Chemicals & The Economy

Its now 18 months since Jack Welch publicly abandoned his views on the importance of shareholder value, and said it was "a dumb idea for executives to focus so heavily on quarterly profits and share price gains". This was very significant, as Welch was generally credited with popularising the idea in a 1981 speech, when head of General Electric.

Since then, a growing number of companies have followed his lead. DSM were one of the first, 6 months ago, when they launched their 'value creation for people, planet and profit' strategy. Now Unilever, the global consumer products giant, with a market capitalisation of $35bn, has taken the concept a step further.

Interviewed in the Financial Times, CEO Paul Polman noted they have stopped giving earnings guidance for the next quarter. And he added that "we certainly don't want to attract the investor base that wants higher and higher and quicker results against targets that we put out every 90 days."

This is a quite striking reversal of previous priorities. Polman went on to put forward a radical alternative statement of the basis for investment in Unilever:

"Unilever has been around for 100-plus years. We want to be around for several hundred more years. So if you buy into this long-term value-creation model, which is equitable, which is shared, which is sustainable, then come and invest with us. If you don't buy into this, I respect you as a human being, but don't put your money in our company."

This sounds very close to the outlook that helped to build the world's major chemical companies in the first place. The blog will continue to follow developments with interest.

The styrene business has been increasingly difficult in recent years:

• CD and video sales went online, removing the need for polystyrene (PS) packaging
• Prices for the main feedstock, benzene, leapt in the mid-2000's, due to US gasoline market changes, forcing convertors to look at alternatives such as polypropylene
• Recycling became an essential part of the packaging 'offer', leaving PS behind
• Increased POSM/SMPO capacity meant styrene prices came under pressure

And one could go on.

The result has been, as discussed at our Conference last week, that the two 'inventors' of styrene, BASF and Dow, felt forced to establish new business models. Dow sold Styron to Bain Capital for $1.6bn earlier this year. BASF announced it would 'carve-out' its business as Styrolution from January 2011. And separately last month, Nova announced they would sell their share of the current INEOS Nova styrene joint venture to INEOS.

Now comes news that Styrolution will become a BASF/INEOS joint venture. Unlike Styron, it will not include the 'sexier' parts of the portfolio - such as expandable PS (widely used in insulation). Nor will it own the Nanjing activities in China. But, assuming anti-trust clearance, it will still be a €5bn ($6.8bn) business and large enough to control its own destiny.

Clearly Styrolution, like Styron, will have to do things differently in the future, if it is to regain a reasonable level of profitability. But both Roberto Gualdoni and Chris Pappas, the CEOs of the two new businesses, have solid track records in the petchem industry, and good teams alongside them.

The blog wishes them well, and hopes they succeed triumphantly.

US housing was the prime cause of the current financial crisis. US banks spent most of the 2000-7 period lending at low 'teaser' rates to borrowers who had no prospect of repaying the loan. And by syndicating the loans to gullible European banks, they ensured that losses were shared equally, when credit standards finally began to tighten.

This lending binge also led to a Boom period for the global chemical industry. US housing starts rose to 2.2 million in 2006, worth $35bn in chemical sales (in 2010 values), with each house worth $16k according to American Chemical Council analysis. In addition, China's export-based manufacturing economy prospered (requiring ever-increasing volumes of chemical imports), as US demand rose for the goods required to furnish all these new homes.

The result is shown in the above chart, based on the authoritative S&P Case-Shiller Index for the 10 major US cities. From a base of $100k in January 2000, US house prices more than doubled to $226k by July 2006. Since then, they have fallen 29%. Housing starts have tumbled to just 600k, worth only $10bn in chemical sales. Now, the question is what happens next?

• Massive Federal support, including $8k tax breaks for purchases, has only led to a very modest price recovery. The index bottomed at $150k in April 2009, then peaked in July this year at $162k, just 8% higher.
• Unsold housing inventory (including foreclosures) already totals 6.3m homes, equal to 2 year's sales at current rates, versus 6 - 7 months in the Boom.
• The index's originators are cautious in their outlook. Karl Case says his Base Case is for prices to remain flat. But with "2 - 1 odds, I'd bet they go down".
• Yale's Prof Shiller refuses to forecast price changes, instead focusing on what he believes is a "catastrophic drop in confidence". He also seems to share the blog's view that we could be entering a New Normal, noting that "there's been a cultural change which goes beyond any short-run forecasts".

Chemical companies finalising their budgets for 2011 cannot afford to ignore this uncertainty. A Scenario approach seems the best way forward, as described in the blog's own Budget Outlook:

• In a Base Case, housing starts and prices might remain broadly stable
• An Upside Case could hope for some improvement
• The Downside Case of lower starts and prices also implies greater uncertainty in the global financial system, as it increases the risk that more banks will fail.

As always, the blog will be happy to discuss these critical issues in more detail, if this would be helpful for your management team.

China's Dalian futures market has become a hotbed of speculation over the past 2 years, since the government doubled bank lending to $1.4trn during 2009, equal to 1/3rd of GDP. Traders have particularly focused on the assumed linkage between LLDPE (linear low density polyethylene) and crude oil, with price movements mirroring each other most months.

But now there are signs the authorities are getting worried. Their concerns are focused on the agricultural sector, as speculative buying has helped cause food prices to rocket, in turn driving inflation to a worrying 4.4% in October. Thus the regulators have been told to "beef up supervision over the futures market to curb excessive speculation".

Hopefully, this will also dampen speculation in polymer markets, which have become a major factor in setting physical prices in China, as well as in Asia and globally. As the chart shows, LLDPE volumes (blue line) reached a record 93 million tonnes in November, nearly 4 times total annual global production.

Interestingly, however, Dalian's record volume did not lead to higher prices (red line), even though crude oil remained above $80/bbl. This may be the first sign that shrewder traders have decided it might be time to take profits and exit the market. Friday's decision to tighten monetary policy also suggests betting against the government is probably not going to be a winning trade.

US auto sales have slowed again. We seem certain to end 2010 at the bottom end of last year's forecasts for demand, which ranged between 11.5m - 12.5m. This seems the main conclusion from analysing November's sales figures.

The blog has developed the new presentation above, showing sales by month since 2005, to assist comparison between years, given the strong seasonal bias to sales. Plus, of course, the sharp decline in Q4 2008, and the subsequent stimulus programmes, have greatly distorted normal year-on-year comparisons.

Two key conclusions can be drawn:

• Sales have stabilised since Q4 2008, but there has been no real recovery. Between 2005-7, only January ever saw monthly sales below 1.1m. But since 2009, only August 2009's $3bn 'cash for clunkers' took them above this level.
• 2010 (orange line) has seen better volumes overall compared to 2009 (light blue). But 2008 (purple) marked a clear dividing line: H1 was in the 2005-7 sales pattern, but H2 began the new pattern seen since then.

Overall, total sales in 2010 will be ~11.5m. This will clearly be better than 2009's 10.4m. But 2009 was the worst year for US auto sales since 1982.

Overall, it means the value of chemical sales into this critical market (using the ACC's estimate of $2973/auto) will have been only $34bn, versus the $50bn seen between 2005-7. It seems the New Normal has arrived in the US auto market.

Benzene is the blog's favourite leading indicator for chemical demand, due to its widespread use in the industry. Its recent price movements versus its naphtha feedstock, may therefore be telling us something quite important about changing supply/demand balances.

As the chart above shows, based on ICIS pricing, its spread versus naphtha has become very volatile in recent years. This is because, as discussed at our Conference last month, there are now no major sources of on-purpose supply to balance changes in demand. Thus although the spread used to be $80 - $200/t, it has usually either been above, or below, these levels since 2004.

Now in recent weeks it has suddenly halved, from $334/t in H1 to $169/t in Q4, to date. There appear to be two possible explanations for the change:

• Refineries have dramatically increased operating rates in Asia and Europe, due to diesel demand. In turn, this will be increasing benzene production.
• Crude oil prices have leapt to $90/bbl under the influence of the US Fed's QE2 Lifeboat policy. History shows this is a level when major demand destruction starts to occur, as consumers cut back on discretionary spending.

Of course, it could also be that we are seeing both these effects in combination. The blog will keep a close eye on future developments.

Crude oil prices are now up 18% since the US Fed announced its QE2 Lifeboat policy at the end of August. This clearly justifies the blog's faith in the 'triangle pattern' in September. The rise is mainly due to financial players, with the Large Speculators dominating the buy-side on the futures markets.

But in turn, average US gasoline prices have now moved back over $3/gal, nearly double their lows in December 2008. And this highlights the key question, of whether the world economy can really prosper with oil prices at the $90/bbl level?

The evidence from history, in both 1979-80 and 2007-8, is that it can't. But there has been a suggestion recently that 'this time it is different' because demand has been growing quite strongly in Asia in recent months.

However, veteran crude oil market watcher Ed Morse of Credit Suisse has a different view. He suggests we have seen "a series of one-off reinforcing factors that, coupled with winter seasonality, have tightened product and crude oil markets":

• The Q3 heatwave in Japan and S Korea, which led to higher electricity demand for air conditioning
• China has shut 1355 coal mines to curb pollution, causing factories to run diesel generators instead
• Europe is having one of its coldest-ever November/Decembers, also increasing heating and fuel oil demand

None of these factors, sadly, are indicators of economic growth. Instead, with China poised for further interest rate rises, to cool inflation, the risk of slower economic growth there is clearly rising.

What happens if you suddenly double bank lending in a country, and make it equal to 1/3rd of total GDP? And, as part of the experiment, add a further 13% of GDP via a $580bn stimulus programme?

We don't know yet, because it has never been done before. But we are about to find out. Because this is what China has done over the past two years, since the Crisis hit, in order to keep its population employed.

The first part of the answer is easy to guess. A massive boom takes place in consumer spending, house prices leap, and demand generally goes through the roof. After all, we've been here before, with the US Federal Reserve's low interest policy following the collapse of the dot-com bubble.

But China's boom has been an altogether different level of magnitude. Even Alan Greenspan, when Fed Chairman, would never have dared to follow China's recent path. So all we do know, so far, is that China has become the main source of global demand growth for the chemical industry. Equally, as the chart shows, housing prices have soared.

According to an official survey by China's top Think Tank, the "actual value of commercial housing in Fuzhou is only 3,998 yuan ($600) per square metre, while the market price is 13,457 yuan". Its analysis suggests this is a 70.3% bubble, with other major cities such as Beijing not far behind.

Plus, today's figures show inflation is now rising very fast. It was 5.1% in November, up from 4.4% in October. Food prices were up an astonishing 11.7%. As the World Bank note in a new report:

"After the massive monetary expansion since the end of 2008 there is a lot of liquidity sloshing around, potentially putting upward pressure on prices, especially asset prices. In this setting, there are reports that speculative activity has driven up prices of several food products."

So will China now follow the Bank's advice and reduce lending, whilst also increasing interest rates? If they do, what will happen to growth rates? If they don't, how far might the housing bubble go, before it finally bursts?

As the blog noted in its Budget Outlook, the world has become a much more uncertain place over the past 2 years since the Crisis began.

Throwing money at the problem, as China is probably about to discover, is the easy part. The more difficult part, of dealing with the consequences of such rapid expansion, now lies ahead.

October is usually a seasonally strong month for chemical production. Factories are back from the summer holidays, and working flat out to meet orders before the Christmas and Lunar New Year breaks. So it is a bit disappointing that, as the above chart from the American Chemistry Council shows, operating rates (OR%) actually slipped slightly to 85%.

Of course, this is still a lot better than the 81.9% seen in 2009. But for the moment, it suggests that we are still in a Base Case Scenario as far as OR% are concerned. Yet crude oil prices have raced higher, to ~$90/bbl, putting them clearly in an Upside Case Scenario and suggesting demand is improving.

This highlights the importance of the comment made last week by Syngenta's Pierpaolo Ferluga, when he noted that "the main concern at the moment is about a tight chemical market and high commodity prices". He also added two very relevant questions - "if this is due mainly to China, or if this is going to end in 2011 into a new crisis"?

Supply constraints (OPEC quotas and plant force majeures), plus the impact of China's lending/stimulus programmes, have clearly been key features of 2010. What happens next to chemical OR% will therefore probably tell us a lot about whether the perception of recovery that these have provided, will translate into sustainable reality.

Source: www.chartoftheday.comThe price/earnings (P/E) ratio is the most fundamental measure of stock market value. If investors are optimistic, they will pay a high price per unit of earnings. If they are cautious, then the ratio will be lower.

Thus the above chart from chartoftheday.com highlights a very significant secular change underway in investor mindsets. It shows the P/E ratio for the US S&P 500 since 1900. And for most of this time the ratio traded between a low of ~7 (green line) and a high of ~22 (red line).

But the rise of the Baby Boomers in the 1980s, which greatly increased stock market investment, took the ratio to a completely new level over the past 20 years. The dot-com bubble took the ratio over 40, and the collapse in earnings during the Crisis left it even higher.

Now it seems to be drifting back towards more realistic levels again. This probably demonstrates the impact of the ageing of the Baby Boomers, who are now in their 50s and 60s. As the blog argued in the Financial Times in September, their increasing life expectancy changes the rules of the game as regards the merits of stock versus bond market investment.

By comparison with stock market volatility, the certainty of a 4% yield for 30 years from a G7 government bond becomes quite an attractive proposition.

The EU loans crisis began 6 months ago, when it became likely that Greece was never going to be able to repay its debts in full. Since then, Ireland has moved into a similar position. And there are expectations that Portugal and Spain will follow during 2011.

Unsurprisingly, however, given the general lack of transparency in the banking sector, it has been difficult to discover who is owed what, in terms of national banking loans. The central bankers' bank, the Bank for International Settlements (BIS), produced a seemingly definitive listing at the time. But now they have revised it, upwards, quite sharply.

The chart above shows their new summary. The vertical axis shows the debt held by each country, so France has lent $49bn to Portugal, and $77bn to Ireland. And collectively, it shows that the world's banks are owed $2.282 trn by the 4 EU countries currently most at risk of default.

Germany and France are most at risk from any default, accounting for $913bn of the loans. But the UK and USA, with $370bn and $353bn, are clearly also on the hook if something does go wrong. This 'wake-up call' no doubt explains last week's recent volte face in France, where serious discussion is now underway about moving to fiscal union, to support EU monetary union.

This, of course, was part of the original German proposals when the euro was first discussed. But it was vetoed by France, concerned as always about national sovereignty. However, events this year have confirmed that one can't have one without the other.

The challenge for 2011 will be whether the EU has the political will to move forward in this area. Failure to do so, will make life difficult indeed within the euro area, and for those who have lent to it.

The blog was very pleased to talk recently to Business News Americas about developments in Latin America. Please click here if you would like to read the full interview.

It highlights the key role being played by Brazil's Petrobras, particularly in the development of 'green polymers'. These are still very small in volume, compared to traditional polymers. But Brazil's climate means that ethanol-based products can actually be viable without subsidy, a very important factor for future sales.

A new study also shows that its CO2 emissions are much lower, over the total lifecycle, even when the product is shipped from Brazil to Japan for use in packaging there. It reports that "1kg of 'green' PE emits 1.35kg of CO2 equivalent of greenhouse gas emissions, compared to between 4.55-5.10kg for traditional polymers, during its life cycle".

Carbon footprint is of major interest to consumers around the world. So this kind of study is powerful evidence for the potential strength of the bio-based opportunity in Brazil.

The blog's 2 White Papers have proved enormously popular this year. More than 10000 copies have been downloaded around the world.

They focused on the New Normal. This reflected the blog's belief that the current recovery is not taking us back to the 2003-7 Boom period. Instead, it is taking us forward to a world where demand patterns will be quite different.

The key influence is changing demographics:

• Western BabyBoomers, who have driven major consumption growth over the past 25 years, are now in their 50s and 60s. They are starting to consume less, and save more, as they enter retirement. This is already leading to lower sales into previously key markets such as autos and housing.

• In turn, this means the emerging economies of Asia, Latin America and Africa can no longer rely on exports to drive their growth. They instead have to stimulate domestic consumption. And given their lower GDP/capita, this will dramatically change their demand patterns too.

The new White Paper highlights these major changes. It builds on the blog's recent Budget Outlook, Budgeting for Uncertainty.

The changes required are not going to be easy to manage, and they will therefore create winners and losers. Its aim is therefore to help you and your company become winners, as the transition to the New Normal continues.

It will be published in the New Year.

Oil price rises reduce chemical demand.

Initially, as we saw in 2007 - H1 2008, and in 1979 - 80, everything seems fine. Consumers continue to buy, and we all reassure ourselves that demand is still robust.

But, in fact, end-use demand starts to fall when prices rise, as individuals cut back on discretionary spending to pay higher gasoline and heating bills.

Europe's polyethylene market currently offers a clear example of this process in action. An excellent ICIS news report by Linda Naylor highlights how:

• "December monthly business is progressing normally".
• "But extra sales are reported at much higher price levels".

She also notes that buyers are "trying to obtain extra volumes in an effort to avoid higher prices in January", whilst "many sellers had taken the decision to hold on to inventories". As a result, LDPE prices for January are now talked €100/t ($130) higher than for December, with HDPE talked up to €160/t higher.

It is clearly impossible to stop this process, once it gets underway. Buyers are paid to buy below market, and sellers to sell above it, not the other way around. So if feedstock costs are moving higher, both sides have to react by building as much inventory as possible.

But demand for inventory is not the same as demand for consumption.

There seems to be gathering concern in Germany about the outlook for 2011. This is very significant, as the economy has done well this year, and business confidence is at record levels.

Bosch CEO, Franz Fehrenbach, who runs the world's largest auto parts supplier, has warned that "the rebound in commodity prices will put intense strain on European industrial companies".

Equally, the highly respected IFO Institute says that "world economic activity has lost momentum since the spring". It expects "the dynamics to weaken", and forecasts global GDP will slow from 4.7% this year to 3.6% in 2011, and Eurozone growth to weaken from 1.7% to 1.4%. It also highlights 3 major risks:

• The current Eurozone funding crisis is a "special risk for the forecast"
• A further risk is "another clear correction of US real-estate prices"
• It also worries about the outlook "for the Chinese real estate market"

Of course, forecasters are paid to be cautious. But one of the blog's favourite indicators, the Baltic Dry Index (which reflects global demand for bulk shipping of coal, iron ore and grains) is also flashing warning signals.

As the chart above shows, it fell very sharply in June/July, before recovering slightly in Q3. But since then, it has been falling back towards its earlier lows. This is particularly worrying, as Q4 is usually a seasonally strong period.

A year ago, the blog was correctly much more optimistic than the consensus about the prospects for 2010. Now, however, as we look forward to 2011, it can only repeat its comment from December 2007, that:

"the need for chemical companies to develop robust contingency plans, in case the consensus is wrong, is looking ever stronger".

The blog is awarding itself a pat on the back today, for its decision to focus on electricity consumption and bank lending as key indicators for China's economy. According to the Wall Street Journal, these are 2 of the only 3 statistics used by China's Vice Premier, Li Keqiang (the other is rail cargo).

Li's view matters, as he is expected to take over as premier in 2012. And he apparently has the same view as the blog about the value of most Chinese statistics. He told the US ambassador that the GDP figure, for example, is "man-made and therefore unreliable".

Thus it is no great surprise to find that Li also seems to share the blog's concern that China's economy is now in danger of over-heating. This has to be a growng concern, given the trends shown in the above chart:

• Bank lending (red column) is on track to be up 38% in H2, versus H2 2008
• Electricity consumption (blue line) is up 24%.

No economy in the world can grow at these rates without building up problems for the future. As China's Academy of Social Sciences has just reported, "high inflation and soaring housing prices have contributed to a growing sense of popular disaffection".

So far, the current leadership is still trying to avoid taking the painful measures that will be needed. But at least a debate seems to be underway, with Li reportedly arguing that "more efforts should be provided to stabilize prices next year" and to define economic growth rate targets "reasonably".

If the blog offered you a choice between taking $3400 today, or waiting a month to receive $3800, what would you choose?

This was the question posed to 5900 economics students from 45 different countries in a novel experiment by the Swiss Finance Institute. And they got significantly different answers.

As the chart shows, only 8% of Nigerian students chose to wait, compared to 89% of Germans. The authors suggest these differences are based on cultural preferences, as the implied interest rate for waiting a month is nearly 12% - far above any market level.

The authors also grouped the responses into 4 cultural clusters:

• Germanic-Nordic; 88% chose to wait
• Anglo-Saxon, Middle East and Asia; 66% - 70% would wait
• E Europe, Latin America and Latin Europe; 52% - 59% would wait
• Africa; only 34% would wait

Of course, there is no 'right' or 'wrong' answer to the question. But interestingly, the researchers didn't find any major differences by age or gender, although older respondees tended to be more patient.

The researchers conclude that cultures with a higher 'patience' level are more comfortable in undertaking long-term research and innovation. They also appear to have greater interest in measures to increase sustainability.

Equally, of course, the study's conclusions may also be helpful for commercial and finance professionals, when they come to formulate proposals for buyers operating in different parts of the world.

70% of China's women regard "housing, a stable income and some savings" as vital for any man wanting to get married.

And they probably don't regard architect Dai Haifei's $300 Beijing 'egg house' (pictured) as their ideal.

The data comes from the "2010 China Marital Status Report", which adds that the man's personality and morals are only relevant if he meets these 3 requirements.

This is why the dramatic rise in China's house prices, following the massive stimulus/lending programmes of the past 2 years, is causing such social tension. As China Daily comments, there is a clear risk that "China may breed a new group of bachelors, men caught in the trap of unaffordable houses."

So far, the leadership seems divided on what to do. Understandably, current premier Wen Jiabao would probably prefer to ignore the problem until his term finishes in 2012. But likely new premier, Li Keqiang, is clearly very concerned that such a delay would then leave him with a bigger problem to solve.

The problem is that the housing crisis, where Beijing homes sell for an average 22 times earnings, is just the tip of the iceberg. As Yu Yongding, a very senior policymaker, noted last week, "the country's investment rate now stands at more than 50 percent - a clear reflection of China's low capital efficiency". And Yu also worried that "investment in real estate development accounts for nearly 25% of the total".

The blog's best guess is that those in charge will continue to take small steps, such as Sunday's interest rate rise, but fail to step hard enough on the brakes. In turn, the current 'boom' in China's demand will continue to support the global chemical industry for the next few months.

But clearly the risk is rising that we may then discover, too late, we have simply been in the middle of yet another China 'boom and bust' scenario.

The blog's readership continues to grow. It is now read in 133 countries and 4362 cities, compared to 121 countries and 1244 cities a year ago. Readers also remain very loyal, with 24% reading it twice a week, and spending an average of 1.5 minutes on each visit.

As the map above shows, readership continues to cover all the main areas of chemical production. The list of Top 10 countries now reads USA, UK, Germany, China, India, Netherlands, Singapore, Turkey, France and Belgium, with Italy, S Korea and Japan close behind.

The blog has branched out this year, publishing two White Papers for the first time. These provided more details on the blog's annual Budget Outlook, Budgeting for the New Normal. They have been most enthusiastically received, with over 10000 downloads from around the world.

The blog aims "to share ideas about the influences that may shape the chemical industry over the next 12 - 18 months", and so it focuses on:

• The major companies
• Key consumer industries, including housing and autos
• Economic data such as GDP, industrial production and exports
• Developments in oil and financial markets

980 posts have been made in total, with 282 written in 2010.

One area that has also attracted great interest is the potential transition to the New Normal. What will this mean for chemical industry demand in 2011? The blog will therefore be covering this key area in a new White Paper, due to be published on Monday. I hope you will find it valuable.

Thank you very much for your continued support.

The US foreclosure process used to take around 36 weeks, once the homeowner stopped making payments.

But as the chart shows, based on information provided by LPS Applied Analytics, this period has doubled since the housing crisis began in 2008. In November, it was taking nearly 72 weeks, or 16 months.

Meanwhile, the number of homes in foreclosure has trebled from 700k to 2.1 million, as home prices have fallen 30% from their peak, and unemployment risen to 9.8%.

And foreclosure volume seems likely to continue rising. Yesterday's S&P Case Shiller home price Index warned that "a double dip is almost here", and noted home sales are down 25% versus 2009 and unsold home inventory up 50%.

The only silver lining is that once people give up on their mortgage, they have more money to spend in the shops. Temporarily, at least, this seems to be helping retail sales, which have been relatively strong in recent months.