Chemicals & The Economy

The rate of unemployment is an important leading indicator for chemical industry demand. It measures the number of people who currently don't have much spare cash to spend on discretionary purchases. And when the jobless rate is rising, it also impacts the spending patterns of those still in work, as they often choose to save any spare cash 'for a rainy day'.

February's rise in Eurozone unemployment to 10% represents the highest rate since 1998, with 15.7m people now out of work. In the whole EU area, 23m people are now unemployed. Equally worrying is the fact that unemployment increased in all 27 member states.

Latvia, in the Baltics, has 21.7% out of work, Spain has 19% unemployed. And 20.6% of all under-25s are now out of work in the whole EU. The blog fears that these depressing numbers will rise further in 2010, as stimulus programmes end, and governments are forced by rising debt levels to reduce the public sector workforce.

The blog is always grateful for good news, no matter the reason. Thus it welcomes March's rise in US auto sales to 850k from February's 615k (black line).

The driver for the rise was Toyota's (red line) record level of price discounts, as it aimed to overcome its disastrous sales slump after the quality problems. Its "incentive spending jumped 44%, or nearly $700 a vehicle, to $2,256". In addition, all returning customers (60% of its sales) "were given two years of free maintenance".

Other manufacturers were forced to respond, taking the average level of discount to $2800 per auto. GM offered the highest incentive of $3500.

But even so, the annualised sales rate was still only 11.8m, well below the 15m-17m range seen between 1995-2007. With each auto using $2973 of chemicals, according to the American Chemistry Council, this meant the market is currently worth just $35bn, versus its peak of over $50bn.

China's demand has been the main driver for the global chemical industry over the past year. And prices on China's Dalian polymers futures exchange have been a key indicator of the boom. But now, the rally seems to be running out of steam. The key signs are in the above chart:

• At the end of January, the linear low density polyethylene (LLDPE) contract (red dotted line) was trading at 11210 yuan/tonne, whilst WTI crude oil (blue line) was $73/bbl.
• But by the end of March, the LLDPE contract had fallen to 11010 yuan /tonne, whilst WTI had risen to $84/bbl.

There are probably three main causes for this decoupling:

• New ME/Chinese polymer capacity is starting to arrive
• Today's high oil prices are starting to cause some demand destruction.
• New government credit controls are reducing speculative demand.

Certainly, the Dalian futures trend matches the recent downturn in Asian HDPE margins. As the ICIS Polymer Margin report shows, integrated North East Asian (NEA) margins peaked at $464/t in February. Last week, they were back at £413/t. And standalone HDPE margins are now in negative territory.

The IeC Boom/Gloom Index (blue column) moved up sharply last month, as Western stock markets rallied further on news that the major economies were now officially exiting recession.

Various definitions exist of recession, with most countries referencing 2 consecutive quarters of negative GDP. The USA measures recessions differently, but the head of the official Business Cycle Dating Committee said Friday that it was "pretty clear", based on the employment figures, that the recession had ended.

Of course, the resumption of economic growth is not always the same as full recovery - as the blog learnt in the major downturns of the early 1980's and 1990's. It shares the view of the Governor of the Bank of England, that "its not the growth rates, its the levels that matter here". On this basis, the earliest date that global GDP might recover in real terms (adjusting for inflation) back to 2008's $58.93trn level is probably 2011.

The US 2009/Q4 reporting season is now virtually complete. It provides a valuable snapshot of company health as the US recession ends:

• Reported earnings (red line) for the S&P 500 have recovered to $51. This is partly due to loss-makers such as GM having dropped out of the index due to bankruptcy. But it also highlights that the supposed V-shaped recovery has, in fact, only taken earnings back to the 2004 level.
• Reported earnings are still 40% below the $85 level seen at the peak of the Boom in 2007. And interestingly, analysts have become more cautious since Q4 about future increases, with Q4 2010 earnings now only expected to reach $62.
• Of course, the cheer-leaders on Wall Street will continue to ignore Reported earnings in favour of Operating earnings (blue line), where the analyst can conveniently discard negative items that spoil the bullish story. Even these, however, seem to have stalled in terms of forecasts, and are still showing Q4 as being 15% below the 2007 peak.
• Companies, however, make their own statement about the outlook when paying dividends (green line). These are normally only cut when the Board believes a quick recovery is unlikely. And they have so far fallen 22% since 2008's $252bn peak, to realign with the 1989-2003 trendline.

2009 was a year when companies cut costs and jobs in order to try and maintain earnings. in terms of future earnings, much now depends on whether companies can start to grow revenues again. If not, then whilst the recession has ended, the downturn will continue, as it did in the early 1980's and 1990's.

The chart above, from the insightful Petromatrix report, highlights the on-going divergence between the bullish sentiment driving prices, and the fundamental reality of crude oil markets.

It totals US stocks of crude oil and the main products (gasoline, distillate and jet kero), by year. And it shows very clearly that stocks in 2010 (red line) and 2009 (light blue) have been much higher than in the 2005-8 period. As Petromatrix comment:

• "Stocks remain at multi-year highs", even though last year's major destocking has now finished.
• "There is no stress on the supply system because OPEC is gently lowering its compliance to quota as demand gently comes back".
• US Gulf "crude oil imports are at the highest level in 12 months.

They conclude that current prices "put the demand recovery at risk". And they also note that "the extreme spread between crude and natgas also means that petchems will switch as much as possible from petroleum based to natural gas based feedstocks", causing further demand destruction in the short-term.

The US consumer accounts for 16% of total global GDP, with a value of $10trn. By comparison, total Asian consumption is under $5trn. China's consumption in 2008 was just $1.6trn, about equal to the UK. Changes in US consumer behaviour are therefore critical to global GDP, and hence to chemical demand.

The chart above, from the ACC weekly report, shows the dramatic change that is taking place in US consumer behaviour. Taken from Federal Reserve data, it shows that total US consumer debt has fallen by $114bn since its peak of $2.561trn in 2008. The big shift is in credit card and other revolving debt, which has fallen by $100bn over the same period.

This represents a major shift in behaviour. As the chart shows, consumer debt actually rose slightly during 1990-94, when the economy last suffered a major downturn. Since 2008, however, the consumer has been paying down debt at the rate of 5% pa (blue line).

Similarly, US household debt peaked at $13.854trn in Q1 2008, and has since fallen each quarter to total $13.536trn in Q4 last year. This represents the first fall since records began in 1946.

This is further evidence for the blog's recent White Paper argument that we are moving towards a 'new normal'. It suggested that all major downturns are periods of transition, from one set of priorities to another. In the 'new normal', the consumer reduces debt levels, as now seems to be happening, and focuses more on 'needs' than on 'wants'.

In turn, of course, this means that underlying growth in chemical demand will be lower than in the 2003-7 Boom years, just at a time when all the new capacity commissioned in those years starts to come online.

The dramatic rise of Asia's economies, including China, has been based on an export-driven model. Their growth powered ahead as long as the West grew, and companies continued to outsource much of their basic manufacturing activity to lower-cost countries.

In 2001, for example, China's exports were just 20% of GDP. But by 2007, they had reached 37%.

Similarly, Asia's exports were just 25% of total GDP (ex-China, Taiwan, Japan) in 1980, but were 50% by 2008.

Today, this model looks more and more unsustainable. Thus the blog welcomes comments by China's Vice President, Xi Jinping, calling for a new direction. Speaking at the weekend, he argued that "we must develop the economy mainly by relying on the domestic market and attach great importance to domestic demand, especially consumption demand, in driving economic development."

This comment suggests that the argument by China's Liu He, a finance Vice Minister, back in August 2008, is now becoming mainstream. He suggested then that 'the era of low costs and high growth has come to an end for China, and an economic restructuring is inevitable'.

The transition, though healthy for the long-term, is unlikely to be smooth. Export-oriented factories cannot suddenly be rebuilt to serve domestic needs. Equally, whilst a stronger currency will help keep domestic inflation under control, it will also reduce export competitiveness and volumes. March's first trade deficit for 6 years may not be its last.

After 3 months of agonising, it seems that a €45bn ($61bn) aid package will be offered to Greece. The Eurozone will offer €30bn, with a further €15bn coming from the IMF.

Greece's GDP fell 2% in 2009. Experts now forecast a 4% fall this year. The government plans higher taxes, lower spending, and a 10% cut in public sector pay. But it still expects the budget deficit to rise from 12.7% to 12.9% of GDP, well above the 3% EU target.

Some form of intervention thus became inevitable last week, as Greece's borrowing costs rose to 7.5%, with traders worrying that it might have to default on its debt. But Greece's loan has come at a price, with Germany insisting on a 5% interest rate for the Eurozone loan, much higher than its own borrowing cost of 3.2%.

The aid package should mean that Greece's immediate problems are solved. But the underlying question still remains unresolved. Is the Eurozone going to become a political union, where wealthier countries such as Germany finance poorer countries? This seems unlikely. And if not, what will happen if a large Eurozone member, such as Spain (GDP $1.35trn), finds itself in the same position as Greece (GDP $0.35trn)?

Chemical company CFOs will need to keep a very close eye on developments in coming months.

The blog's early career, as a petchems trader in Houston, taught it to look out for moments when prices in one market start to diverge from those of a related product. These can often provide advance warning that a trend change is underway.

Thus it is fascinated by the above chart, from commoditycharts.com. It shows US crude oil prices (black line) since December, versus the S&P 500 (red line) and natural gas (green line). Oil and the S&P 500 have continued to move together, as they have for over a year. This has been a self-supporting trade, where higher oil prices provide evidence that a strong recovery is underway, and vice versa.

But natural gas prices have clearly diverged over the past few weeks. They peaked, as normal, in December-January, but are now down 21% versus early December. And in recent weeks, oil has also begun to struggle to keep up with the S&P. It has only risen 1.5% over the period, versus a 7.75% S&P increase.

Lower prices are excellent news for US gas-based chemical producers. And they should continue to be weak. Gas inventories are currently 12% above the 5 year average, and Bloomberg suggests they could reach record levels over the summer as new supply comes online.

Of course, as the blog noted last week, oil also has poor fundamentals, with US stocks well above normal levels. But Wall Street analysts remain bullish, based on "technical" signals. So it will be interesting to see whether declining natural gas prices do now indicate a trend change.

Many chemical industry executives will be grounded for at least the next 24 hours, as a major volcanic eruption in Iceland is shutting down airspace in most parts of NW Europe this afternoon.

UK and Scandinavian airspace is totally closed as a result of the eruption, pictured above. The dust cloud contains minute particles of silicate, which can seriously damage aeroplane engines. Experts suggest the problem is likely to spread across northern Europe, given prevailing wind conditions. Already main airports in France are closing, with Germany and the Low Countries expected to be affected soon.

The cloud is drifting at 18000 - 33000 feet (5500 - 10000 metres) and not thought to represent a threat to human health. The UK's air traffic control service said it was "the worst airspace restriction in living memory". It seems unlikely that the airspace will re-open for at least 24 hours.

Every now and then, a single quotation summarises a complex situation.

In August 2007, CitiGroup CEO, Chuck Prince, described their blindness to the financial crisis about to unfold. "We see a lot of people on the Street who are scared. We are not scared. We are not panicked. We are not rattled. Our team has been through this before.' We are 'still dancing'".

Similarly, a quote from Lloyd Blankfein, Goldman Sachs CEO, may well come to typify the aftermath of the crisis, as regulators begin to sift through the wreckage. Giving evidence to Congress in January, the New York Times (NYT) quoted him as saying "when Goldman sells a security that subsequently goes up (i.e., on which the other party makes money), "we wish we hadn't sold it"."

As the NYT commented, "so much for putting the customer first".

Today, the Wall Street Journal reports that the main US regulator, the Securities and Exchange Commission, has charged Goldman with fraud in respect of a sale of mortgage securities which the SEC says left investors with "losses of more than $1bn". The SEC says Goldman earned "about $15m for structuring the deal and pitching them to investors".

Last year, Blankfein also described himself to the London 'Sunday Times' as "doing God's work". The blog is not sure that investors would necessarily agree.

The UK has long had a tradition of two-party government, whereby the Labour party will alternate with the Conservatives. Thus Mrs Thatcher became Prime Minister in 1979 for the Conservatives, and was followed by John Major. Then Tony Blair won for Labour in 1997, with Gordon Brown taking over two years ago.

Now, however, this tradition is under threat. Many worry that this could lead to an unstable government, although the much-admired German system would seem to suggest that coalition politics can, in fact, be more stable. Certainly the latest polls, taken after the LiberalDemocrats strong performance in the UK's first-ever Prime Ministerial Debate on Thursday, suggest that the 3 parties are closer in support than ever before.

One online poll, above, for the Mail on Sunday newspaper even has the LibDems (yellow) in the lead versus the Conservatives (blue) and Labour (red). The Liberals, now the Liberal Democrats, last won a General Election in 1906, so this is a major shift in opinion. Of course, its still over 2 weeks till polling date, but clearly the election is now too close to call.

One key fact stands out. As the BBC note, in the latest polls "63% agreed with the statement that "neither Labour nor the Conservatives are being honest about how they would reduce public spending"." And this is probably the main reason why the LibDems are doing so well, as they are campaigning on exactly this issue.

The question is whether the other two main parties now respond to this public demand. People may not like the idea of cuts, but they seem to dislike even more being treated like children by the 2 main parties, who have so far pretended that everything can continue as in the Boom years.

(In the interest of full disclosure, the blog is a floating voter, and has not yet decided how it will vote in the election)

There are increasing signs that China is getting serious about tightening its lending policies. The above chart, from China's central bank, shows how lending has fallen since January. Then, it was 14% down versus 2009. But by the end of Q1, lending was down 43% versus Q1 2009.

In addition, the government has begun to take major steps to cool the housing bubble. House prices in some areas, such as Hainan, have risen 53% over the past year. Now, banks have been told to stop loans for purchases of 3rd homes, whilst buyers also have to provide tax returns and proof of social security contributions.

China Daily notes that 2-bedroom apartments in Shanghai are now selling at 20-30 times annual average earnings, well above comparable costs elsewhere in the world. It also suggests that a property tax may soon be introduced in some cities on a pilot basis.

As the blog warned in February, "chemical companies therefore need to carefully reassess likely levels of Chinese demand for their products, given that key elements of last year's major stimulus programmes may now start to be removed."

The impact of government scrappage schemes continues to dominate European auto sales. As the chart shows, sales were up 9.2% in Q1, and March was up 10.8%, versus 2009.

On a national basis, Germany continued its decline after the end of its scheme, with sales down 26.6% in March. But this was offset by UK sales of almost 400k, as the government focused on supporting the economy ahead of next month's election. Sales were so high, that the UK was the strongest national market in Europe.

Italian sales were similarly up 20%, France up 18%, whilst Spain was up 63% - in March 2009, it had been down 39%. Hungary, facing major economic problems, sold 4371 autos, only 1329 more than last month.

We are often told that investment bankers are much cleverer than the rest of us. But sometimes, they do seem to lack common sense.

Their behaviour since the Crisis, in paying out $bns in bonuses to the lucky few, seems no way to appease understandable public anger over the cost of the banks' bailout. The International Money Fund (IMF) today calculates this cost at a staggering $862bn, c1.5% of global GDP.

Thus they shouldn't be too surprised that the IMF is today proposing two new taxes. One is aimed at financing any future bailouts, whilst the other is a more general Financial Activities Tax, or FAT. And when the IMF bothers to think up an acronym like this, you know it means business.

Equally, chemical companies should also be concerned at the way bank profits routinely tower above theirs. As the above Financial Times chart shows, UK banks Return on Equity (the purest measure of profitability), has been consistently over 20% in recent years. Other Western banks have been similarly profitable. By comparison, BASF's ROE between 2000-9 averaged 16%.

The easiest way to start restoring the balance might be a more cautious response when taking investment bankers' calls re prospective M&A targets. This activity accounts for a high proportion of banks' profits, yet all the evidence suggests that most M&A destroys value for the acquirer.

Being smarter at M&A, and only doing higher quality deals, might therefore be an excellent way to boost companies' ROE whilst reducing that of the banks.

Somewhere at the back of the blog's mind is the memory of a major 1980 eruption by Mt St Helens in Washington State, NW USA.

According to the Wall Street Journal, the lessons learnt by Alaska Airlines from this eruption could have avoided the closure of Europe's airspace last week, if they had been picked up by the relevant authorities.

Mt St Helens is just 35 miles from Alaska Airlines' base in Seattle. And the airline encounters ash every couple of years, from other volcanoes in Alaska itself. Its hard-learnt lessons on how to cope seem to be:

• Planes cannot take off, fly or land in ash
• But it is perfectly possible to find safe flight paths
• The rule is you have to be at least 35 miles (56 km) from the ash
• A combination of computer modelling and in-flight observations can predict safe paths

So why did we all endure 6 days of chaos? According to Giovanni Bisignani, CEO of the International Air Transport Association (IATA), because governments "based decisions to close airspace on theoretical models with no data or tests". IATA claims that "had tests been run earlier in the crisis, large-scale flight operations could have continued".

LyondellBasell (LBI) is to exit from Chapter 11 bankruptcy on 30 April, 15 months after entering it in January 2009.

The past 15 months have been an expensive lesson for those debt-holders who financed Basell's purchase of Lyondell in July 2007, at the peak of the market.

LBI entered Chapter 11 with $24bn of debt. It will now exit with just $5.2bn of net consolidated debt. Holders of senior secured debt will receive 93% of the new Class A shares in exchange for their claims. The value of these will depend on the outcome of LBI's proposed IPO in Q3. Most other original lenders are wiped out.

LBI is the world's 3rd largest independent chemical company, with 2009 sales of $30.8bn. Its predecessors, Lyondell and Basell, were also excellent companies. This has been demonstrated by the way in which employees have maintained their morale during an immensely difficult time. The blog congratulates them, and LBI itself, on their successful exit.

The political firestorm inspired by the SEC's citing of Goldman Sachs for fraud shows no sign of dying down. It has even inspired a Broadway song that describes how another hedge fund, Magnetar, allegedly made money out of betting against the housing securities it helped to create. Click here to see it (the video is at the bottom of the webpage link).

INEOS CEO Jim Ratcliffe has told the Sunday Times that the UK government "refused financial help" last year, when sales collapsed. He revealed that:

• The company had approached the UK government for help with liquidity, including deferral of VAT (sales tax) payments, but "got absolutely nowhere".
• Ratcliffe had even found it "quite difficult to get access" to senior Government ministers, despite it being the UK's largest privately-owned company.

The blog shares INEOS' frustration, and hopes that the next UK government will prove more responsive to industry's needs.

Its private lobbying of government on chemical industry issues has had some success over the past 18 months. But on one super-critical issue, it received more support from the Bank of England than the politicians.

Trade protectionism is on the rise around the world, as the blog forecast in its Budget Outlook back in October.

It suggested that "arguments about the 'export of jobs' will increase", and argued that "chemical companies will need to keep a close eye on the political arena, as they operate in a complex value chain, and may not otherwise appreciate the potential impact of a development in a key supplying or consuming industry".

Now the GPCA (Gulf Petrochemicals and Chemicals Association) is holding a high-level workshop on the subject in Bahrain next month. It notes "there have been a number of antidumping cases brought against petrochemical and chemical producers in the GCC (Gulf Co-operation Council) recently". It says this creates a need to discuss "this very relevant and important issue".

The chemical industry has gained enormous benefits from the growth of free trade over the past 20 years. And it has passed on these benefits to consumers around the world, in the shape of lower prices, product innovation and higher quality production. It is therefore good to see the GPCA starting to take a lead on this important issue.

Shell CEO Peter Voser has made a fascinating speech in China, where he highlights the length of time taken for new energy technologies to gain adoption.

He says Shell's research shows it takes "30 years for new energy types to capture 1% of the market". And he contrasts this with the electronics industry, where a new mobile phone has to be commercialised within 18 months, "to beat the competition".

The issue is the complexity of the development process, and the sums of money involved:

• It takes 3 years to built a pilot plant, after the original scientific breakthrough
• Then start-up takes a year, and 2 - 5 years to achieve reliable operation
• It takes another 10 years to build 12 or more plants
• And then it takes another decade to gain public acceptance

Thus biofuels is only now reaching its 1% market share, after starting in 1980. Wind, which began in Denmark and the USA in the mid-1980's, is also on track to reach 1% by 2015. Similarly nuclear power took from 1950-80 to become established.

Voser notes that "the 30-year law is not a natural law. It is a societal one". So in principle, it should be possible to speed up the process, if governments give their support. But even so, he cautions that "there are no easy and quick successes", even if "we all feel a sense of urgency".

The PowerPoint programme revolutionised business meetings in the early 1990's. No longer did people turn up with a few notes, and spend 15 minutes drawing out ideas on a flip chart or acetate. Instead, they collected their thoughts beforehand into a well-worked-out proposal.

But PowerPoint has also had unintended consequences. The above slide, from the US Army's Afghanistan strategy planning, is typical of these. As the US/NATO commander General McChrystal commented when it was first shown, "when we understand that slide, we'll have won the war."

Many Generals are now rethinking their use of PowerPoint. General McMaster, who banned its use in his Iraq campaign, told the New York Times, "its dangerous because it can create the illusion of understanding and control." He believes that overuse of PowerPoint not only ties up valuable resources at operational level, but also stifles discussion, critical thinking and thoughtful decision-making.

February was a milestone in US house markets. For the first time since December 2006, prices were higher than a year ago, according to today's authoritative S&P/Case Shiller Index. But the rise in the 10 City and 20 City indices was just 1%. And as the above S&P chart shows, prices are still only at Q3/Q4 2003 levels, even before adjusting for inflation.

S&P expect further gains in March/April, as buyers rush to beat this week's expiry of the $8k buyer's tax credit. But fears are rising that this $12.6bn programme (like auto scrappage schemes) has only brought forward already-planned purchases and not created much new demand.

Yale University Prof Robert Shiller, co-author of the Index, worries about this, noting that "I do have concern about a double dip" once Federal support is removed. The problem is that 1.1m homes are now in foreclosure, up 20% versus last year. Whilst another 4.8m people are either 60 days overdue on their mortgage payments, or already entering foreclosure - a 30% increase on 2009.

Banks have $2.6trn of mortgage loans on their books, and been very slow to crystallise their mortgage losses. This has caused 'shadow' inventory to build, in addition to those houses publicly advertised via realtors. The Wall Street Journal estimates it would take 9 years to work through published and 'shadow' inventory, at current sales rates.