Chemicals & The Economy

After 2.5 years of 0% interest rates, $5trn of government stimulus and a payroll tax cut, the US economy is finally beginning to create jobs again. The jobless rate fell last month to 8.8%. And the wider U-6 jobless rate, which includes those unemployed for more than 6 months, fell to 15.7%.

In turn, this helped to boost auto sales last month, as the chart shows. For only the 3rd time since the Crisis began, sales (red line) were over the 1.1m level. They were still well below the 1.4 - 1.6m level seen in March until 2008. But one cheer is better than none at all.

Obviously there was some element of consumers buying ahead of likely price rises, following the Japanese disaster. Shortages of some models are being widely forecast, as parts supply dries up. Thus GM was able to reduce its purchase incentives to the lowest level since its bankruptcy.

Shortages are also more likely, due to a marked shift in consumer buying patterns. High gasoline prices meant sales of compacts are rising. And the ratio of car sales to trucks has reversed with cars now outselling trucks by 53%: 47%, as consumers go for more fuel-efficient vehicles.

Q1 was a very strong quarter for Western companies operating at the upstream end of the chemicals value chain:

• Plants were generally operating well, with few force majeures
• Most importantly, the crude oil price jumped 20%.

Many buyers had reduced inventory in December for working capital reasons. Then they found they had to restock in a rising market.

The boom is captured in the record reading on the IeC Boom/Gloom Index in February (blue column). But significantly, it fell back to earlier levels in March.

At the same time, the Austerity reading (red line) started to rise again. This highlights the growing number of problems in the global economy:

• December's US payroll tax reduction has helped to spur some job creation. But rising oil prices have caused consumer confidence to fall at near-record levels.
• Japan has not yet solved the nuclear crisis at the Fukushima Daiichi plant. French scientists believe it suffered temperatures of 2750°C (5000°F) around the reactor cores.
• China's economy seems to be slowing, as interest rates and reserve ratios are increased. This is described in detail in John Richardson's latest post on the Asian Chemical Connections blog.
• The Middle East is seeing continued unrest. Libya is still the current flashpoint, but pressures continue to build in Yemen and Syria.
• And, of course, in the shadows, the financial crisis in Europe is building towards a climax. Greece, Ireland and Portugal are in serious trouble, with Spain next in line.

Companies closer to the consumer are thus seeing increasingly difficult conditions. Wal-Mart, the world's largest retail group, does not exaggerate. And its CEO is now warning of "serious inflation" as "cost increases are starting to come through at a pretty rapid rate".

Overall, it is clear we are now facing the same situation as 1973/4, 1979/80 and 2007/8. So we know how this story will end. After the party, comes the hangover. It is a simple fact that the world economy has never yet been able to operate successfully with oil prices at today's levels.

And as all investors and business people know, the most expensive phrase in the English language is "this time its different".

Crude oil has been a speculators' paradise for the past 9 months. Central banks have been making large amounts of cash available at 0% interest. In turn, this has funded larger and larger speculative positions in financial and commodity markets.

CME, the world's largest derivatives market, saw volume up 31% in March vs 2010.

The chart above, from Petromatrix, highlights the problem. It shows net NYMEX length for the Large Speculator category in WTI crude oil futures:

• Since last August, when the Fed first announced QE2, the Speculators built net length of 200kbbls by December (light blue line)
• This year, they have increased this position by over 25% (green line)
• Their net length is now 250% higher than last April, and 500% larger than in 2008 - when the market was heading towards its $147/bbl peak

We are, of course, getting close to the start of the US driving season at the end of May. And already gasoline prices are approaching the $4/gal level, which has proved politically very sensitive in the past. This week, they will reach $3.77/gal nationally, and $4/gal in California.

In Europe, prices are already higher than in 2008, due to Brent's premium over WTI and currency weakness. The blog's local garage has been open 31 years, but may well now close as the working capital needs have become so large. One tanker of gasoline now costs it £250k ($400k).

Yet as noted many times in the blog, global inventories remain near record levels.

Petromatrix raise the key question - will today's high prices lead politicians to start asking questions about the value of all this speculative activity? If they do, we might discover some interesting answers.

Sadly, we still seem no closer to a solution to Japan's nuclear nightmare at the Fukushima Daiichi plants. It is now certain that there will be no quick 'return to normal'.

Tokyo itself accounts for ~40% of Japan's economy. And life there is already quite different from its pre-disaster pattern, with all non-essential lighting dimmed or turned off, and heating at low levels.

Most noticeably, according to the Financial Times, torches and batteries - not the iPad - have become "the most sought-after technology", as people seek to cope with rolling blackouts. As the WSJ chart shows above, Tokyo Electric's (TEPCO) 17 nuclear reactors are in crisis.

Only 2 are in full operation (green dots). 4 of those at Fukushima (red) are destroyed, whilst the other 2 (grey) are unlikely to restart soon, given local outrage at the company's performance. 3 reactors at Kashiwazaki Kariwa (orange dots) are still shut, 4 years after the earthquake there.

The WSJ notes that up to 23% of TEPCO's generating capacity may therefore be shut over the summer, when demand soars for air conditioning. And the situation may become worse, if damaged generating plants are included.

In turn, of course, this will impact industry and the lengthy supply chains that carry key components from Japan to the rest of the world. Just one example, again from the FT, gives a sense of the scale of the problem:

• Renesas Electronics make 40% of the microcontrollers used in the world's cars. Most cars use between 50 - 100, to open windows etc.
• Their main factory, at Naka, will not restart until at least July, as the earthquake damaged the 'clean room' where semi-conductors are made.
• It is unclear what will happen to customer orders, once current inventories run out in May. Currently, the plant still has no electricity.

The blog has been visiting Japan since 1987. Even with these vivid examples, it still finds it hard to take in the full extent of the problems. Its fear is that as time goes on, we will learn the hard way, just how bad the disaster has been.

Financial markets are different from other markets. And the way we relate to them is different too.

Shops, for example, would never seek to win new customers by advertising 'Prices increased 10% last week'. Instead, they splash red signs across their windows featuring their 'new, lower prices'.

But sellers of financial products do the exact opposite. Their advertising focuses on funds that have recently moved up in price. Neither they, nor share tipsters, spend much time on companies whose price has recently fallen.

CEO's are just the same as the rest of us. None got out their cheque book to make an acquisition 2 years ago, when most shares were dirt cheap during the height of the Crisis. But now prices have doubled, or more, they are lining up to buy.

As Bloomberg note:

• Specialty chemicals have seen deals worth $25bn so far this year
• This is the highest M&A (Mergers & Acquisition) level for a decade
• In 2010, just $3bn of deals were done in the whole of H1

Are specialty chemical prospects suddenly that much better than a year ago, or 2 years ago, when expectations and prices were very much lower? The blog, being a good contrarian, rather thinks not.

Lubrizol, Danisco, Rhodia and the other recent acquisition targets are all good businesses. But the current frenzy of deal-making is perhaps yet another warning sign that the top of the market is not far away.

The blog has an incredibly loyal following around the world. 24% of its readers visit twice a week, or more.

They also recommend it to colleagues. Visitor numbers jumped 50% last month.

The issue is the rising uncertainty over the outlook for the world economy. This has clear potential to cause problems for the chemical industry.

The White Paper, Budgeting for Uncertainty, discusses this in more detail.

Now the blog is delighted to announce two major new developments. Both are with ICIS Asia director, John Richardson, co-author of the Asian Chemicals Connections blog:

• June 16-17 will see the 2nd New Normal seminar, in Frankfurt, Germany. This follows February's very successful Singapore launch. It will cover the major changes taking place in chemical demand patterns around the world. The focus will be on:

The Value Proposition for both initiatives is very clear. The past 20 years have seen managers able to focus on developments down their vertical silo. Demand growth has been very stable, as the vast Western BabyBoom generation moved into the 25 - 54 age group, when consumption peaks as people marry, settle down and have children.

This means that we cannot rely on consumption growth, in the developed and emerging economies, to continue in a straight line. Managers instead need to refocus on understanding developments up and down the chemicals Value Chain. This will enable them to identify the challenges ahead for their businesses, and exploit the opportunities that will arise.

Further details of the e-book will be available soon. Please click here for more details of the Frankfurt New Normal seminar in June.

They don't ring bells at market tops, to warn about what might happen next. But the above chart may turn out to be the next best thing.

It shows the relationship between WTI crude oil prices (blue line) versus LLDPE (linear low density polyethylene, red line) on China's Dalian futures exchange.

The exchange has been a hot-bed of speculation for the past 2 years, powered by China's easy money programme. LLDPE has been the main proxy for those betting on the direction of oil prices. In some months, the volume traded has reached nearly 100 million tonnes.

Critically, since Q3 2008, price moves for WTI and LLDPE have mirrored each other, up and down. But now LLDPE has failed to follow the latest upward move on WTI. The last time this happened was during WTI's final run to $147/bbl, as demand destruction intensified.

And as Petromatrix note, China's own diesel and gasoline prices are now 30% higher than in July 2008, due to the removal of price controls.

The blog's friends in the trading community have been correctly bullish for the past 2 years. They say it is still too early to go short on crude oil, given the momentum that has built up. But the forces behind this speculative mania may be ending:

• China bank lending has slowed, and interest rates are rising
• The US Fed may well end its QE2 lending programme in June.

Central bank liquidity has been the life-blood of the rally over the past 2 years. As and when it slows, trouble lies ahead.

The blog spent much of 2007/8 warning of the likely impact of high oil prices on chemical demand. It was then renamed 'The Crystal Blog' in November 2008, as the full extent of the problems finally became clear.

Today we are back in the danger-zone. The chart above shows annual oil prices since 1970 - in $s of the day (blue dotted line), and $s adjusted for inflation (red line) - with extra points for H2 1990 and Q1 2011. The red shaded areas mark periods of recession in global chemical demand.

Every sustained period of oil prices above $50/bbl in real terms has been followed by a sharp slowdown in chemical demand:

• As oil prices rise, so consumers cut back on discretionary spending
• This reduces demand for those products which drive chemical demand
• Yet chemical buyers have to start buying forward, to protect supplies
• The eventual oil price peak is thus followed by destocking
• Operating rates then collapse down the value chain.

The blog saw this process at first-hand in 1979-80, as a young sales rep. Then, as in 2007/8 and today, it was assumed that the combination of tight markets with rising oil prices, meant demand was still robust. But the evidence of history makes this assumption very doubtful.

Every speculative mania, such as today's, has its own illusion. As the blog pointed out in the Financial Times in September 2007, the myth behind the sub-prime disaster was that US house prices would never fall. Now they are down 30%, and still falling.

The myth behind the crude oil rally has been that the liquidity provided by central banks is the same as capital. It isn't.

The aromatics market is a very liquid market compared to other chemical markets. It is an excellent leading indicator for industry pricing and volume trends, and forecast the current rally in April 2009.

The chart above shows how Brent crude oil prices have moved since January 2009 (purple line), versus China's prices for PTA (terephthalic acid, red), PX (paraxylene, green) and PET bottle resin (blue).

As can be seen, changes in Brent led prices higher for the C8 chain until early in 2011. But since then, they have begun to move in different directions:

• Brent has continued higher, and is nearly 200% of its January 2009 level
• The C8 chain, however, has slipped back in recent weeks

Yet PX supply problems in Japan should have led to higher prices, as China imported 1 million tonnes from Japan in 2010.

This divergence in price trends between crude oil and the C8 chain is therefore an important warning signal. Sadly, a downturn in chemical demand may not be very far away.

Chemical companies are about to report excellent results for Q1. Those upstream may well record even higher profits than in 2007/8.

CEOs and CFOs therefore face a critical decision.

Do they assume today's trends will continue, and forecast excellent profits for the rest of the year? This would be very tempting, and is clearly the easy option.

But it risks storing up major trouble for the future.

This week, the blog has provided worrying evidence that today's high crude oil prices could well be followed by a major downturn:

• China's markets for polymers and aromatics have clearly stalled
• Today's crude oil price levels have always led to downturns in the past

The cardinal rule for financial markets is, of course, 'no surprises'.

Many investors would be shocked by the idea that problems might lie ahead. But for CEOs to say nothing now, risks an even greater surprise later in the year.

Finally, the authorities have admitted that the Fukushima Daiichi nuclear problem is very serious, and still unresolved.

Its rating has now been raised to 7, the highest possible - equal to the Chernobyl disaster. The picture, from the Wall Street Journal, shows the state of the reactor building on Sunday.

Equally, the impact on the global auto industry is being more widely recognised. One senior manager at a German major told the blog that his company regard the issue as being "very serious - people don't realise just how serious it is".

Toyota will likely lose 40% of their global production in Q2, for example.

The key issue is the lack of electricity. This cannot be restored quickly, as the power stations need to be repaired and many of the nuclear reactors are offline. Japan also looks likely to be prioritising household supply over the summer, rather than industry.

The blog was in Brussels this week, chairing the ICIS European Purchasing Conference.

It was a packed room. Buyers are clearly very concerned about the high level of current raw material prices, and their volatility.

I was also interviewed by ICIS' Will Beacham. The discussion covered:

• The effect of high oil prices on demand
• The risk of a downturn and
• The likely impact of the ageing BabyBoomers (those born between 1946-70) on future demand patterns.

Please click here if you would like to see it.

China's inflation hit 5.4% last month. As the chart above shows, it has more than doubled over the past year. And food prices jumped 11.7%. Clearly, inflation is now out of control, with the Ministry of Finance admitting the situation is "severe and hard to handle".

A sign of the scale of the problem is that the government is taking increasingly desperate measures in response:

• Major industry associations have been ordered to delay or cancel all price increases
• Price controls are being applied to basic products such as flour and cooking oil.

Equally, it is still moving far too slowly on the key issue - the credit bubble that has developed as a result of its bank lending binge of the past 2 years. Q1 bank lending was down 13% versus 2010, but at $330bn it was still 70% above 2008's pre-crisis level.

Sadly, therefore, the blog sees no reason change its December view that China is between a rock and a hard place in terms of policy options. It feared then 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 first signs of this bust may now be emerging. An excellent ICIS Insight analysis by my blogging colleague, John Richardson, suggests "sharp corrections are on their way" in many key petchem markets. Its title says it all - "Events in China could signify dark days ahead".

UPDATE: China has raised reserve ratios by a further 0.5% today. Whilst the IMF has warned of "boom-bust cycles" if Asian governments fail to deal quickly with overheating problems

The chart above is a flashing amber light for European cracker operators. Based on ICIS Pricing data, it shows the delta between (a) European and US ethylene contract prices (blue line), and (b) Europe and the North East Asian spot price (red line).

Usually, these deltas range between -$50/t and $100/t. H2 2008 was clearly exceptional, as Europe was still on a quarterly contract system whilst crude oil was collapsing from $147/bbl to $31/bbl. But since then, Europe's prices have generally been much higher.

This might not have mattered much in 2009-10, when lower refining runs, and OPEC quotas, limited olefin production in Europe and the Middle East. Equally, as LyondellBasell noted in November, force majeures meant the US didn't fully exploit its shale gas-based feedstock advantage.

Of course, ethylene itself hardly moves between regional markets, due to shipping and logistic costs. But its derivatives, such as polyethylene (PE), ethylene glycol (MEG) and PVC, can certainly move quite easily.

And today, export volumes seem to be increasing, as one would expect when the US and NE Asia enjoy near-record ethylene price advantages of $500/t and $400/t respectively versus Europe:

• ICIS' Nel Weddle has noted that 20% of US ethylene derivatives are now being exported, and up to 40% of PVC production
• Similarly, as ICIS' Linda Naylor reports, re-exports of PE from China are expected to arrive in Europe during Q2

Of course, Europe's producers have little room for manoeuvre. Crude oil and feedstock prices are also at record levels versus US natural gas. But if China is really slowing, and US producers are stepping up their exports, the rest of this year could become very difficult indeed.

The decision by S&P, the ratings agency, to put the USA's AAA debt rating on review is a potential game-changer for US economic policy. It means that policymakers can no longer pretend the $5trn they have spent over the past 2 years on stimulus measures somehow "doesn't count" in terms of needing to be repaid.

Oil markets will be first in the line of fire. The S&P move makes it much less likely that the US Federal Reserve will be able to follow QE2 with QE3. And QE2 has been the prime reason why oil prices have risen from $75/bbl to $125/bbl since August, when it was first announced.

Attention will now start to shift back towards the fundamentals of supply and demand. So the reactions of Saudi Arabia and Russia, as the world's two largest oil producers, are critical. In 2010, they produced 25% of total output. And today, they seem to have differing viewpoints:

• Russia's Finance Minister says he still expects prices to fall to $60/bbl at some point in the next 2 years. And he warned that "with oil prices above $110/bbl we are already in the zone of a slowing global economy".
• Saudi's Oil Minister has agreed that the "market is over-supplied". But his response, as the Petromatrix chart shows, has been to cut output.

This reaction mirrors the Saudi response to lower oil demand in the 1980s. Between 1981-5, production was cut from 10.3mbd to just 3.6mbd, in an effort to support a $30/bbl oil price ($85/bbl in 2011 money). Prices then collapsed to $16/bbl in 1986. And it took till 2003 before Saudi production regained the 10mbd level.

Today, Saudi probably needs to sell at least 8mbd at a price of $70/bbl in order to balance its budget. This could prove a very difficult balancing act, if demand really does weaken. So this pre-emptive move by Saudi, to cut production early, makes perfect sense. But whether it will be enough on its own to hold prices, remains to be seen.

EU auto sales are a critical market for chemical companies. So far, 2011 volumes have been stable, down just 2% in Q1 versus 2010. But the trend seems to be weakening, with March volumes at 1.6m down 5% (red line), as shown in the above chart based on ACEA data.

The key worry is the continuing divergence between the major markets. Normally, the 'Big 5' move together. But many countries are facing major debt problems. This is causing their populations to become much more cautious about making 'big ticket' purchases such as autos:

• Germany was the largest market in Q1, with 763k sales, up 14%
• France was also strong, with Q1 sales of 647k up 9%
• But the UK was down 9% with 558k sales
• And Italian sales fell 23% to 513k, whilst Spain was down 27% at 208k

Outside the 'Big 5', the Netherlands (up 25% to 181k), and Belgium (up 5% to 169k), were the main support for sales.

There seems little chance of any quick solution to the European debt crisis now impacting Spain, Portugal, Ireland and Greece. So the question is whether Germany, France, Netherlands and Belgium can continue at present levels. There are also growing concerns that component supply problems ex-Japan could have an increasing impact as time goes on.

The South China Mall opened nearly 6 years ago. Nearly 3 times the size of Minnesota's vast Mall of America in the USA, it supposedly symbolised China's arrival as a consumer power.

But as this Australian TV video shows, the Mall today is virtually empty. As are numerous other shopping malls built more recently. Yet it was supposed to attract 70000 shoppers every day.

This is because China's drivers of economic activity are different:

• The phrase 'middle class' doesn't mean the same as in the West, where average GDP/capita West is ~$40k. In China it is only a tenth of this. 94% of taxpayers earn less than $8k a year.
• Equally, China's reported GDP figures reflects its status as a 'command economy'. Its GDP figure is a target for the regional party bosses to achieve, not a statistical report.

China's construction activity has been a great growth story for the chemical industry. But there are now 64.5m empty apartments and houses in China's urban areas. These have been bought speculatively, on the basis that "the government would never let prices fall".

Yet food inflation at 11.7% means the government risks serious social unrest if it fails to tighten economic policy and lending. But if house prices then begin to fall, what happens next?

ICIS pricing reports are a treasure trove of information for buyers and sellers. They can also provide an interesting insight into the overall mood of the chemical industry.

This might be one of those times. My blogging colleague, John Richardson, noticed several pricing reports mentioned last week that buyers were operating on a 'hand to mouth' basis.

It turns out 10 separate reports* each contained this phrase. As the chart above shows, 5 came from Europe, 2 from China, and 1 each from the Middle East, Asia and the USA. Most were from the polymer chain, where 6 reports mentioned the phrase.

This suggests that some buyers are nervous about future price moves. Probably they were building inventories as oil/feedstock prices rose, and would now like to reduce these to more normal levels.

Of course, there is nothing to say these buyers are right to be cautious. Oil prices might be about to leap up again. But its certainly interesting as anecdotal evidence of buyers' expectations.

* Thanks to Barbara Ortner and Harriet Bourne for the research

The New Normal has definitely arrived in the US housing market.

US new home sales are down 80% from their peak, and builders are getting desperate. Offers in the Chicago area now include a $17k credit for a GM car, when a buyer closes the deal.

As the New York Times comments, "a long-term shift in behavior seems to be under way":

• Buyers no longer want "the biggest and the newest"
• Insead, they prefer "something smaller, cheaper"
• They also want to be "as close to their jobs as possible"

These are dramatic changes, with major implications for chemical companies.

The blog will soon start exploring the key demographic issues behind these changes, in a new eBook, co-authored with John Richardson.

Titled 'Boom, Gloom and the New Normal - How the Western BabyBoomers are changing Chemical Demand Patterns, Again', it begins publication on ICIS.com next month.

A major demographic shift is underway in the Western population. 253 million babies were born in the 1946-70 period in the G7 wealthiest countries (USA, Japan, Germany, France, UK, Italy, Canada).

They have driven consumer spending over the past 15 years, as the majority of them moved into the 25 - 54 age group. This is when people typically marry, settle down, and have children.

But now, they are moving into the 55+ age group. They are starting to save more and spend less. They have to save much more, as their life expectancy is 10 years longer than the previous generation's.

And the younger generation is 38 million smaller. Only 215 million babies were born in the G7 between 1971-95. Thus consumption of many current products will fall 15%.

Equally, of course, the ageing BabyBoomer population will instead want to buy new products and services. This will create plenty of opportunities for companies to increase their sales, at the expense of those who remain stuck in the Old Normal.

This challenge is the basis for the next New Normal seminar, to be held in Frankfurt, Germany on June 16-17. It is a vital issue for anyone involved in commercial or planning activities.

I hope to see you in Frankfurt.

The major retail groups are excellent indicators of future trends in chemical consumption.

Since before the Crisis began, consumers have been focusing more on price and value-for money. Now Wal-Mart is reporting that consumers face "more pressure than a year ago".

This suggests that demand destruction is already well underway. And Wal-Mart CEO Mike Duke notes they are seeing:

• More shopping at the start of the month, after paychecks arrive
• More use of online comparison shopping, to identify low prices
• Food price inflation is having a major impact
• However, consumer electronics sales are benefiting from lower prices

Duke added that higher fuel costs are a major factor.

The problem is that average US gasoline prices are already close to their all-time high in 2008 of $4.16/gal, even though crude oil is still $35/bbl below its peak. This is because of lower refinery operating rates. Duke noted these high prices "are really having an impact on the consumer".

There are always two sides to every debate.

Dow Chemical CEO, Andrew Liveris, clearly has a radically different point of view to the blog's about the likely outlook for China's demand.

Liveris told analysts in this week's earnings call that "any indications of high inventories (in China) are likely to be transitory". As ICB editor Joe Chang reports, he went on to describe China demand as "quite robust", arguing that:

• "There is some decline in credit growth due to tightening to curb inflation, but the Chinese run a fairly directed economy, so it's really to avoid the speculative side on property"
• "Household savings are still very high and the government's 5-year plan is to stimulate the domestic sector. So any aberrations of the inventory kind are very short term"
• "They're spending on infrastructure, energy, the environment, new materials for aerospace and automotive, and that is all very directed"
• "In the next five years, they want to spend $1.7 trillion (€1,120bn) in these sectors".

Liveris concluded that "I don't think we have a lot to worry about in the short term".