Chemicals & The Economy

'Budgeting for Uncertainty' seemed the best title for the blog's new White Paper. And already developments in the Middle East are suggesting this could have been a wise decision.

As the above chart of average annual oil prices shows, the 1970 oil price was just $1.80/bbl in nominal terms (blue dotted line), equal to $9.94/bbl in 'real' 2010 dollars (red line). Since then, there have been 4 oil price peaks:

• 1973-4 OPEC oil embargo which took 'real' prices to $50/bbl
• 1979-80 Iran hostage crisis took them to $96/bbl
• 1990's Iraqi invasion of Kuwait took them to $39/bbl
• 2008's Israeli threat to bomb Iran, led to $97/bbl

Now, Brent prices have moved back above $100/bbl, as unrest builds in Egypt and other Middle East/N African countries. Egypt is, after all, a key country in the region.

Sadly, this is a major 'own goal' for US policymakers. As the blog noted in the White Paper, the US Federal Reserve has been explicitly targeting higher asset prices, via its QE2 Lifeboat policy. Just 2 weeks ago, its Chairman, Ben Bernanke boasted that:

"Policies have contributed to a stronger stock market just as they did in March 2009, when we did the last iteration of this. The S&P 500 is up 20%-plus and the Russell 2000, which is about small cap stocks, is up 30%-plus."

And, of course, this has also fed the 'correlation rally', raising the price of food and oil, and so led to growing political unrest amongst poorer people in the Middle East and other emerging economies. It now threatens higher oil prices, and regime change amongst governments friendly to Western interests.

Yet as OPEC's secretary general, Abdalla El-Badri noted Monday, "the oil market is well supplied" with strong inventories, and "demand is less than last year" at this time. And, revealingly, he added that "I don't see why we have this high price."

What happens next is, of course, the key question?

• The most likely outcome is that the army will broker an orderly transition to a new government. In turn, this might lead OPEC to seek lower oil prices via extra production, to reduce the risk of further unrest spreading to other key states.
• But if there is instead a disorderly transition, then the rises seen since Friday might well continue, returning prices to the $100+/bbl levels seen in 2008.

As we cannot be certain which way events will develop, the blog suspects its July 2008 advice, in response to the Iran threat, may again prove helpful. It suggested then that "prudent CFOs and business managers might well wish to consider hedging their purchases and sales against both these possibilities", given the problems that a major move in either direction could cause.

After the events of the past few days in Egypt, it seems timely to look at the latest state of the 'correlation trade' currently ruling global financial markets. As the chart shows, prices for WTI crude oil (green line), continue to follow those of the S&P 500 (blue) in most remarkable fashion.

The trade is led, as discussed yesterday, by the US Federal Reserve's programme of quantitative easing (QE). It has now spent ~$380bn of its latest $650bn tranche. Both the S&P 500 and WTI are up over 20% since this was first announced last August.

'Don't fight the Fed' has always been one of the main rules of stock market investment. But its mandate from Congress does not mention support for asset prices. It is supposed to aim for "maximum employment, stable prices, and moderate long-term interest rates".

Against these targets, the Fed's current policies seem wildly unsuccessful:

• The 9.4% US unemployment rate remains at record levels, with 14.5m jobless. The wider U-6 measure, including discouraged workers, is near 17%.
• Similarly, inflation is now at 1.5%, with energy up 7.7%. And worryingly, 43 million Americans are now on food stamps, 1 in 7 of the total population.
• Mortgage interest rates have increased since QE2 was announced, due to inflation fears, putting more pressure on an already weak housing market.

Thus the Fed is actually creating new problems, rather than solving the ones it is supposed to target. Plus, of course, from a chemical industry viewpoint, today's ever-higher feedstock costs must be impacting final demand globally.

The Fed should know that there has never been a time when the global economy was able to operate successfully at today's oil price levels. It is wishful thinking for it to continue with current policies, in the hope that 'this time, it is different'.

2011 has been named International Year of Chemistry by the United Nations. The date coincides with the centenary of Marie Curie winning the Nobel Prize for Chemistry.

A range of activities is being planned on a national and international basis to support the Year. It gives the industry a welcome chance to promote the positive nature of its activity.

Further information can be found at the website www.chemistry2011.org. And EPCA have also produced a charming video to highlight some of the chemical industry's key benefits to society.

US auto sales disappointed again last month. As the chart shows, January (red square) came in well below the 1.1m level that was normal during the Boom years. And even this 819k sales level required major increases in incentives.

GM, of course, was focused on stabilising its stock price after the IPO, so it needed to report an encouraging number. But even so, its sales of 179k were only achieved by near record discounts of $3762 per auto. This was up $507k from December's already high level.

This is worrying from a chemical industry viewpoint. If Detroit is busy reducing its prices, it makes it much harder to push through the cost increases required by higher oil and raw material costs.

Separately, an interesting article in the Wall Street Journal suggests auto manufacturers are seeing major changes in consumer buying patterns. It reports that 25% of Renault's global sales are now of low-cost models.

These were introduced in 2004 to target emerging markets such as India. But they are now increasingly popular in developed markets. 50% of low-cost sales last year were in Europe, where prices start at €7600 ($10300) versus standard models such as the Clio at €14k.

This seems further evidence for the blog's theory that demand patterns are seeing major changes as we enter the 'new normal'.

The blog's Boom/Gloom Index presents a fascinating picture this month.

The main Index (blue column) remains strongly positive, in keeping with the solid performance of most stock markets. It confirms evidence from other sentiment indices that investors are optimistic about the outlook.

But the Austerity index (red line) refuses to collapse. It is, of course, much lower than during the Eurozone crisis last May/June. But it is also very much higher than during the SuperCycle years until 2008.

These two different readings can continue for some time in an uneasy coexistence, as they did in June 2008, when the blog headed its post 'High Inflation or Global Downturn?'.

Worryingly, much of its analysis still remains relevant today - if you have a minute, it may be worth clicking through to check for yourself.

The blog will therefore keep a very close eye on future developments, for clues as to how events may develop.

The blog is excited to learn that there should be a good attendance for its first New Normal training Workshop in Singapore. This is being held in association with ICIS, on 24 February.

The Workshop aims to provide a comprehensive understanding of the factors that will impact the petrochemical market over the next few years:

• What is the New Normal and how will it change the petrochemical landscape?
• What will it mean for key feedstock and end-user markets?
• What will be the key price drivers for the market?

The New Normal is being driven by the major demographic changes now underway in the Western world. The BabyBoomers born between 1946-70 led to massive gains in consumption, as they entered the 25 - 54 age group. This is when people typically marry, settle down and have children.

But now, as the chart shows, they are entering the 55+ age group, when people normally save more and spend less. This is already having profound effects on demand patterns in Asia. Exports to the West now need to be replaced by increased domestic consumption.

Please click here if you would like further details of the course.

Super-fast computers continue to increase their role in financial markets.

They first came into prominence in H2 2009, when the 'correlation trade' began. Their role is nothing to do with price discovery, the traditional market function. Instead, they trade on algorithms.

Their aim is trade arbitrage opportunities between markets on a nano-second by nano-second basis. These discrepancies are incredibly small, so they make their returns by leverage, trading millions of contracts at a time.

18 months later, the computers now dominate many markets. The above chart from Petromatrix details the position during Q4 on one of the biggest US exchanges, the Chicago Mercantile Exchange (CME). It shows the Algorithm computers traded:

• ~70% of equity volume (red column) and 50% of all contracts (blue)
• ~50% of all energy volume, including oil, and over 30% of contracts
• ~80% of all foreign exchange (Forex) volume

The problem, of course, is that the correlation trade creates a situation where no single market knows what it is trading. Fundamentals of supply/demand become irrelevant, particularly if central banks such as the US Fed make available vast quantities of liquidity through QE2 to fund the trading.

Fundamentals will, of course, become important once the Fed withdraws its QE2 liquidity. When this happens, probably in Q2, we may well see considerable re-pricing take place, as physical market conditions suddenly become important once again.

History doesn't repeat, but it sometimes rhymes. That was the insight of the famed American writer, Mark Twain.

2 weeks ago, this led the blog to highlight the similarities between the geo-political concerns then developing in Egypt, and the Israel/Iran stand-off which had marked the oil price peak in June 2008.

We still cannot be sure what will happen next, but it currently appears that the blog's "most likely outcome of the army brokering an orderly transition" will take place. And the past 2 weeks have given us important clues about the likely future direction of oil prices:

• Speculators pushed Brent prices to $100/bbl, but failed to move them higher
• The WTI price hardly moved, and is now back to 1 December levels
• OPEC compliance with its quotas has fallen to just 48%
• Iraq (outside the quotas) raised output by 250kbbls in January

This suggests that prices are unlikely to increase much in coming weeks, if geo-political tensions continue to subside. The bulls have had their chance to rush prices higher, just as they did with Iran. Both times, they appear to have failed.

Instead, the bulls may now begin to find themselves under pressure. Gasoline prices are already at record levels in China. Equally, the euro's weakness means, as the chart shows, that today's €75/bbl price is now very close to the Q2 2008 peak.

Major changes are underway in Western housing markets. They are generational in nature, meaning that we are starting to see a New Normal develop in terms of future demand patterns for chemicals and polymers.

The past 30 years have seen Western leaders committed to the concept of a 'property-owning democracy'. Both US President Reagan and UK Prime Minister Thatcher believed that giving people ownership of their home would help stabilise politics, after the traumas of the 1960-70s.

In the US, Reagan decided to use the government-owned Fannie Mae and Freddie Mac agencies as the main vehicle for this expansion of home ownership. In 1981, Fannie Mae was allowed to issue its first mortgage backed security, building on a successful earlier experiment with Freddie Mac.

This provided government insurance for private mortgages, as long as they confirmed to certain standards. Essentially this reduced the risk of home lending, and meant interest rates on mortgages were reduced, to reflect the benefit of the government's guarantee.

Future Presidents, including George HW Bush in 1992 and Bill Clinton in 1999, then widened eligibility to encourage low and moderate income borrowers. But then, during the 2003-8 period, the introduction of 'sub-prime loans' allowed people with very low incomes to access cut-rate mortgages.

The result was disaster. Credit standards collapsed, as the economy headed towards its Minsky Moment. And as the blog forecast in its September 2007 "every mania is based on an illusion" letter to the Financial Times, the government was eventually forced to step in as the 'buyer of last resort', to stabilise the position.

Both Fannie and Freddie were taken over by the US government in September 2008. Their losses to date now stand at $150bn, with a lot more probably to come. Since then, as the chart from the Wall Street Journal shows, private lenders have virtually disappeared from the mortgage market.

92% of all new US mortgage loans now rely on government support. Equally worrying is that Fannie is now the world's largest bank by assets, and Freddie is in the top 10. Winding them down, as suggested in the White Paper, is going to be very costly indeed. China, for example, is owed $450bn.

In addition, the White Paper aims to "dramatically transform the role of government". Treasury Secretary Geithner wants home owners "to put more equity into their home". This, of course, will reduce home ownership by reducing mortgage eligibility and increasing costs for buyers.

The aim in the future will be "affordable housing", whether via renting or owning. This is clear enough evidence that a generational change in direction is now taking place. We will not see housing starts back at 2003-7 levels for decades, if at all.

Equally, the era of people buying the largest home they could, with the highest possible leverage, is also now behind us. It was driven by the idea it could lead to risk-free capital gains. But with 27% of US homeowners now underwater on their mortgage, this myth is also dying.

US housing was a $35bn market for chemical and polymer sales at its 2003-7 peak, with each home worth $16k of sales. Today, with house starts ~600k, it is worth just $10bn. Companies will therefore need to look to new areas for growth, if they wish to succeed in the New Normal.

UK housing markets followed the US lead in recent decades. Conservative and Labour governments both shared a belief in extending property ownership as widely as possible. But what neither foresaw was the 'unintended consequence'.

Their policy of boosting home ownership coincided with the entry of the BabyBoom generation (those born between 1946-70) into the 25 - 54 age group. This is the period when people normally settle down, marry, and have children. And UK births had risen 15% over the period versus the previous 25 years, making it the largest generation in UK history.

Naturally, they responded enthusiastically as successive governments promoted the concept of home ownership. They particularly liked the fact that any gain on the sale of one's main residence was completely free of tax. Thus rising home ownership led to the rise of the 'wealth effect'.

House prices rose dramatically as the Boomers married and settled down, allowing them to re-mortgage and extract equity. And as in the USA, they used this extra cash to buy exactly those items most linked to chemical and polymer consumption - new cars, new kitchens and new bathrooms.

Of course, this pattern should have ended with the dotcom downturn in the early 2000s. But unfortunately in the UK, as in the USA, the central bank believed it was a master of the universe. Thus as the Governor of the Bank of England told Parliament in March 2007:

"Confronted with what we saw we knew that we had to stimulate consumer spending. That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out."

Sadly, this "legacy" is now finally beginning to be sorted out. Home prices, like consumer spending, were supported during 2009-10 by record low interest rates, which meant homeowners on variable mortgages (the vast majority) had a major boost to their discretionary income.

But now, as the above chart from the UK Land Registry shows, prices seem to have begun to fall again. And Justice Secretary Ken Clarke, a successful Finance Minister in the 1990's, warned at the weekend that "I don't think Middle England has quite taken on board the scale of the problem that will emerge as the (government's) cuts start coming home."

Housing's share of China's GDP has tripled over the past decade to 6%. This, of course, has stimulated demand for chemical and polymers. But as the Bloomberg chart shows, it is also worryingly close (blue line) to the peaks seen in the USA (black line) and, before then, Japan (dotted line).

The rise has been most dramatic over the past 2 years. The National Bureau of Statistics (NBS) reports property investment jumped 33% in 2010 to 4.8trn yuan ($725bn). In December alone, it says 557bn ($85bn) was invested, whilst the value of sales was 5.25trn yuan ($800bn), up 18% from 2009.

Nationally, house price growth is clearly starting to slow as the government raises interest rates and bank reserve requirements. Average prices in December rose only 6% versus 15% in April. And the State Information Center has warned they may fall in 2011.

Yet in Shanghai, for example, NBS data also shows that average urban household income is just 36000 yuan ($5450), whilst the average 1100 square foot apartment reportedly sells for $200k. So it seems likely that we are now entering a dangerous phase, when the government will hope to stabilise prices, rather than allow them to crash.

The experience of Japan, and more recently the USA, does not suggest this will be an easy task. Thus although chemical companies will naturally continue to hope the government will be successful, some time spent on scenario planning might well prove most valuable in the future.

The blog's special series this week has focused on housing in 3 key markets - the USA, UK and China.

Housing is a core sector for chemical and polymer demand, and it has been particularly important over the past 30 years:

• The Western BabyBoomers (those born between 1946-70) have been in the 25 - 54 age group, when people typically marry, settle down and have children. Thus their demand for housing has been at its highest.
• Each new house uses a wide range of polymers, coatings, fibres and adhesives. In the US, this adds up to a total value of $16k per new house. And, of course, the Boomers have often replaced kitchens, bathrooms etc when moving into older homes.
• Equally, the rise in house prices has enabled Boomers to extract equity. They have often spent this on auto and other purchases, creating a multiplier effect for chemical and polymer demand.
• More recently, emerging economies have followed the Western lead. China is now investing 6% of GDP in the residential property area, equal to recent peaks in the USA. Unsurprisingly, this has led chemical and polymer demand to boom.

The question is whether China can be a 'special case' and avoid the problems that followed on from this high level of investment in Japan and the USA?

There are a number of warning signs, not least the pervasive belief amongst ordinary Chinese that 'the government would never let prices fall'. This belief has been proven false in both Japan and the USA, as well as in European countries such as Spain and Ireland.

It therefore seems important for companies to develop a Scenario approach to sector developments. And it also reinforces the blog's belief that Prof Michael Porter may very well be right with his new Harvard Business Review article.

His 'Shared Value' approach may well help business managers to sidestep problems in the housing sector, and instead "unleash the next wave of global growth" for their company.

The fascinating chart above from Dave Rosenberg at Gluskin Sieff confirms the blog's fears above the impact of today's high oil prices on US consumer spending.

It shows that consumers in the world's wealthiest econony have very low expectations for their real income. These are now at the 4th lowest level since the survey began. And all 3 previous troughs - in 1979-80, 1990, and 2008, coincided with spikes in the oil price. Today's low expectations fit this trend.

Consumers have no real choice about their spend on gasoline and energy bills. And its only after these have been paid, that they decide whether they can afford the discretionary spending that drives chemical and polymer sales.

Of course, sentiment indicators, even well-established ones like this from the University of Michigan can be wrong. But it just adds to the blog's sense of uncertainty about what is really happening to end-user demand, and to inventories down the value chain.

When China announced that inflation had reached 5.1% in November, the authorities insisted it was only a temporary peak. But this seems less likely today, with January's inflation still at 4.9%.

The surge in food prices is very worrying. They jumped 10.3%. And with a major drought underway in the North East, there is a clear risk that basic food prices could shoot higher, if the wheat crop is hit.

Equally, the government's loose lending policies must take some blame:

• It may have seemed a good idea in early 2009 to double lending in response to the financial crisis. But the amount was far too much, at $1.4trn, one third of GDP, in addition to a $580bn stimulus programme worth another 13%.
• Policymakers then added to the problem by maintaining a high level of lending last year, at $1.2trn. This money helped to fire up speculation on the Dalian futures exchange and in property markets.

And, as the chart shows, 2011 has continued on the same path. January's lending was still over Rmb 1trn ($158bn).

A month ago, the central bank started to tighten lending. But it seems they were then over-ruled by the politicians. Of course, interest rates were raised this month. But when one could earn 21% last year in the Shanghai property market, an extra 0.25% interest cost is a drop in the ocean.

The government seems increasingly caught between a rock and a hard place. If they now clamp down on lending, they risk a downturn in the economy. Credit bubbles of this size don't usually go quietly. But if they allow the boom in lending to continue, higher food and property inflation seem inevitable.

Sadly, therefore, the blog sees no reason to change its December view that:

"Those in charge will continue to take small steps, 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 ICIS weekly margin reports continue to provide essential reading for anyone in the petrochemical value chain.

The above chart is particularly fascinating, as it highlights the significant differences between cracker margins on a regional basis over the past 2 years:

• Europe (red column) is the clear winner over the period. Its margin bottomed at $200/t in H1 2009, and then doubled to $400/t in H2. It then rose steadily to peak at $600/t in Q3 2010, before slipping back to $300/t in Q4.
• These are astonishing results by historical standards, and particularly in the light of its low operating rates (OR%). They are explained by the relative strength of co-product prices for propylene and butadiene, and the tight feedstock position created by low refinery OR%.

• The USA (blue) did less well in 2009, but 2010 saw a strong performance due to the arrival of lower ethane prices, as shale gas production increased. Remarkably, the US is now much closer to the Middle East's (ME) 'advantaged feedstock' position. And it further benefits from being able to maximise output, whilst OPEC quotas on crude oil restrict ME ethane supply.

• NE Asia (yellow) is clearly the weakest region. In 2009, only Q3 saw a margin above $200/t, and it was again back below this level by Q4 2010, after a better H1. It is being hit, as the GTIS trade statistics highlighted recently, by increased low-cost polymer imports from the ME and the USA.
• In addition, as forecast by the blog in August, China is now running its new refinery capacity hard. This combination caused margins to drop again to the $100/t level by Q4 2010, even though as a naphtha-based region, it also benefits from co-product credits

ICIS' Paul Ray tells the blog that so far in 2011, naphtha-based producers with feedstock flexibility are benefiting from relatively weak naphtha prices and lower LPG levels. And at the same time, Q1 margins have strengthened for both ethylene and polyethylene versus Q4. Thus European margins are again leading the field, even though US ethane margins remain strong.

The blog is changing its chart for EU auto sales. The aim is to better show seasonal trends, and also enable easy comparison with US sales.

It now shows sales by month, since 2005. Performance in 2007 (green line) and 2010 (brown) is highlighted, as this represents the peaks and troughs.

January's 1 million sales (red square) were in line with 2010's performance. But this disguised a growing 2-speed performance across the region. As ACEA (European Association of Auto Manufacturers) note:

• France was up 8% and Germany 17% versus 2010, but
• UK, Italy, Spain (the other major markets) were down 12%, 21% and 24%
• And Greece, suffering from major austerity measures, saw sales fall 63%.

The OECD's leading indicators for the global economy suggest that GDP growth is continuing to slow.

As the above chart from the American Chemistry Council shows, the OECD's three key indicators have all slipped from H1 2010's peaks. The composite indicator (blue) has fallen sharply to +5% from +13%, whilst industrial production (red) is down to +8% and global trade (green) to +13%.

The reason seems to be a more varied performance by individual countries. The ACC note that:

• USA, Germany and Japan are seeing "robust expansion" relative to trend.
• Canada, France and the UK are now seeing "moderate expansion".
• But indicators for India are "pointing towards a slowdown."
• And for China and Italy they "point to a downturn".

The blog has had an exciting time in Singapore this week. 21 delegates had registered for the first-ever New Normal seminar, and we had a fantastic range of expertise in the room.

Attendees came from China, India and Saudi Arabia, as well as from South East Asia. And they represented a wide range of industries, including personal care as well as petrochemicals and polymers.

Some key conclusions were as follows:

• Events in the Middle East are creating major uncertainty in oil and feedstock markets
• Changing demand patterns in the West are impacting export-oriented economies in Asia
• Companies can therefore no longer simply focus on their own product and market silos
• Major new opportunities for growth are also emerging, such as Tata's Nano car (above)

The object of the seminar is to help companies understand the new landscape that is emerging. It was very inter-active, and seemed to be really appreciated by those who attended.

Feedback afterwards suggested that 1 day was perhaps too short to cover all the issues properly. We will therefore look at extending the time to 1.5 or 2 days for the next Seminar, which is currently scheduled for June 23 in Germany. And buoyed by this success, we will also look at dates for a US course, as well as a return to Singapore later in the year.

The blog's thanks go to everyone who attended, for a really stimulating day. Plus, of course, to fellow presenter and blogger John Richardson, as well as to Roland Kester Cher and his ICIS organising team in Singapore.

The blog's recent White Paper, 'Budgeting for Uncertainty', warned that "geo-political issues have been quiet recently, but the potential for Middle Eastern conflict cannot be ignored, with its potential to impact oil supply and prices".

Just a few weeks later, they have now taken centre stage.

Libya is the main issue, and events there are being used by speculators to hype oil prices above $100/bbl. But, even if one ignores the fact that oil inventories are at high levels, their argument is still not very convincing:

• Libya supplies only 1.8% of global output (1.6mb/d)
• The Saudis have already said they will replace this volume if necessary
• The fact of it being 'light crude' is also a diversion
• Plenty of refinery capacity currently exists to process all types of crude

• Libya is a key supplier for the future
• The Gaddafi regime is very centralised, with only tribal structures outside it
• It is also toxic, with many countries most unwilling to provide refuge - it is rumoured that even Mugabe in Zimbabwe is not keen to host the family
• Therefore whilst we might see them depart for a minor African state, there could be a bloody end

Thus there is a serious risk that the country could soon break up and become a 'failed state'. Insurgents have been operating in the south for years. And if they were now to link up with groups in Algeria, Tunisia and Morocco, there is the potential for a major uprising in a belt across the Sahara.

In turn, this would make oil E&P (Exploration & Production) very difficult, thus potentially reducing Libya's role as a key future supplier.

This, as always, would lead to recession, just at the time when a tentative economic recovery is underway. Asian GDP growth would fall 1-2%, for example: SE Asia would be spending ~15% of national budgets on subsidies.

Hopefully, policymakers are alert to this problem, after the experience of 2008/9, and will take steps to prevent a repeat performance. But whether they do or not, it is clear that economic and geo-political risks are rising.

Thus the blog maintains its White Paper advice to Boards and business managers, that time spent today in Scenario Planning will probably be the best investment they will make all year.