Chemicals & The Economy

Over the past century, many parts of the world have seen an extraordinary increase in living standards and life expectancy.

As the Financial Times notes, we used to marry at c15 years, become grandparents at c30 and die at c45. Yet whilst 15 - 30 - 45 is still the demographic cycle in the poorest countries, developed economies are now moving to a 25 - 50 - 75 cycle, and some to a 30 - 60 - 90 cycle.

The chemical and pharma industry has played a major role in enabling this improvement to take place. Its products are critical for the supply of clean water, improving food production/storage, and in healthcare.

Now Anna Jagger has written a very interesting ICB article looking at likely Next Steps in terms of the long-term societal megatrends that will drive chemical/pharma industry growth during the 2010's.

She notes that companies are not only redesigning their innovation processes to cut carbon emissions, but are also focusing on key areas including Renewable Energy, Food, Energy Efficiency and Water.

She highlights some of the activities underway at leading companies including Bayer, DuPont, Dow Chemical, Dow Corning, Evonik, ExxonMobil and Wacker. And she also summarises new studies by McKinsey (for the International Council of Chemical Associations), the United Nations and the World Economic Forum.

Extended downturns, of the type that we are now suffering, generally mark a transition period from one set of business conditions to another.

I look at what might be in store for us during this transition, in this week's edition of ICIS Chemical Business. The analysis focuses on the key areas in the chart - Restructuring, Supply Chain, Technology, Financial Size and Commercial.

It suggests that companies need to balance today's immediate priorities with future needs, under the motto 'Think about tomorrow, and act today'. I hope you find it helpful.

The IeC Boom/Gloom Index remains cautious as we enter the New Year.

Meant to track sentiment in financial markets, it shows clearly that talk of 'green shoots' (green line) leading to a quick recovery has virtually stopped. Whilst the reading for 'frugal' (red line) steadied, as we went into the Christmas period.

The Index itself (blue column) is confirming the caution shown in most chemical company comments in recent weeks. It has failed to recover the levels seen before the end of 2007. The next few weeks may well provide a good indication of whether this caution is justified.

The Financial Times' Investment Editor argues this week that "there is no point in forecasting stock market performance to the last digit".

Instead it presents 3 scenarios for 2010:

• Standard Bear Market. This view suggests that the current rally is "the normal adjustment after a market crash". After the rally ends, we will then see "a decade of trading in a range", with money to be made "by traders rather than long-term investors".

• Great Panic. This suggests 2007-9 was merely a "panic". Now "the risk of disaster" has gone, there is a "buying opportunity" for investors, and "profit opportunities for companies, as they can cut costs more easily".

• Second Great Bust. The downside fear is that whilst "cheap government money rescued markets" last year, this caused a "credit bubble" in China, and meant "the US put its credit rating on the line". The likely "next event will be a market disaster", taking us below 2009's lows.

The FT has sympathy with all 3 scenarios, but suggests the odds favour the Bear Market view at 60 - 70%. It gives a 10 - 20% probability to the upside and downside views.

It says its prefered measures of stock market value, Tobin's Q and the cyclically adjusted price/earnings ratio, both show markets are now overvalued. The FT therefore concludes that "it is still a very risky world".

US auto sales last year at 10.4 million were the worst since 1982. Even this figure was slightly artificial, due to the support provided by the $3bn 'cash for clunkers' programme in the summer.

This impact can be seen in the chart, with total volumes (black line) picking up again in December under the impact of major discounting as manufacturers cleared stocks of deleted model lines. Overall:

• Toyota (red dotted line) moved into the No 1 spot for the first time
• GM (blue line) continued to downsize, after its bankruptcy
• Ford (green line) remained the most successful American manufacturer
• Chrysler (purple line) made little progress under Fiat's ownership

Total sales of chemicals and polymers to the US industry were worth just $31bn in the year, based on the ACC's estimate of $2973/auto. Between 1995- 2007 they were worth $45-50bn at today's value, with auto sales steady at 15 - 17 million/year. And even the most optimistic analysts only expect 2010 sales to recover to 12.5m.

On a more positive note, China is now the world's largest auto market at 13.6m. Its sales grew 46% last year, under the impact of the government's stimulus programme, which including halving the sales tax on smaller cars. But analysts suggest growth will moderate to 5% in 2010.

The other bright spot for auto sales this year should be India, where sales rose 17% in 2009. But analysts expect Europe and Japan to remain difficult, as consumers continue to cut back on non-essential items. Even with incentives, Japan expects 2010 sales to be at 1978 levels.

The Financial Times reports today that Ineos has postponed plans for an initial public offering. It says this "was one of a range of options that had been considered by the company to strengthen its balance sheet, which was burdened with more than €7bn ($10bn) of debt". It adds that Ineos is still looking at "full or partial sales of operating businesses to help reduce its debt", as noted last month by the blog.

The FT says that the possible IPO was discussed with Barclays Capital, one of Ineos' main lenders. But it notes that in today's investment climate, "highly leveraged companies such as Ineos may find it difficult to float". It says Ineos' net debt "was €7.49bn at the end of 2008, roughly seven times last year's expected EBITDA" and compares this with "a survey of investors by RBS Hoare Govett in the summer (which) revealed investors' reluctance to support IPOs for companies whose net debt after flotation would be more than three times their EBITDA".

Blog readers have a wide range of interests.

That is clear from the list below of the Top 10 posts in 2009.

It also confirms the complexity of the chemical industry, and its fascination.

In alphabetical order, it is as follows:

• Bubble, bubble, toil and trouble
• Companies remain cautious on the outlook
• "Green shoots" likely to be "yellow weeds"
• IEA warns on economic downturn, lower oil demand
• 'It's the price that matters': Wal-Mart and Tesco signal a major change in consumer priorities
• New US auto fuel standards provide chemical companies with major opportunities
• OPEC worries about weak oil market fundamentals
• Rotterdam oil storage running out of space
• Russia's chemical production tumbles
• The nudist beach on Wall Street

Interestingly, the list includes 2 'classic' posts from 2007 and 2008, which are obviously still valued by many readers as reference points:

• The insight from Tesco and Wal-Mart which pinpoints the moment at which consumer priorities began to shift from 'wants' to 'needs'
• Warren Buffett's then controversial views on financial markets, just before they began to implode.

Iceland, "the first country to be run like a hedge fund", was the original warning sign of the current financial crisis. Today's chaos in the country, following its rejection of the €4bn bank compensation deal agreed with the UK and The Netherlands, may similarly prove to be the fore-runner of the next stage in the crisis.

Back in March, the blog suggested that public reaction to the financial crisis would probably follow the Phases first described by Elizabeth Kubler Ross:

• 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

Today, some are still in Denial mode - particularly those in financial markets, who claim to believe in a rapid V-shaped recovery back to 2007 Boom levels. This Denial of reality is helping to fuel a rapid rise in Anger amongst the rest of the population - particularly as 2009 bonus payments seem likely to reach $65bn.

In the US, Nobel laureate Paul Krugman is now warning that "there's a populist rage building in this country, and President Obama's kid-gloves treatment of the bankers has put Democrats on the wrong side of this rage". If such Anger, however understandable, comes to dominate political debate, then it will become very difficult to move to a Bargaining phase that seeks to mitigate the major problems we now face.

It doesn't often snow in London. And when it does, it usually melts quickly.

In fact, the last really severe winter was in 1980, and before that 1963.

So I thought you might like to see a picture of the blog sledging today on Hampstead Heath - where a 400m run was available down to the ponds. In the background of this photo, taken from the top of Parliament Hill, you may be able to see the Post Office Tower.

Pity your poor Purchasing Director this week. They know the West is having a cold winter, but they have done their analysis and can show you slides, such as the one above from Petromatrix, that indicate the US has the highest stocks of distillates since 1999. In addition, the world has 75mb of distillate in floating storage. So there is no shortage of product.

So why are oil prices above $80/bbl?
• Is it because crude oil is somehow short, or gasoline? No. We have high stock levels for these as well, plus plenty more in floating storage.
• Is it instead because higher prices are needed to justify sufficient E&P investment in finding more oil for the future? Perhaps, but then we have to ask the related question, namely 'what level of global GDP growth can be maintained if oil is going to be $80/bbl or higher'?

Or to put the issue another way, can industries such as chemicals successfully pass through such prices, and maintain previous growth levels? We all know, after the experience of 2007-8, that the perception of today's high prices being easily absorbed is not the same as reality. Purchasing managers are virtually forced to buy forward, if they see higher prices round the corner. But this doesn't mean their sales colleagues can sell the same volume, or maintain the same margins.

And in reality, as will likely become clear as and when prices fall again, high oil prices (as we first saw in 1973-4, and 1979-80), in fact cause demand destruction. They effectively act as a tax on the general population, who have to heat their homes, and travel to work and the shops. This gives them less to spend on other products and services.

So, then, why are oil prices so high? The answer is very simple - 'money talks'. As the Wall Street Journal notes this weekend, banks "including Citigroup Inc., Bank of America Corp., J.P. Morgan Chase & Co. and Morgan Stanley are offering levels of borrowing--known as leverage--that they haven't provided in more than two years". But this money is not flowing into loans to industry.

Instead, its going straight into trading activity in financial markets. And in so flowing, it has the remarkable effect of creating the illusion of recovery, as outsiders look at high oil prices, and assume that demand levels must have recovered. This could become a very dangerous assumption indeed, if it becomes shared by policymakers.

CEO's are now preparing their comments on 2009 performance, and the 2010 Outlook. It would be very helpful indeed, if they included a paragraph that noted what is happening in oil markets, and questioned why this is being allowed to continue.

The Dalian polymers future market had a strong end to 2009. As the chart shows, Linear Low Density Polymer volumes (blue line) jumped to 44 million tonnes. The new PVC contract saw the same volume.

But there are growing signs that this may prove a 'last hurrah'. The government is clearly starting to worry about the impact of speculative excess from its major loan/stimulus package last year:

• Today, the central bank raised deposit reserves by 0.5%, which starts to reduce the amount banks can lend
• It has also begun cracking down on banks' off-balance sheet loans, the 'hidden loans' that don't show up in official figures
• Premier Wen Jiabao has pledged to tackle "excessive" house price rises, after they rose 5.7% in November alone

China's rise to become the world's leading exporter in 2009, overtaking Germany, also means the government will come under more pressure to let the currency rise.

In turn, these measures may start to slow China's demand for polymers. This has been a major boost for hard-pressed Western companies, facing slow domestic markets. But with the China Daily now carrying stories about how young people can't afford to marry, because of high apartment prices, it is clear that policy changes are round the corner.

The blog has been worrying for some time about what will happen when governments end their stimulus programmes. It does not share the optimism of financial markets, that these will provide to be the "escape velocity" for a quick return to 2003-7 Boom conditions.

Today's data from Germany seems to support its concerns. According to Roderich Egeler, German statistics office president, "the German economy contracted for the first time in six years - and at a pace not seen before in post-war history". The office estimates GDP declined 5% in 2009, and says the economy "stagnated" in Q4, following the end of the pre-election government support measures, such as the car scrappage scheme.

Equally, the Wall Street Journal reports that small/medium size companies (SMEs) in Europe and the USA are finding it increasingly difficult to obtain vital loans to keep their businesses alive. These are critical players in the chemicals value chain, accounting for 70% of EU private sector workforces, and 49% in the US. As a result, the Journal says that insolvencies and job losses are likely to continue to rise.

One by one, Western political leaders are coming to the conclusion that taxes on the banks need to rise. Last month, the UK proposed a 50% 'super-tax' on bonuses, on the grounds that "investment banks are making exceptional profits as a result of the intervention of government".

At the time, the blog thought it spotted an emerging trend, even though the US administration was critical. And so it has proved. Today, President Obama has proposed a $90bn tax to recoup the costs of the bailout.

Even more interesting was his comment during the announcement that "What I say to (bank) executives is this: Instead of sending a phalanx of lobbyists to fight this proposal or employing an army of lawyers and accountants to help evade the fee, I suggest you might want to consider simply meeting your responsibilities."

It is a long time since the blog last heard a Western politician, let alone a US politician, suggesting that investment banks were part of the problem, not the solution. Clearly, the zeitgeist is indeed changing.

The blog has come across an interesting example of the impact of China's credit growth, courtesy of Merryn Somerset Webb in the Financial Times. She highlights a YouTube video (link above) which investigates the new city of Ordos.

The old city has become known as "China's Texas", because of the recent wealth generated from the local coal industry. It claims the highest GDP/capita in China after Shanghai. Over the past 5 years, this has led the authorities to build a new city, 30km away, to house 1 million residents. Now the new city is complete, but it is apparently empty.

From the government's point of view, it's a success, because it has made a significant contribution to GDP growth. And the housing has all been bought by speculators, who believe (as we used to in the West) that prices always rise over time. For them, as an academic working in China notes during the video, "its not a place to live, but to put your money".

Webb closes her analysis with the disturbing comment that, according to the US National Bureau of Economic Research, the best indicator of a coming financial crisis is "rapid credit growth". It certainly adds to the worries about the sustainability of chemical and polymer demand expressed by my fellow-blogger, John Richardson, last week.

Almost unnoticed, the EU became the largest regional auto market last year. Thanks to the support of scrappage programmes (particularly Germany's €5bn scheme) it sold 14.4 million autos, compared to just 10.4m in the USA and 13.6m in China.

W Europe continued to see higher sales than Central Europe, due to greater government support. But overall, EU sales were still down 1.6% versus 2008 and 9.5% versus the peak Boom year of 2007. Unsurprisingly, the scrappage schemes boosted sales of smaller, more fuel-efficient autos, causing Ford, Renault and Fiat to gain market share. BMW and Mercedes dropped to 8th and 9th place.

It seems unlikely that governments can afford to maintain this level of support in 2010. GM Europe president Nick Reilly expects sales to decline by at least 1.6m, whilst analysts JD Power forecast a 10.5% fall to 12.2m sales. In turn, this suggests chemical and polymer sales into this important market will remain under pressure.

The downside of the credit bubble continues to impact the UK's Premier League, and the blog's own soccer club, Manchester United.

Today's Guardian notes that United were bought by the US Glazer family for £810m ($1.3bn) in 2005, using £540m of debt. Since then, it says this debt has "cost United £340m in cash" in interest/fees. "Over £200m" of interest is also secured on the Glazers' own shares, via PIK (payment in kind) loans at 14.25% interest.

Now the club intends to refinance again. The Guardian says this will allow the Glazers "to reduce the amounts they owe in PIK" loans, and to "take almost £130m cash out of the club next year".

This financial engineering is clearly a short-term win for the Glazers. But longer-term, the picture is not so rosy. The interest bill on the new £500m bond will be £45m alone. This cash might otherwise have enabled United's manager, Sir Alex Ferguson, to buy new players to support his title hopes. Equally, ticket prices have doubled, which will no doubt reduce the fan base for the future, as families can no longer afford to attend.

Last September, the blog noted '4 tips for survival in the New Normal'. Now, 3 years of research by a team of UK and Dutch academics has identified companies that have achieved almost uninterrupted success over a 20 year period, and asked senior executives about their experience.

As summarised by Stefan Stern in the Financial Times, corporate survival over the longer-term depends on 4 key areas:

• Continuity. The company reinvents its business model as markets change, but doesn't try to follow every new trend.
• Anticipation. New leaders are able to re-shape the future business, not forced to continue with the policies that brought success in the past.
• Disagreement. People are actively encouraged to challenge current thinking. Constructive argument, without the politics, is vital.
• Meritocracy. A flexible recruitment policy is essential, that puts the best person in the job, whether or not they have been in post longest.

The study completely accepts that alignment and focus on operational issues are critical to short-term success. But it concludes that these strengths alone will not keep the business alive over the longer-term. Companies whose culture can tolerate genuine debate, and who then effectively implement its conclusions, are the ones that survive.

Greece's problems are getting worse, not better. And there seems no obvious solution to them.

Does this matter to the chemical industry? Yes. Greece may not be a major player in chemical markets. But it is a member of the eurozone. And so its financial difficulties could prove very disruptive for any company that trades in euros.

Greece, like some other eurozone members, joined the euro in 1999 for prestige, not out of conviction. It never made much effort to match its spending with its income, and it now turns out that even the figures it did publish were false. Its excess of spending last year was 12.7% of GDP, compared to the supposed 'limit' of 3%.

So what happens next? As former EPCA speaker Martin Wolf notes, none of the alternatives look very attractive:

• Will it introduce meaningful spending cuts? Unlikely, as that would plunge the country into deep recession overnight (and make the deficit larger in the short-term).
• Will other eurozone countries bail it out? This also seems unlikely. Would the German public, for example, would be happy to do this?
• Will it be forced to default on its debts, or to leave the eurozone and devalue? Possibly, but this would create a major crisis of confidence for the whole eurozone.

There are no good alternatives available. So probably the Greeks will continue as they are, and try to 'tough it out'. If they are lucky, this will work. If not, the eurozone will then have to confront the question of whether it becomes a political union, and not just a currency union.

Germany's Chancellor, Angela Merkel, is not given to over-statement. Her comments on the situation well summarise the problem: "the Greece example can put us under great, great pressures. Questions are being asked that are anything but trivial. As a result, the euro is in a very difficult phase for the coming years." Chemical company CFO's are no doubt already preparing their contingency plans.

Will Beacham of ICIS interviewed me yesterday in London's Trafalgar Square. Please click above if you would like to see the discussion. Or click here if you would like to see Will's summary on ICIS news.

US housing is still limping along the bottom. December's housing starts were only 0.2% above 2008 levels. Overall, 2009 saw just 554k starts, the lowest level for 50 years, despite the support of the $8k tax credit.

During the Boom period, as the ACC's chart above shows, starts (blue line) peaked at a 2.2 million rate. This was worth $35bn in terms of total chemical sales, with each house using $16k of products (in 2009 money). The current figures imply a market of c$9bn.

On the positive side, building permits (red line) rose 16% in December versus 2008. This is hopefully a leading indicator that some confidence is returning to the market. But a full recovery to the 2006 peak would require a 400% increase from today's levels. The blog would not bet its own money on this happening any time soon.

The US government used to depend on China to fund its deficit. In 2006, China bought 47.4% of all US bonds issued. But last year, as the chart from the NY Times shows, China bought just 4.6%, leaving US investors to buy the rest.

This is a yet another indicator of the profound changes underway in global finance. China couldn't afford to lend as much to the US, as it was already lending $1.4trn to its domestic economy. Equally, the so-called 'virtuous circle', whereby China lent money to the US to fund purchases of China's goods, has come to an end.

China's departure has hardly been noticed in US government bond markets, even though interest rates are low, and US borrowing has risen from $300bn in 2007 to $1.4trn last year. Clearly, with stock and housing markets looking increasingly risky, US investors seem happy to prioritise 'return of capital' versus 'return on capital'.

Sometimes, a picture is worth 1000 words. That's the case with this photo (used by most of the world's major news media), showing President Obama with former US Fed Governor Paul Volcker by his side.

Volcker's re-emergence is the first real sign of a serious shift in policy towards the financial sector. And the blog is thoroughly delighted with his return. It summarised Volcker's key arguments last month, when suggesting that current policy "continued to confuse being 'market friendly' with being 'friendly to markets'".

There is absolutely no reason why banks should be allowed to maintain the "pervasive conflicts of interest" that Volcker describes. Equally, Volcker's belief that "we need to produce more, finance less" is a powerful message of support for people working in the chemical industry value chain. As one senior industry figure told the blog, "It's a mega change in the history of lending. No more big balance sheets and implicit Government 'insurance' to prop up flaky lending".

The above chart, based on data from the excellent weekly American Chemistry Council report, highlights the changes in chemical production over the past year.

November saw world production (black line) finally turn positive again versus the previous 12 months, for the first time since August 2008. For an industry used to steady growth in line with GDP, the past 15 months have been traumatic. And, of course, as the ACC note, total production in 2009 seems likely to be down 3.8% versus 2008.

The strength of China's recovery is also highlighted in the chart, with Asia Pacific output (dotted brown line) up 8% versus November 2008. N America (blue) and W Europe (green) also saw production rebound, although at a slower 3% rate. This was in line with the Middle East's performance (purple), although the latter was more impressive as it grew steadily till May 2009, before entering a shallow downturn.

Still showing negative annual growth are Latin America (pink), down 4%, and Central/Eastern Europe (light blue), down 9%. This highlights how those with small domestic regional markets have been worst affected by the overall fall in demand. Hopefully, though, these regions will also soon start to see a return to annual growth during 2010.

European consumers remain very wary about the future. The slide above, from the monthly CEFIC report, shows that fear of unemployment is THE major concern. Almost half the population, a net balance of 44.3%, worried about this in December (yellow column), only slightly fewer than in November (blue column).

This concern creates a major headwind for overall consumer confidence, which remains negative (left hand data). Equally, more people now expect the economic situation to get worse over the next 12 months (centre columns), with the total now at a net -7.5%. In turn, this makes it likely that their discretionary spending, a key demand driver for many chemical products, will remain weak.