Chemicals & The Economy

Our 8th European Aromatics & Derivatives conference, co-organised with ICIS, has a number of distinguished industry speakers including:

• BASF, Jaroslaw Michniuk, Group VP, Styrenics Europe
• Reliance, Rajen Udeshi, President Polyester Chain
• Shell Chemicals, Jonathan Forbes-Lane, GM, Aromatics Europe

In addition, the blog will be presenting its thoughts on "5 Key Steps to Take in 2010" to help your business cope with the twin problem of increasing capacity and slowing demand growth.

It will be held in Amsterdam on 25-26 November. The 'early bird' discount on delegate fees ends this weekend on 27 September.

For more info on the agenda and booking, please click here.

Further evidence of the trend towards a more frugal consumer comes from L'Oreal, the world's largest cosmetics company.

Like Procter & Gamble, it was slow to react to the trends identified by the major retail chains some 2 years ago. As a result, its profits fell 14% in H1, after decades of 10% annual increases.

And like P&G, it is undertaking a fundamental reassessment of its product portfolio and mission statement. As CEO Jean-Paul Agon notes, its new focus is on "affordable innovation" rather than "premium-isation".

Until recently, its aim was "more performance and higher prices". Now, Agon says the drive is to "create affordable ranges".

Agon also casts doubt on the idea that lipstick sales increase during a recession, as consumers seek "an inexpensive indulgence". He says this is no longer true, and that instead women want their "skin to look perfect". No doubt readers, as well as my fellow-bloggers Barbara, Malini and Doris, will be able to provide global insight on Agon's new theory?

September's IeC Boom/Gloom Index© is slightly higher than August. But the 'Green Shoots' level (green line) has fallen sharply, indicating that sentiment has become less positive about the staying power of the recent rallies in financial markets. The index now includes a new reading for "frugal" (red line), as this may be worth watching in future months.

Other indicators are also showing signs that "green shoots" may be withering. China's Shanghai index is now in a bear market, having fallen 23% from its 3471 peak on 4 August, whilst benzene (a good leading indicator for chemical markets) is down 28% since its $1060 peak.

Optimism can carry markets along for a while. But at some point, clear evidence of an upturn has to appear. And so far, as the blog found in Germany last week, there are few signs of this. September's volumes will be a critical sign of whether recovery is really just around the corner.

A key rule for any successful trader is that high volume is always bullish, and low volume is negative. The blog first learnt this when trading oil products in Houston, on secondment from the UK in the 1980's. And it has proved an invaluable guide ever since, in a wide range of markets.

The rationale for the rule is simple, namely that (a) more people join in a rally as it strengthens and (b) the end of a bear market is signalled by a "give up phase", when volume rises as people finally lose faith in recovery. In turn, this sets the scene for a new trend to emerge.

Thus the chart above carries a fairly clear message. Trading in linear low density polyethylene (LLDPE) on China's Dalian futures exchange leapt earlier this year, just as benzene prices also surged. By April, Dalian was trading 80 million tonnes - 4 times total annual world production. But August's trading was down 58%, whilst benzene prices have also fallen.

Clearly, the "smart money" feels that it is now time to move on, having made a healthy profit. In turn, this confirms the blog's growing sense that the speculative price rallies of the past 6 months, in commodity and financial markets, may now be coming towards an end.

One of the blog's major themes is that it fears the idea of a quick V-shaped recovery will prove wishful thinking. New figures from the Bank of England seem to bear out its caution.

The slightly complex chart shows that net UK lending for mortgages (yellow line, then red diamond) has been falling steadily since the beginning of 2008. And provisional data (not included in the chart) suggest it actually fell in July, for the first time since records began in 1993.

Overall, mortgage holders paid back £418m ($681m) more than they borrowed. This was in spite of approvals for new mortgages reaching a 17-month high. As the Guardian notes, "cautious consumers and strict lending criteria kept net lending low".

The UK's housing bubble created major demand for most chemicals. If consumers and lenders remain cautious, as seems likely, it will prove very difficult to quickly replace these volumes with other applications.

Today is Labor Day holiday in the USA. But sadly, the latest news on jobs remains deeply worrying. As the chart from the New York Times shows, jobs are still being lost (blue line), long after recovery had begun in downturns from 1974 - 2000. And far more jobs have already been lost.

Total jobs lost since the downturn started now amount to 7.4m, the largest decline in any slump since World War 2. Unemployment rose to 9.7% in August, with 14.9m Americans out of work. And a further 5m were out of work for over 26 weeks (and not counted in the 9.7% rate).

These job losses have continued even with major stimulus programmes in place. And the Financial Times reports that 40% of the 35m Americans now on food stamps (worth c$290/month) are also working part-time, which suggests that wages outside the financial sector are starting to fall.

The figures make it seem very unlikely, to the blog at least, that any "recovery" in official GDP figures will lead to a rapid rise in consumer spending. And that, at the end of the day, is the key factor that will determine chemical company sales and profits next year.

Last April's G-20 Summit brought together the leaders of the major world economies. Yet in terms of their announced goals for the Summit, financial regulation seemed to be the only one that gained traction.

That impression is confirmed by the weekend's meeting of Finance Ministers, in preparation for the next Summit in Pittsburgh later this month. The key deliverable now under discussion is that of requiring banks to reduce their leverage. There may also be some minor curbs on pay mechanisms within the finance sector.

As the blog has continuously warned of the dangers of excess leverage, it has to applaud the G-20's efforts, even if they are an example of shutting the stable door after the horse has bolted. But it will save its full approval for the moment when the G-20 endorses the new Trade and Development Report, published today.

Issued by UNCTAD (UN Conference on Trade & Development), this notes that "in the United States, the share of the financial industry in GDP grew from 5% to 8% between 1983 and 2007, while its share in total corporate profits rose from 7.5% to 40%". As chief economist Heiner Flassbeck suggests, the real need now is "to focus banking on supporting investment in productive businesses".

Last year, OPEC meetings led to newspaper headlines. But today's session in Vienna seems to have slipped off the radar. Yet the oil market remains as important as ever to chemical companies.

As the chart shows, the prime driver for oil prices (blue line) is still the financial market. Traders continue to believe recovery is "just around the corner", but other factors include worries about the strength of the US$ and a desire to own a tangible asset in times of uncertainty.

From an OPEC point of view, though, concerns are mounting:

• OPEC understands that the world economy is fundamentally weak, and that this represents a potential threat to current price levels
• Recent higher prices have led to more cheating on quotas - from a peak of 80% compliance, OPEC are now down to just 68%
• Russia has broken ranks completely and is now exporting more oil than Saudi Arabia (7.4mbd versus 7mbd)

In addition, a new 'joker in the pack' has appeared with China's announcement this week , that it supports those companies who face huge losses incurred last year on derivatives contracts when oil prices plunged. China Eastern airline, for example, said in January it faced a loss of $900m on jet fuel contracts, but seemingly now claims the contracts "may be void, invalid or unenforceable".

The chart suggests that oil prices are now plateauing. Whilst normal winter restocking, and Wall Street's bullish trend, may hold them at this level, the downward pressures continue to mount.

China was the first major country to feel the impact of the financial crisis. In August 2008, it noted that "the era of low costs and high growth has come to an end for China, and an economic restructuring is inevitable".

Since then, of course, China's export-dependent economy has meant it has been one of the worst-hit economies. GDP growth fell to 0% in Q4 last year, when 23m jobs were lost. Thus the blog was fascinated to read a detailed status report on the government's recovery efforts by Premier Wen Jiabao in today's China Daily.

Wen says China has so far only replaced 6.66m of the lost jobs, and warns that "to counter the global financial crisis is a long-term and arduous task". He adds that "the impact of the crisis is as strong as ever and is unlikely to disappear anytime soon". And he worries that "the stabilization and recovery of the Chinese economy is not yet steady, solid and balanced. With many uncertainties remaining in the prospects of the world economy, we still face tremendous pressure of the decline in external demand".

Last year, exports represented 37% of China's GDP, and these are still down over 20% versus 2008. Just replacing this volume is itself a major task. Wen is therefore only being realistic when he suggests that "perseverance" is required as boosting "domestic demand is a long-term strategic policy", and not the 'quick fix' assumed by financial markets.

Any executive whose business depends on China, directly or indirectly, would probably find the full speech well worth reading, for the perspective it provides on the government's current ambitions and future goals.

Globalisation flourished whilst economic growth was strong. Jobs lost in Western countries were replaced by new jobs. Whilst cheaper production offshore kept consumer prices low, as well as bringing more people into the world economy.

But today's economic downturn means this virtuous circle is turning vicious. Western countries are becoming more protectionist and hope to repatriate offshore jobs. Thus the USA, with nearly 10% unemployment, has now imposed a 35% import duty on Chinese tyres.

The justification is the 3-fold increase in China's US market share to 17% between 2004-8, whilst 4 US tyre factories shutdown. Such "market disruption" allows punitive duties to be imposed under World Trade Organisation rules. Thus. as we forecast in our landmark 'Feedstocks for Profit' Study last year, regionalism is now making a comeback.

Chemical companies supplying the tyre industry will be amongst the first to have to consider relocating their plants back home. But with high oil prices also increasing the cost of extended supply chains (as P&G have noted), many others will need similar debates as the downturn continues.

6 months ago, when the blog last reviewed global stock market performance, it thought it likely we would "continue to see major bear market rallies". Coincidentally, 7 March proved to be a market bottom, since when markets are up a minimum of 36%. Russia is the best performer, up 108%, whilst China is the weakest. India is up 95%, with other markets up around 50%.

It has been a good time for those able to catch the bottom, and bad news for bears who forgot that the biggest rallies occur during major market collapses. But as the chart shows, even after these rallies, markets are still in a very bad way. Shanghai and Russia are down more than 50% versus their earlier peaks: even the best performer, Brazil, is down 21%.

This suggests we are following the classic pattern identified by Merrill Lynch's technical market guru, Bob Farrell, that "bear markets have three stages - sharp down, reflexive rebound, a drawn-out fundamental downtrend". The blog therefore fears we are coming closer to the end of Farrell's 2nd phase, and towards the start of the most painful phase of all.

After destocking, and then restocking, what next?

The blog is a great believer in following the insights of the major retailers, who have been consistently "on the money" in their analysis. Thus it takes very seriously the comments of Wal-Mart CEO, Mike Duke, who has joined the camp of those who believe we face a "new normal" - not a return to the levels of demand seen in the 2003-7 boom period.

Interviewed by the Financial Times, Duke was quite clear about the challenges ahead. "The 'smart' shopping, the customer that really looks at price and value and quality, the deferral of purchases ... this is something that will be with us for a long, long time."

Whilst chain-store JC Penney, which targets middle- America, told investors that "consumers are acting rationally, they are paying down their debt, they are spending for things they need. And for the more discretionary thing, they are being more cautious." US Federal Reserve data confirms this trend, with consumers repaying $21bn of debt in July, the largest amount ever seen since records began in 1943.

Equally, the head of ING, the largest US thrift bank told US investment magazine Barrons that "a lot of the data is showing there's a fundamental shift in spending habits". CEO Arkadi Kuhlmann said demand for the critical Christmas sales will be relatively slow as 80% of people now believe that "having money in the bank" makes them happier than "buying something".

US private consumption is worth $10trn and accounts for 16% of total world GDP. So this change of spending habits carries enormous implications for chemical industry demand. The blog's annual Budget Outlook, due next month, will tackle the issue in more detail.

It might be interesting to see whether blog readers agree with the ING opinion poll results.  You can vote below, if you wish.

Coincidentally, both the US Federal Reserve and the Bank of England yesterday signalled the probable end of the 'the recession' yesterday. But as the blog noted last month, statistics don't tell the whole story.

The issue is that economists usually define recession as simply being 2 or more quarters of negative growth. Automatically, therefore, any improvement - however small - marks the end of 'the recession'. This is what both Ben Bernanke and Mervyn King are now signalling. Both, however, added important caveats to their comments:

• Bernanke noted that "even though from a technical perspective the recession is very likely over at this point, it's still going to feel like a very weak economy for some time as many people will still find that their job security and their employment status is not what they wish it was."
• Whilst King went further, noting "It is very important not to lose sight of the fact that growth rates don't tell the story. It is the levels that really matter. The depth of the recession is great and it will continue even if we get a small positive growth rate over the next few quarters."

Some readers may remember the 2007 and 2008 reports from the Bank of International Settlements (the central bankers' bank). In July 2007 the blog titled its summary '4 risks to the world economy', and July 2008's was titled 'The difficult task of damage control'.

Not all of the BIS's forecasts proved correct, but it was the only major financial institution that came remotely close to forecasting the current downturn. Thus the blog paid particular attention today to an article by the author of those reports, William White, who has now retired from the BIS, and is therefore free to speak his own mind. White's key points are as follows:

• Trying to avoid recessions "at all costs" is a dangerous policy. White believes today's problems could have been avoided if central banks had not cut interest rates in previous downturns eg the 1997 Asian crisis, 1998 Long Term Capital Management collapse, and the 2001 dot-com debacle.
• He says the result was equivalent to allowing "undergrowth to accumulate in a forest". It made "subsequent downturns more dangerous", and "available policy instruments less reliable in response".
• White argues that efforts to stimulate demand ignore the fact that we "also have an undergrowth problem on the supply side". He cites autos, banking, construction, transport and distribution as examples of industries which have been allowed to become "too big and must be wound down".

The core of White's argument is that "many countries that relied heavily on exports as a growth strategy are now geared up to provide goods and services to heavily indebted countries that no longer have the will or the means to buy them". In this, White allies himself with those, like the blog, who believe we face a "new normal" now recession is ended, where demand will be much slower than in the 2003-7 boom period, as people choose to save more, and spend less.

White argues that his former central bank colleagues don't seem to understand that "good crisis management also contributes to crisis prevention". He believes that cash-for-clunkers and other demand stimulation "policies are equivalent to trying to resuscitate a patient long since dead". And he worries that by encouraging the current boom in asset prices they risk creating "yet another boom-bust cycle", far worse than anything we have yet experienced.

The above chart, from Moncef Hadhri's excellent monthly report from CEFIC (the European chemical industry association) provides an interesting snapshot of the state of the EU chemical industry.

On the positive side, it shows that recovery from the destocking period was well underway in June (the latest data available). Volume (green line), had risen 10% from November's low of 82. And versus June 2008, volume is now down 'only' 12.4%, versus November's 25% decline.

But on the negative side, EU volume is now down 18% versus the all-time peak of 110 seen at the end of 2007. Volume is also 10% below 2005's average level of 100. This figure will clearly improve as restocking continues down the chain. But even if we get back to the 100 level, this will still mean the industry has effectively 'lost' 3 - 4 years of growth.

US corporate earnings were down a record 89% in Q1 versus the previous 12 months at just $7. Q2 saw only a minor improvement with earnings at only $8. Its interesting, therefore, to see market expectations for 2010.

The chart is based on S&P analyst forecasts, and shows "reported earnings" (red line) are expected to recover to c$45 in 2010 as restocking continues. But this would still only take them back to 2003 levels.

Unsurprisingly, therefore, analysts are choosing to focus on "operating earnings" (blue line) which, as the blog discussed last month, exclude many negative items that have to appear in "reported earnings" under GAAP accounting standards.

This discrepancy featured in the 2000-2 downturn, but was not seen in the 1990-4 downturn. It thus usefully highlights the wide gap between those expecting a quick V-shaped recovery now restocking is underway, and those who (like the blog) fear a more prolonged U-/W-shape will develop.

Pity your poor CFO. As well as keeping cashflow positive, they are also coping with major US$ volatility. In July 2008 it was trading at $0.63: €1, but then rose 43% to $.80: €1, before declining 28% to $0.68: €1 today.

The catalyst for this volatility seems to be oil price movements. As the chart shows from a new report by the James A Baker III Institute (kindly forwarded by my fellow-blogger John Richardson), there has been an 82% inverse correlation between the US$ exchange rate index and changes in crude oil prices since 2001.

The reason is that tighter crude oil supply/demand balances have led to higher oil prices. As a result, US oil imports cost $331bn in 2008, and were 47% of the US trade deficit, versus just 19% in 2002. So last year's collapse from $147/bbl in July to December's $34/bbl was good news for the US$. But this year's recovery to $70/bbl has caused a further US$ fall.

Adding to the CFO's problem is that 2009's price movements have been purely speculative, as traders 'look through to economic recovery". OECD crude oil inventories have actually risen steadily, from 52 days in June 2008 to 57 days by December, and then to 62 days by July 2009. Equally, today's US distillate stocks are the highest since 1983, whilst European heating oil stocks are at an all-time record.

Nothing is certain in life but death and taxes. But with refining margins now only $3.42/bbl, a fall in crude prices back towards $40/bbl would not be too surprising. CFO's probably need to consider whether to hedge against this possibility, and the problems it could cause - not only with year-end inventory, but also via a "surprise rally" in the US$ as well.

ExxonMobil Chemicals was 6th in the ICIS list of Top 100 companies in 2002, during the last downturn. By last year, it had risen to 2nd place, according to the latest ICIS list.

One of the secrets of its success was set out in an interesting Bloomberg interview yesterday with Basic Chemicals SVP, TJ Wojnar. This made it clear that EM is focusing ever more intensively on optimising production along the refining/petchem interface. Thus Wojnar noted that "the company would only consider buying plants that can be connected directly to Exxon Mobil oil refineries", in order to ensure that "by-products of the refining process can be turned into chemicals when fuel demand and prices are low".

Wojnar also gave an interesting example of this strategy in action, revealing that over the past 3 weeks, EM has been increasing the amount of refinery-produced vacuum gasoil (VGO) used in ethylene/polyethylene production, due to slowing gasoline demand. As he noted, the rationale for this move was simple, that "VGO is in surplus", and so it made sense for the company to take advantage of the lower feedstock cost..

Last November, the blog suggested "4 tips for survival", based on a Financial Times series on recession survival strategy. A new article this week on 'Leadership beyond a Downturn' provides some key tips on how to manage next steps:

• Prepare for continuing downturn, but also for some growth to return.
• Look outside to see what's changed, don't rely on old strategies.
• Continue to keep a close eye on cash-flow, but loosen some constraints.
• Maintain clear and honest communication, acknowledging uncertainties.

The blog believes that the landscape has changed during the current downturn. We came into it on the back of a major boom in consumption, supported by reckless lending and borrowing. This mind-set seems unlikely to return quickly.

Instead, as the period of destocking/restocking comes to an end, we may face a "new reality". This probably involves a paradigm of higher savings, lower consumption, and global GDP growth of perhaps 2.5% rather than the historical 3.5%.

This scenario is more challenging than the consensus view of a quick V-shaped recovery. But if correct, it will also present a number of major opportunities for those companies who recognise that the basis of industry competition has now changed.

I outline some of the key issues in a new article for this week's ICIS Chemical Business. Please click here if you would like to read it. As always, I would welcome your insights on the points discussed.

Destocking is now well underway in crude oil markets. This is focused on the vast amounts of floating storage that built up in H1.

According to a Financial Times analysis, April saw 56 ships being used for storage, versus a normal level of 5 - 7 vessels.

29 ships are still in use today, with c50-60 mbbls in store. But the price incentive for this storage has disappeared, with future month prices only c$5/bbl higher than spot. As the chart shows, this 'contango' had reached nearly $24/bbl earlier in the year, allowing traders plenty of margin to sell forward on a risk-free basis, as floating storage costs just 50-60c/bbl.

The first stage of the destocking process caused oil prices to stabilise around $70/bbl. Now, though, there are signs that the next phase could take prices lower, as a major increase in demand seems unlikely. As Petromatrix note, September's US auto sales are likely to be the lowest of the year, now the scrappage scheme has ended.

When the G-20 met last April, it issued a Communiqué containing just 688 words. Its Pittsburgh meeting over the weekend produced a Leader's Statement containing 9292 words.

"More" does generally not mean "better" when it comes to writing action plans. Instead, the document simply seems to be a catch-all of comments from the 20 leaders. It still ducks most of the key issues, although finance ministers will press on with their work to strengthen financial regulation.

The blog is also concerned by the G-20's assumption that the current stimulus/inventory "bounce" will now lead straight to a full recovery for the global economy. Using the phrase "It worked" in the Statement, to describe the impact of recent measures, seems far too optimistic.

Coincidentally, another view is provided by Mohamed El-Erian, CEO of Pimco, the world's largest bond fund. He suggests that its "the absolute levels of income, debt, wealth and unemployment, not just the rates of change, are what matters today". Or, in the blunt view of the Governor of the Bank of England, "It's the level, stupid - its not the growth rates".

There is increasing evidence for the blog's belief that the auto industry is embarking on a fundamental shift in its approach. An interview in just-auto with Daimler's R&D head, Thomas Weber, provides some important insights into the opportunities that may develop for chemical companies as a result.

Weber notes that "cost, knowledge and speed" are the "key to future success". He adds that Mercedes now has 3 "key strategic directions":

- More efficient engines. These will also become smaller.
- Hybrids. Infrastructure issues (eg battery top-up) need resolving.
- Reduced fuel consumption. Lighter materials will be crucial

This implies increased demand for polymers, and other lightweight products. In addition, greater fuel efficiency will free up more feedstock for the chemical industry, helping to keep raw material costs down.

Coincidentally, EPCA delegates in Berlin will be able to see some of these ideas in prototype, as Sunday's opening event is being held in Mercedes World.