Chemicals & The Economy

Last month, the blog introduced its new Boom/Gloom Index, designed to track sentiment in financial markets. The chart above now updates it to reflect the whole of June.

The Index has continued to move up, and is close to the levels last seen in October 2007. Equally remarkable is the performance of the Green Shoots Index, which has hit another all-time high. There is little doubt that the performance of the two indices is related. Investors clearly want to believe that recovery is 'just around the corner', even though there is little hard evidence to support this belief.

Chemical companies have done well in exploiting this improved sentiment. Dow managed to raise nearly $10bn to repair its balance sheet, via asset sales and equity/debt issues. Ineos are well on the way to agreeing new covenants with their lenders. Neither looked easy to achieve before the market began its March rally.

Now, of course, comes the hard part. Will the current restocking process turn into a real recovery? The blog maintains its doubts, and fears the green shoots may wither to become yellow weeds.

Capacity closures are always hard to achieve in the petchem industry:

• First, these are a 'zero sum game' - if I shut my plant, then other producers gain in terms of overall operating rates and margins, at my expense
• Secondly, there is the integration issue. Closing a consuming plant also impacts output from an upstream plant, and may make it unviable

Dow Chemical's announcement of US capacity closures reflects this underlying logic. By shutting downstream consuming plants, and an ageing cracker, Dow will align its overall US ethylene balance. It will no longer purchase ethylene in the merchant market. Dow is therefore passing on the pain of any necessary upstream closures to its suppliers.

But Dow also added a wholly new dimension to the debate, when Brian Ames, Global Hydrocarbons Business director, spoke to ICIS' Nigel Davis. His comment, no doubt carefully prepared, was that US capacity had to shut because "demand overall is lower than it used to be".

The blog shares Ames' view. US exports must suffer, in spite of the Gulf Coast's ethane advantage, as major new capacity arrives in the Middle East and Asia. Equally, there must be doubts about underlying US demand, unless housing and autos recover quickly to their former levels.

Dow's moves are therefore likely to prompt further debate about how to best manage capacity closures during depressed market conditions.

The good news from the latest reports on US house prices and auto sales was simple - things have stopped getting worse. US house prices saw "some stabilisation in some regions" according to the S&P/Case Shiller Index for April. Whilst auto sales are clearly bouncing along the bottom, down "only" 29% in June versus May's 35% decline.

The bad news in terms of house prices was that the decline is really only just getting underway in some key markets. Chicago and New York, for example, "posted record annual declines in April", and are now down 19% and 13% respectively. By comparison, Phoenix, the worst market, was down 35% versus last April, and 54% from the 2006 peak.

Anecdotal evidence from the blog's recent New York visit certainly suggested that the city's bankers are only now beginning to sell up. Initially, those newly unemployed in Q4 had held on to property, believing that they would quickly find new employment. But now cash is getting tighter, and H2 may well see more homes up for sale.

The auto market is also showing diverging trends. Ford seems to be on a bit of a roll, as the chart shows, even though its sales were down 11%, and it claims to be reducing price incentives. Other producers fared less well, with Chrysler having to increase its incentives by up to $750.

The other good news is that auto inventories are also coming down, due to the recent plant closures. Ford is actually increasing Q3 production by 25k vehicles, having dropped inventory by 214k since last June. GM has also reduced stocks by 206k over the same period. This should certainly help hard-pressed chemical and polymer suppliers.

Crude oil markets have risen 60% in recent months, as traders speculate on a quick V-shaped economic recovery. But there are growing signs that reality, in the shape of evidence of falling US and global oil demand, may be about to reassert itself.

Latest US statistics remain very negative:

• Total oil product demand is 6% below H1 2008 levels
• Crude oil stocks at 350mb are well above normal seasonal levels
• Current stocks are 18% higher than a year ago

In summary, the story of 2009 continues to be stocks rise, demand drops, prices rise. This is an obvious inconsistency, which can only be resolved by either an increase in demand, or a fall in prices.

The blog's reading of the International Energy Association's (IEA) new 'Medium-Term Oil Market Report' suggests the latter outcome is much more likely. As the chart shows, the IEA is now expecting negative 'real' (ie adjusted for inflation) global GDP growth in 2009. This did not happen even in the recessions of the early 1980's or 1990's.

The IEA is therefore expecting an actual decline in global oil demand this year. And it has introduced a "lower case scenario", which it says is "just as likely" as its previous "business as usual" case (which was based on a V-shaped economic recovery). This new scenario pushes out any "supply crunch" until 2013, as consumption only returns to 2008 levels by 2012.

Geopolitics (eg Iran, Nigeria) can always change oil market balances very quickly. But in the absence of supply disruption, chemical companies need to keep a close eye on changing sentiment in financial markets. Thursday's worrying US unemployment rise, unless quickly reversed, may prove to be the catalyst for such a change to take place.

The chemical industry has benefited from a benign paradigm over the past 25 years:

• Demographics in the west have encouraged consumption, as the baby-boom generation reached middle age
• Globalisation meant this could be achieved at lower cost, by outsourcing production to lower-wage countries in the east
• Workers in the east saved their money, which allowed banks to make good profits by lending it back to consumers in the west

Now, all three pillars of this paradigm are under threat:

• The baby-boom generation is starting to retire and a new, more frugal, type of consumption is emerging in the west.
• Asian countries are trying to rebalance their economies, to promote more domestic demand and replace lost exports.
• And many banks are amongst the ranks of the walking wounded, unable to resume lending at previous levels

What happens next, is therefore a key question. The Bank for International Settlements (BIS), the central bankers' bank, suggests that "A financial crisis bears striking similarities to medical illness. In both cases, finding a cure requires identifying and then treating the causes of the disease."

Its analysis, in its newly-released Annual Report, suggests that investors, consumers and policymakers have been "fooled into thinking that trend growth was higher than it really was". And the BIS's conclusion is that "countries have been left with bloated financial sectors, the ability to build more cars than their populations need and, in some cases, surplus housing stocks."

Housing and auto demand have, of course, been a key support for chemical demand in the past few years. If the BIS are right, then considerable downsizing awaits the industry over the next few years, as it adjusts to the new realities.

Q2 saw an outburst of speculative frenzy all around the world, and in a wide variety of financial markets. China's Dalian futures market saw LLDPE volume soar to 80 million tonnes - around 4 times total annual world demand. China's easy money policy meant it was easy to borrow to speculate on a quick recovery.

But at some point, green shoots have to turn into real demand, if market rallies are to be sustained. And as the chart shows, Dalian's volumes have since fallen away. June was down more than 50%, at 35 million tonnes. Pricing has also slipped, from 10, 285 yuan in April to 9,555 yuan last month - even though crude oil was rising from $50/bbl to $73/bbl.

Volumes are still very large by any normal standards, of course. As Becky Zhang points out in ICIS news, China's total annual production is only 2.19 million tonnes. But in futures markets, the trend is your friend. Rising volume is always bullish. Today's falling volume indicates that more questions are now being asked about likely levels of actual demand in H2.

After yesterday's post, Edwin Pang of Credit Suisse in Hong Kong has raised an interesting question over the likely rationale for China's massive increase in petchem imports, such as polyethylene (PE), in 2009.

As the chart shows, its monthly PE demand (production plus net imports), was very steady in 2007-8. It averaged 980kt in 2007, and 970kt in 2008. Yet in 2009, it has soared to record levels, averaging 1270 kt/month.

This makes no sense at all in terms of real demand. China's total exports are down 26% so far this year. And it defies belief that the government's fiscal stimulus could have caused such a massive increase in domestic demand, in so short a time.

The blog's view is that the rise is instead due to traders':

• Desire to bet on the rising oil price, and a global economic recovery
• Ability to access cheap credit, as part of the fiscal stimulus

This creates a serious risk that a vicious circle could develop, if the oil price continues to slip, and global demand does not recover in H2.

The blog therefore continues to worry, as it noted back in March, that "China may well end up having to dump this inventory on world markets, at whatever price they will fetch".

Sometimes, the blog gets lucky with its timing. A week ago, it wrote bearishly on crude oil markets, and suggested that "chemical companies need to keep a close eye on changing sentiment in financial markets". By Friday, oil prices had tumbled 11%, as the US S&P 500 index continued to weaken from its 12 June peak.

The blog does, however, feel able to give itself another pat on the back for its underlying analysis. Back in May, it thought there was a good chance that oil prices (then $60/bbl) could well see a "move towards $80/bbl by the summer, if investors remain confident". And it also cautioned that if financial market "sentiment begins to change", then a downwards move towards "$40/bbl could happen very quickly".

The driver for the changing sentiment in financial markets seems to be changes in the US$: € rate. The evidence for this is as follows:

• The US$ hit a high of 1.26 versus the euro on 3 March
• The S&P 500 bottomed 3 days later at 666.
• The euro then rallied strongly, peaking on 3 June at 1.43 versus the US$
• The S&P 500 also rallied strongly, peaking on 11 June at 956.

And as the updated chart above shows, WTI continues to track the S&P very closely. It also peaked on 11 June, at $72.69/bbl.

The blog will keep a close eye on future $:€ developments. It would welcome readers' insights as to why these might currently be so crucial.

Source: Wall Street Journal

Everybody's favourite Christmas film is 'Its a Wonderful Life', in which the hero rescues a failing US bank during the Depression. But until today, the blog had never realised that a major role model for the plot-line came from Chicago in 1932.

Nouriel Roubini's blog notes that the city saw the largest and most important bank panic of the Depression, after Chicago ran out of money and had to start issuing IOUs to employees, creditors and others.

Fast forward 77 years, and the situation is now repeating itself in California. If independent, the State would be the 8th largest economy in the world. Yet it ran out of cash on 1 July, and has since had to start issuing IOU's to employees and creditors, just as in Chicago.

The State has a budget deficit of $26.3bn, on revenues of $113bn, according to the Financial Times. And it is constitutionally unable to raise taxes in many obvious areas, due to voters' reluctance to vote the necessary increases. Their ability to pay higher taxes is also questionable, with unemployment already at 11.5%, and house prices down c20%.

Nobody currently expects California to default on its $59bn debt load. The Federal Government would probably feel forced to intervene before that happened. But with Hollywood within the State's border, no doubt President Obama is already nervously wondering if he will end up starring in 'Its a Wonderful Life - 2', this time in real-life.

If you want a loan, go to China. That's the message from the chart, courtesy of Credit Suisse, which shows the staggering growth in bank lending since the start of the year. Now, even the People's Bank of China is starting to get concerned.

Lending so far this year has reached $1trn, equal to a quarter of the country's annual economic output. $223bn was lent in June alone, as local banks scrambled to meet government targets by the end of the quarter.

This is not an academic issue, as far as the global chemical industry is concerned. As a senior executive from a N American company told my fellow blogger, John Richardson, "I keep returning to the fundamentals and cannot understand why prices have risen so steeply since mid-February."

But what would you do, if the government offered you a cheap loan, and you saw the oil price was rising? Would you buy polymer, and store it? Just as US homeowners took subprime loans at cheap rates and bought houses they couldn't afford, on the basis that prices couldn't fall?

The blog hates to be a party-pooper. But it is growing increasingly worried by the 'China story', and continues to fear that it will all end in tears.

Any improvement in the troubled auto sector is extremely good news for the chemical industry, after the battering of the past few months. Thus the blog welcomes news, as the chart shows, that European sales increased 2.4% in June, the first rise for over a year.

Government support for scrapping older cars has led the way. The German market is up 41% versus 2008, and may hit 4 million sales in 2009. Italy was up 12% and France 7%. But the UK and Spain were both down 16%, as homeowners worry about negative equity.

Analysts JD Power warn that the market could collapse again, if the schemes are not renewed for 2010. They suggest Germany, for example, could see a 35% fall to 2.6 million sales. But for the moment, at least, government action on both sides of the Atlantic continues to keep chemical and polymer sales moving through the auto supply chain.

In 2007, Sweden was the largest private equity market in Europe, as a percentage of the country's GDP. And the local banks lent freely, as elsewhere, to fund investments. Now they, and other Nordic banks, are struggling to minimise their losses.

According to Bloomberg, Sweden's second-biggest bank, Handelsbanken, "seized parts of Plastal Group and Plastal Holding AB on July 2, after a cash infusion from Stockholm-based private equity firm Nordic Capital failed to save the plastic-parts maker from bankruptcy".

75-year old Plastal had sales of €1.3bn in 2007, and 6000 employees in 10 countries. But since then, it has been badly hit by the downturn in its core automotive market. Now "Handelsbanken, which loaned the company 2.1 billion kronor, plans to merge Plastal's Belgian, Norwegian and Swedish units into a new company".

Sadly, Plastal is unlikely to be the only company whose ownership moves from private equity to their bankers, as the downturn continues.

As expected, Ineos have today confirmed that their proposed new covenants have now been accepted by their lenders.

For those unfamiliar with the mechanisms used in the world of high-yield debt, this does not involve any new money, or a refinancing. Instead, it means that the lenders have agreed to provide Ineos with more head-room in terms of its day to day operations. Thus the company have confirmed that there will be a "reset of the Leverage, Interest Cover and Debt Service Cover covenant levels, effective from September 2009".

This sounds like financial small print. But it means Ineos and their lenders have agreed to make an adjustment to the conditions of existing loans, rather than to change the whole capital structure of the business. So Ineos employees, as well as their customers and suppliers, will no doubt be very reassured that everything has now been finalised.

The blog is rather pleased with the performance of its new Boom/Gloom Index©, as financial markets continue to respond positively to any suggestion of "good news".

The Index is based on Ben Graham's famous concept that markets are:

• A voting machine in the short-term but
• A weighing machine in the long-term

It is therefore meant to identify whether positive or negative sentiment is driving short-term performance. And clearly, market sentiment is indeed still remarkably positive, in spite of the fact that there is no sign of any real improvement in the underlying fundamental position.

One example of the continuing influence of positive short-term sentiment can be seen in the positive reaction to the news that US housing starts rose 3.6% in June to an annualised rate of 582k. Yet as the above chart from the American Chemistry Council shows, the long-term fundamentals still remain dreadful:

• Last month's starts were 46% down on June 2008 levels, and were worth just $9.3bn in terms of chemicals sales (each house uses c$16k of chemicals) on an annualised basis.
• This compares with sales worth $35bn of chemicals during the boom period, when starts were running at a 2.2 million level in 2006/7.

The blog is very mindful of Keynes' insight that "markets can remain irrational for longer than most investors can remain solvent". It will therefore be keeping a close eye on the Boom/Gloom Index©, to identify when today's positive sentiment starts to wane.

A year ago, the blog brought news that July's Paris fashion sales were seeing prices reduced by 70% on shoes, bags and dresses. Today, the slowing global economy is apparently leading to even more bargains.

According to the Financial Times, "desperate times are forcing the likes of Armani, Dolce & Gabbana, and Jimmy Choo to launch half-price sales". An Armani leather jacket is now "only" £1250 (€1500, $2000). Burberry clutch bags are "just" £500 (€600, $800). Smythson, Donna Karan, Ralph Lauren and Radley are all offering discounts of up to 50%.

There is even a secret French website, www.vente-privee.com offering up to 70% off luxury brands in one-off sales. No doubt my fellow blogger, Barbara, is already a member. (photo: purse.com)

California's Governor, Arnold Schwarzenegger, has now made a provisional agreement to reduce the State's soaring budget deficit.

Its main features are a $9bn temporary cut in the education budget, plus multi-$bn cuts in welfare and health programmes.

The only good news is that it clears the way for oil drilling to resume off the Santa Barbara coast. The ban, aimed at preserving California's beaches, had clearly become an expensive luxury for the US's most populous state.

In another sign of the economy 'bouncing along the bottom', US drivers appear to have returned to the road in recent months. Latest figures from the US Highway Administration show a 0.1% rise in vehicle miles travelled during May, the second consecutive month of positive growth since 2007.

But this is unlikely to provide much support for increasingly hard-pressed refiners. European players saw crack margins tumble 62% in Q2 to $1.20/bbl, versus an already low $3.20/bbl in Q1. Weak demand is leading to low refinery operating rates, whilst normally strong diesel margins have failed to keep up with higher crude oil prices.

US refiners are also worried, with new government proposals for carbon 'cap-and-trade', likely to increase their costs significantly. Plus, of course, new CAFE standards aim at raising average auto mileage by 42%, at the same time as legislation to promote ethanol usage is also effectively reducing oil product demand.

Last August, we published a major Study, 'Feedstocks for Profit', with refining experts Wood Mackenzie, which forecast that "competition is likely to increase within the main regions, as exporters find life much more difficult." This scenario now seems to be coming true.

In terms of chemical sales, the increased competition comes at a time when demand is already weak. But on the positive side, refiners' problems could well provide chemical companies with an opportunity to mitigate their problems, by accessing feedstocks at distressed prices.

There are two main views on the financial crisis that began last September. The mainstream view, as expressed by the US Federal Reserve, is that it was a problem of liquidity. Banks became frightened to lend, and so the Fed stepped in as "lender of last resort". So given time, everything will soon be back to "normal".

The other view, as expressed by Pimco, the world's largest bond fund managers, is that the crisis was, and is, about solvency. As they describe it, US consumers have suffered a wealth loss of $15 trn, and global consumers a loss of "multiples of that figure". As a result, Pimco forecast a "new normal", for at least a generation, of "higher savings, lower consumption ...and growth closer to 2% rather than (the historical) 3.5%".

The blog continues to side with the Pimco analysis, for one simple reason. This is that it has long argued that the heart of the financial crisis was the reckless lending to the housing sector. Yet these loans are still on the books of the lenders at close to their original value, at a time when US house prices have fallen by more than 30% from their peak, and the number of foreclosures is still increasing.

Now, a very detailed article in the Wall Street Journal by 2 Stanford University professors analyses the real value of these loans. And they are "clear that the problem was not liquidity, but rather the insolvency risks of counterparties with large holdings of toxic assets on their books".

It may suit the lenders, and the Federal Reserve, to maintain that the issue is just liquidity. But after reading this article, and the lack of transparency that it describes about the real value of these loans, the blog feels it is only prudent to follow Pimco's analysis, rather than the Fed's.

The excellent weekly report from the American Chemistry Council (ACC) has a number of interesting insights:

• As the chart shows, global chemical production seems to have bottomed. All regions are, however, now showing a decline versus 2008.
• Separately, the ACC has updated its valuable survey of the state of inventories down the US polymer chain. This suggests that these were finally being rebuilt in May and June, for the first time in a year.
• Equally, they note that total inventory of existing US homes reduced to 9.4 months, with sales stable at similar levels to June 2008.

The latter is a critical leading indicator for chemical sales. But according to the US Realtors Association, the housing market is now seeing 2 quite different sets of drivers:

• Homes priced under $250k are selling fast, often via foreclosure, and inventories are down to 6 months
• But homes priced over $1m are seeing very little activity, with inventories now at 20 months.

The question, of course, is what happens next? The risk is that rising unemployment starts to force owners of more expensive homes to sell on a distressed basis. This would clear inventories, but would also cause further problems for the financial system, as lenders would then have to go through another round of debt write-offs.

Hopefully, these owners will be able to hang on. But even then, the chances of a V-shaped recovery remain low. As the ACC note, it is likely that "headwinds from massive deleveraging and lingering fallout from housing will offset the typical inventory bounce".

Source: Chartoftheday.com
There are "lies, damn lies, and statistics" according to Mark Twain, the famous American humorist. His argument was that statistics are often (a) untrue* and (b) used without the necessary context.

Last week provided a perfect example of the latter. As the blog's own Boom/Gloom Index© shows, sentiment is currently very positive in global financial markets. And so US markets rallied 4%, on the basis that reported company earnings were "above estimates".

Yet in context, this "outperformance" disappears. The above chart from ChartOfTheDay.com (COTD) shows 12-month, 'as reported' S&P 500 earnings, adjusted for inflation. And COTD highlight that these are now down over 98% since peaking in Q3 2007. Equally, they say this is "by far the largest decline on record (the data goes back to 1936)".

Also ignored last week was S&P's own report on Friday that forecasted total S&P 500 earnings for the 12 months to September "to be negative ($-1.01 EPS), for the first time in index history". Howard Silverblatt, S&P's senior equity analyst noted that any recovery in earnings will depend on a recovery in sales, as "you can only cut so much, and for so long".

*The blog carefully checks all those it uses with reputable sources

Its not only the blog (and fellow blogger John Richardson), who worry about the speculative frenzy underway in China, and its impact on global polymer and chemical markets.

Wu Xiaoling, former deputy governor of the central bank, has called the growth in new lending "excessive", and warned it is creating "bubbles in the property and stock markets".

Wu says China's bank lending in 2009 will be "a staggering increase of 40% of the entire stock of outstanding loans". The blog had to read this statement several times to fully grasp its importance.

It does not mean that bank lending will increase by 40% in 2009 versus 2008 - which would still be a very large increase. It means that the total value of all bank lending at the end of 2008 will have been increased by 40% during 2009.

Equally, Stephen Roach, chairman of Morgan Stanley Asia, and a long-time China bull, says he "is starting to worry" about the direction of current policy. The blog likes Roach, particularly for his accurate analysis in December 2007 that "decoupling (of China's economy from the West) is a good story, but it's not going to work going forward". He notes:

• In 2007, premier Wen Jiabao warned the economy was becoming "unstable, unbalanced, uncoordinated and ultimately unsustainable"
• Roach claims that current policies "compound the very problems the premier warned of: aiming a massive liquidity-driven stimulus at its most unbalanced sector"
• He adds that they "leave little doubt as to how bad it was in China in late 2008 and early 2009", to cause the government to react in this way

But Roach warns the loan growth is "ultimately a recipe for failure".

This week, the government began to respond to its critics, with regulators starting to insist that its Rmb 7400bn ($1080bn) of loans so far this year, be "used to bolster the real economy and not to speculate". But as we know from recent experience, bubbles on this scale don't usually subside gently. And when they burst, a lot of innocent people can get hurt.

In May 2008, the blog aligned itself with Harvard's Prof Martin Feldstein, who declared that the Q1 2008 US GDP report was "grossly misleading". Feldstein, after all, was in a position to know, as he was then chairman of the official body that decides whether the US is in recession.

15 months later, the US Commerce Department has finally admitted that Feldstein was right. It has revealed that "the first 12 months of the US recession saw the economy shrink more than twice as much as previously estimated".

The blog learnt long ago that if something seems "too good to be true", then it probably is. It awards itself a pat on the back for not falling into this trap on the US GDP numbers.