncompetitive supply contracts with parts makers".
• So far, auto suppliers have received a $5bn support package from the government in March. But we don't know whether any more money will follow this, or on what conditions.
• Chapter 11 will probably only apply formally to GM's US-based companies. But there is clearly a strong risk that some lenders will also seek to involve GM's overseas affiliates (as we have seen with LyondellBasell), adding to the complexity.
• Emotional issues will also come to the fore. Not only will many people be losing their jobs, and their businesses, but brands such as Pontiac have iconic status. Nobody can therefore predict just how the media and wider population may react.

As the Journal warns, the Chapter 11 process "could lead to a unintended collapse of the whole network of companies dependent on the two companies". An up-front investment of time now, in finalising a contingency plan, could be a very wise move.

Japan and Germany are the great exporting countries of the industrialised world. They didn't have the consumer booms seen in the USA and UK. Yet their economies are plunging, as export opportunities dry up.

Yesterday, the Japanese finance minister, Kaoru Yosano, told parliament that the country was in "an economic crisis". These are strong words, but the facts support them. The government is now forecasting that exports will fall 28% this year, whilst industrial production will decline 23%.

Meanwhile, in Germany, a 5% fall in GDP is expected this year, as export markets dry up for major industries. In turn, this is influencing political debate ahead of September's general election. The head of the powerful IG Metall union, Berthold Huber, is already questioning whether the country's current "dependence on exports" is sustainable.

And as Nigel Davis has noted in an excellent ICIS Insight analysis on Japan, the downturn in exports will also lead to painful chemical company restructuring. The political fall-out from the export downturn is probably only just beginning.

Today saw further anecdotal evidence of speculative crude oil buying. A senior manager at the Port of Rotterdam told Bloomberg that oil inventories were the highest he had seen since he began work there in 1985. Rotterdam can hold 75 million barrels. Whilst there are also reports of tankers at anchor along the UK's southern coast, supporting the idea that land storage is filled close to capacity.

Meanwhile, the US Energy Information Agency reported US crude inventories rose for the 8th straight week. As the chart shows, these are well above the normal range, and 18% above this time last year. EIA also said total US oil product demand was down 6.8% in the past 4 weeks versus 2008. Refinery operating rates slipped to only 82.7%.

BASF, the world's largest chemical company, said today that they see "weak demand for chemical products" continuing through 2009. In response, plants and sites "will be closed or sold where necessary". These are clear statements about the outlook, backed up by commitments to take action.

Yet volumes and prices in financial markets are rising, as traders "look through to the recovery". Nowhere is this more evident than China where, as the chart shows, April volumes in Linear Low Density Polyethylene (LLDPE) soared to 77 million tonnes, 3 times total annual world production. In turn, prices rose 21% over the month.

CEOs have some tough decisions ahead of them. Do they follow the BASF example, and start closing capacity? Or do they listen to the siren voices of the traders, promising that all will soon be back to normal?

The blog continues to believe that fundamentals matter in the end. Key chemical markets such as construction, autos, and electronics seem to be stabilising. But they show no signs of real recovery. BASF are making the right decisions, difficult though these are.