Chemicals & The Economy

China's Dalian futures market has been the global centre of speculative polymers trading for over a year. It traded an amazing 80 million tonnes of LLDPE in April 2009, as excitement built. And volume (blue line) remained positive on a year-on-year basis until January. But since then, comparisons have been negative:

• February's volumes were down 50% versus 2009; March was down 38%; April was down 74%; and now May was down 46%.
• Volumes on the new PVC contract are also lower, at just 7 MT in May versus 44 MT in December.

Equally, pricing (red line) has been on a declining trend since February, even though crude oil prices rose strongly until April. This divergence is also a warning sign, as it suggested traders were beginning to question the physical market's ability to pass-through ever higher prices.

For the moment, both the bulls and the bears can still present an argument for their case. But the bulls need a quick recovery in volume, if prices are not to remain under pressure.

A year ago, the blog launched its IeC Boom/Gloom Index. This was based on the concept that markets are driven by both sentiment and fundamentals. And whilst fundamentals can be understood by analysing hard data (eg auto sales, housing starts), it is equally important to understand sentiment, and what markets think will happen next.

Analysing the Index's performance (blue column) over the past year, it seems to have done its job. It has certainly reflected the positive sentiment that propelled most financial markets into major rallies. Equally, its inability to regain pre-Crisis levels since October 2008, indicates that some investors remain more doubtful.

It has also tracked mood swings. A year ago, many in financial markets were focused on signs of the 'green shoots' of recovery, and were expecting government stimulus programmes to create a quick V-shaped recovery to the levels seen in the 2003-7 Boom period.

The 'green shoots' measure (green line) captured this mood. Since then, worries that we might face a more 'frugal' world have surfaced, and these have now led to a fear that we may be moving to a world of 'austerity'. The blog's dictionary defines this as "severe simplicity, lack of luxury".

Austerity has therefore being added to the chart (red line), replacing frugal. This sentiment increased dramatically during May, as sovereign debt problems grew in Southern Europe. It will be interesting to see whether it proves to be just a temporary concern, or longer-lasting.

The blog's White Paper, 'Budgeting for a New Normal', proved enormously popular when it was published earlier this year. ICIS therefore suggested that it would be useful to update it, 6 months later.

This Update is now published. It looks at the current state of the global economy, six months on, and then covers the outlook for key chemical markets such as construction/housing and autos, as well as the latest views expressed by chemical companies themselves on the outlook.

Please click here if you would like to download a free copy.

Every day, the word "unexpected" appears next to a downbeat economic report. The latest example was yesterday's US employment report, where the consensus forecast was for a jobs gain of 180k. Yet it has been clear for months that this has been a 'jobless recovery', and so the actual figure of only 41k new jobs should not have been a real surprise.

This chart above, from thechartstore, shows US payrolls from 1939, and highlights how:

• Payroll growth was very steady until 2001, through wars and recessions
• The recovery from the 2001 downturn was followed by only a slow, and relatively small gain in payrolls
• The current downturn has taken payrolls back below the 2001 level
• 1 in 6 Americans is currently unemployed according to the U6 measure

Equally worrying is that the average jobless person is now unemployed for 34 weeks. This is the highest level seen since records began in 1950. The previous high was just 22 weeks, in 1984.

70% of US GDP comes from consumer spending, and it is a key driver for global chemical demand. Unemployed people don't have much money to spend, whilst fear of unemployment makes others more cautious.

Sadly, nothing is likely to change for the better, whilst policymakers and analysts continue to fool themselves that every piece of bad news is "unexpected".

6 months ago, the blog suggested that normal seasonal demand patterns could resume in 2010. And it optimistically forecast "a strong H1", on the basis that "consumers should need to restock ahead of the usual Q2 demand peak in autos/construction".

This optimism was based on the American Chemistry Council's excellent analysis of polymer demand, which indicated a likely turn in the inventory cycle. And the ACC's latest report (above) shows inventories (red line) have indeed risen sharply, ahead of demand (blue line). In turn, of course, this has led to a welcome improvement in company results.

The blog also suggested that we would then see a "slower Q3 holiday season", and this still seems a likely outcome. But it also worried about the risk from crude oil pricing, and the 'correlation trade'. And this has become a greater worry in recent weeks, as prices have tumbled.

The problem is that too many pension funds have rushed to invest in crude oil, based on a belief in an eternal boom in China. This has led to bumper profits for the trading and storage community, as storage tanks around the world have been filled with oil and oil products.

But now prices are beginning to fall. And worries are appearing about the pace of growth in China, as the government seeks to cool overheated housing and construction markets. There is therefore a real prospect that prices could continue to fall to $60/bbl, as the funds realise their mistake.

If this happens, then we may well see an element of destocking down the value chain, in addition to Q3's seasonal weakness.

"Money makes the world go round" as the song from the musical Cabaret tells us. But the chart above, from BofA Merrill Lynch, suggests there isn't too much money circulating in the world's largest economy today.

It shows M3 (the broadest measure of money supply). Merrill note that its growth is now close to the lowest level seen since 1960. And a new estimate today suggests it fell 10% in the past 3 months - something not seen since the 1930's Depression.

The reason is that banks are being forced to cut their leverage, after the financial crash. But this is easier said than done:

• Traditionally, prudent leverage was thought to be 12.5: 1. In other words, banks had to keep $1 in reserve for every $8 of lending
• But during the Boom, banks used leverage of two or three times this amount. This meant they had only $4, or even $2.50, for every $100 lent.

Deleveraging, as the blog has noted before, "is an ugly word and it has ugly implications". The slowdown in M3 is a clear warning that the return to prudent lending policies could be a very painful experience over the next few years.

Politicians finally seem to be giving up on the Stimulus economy. 9 months ago, the leaders of the G20 Group (the world's major economies) were congratulating themselves on having delivered "the largest and most coordinated fiscal and monetary Stimulus ever undertaken", and claiming "it worked".

Now, Germany, Europe's largest economy, has announced €80bn ($96bn) of budget cutbacks. And after the G20's recent Finance Minister meeting in Seoul, French minister, Christine Lagarde, noted that "For the vast majority, addressing finances, budget consolidation, is priority No. 1." Even US Treasury Secretary, Tim Geithner, was in downbeat mood, telling his colleagues that "they should not rely on spending by American consumers for their economic recovery".

The problem is that this change of heart comes rather late in the day, after $trns have been wasted on auto and housing incentive schemes. Many politicians seem to have preferred to believe the Crisis was due to lack of confidence and liquidity. But as the blog has long argued, the fundamental issue is one of solvency - too many of the debts built up in the Boom years will never be repaid. And the extra spending caused by the Stimulus programmes has made this problem worse, not better.

For the past 20 years, the chemical industry has been making steady progress in improving its environmental, health and safety performance. More recently, security has been added to the list of key items covered by the voluntary Responsible Care initiative, which covers c90% of chemical production.

Now, however, this enormously important activity has moved into the political spotlight, following the attack by President Obama on BP's CEO, Tony Hayward, where he said he knew "whose ass to kick" and added "He wouldn't be working for me".

In the public mind, of course, oil and chemicals are closely linked. Even more unfortunate is the connection being made with the problems in the banking sector, with 'self-regulation' seen as the underlying cause in both areas. So it is most unlikely that vote-seeking politicians, or nervous regulators, will seek to draw distinctions when legislating in response to the Deepwater Horizon disaster.

It is almost inevitable, therefore, that we will see greater regulation on chemicals manufacture as a result of Deepwater Horizon. This will impact innovation, as well as increasing costs.

China is a very difficult country for foreigners to understand. The blog suspects that the best approach is to apply Winston Churchill's insight on Russia, namely "I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is Russian national interest."

Looking at China in this light suggests that social stability is the key national interest at present. In turn, this means that policymakers at the Commerce and Finance Ministries have difficult issues to resolve:

• The Commerce Ministry has to deal with increasing labour unrest. As the Financial Times notes, "Signs are emerging that the labour protests in China are far more widespread and co-ordinated than previously thought".
• The Finance Ministry has to cool a speculative boom, which is pushing up inflation and causing problems in the property sector. China's home prices rose 12.4% in May, whilst inflation rose above target to 3.1%.

These two concerns are, of course, connected. Rising inflation and house prices naturally cause workers to demand higher pay, to maintain their standard of living.

Policymakers cannot afford to inflame further discontent. So they have to reduce lending from last year's peaks. As the above chart shows, this is now down 31% by comparison with the first 5 months of 2009. Equally, there is increasing reliance on exports as a source of growth, with May seeing a 48.5% rise versus 2009 - a 6 year high.

But this focus on domestic issues risks increasing friction with the USA, where US Treasury Secretary Tim Geithner, told Congress this week that "China's exchange-rate policy prevents a balanced global recovery". US politicians cannot afford to seem uninterested in trade issues, with mid-term elections due in November and 1 in 6 Americans out of work.

US legislation in reaction to China's exchange rate policy therefore looks increasingly likely. If this happens, the chemical industry, which has relied on exports to Asia over the past year, risks being caught in the cross-fire.

The blog, an old-fashioned romantic, has always thought that flowers were the way to woo a lady. But apparently no longer in Japan, according to government adverts.

Bloomberg reports the Ministry of Finance is advertising Japanese Government Bonds (JGBs) under the slogan "Men who hold JGBs are popular with women!!".

The campaign, developed by Japan's largest advertising agency, Dentsu, quotes women saying "I want my future husband to be diligent about money. Playboys are no good."

Japan's campaign highlights, of course, the increasing problems being faced by many governments, as they seek to finance rising debt levels. But somehow, the blog doubts that the next James Bond movie will feature this new line in seduction.

Consumer spending, particularly in the developed economies, is critical to the chemical industry. And there is increasing evidence that a two-tier pattern is developing:

• Wealthier consumers are maintaining their spend, helped by lower interest costs on mortgages and recent stock market gains
• Lower and middle-income consumers remain under pressure, as they are more likely to be unemployed and to rent their home

Thus luxury retailers, and budget stores, are both seeing higher volumes of trade. For example, in the USA last month, Neiman Marcus saw sales up 8%, whilst Costco was up 5%.

Overall, of course, this means retail sales remain under pressure. As the above chart shows, EU volumes were down 1.2% in April. And in the US (which reports its data faster), they were down a similar amount in May.

The blog has been out and about in recent days, visiting some of the major European chemical companies. Most continue to see strong order books. In normal circumstances, this would lead to considerable confidence about the outlook for the rest of the year.

However, there are increasing fears, as Nigel Davis has noted in ICIS Insight, that underlying growth may already be slowing. One tangible example of this slowdown is the chart above, showing that EU auto sales fell a further 9.3% in May.

Last year, of course, Europe was the world's largest auto market, with sales of 14.4m. And volume continued to be positive versus 2009 until March, helping to boost chemical and polymer demand. But few expect H2 to be as strong.

ACEA (the European auto manufacturers association) note that the sales decline reflects both "the end to government support schemes and the further challenging economic situation". In turn, this reinforces the blog's New Year worries that Restocking is not the same as Recovery.

Spring should be a boom time for building new homes in the USA. But in fact, May's single family housing starts (bottom chart) fell 17.2% versus April, as the $8k tax credit ended. Yet affordability should be high, with prices down 30% from the peak, and mortgage rates at the lowest levels for decades.

This picture mirrors yesterday's news on European autos. As many feared, the stimulus programmes have not created new demand, but merely brought forward existing demand, with buyers taking taxpayer's money whilst it lasted.

The top chart, also from the Wall Street Journal, also confirms how industrial production (and chemical demand) has rebounded under the influence of seasonal factors and stimulus incentives. But although May's 1.2% rise is welcome news, it means the index is still only just above 2002 levels.

This week's data thus confirms the blog's fear that although we are seeing relative improvement, this is from a low base in absolute terms. And if autos and housing demand stay depressed, this must feed through into slower chemical demand in the seasonally weaker Q3 period.

The blog is delighted to see that Ineos is to build its first European BioEnergy Process Technology plant at Teesside, UK.

The £52m ($75m) plant will produce 30m litres (24 million tonnes) of bioethanol, and 3MW of electricity on start-up in 2012. It will fuel 250k autos running on E10 blend, and provide electricity for 6000 homes.

Feedstock will be c100KT of biodegradable household/commercial waste.

This is one of the first investments under the UK government's £60m scheme to equip Teesside to become a centre of low carbon technology. It is excellent to see the process engineering skills of the chemical industry being used to develop the technologies of the future.

The chemical industry can be very proud of what it has achieved with the Responsible Care programme since 1985. But it may need to consider how this develops, in the light of the Deepwater Horizon disaster.

One key question emerged from this week's US Congressional hearing with the heads of ExxonMobil, Chevron and Shell. It seems they all disagreed with BP's drilling practices:

• EM's CEO Rex Tillerson said "We would not have drilled the well the way they did".
• Chevron chairman John Watson noted "It certainly appears that not all the standards that we would recommend or that we would employ were in place".
• Shell's president Marvin Odum added that "It's not a well that we would have drilled in that mechanical setup".

And according to the New York Times, "The executives of the other companies asserted Tuesday that they believed BP was an outlier, cutting corners to save time and money in ways that they would not tolerate".

As far as the blog knows, there is no equivalent of Responsible Care in the oil industry. But this does not mean that the chemical industry couldn't find itself in a similar position. Compliance with the Global Charter has always, for very understandable reasons, been mainly based on a company's own interpretation of the programme.

So what would happen if a serious incident were to occur, on the scale of Deepwater Horizon, and it became clear that this was due to poor practice at a company signed up to Responsible Care? Could we see the same process taking place in Congress, with other companies blaming the supposed "outlier" for not using best practices?

But by this stage, as with deepwater drilling today, the issue might well have already become one of 'licence to operate' for all those involved, not just the offending company.

The above chart is the blog's best effort to correlate the change in China's bank lending with the real economy. It shows electricity consumption (blue line) and lending (red column) since July 2008.

Electricity consumption is an excellent proxy for the real economy, and probably more reliable than GDP figures, which are widely believed to be manipulated by regional governments to meet central targets:

• Electricity consumption fell 14% from Q3 to Q4 2008, and then a further 3% in Q1 2009, as China's exports collapsed due to the financial crisis.
• Bank lending was also falling until November 2008, along with exports. But it then revived dramatically, as government introduced new targets.
• Lending jumped to $70bn in November from October's $27bn, and more than trebled in Q1 2009 versus Q4 2008.
• This increased lending then stimulated the real economy. Electricity consumption rose to record levels, with Q2 2009 up 12% versus Q1, and Q3 up a further 16% versus Q2.

What happens next is, of course, the key question? From the petchem viewpoint, the main issue is the likely impact from the government's $580bn stimulus programme, which aimed to ramp up output in key growth sectors for employment such as refining and petchems.

This is clearly now happening. Refining runs are expected to be up 8% in June, versus 2009. And average naphtha yields are up from 10.9% to 11.3% over the same period. So feedstock volumes into petchems, and hence petchem production, have risen 12% since June 2009.

This is a massive increase in petchem output, especially when economic growth (as measured by electricity consumption) is now stabilising. So the pressure will come on import volume into China. In addition, this weekend's currency revaluation will probably add to pricing pressures, as China seeks to ensure its higher volumes remain competitive.

Stock markets have always been somewhat unreliable as a forecasting tool. And their record has got worse in recent years, as long-term investors have been replaced by high-speed day traders. In turn, this affects the Leading Indicators produced by the OECD, and others, as these rely on stock price movements in their analysis.

A more reliable Leading Indicator is that produced by the US Economic Cycle Research Institute. This has only produced one 'false' reading over the past 40 years - following the October 1987 stock market crash. Otherwise, it has a perfect record in forecasting recessions. And as the above chart shows, it fell last week to -5.7%, which has accurately signalled recession ahead of the past 7 US downturns.

Of course, it may be wrong. But it adds to the mounting evidence that the downturn in the West is set to continue, as the boost from stimulus programmes and restocking fades. And as Dave Rosenberg of Gluskin Sieff notes, it did accurately forecast the relapse in 2002 when, as today, the consensus was forecasting 3% GDP growth for H2.

The blog is in gloomy mood today, in spite of last night's England World Cup win. Not because Wall Street 'analysts' maintained last month's 33% drop in US new home sales was 'unexpected'. Nor even that the consensus forecast is still for 700k housing starts this year, when current data suggest that last year's 560k total may actually prove hard to beat.

Its gloom is due to its perception that most policymakers seem totally unprepared for the possibility that things might get worse in H2. Of course, its good to be optimistic and hopeful. But after the events of the past 2 years, it would surely be only prudent for them to consider a Downside scenario?

Hopefully, chemical companies have not fallen into the same trap with regard to contingency planning, given the importance of housing to overall sales. To help with this process, the blog strongly recommends the above CNBC interview with Meredith Whitney, the only US bank analyst to correctly forecast the downturn.

She may not be right with her forecasts of a further decline in housing markets and consumer spending, and an increase in bank write-offs. But, like the ECRI indicator, her track record is hard to beat.

At the mid-year point, its interesting to look at the performance of the total chemical industry, including pharmaceuticals.

The chart, from the American Chemistry Council, shows global demand has now recovered to 2008 levels. Pharma is more recession-proof than other parts of the industry, as people still become ill and need treatment.

In terms of Regions, N America remains the weakest performer:

• N America was up 5% in May versus 2009, with the ACC noting that "activity in the US softened". Weakness was centred on petchems, organic intermediates and polymers.
• W Europe was up 12%, and growth seems to be peaking.
• Asia was up 12%, with earlier sharp gains now slowing.
• Middle East was up 13%, maintaining its performance as new plants come online.
• CEE was up 20%, as it benefits from the W European recovery.
• Latin America was also up 14%, helped by demand from China.

The Baltic Dry Index of freight costs (for iron ore, grains and coal) follows changes in global demand for bulk shipping. As such, it is an important leading indicator of future economic activity, and chemicals demand.

The blog first noted Index movements in October 2007, when this was accurately forecasting the H1 2008 boom. In May 2008, the Index then began a 90% fall that preceded the H2 collapse. Now, as shown in the chart above from Bloomberg, it is again flashing a warning light.

The Index bottomed last October, as companies cut back on inventories ahead of year end. But it then moved up sharply, before the seasonal weakness in Q1 (when shipping conditions are poor). But in the last month, its rally since March seems to have collapsed. The Index is now back at the October lows.

The FT notes that "the fall in freight rates reflected a gloomier outlook for the global economy". An analyst with ICAP, the broker, added that in their view "the Chinese are tightening seriously. We're not very positive on the short-term global outlook".

The blog is a great believer in the retail sector's ability to help us forecast chemical industry trends.

McBride is Europe's leading 'own brand' in the household and personal sector. Its profit warning on Thursday of "weak retail sales across Europe", therefore rings alarm bells. The sector is a large outlet for chemicals, and has recently seen BASF pay €3.1bn ($3.8bn) for the Cognis business.

'Own labels' have generally done very well in the downturn, with consumers focusing on price and value. McBride is a well-managed company, and as recently as February was forecasting continued good earnings. Now it says the current quarter will be 3% below 2009 levels.

The warning was a shock to investors (as shown in the Yahoo chart above), with the shares falling 40% after the news. And the Financial Times adds that McBride is facing "a fightback by brand owners" that includes price discounts. Clearly, the rollout of more Basic brands by majors such as P&G over the past year, is now having a serious impact.

In turn, this is going to put pressure on chemical industry volumes and margins, just as we enter the seasonally weak Q3 period.

When the G-20 met in London in April 2009, they produced a Communiqué containing just 688 words. And as the blog noted in conclusion, there was "no sign of a 'Plan B' being developed", in case the Stimulus measures failed to work.

This was still the case last September in Pittsburgh, when the Leader's Statement had grown to 9292 words. Now, after this weekend's Toronto summit, the Declaration's word-count has risen still further, to 10713 words and 27 pages.

This highlights a sense of drift and ineffectiveness within the G-20. The key output required in a report are answers to the questions 'Why?, What?, When? and How?' But these questions, let alone their answers, are sadly lacking. There is no clear action plan to address the key issue of how the G-20 will help to return the global economy to a growth path.

And yet, by its 4th point, the leaders recognise that "serious challenges remain". And they add that "while growth is returning, the recovery is uneven and fragile, unemployment in many countries remains at unacceptable levels, and the social impact of the crisis is still widely felt."

This is quite a shift in mood from the "It worked" comment in Pittsburgh. And it is accompanied by an acceptance that "those countries with serious fiscal challenges need to accelerate the pace of consolidation". This group, of course, includes much of the European Union, which accounts for 28% of global GDP - a larger share than the USA.

If nearly a third of the world economy is now in "consolidation" mood, then it is wishful thinking to imagine that the other 2/3rds can effectively compensate. Plus, of course, once we are past the mid-term elections, no doubt the USA will formally join the consolidators camp.

Deflation and protectionism are becoming bigger and bigger risks for the chemical industry as the Crisis continues.

Darwin hit it on the nail when he wrote in 'Origin of the Species' that "Unless profitable variations occur, natural selection can do nothing".

His message is echoed today by US Fed Governor Kevin Warsh, one of the few policy-makers who deals in reality rather than wishful thinking.

Warsh sets out to "debunk some popular truths that have become part of the crisis narrative"::

• "Subprime mortgages were not the core of the global crisis, they were only indicative of the dramatic mispricing of virtually every asset everywhere in the world".
• "The volatility in financial markets is not the source of the problem, but a critical signpost."
• "Excessive growth in government spending is not the economy's salvation, but a principal foe."
• "The European sovereign debt crisis is not upsetting the stability in financial markets; it is demonstrating how far we remain from a sustainable equilibrium."
• "Turning private-sector liabilities into public-sector obligations may effectively buy time, but it alone buys neither stability nor prosperity over the horizon."

Warsh believes we delude ourselves if we think today's problems are essentially "a series of unrelated, unpredictable, unfortunate financial shocks" and due to "bad luck".

He concludes by arguing that instead of continuing to focus on short-term 'fixes', "we should take the necessary measures to ensure that our economy is strong over the long term".