Chemicals & The Economy

Shipping markets are usually a good leading indicator of future economic activity.

They have their own supply/demand balances, of course. Not every uptrend or downtrend can be taken too seriously.

But the Baltic Dry Index of ocean freight costs has done a good job for the blog in the past.

So one cannot simply dismiss its message today.

It is an excellent proxy for world trade and activity in China, as it covers the heavy bulk products (iron ore, grains, coal). It was strong through 2007/8, before collapsing. Last March, it was the first indicator to signal the start of China's slowdown.

As the chart shows, it has now been falling steadily for over a month. Day by day, every day. So far, it has fallen for 28 days in a row. This is quite remarkable behaviour for any market.

It is now back at the levels seen in December 2008.

Optimists who believe that China is about to see a renewed boom will continue to ignore the Index. They will argue its decline simply reflects the fact that too many ships were ordered at the height of the boom.

But this seems too simplistic a response. The recent price weakness is far too dramatic to be simply reflecting this already widely known fact. The blog suspects that the Index is also reflecting a serious slowdown in world trade. It is yet another sign that a new recession is probably underway.

UPDATE. The Index today fell 2.6% today, and is now at a 25 year low.

The US housing market was the original cause of the current financial crisis. It has gone quiet recently, but this does not mean that the problems are resolved. Quite the opposite, in fact.

True, foreclosures have slowed recently, due to legal issues. This is helping to boost consumer spending temporarily, as people stop paying their mortgage whilst they wait to be evicted. But there are still 14 million homes at risk, once the system starts working again. And prices have already begun to fall again.

Equally, the Federal Housing Agency has taken over the business of making risky loans, to help support the market. But according to Barrons, the US investment magazine, 18% of its loans are now missing one or more payments. And it only has $1.2bn of capital supporting $1tn of loan guarantees, so its finances look risky, to say the least.

The chart above shows the impact on housing starts (blue line) and on permits to build new houses (red), since records began in 1959. Quite clearly, the past 3 years have marked a completely different period:

• 2011 starts were just 607k, and permits 612k
• They were never before lower than 939k even in 1975

The issue is that the ageing of the BabyBoomers means that the rate of household formation has reversed. There are fewer young people in the Wealth Creator 25-54 age group to need new homes. And high youth unemployment means they cannot usually afford them.

So the new trend, as we describe in chapter 8 of 'Boom, Gloom and the New Normal', is for families to move back in together. 51% of Americans (17%) are now living in homes with two adult generations, up from 42 million in 2000:

• The 'parent' adults are worried about future medical bills, so don't want to spend money on a home when prices are still falling
• The adult 'children' often have both parents working, so want to avoid the cost of childminders
• There is also a Shared Value aspect to the arrangements, as the grandparents have someone to look after them if they become ill, whilst they can monitor the children's behaviour when the parents are working

Encouragingly as well, Lennar, the 3rd largest US housebuilder, has picked up on this trend. They are now marketing 'Next Gen' homes in 40 communities, under the slogan 'the home within a home'.

These homes are not the traditional 'granny flat' where granny lives once her husband has died. They have separate cooking areas, and allow both sets of adults to be independent within the shared accommodation.

This is the New Normal in action. It is different from the 1982-2007 SuperCycle, and is not easy to navigate. But it provides excellent opportunities for those who are prepared to take the time and trouble to understand what is happening.

We hope the examples in Chapter 8, and our new strategy courses, will help companies go up the necessary learning curve as fast and profitably as possible.

The blog, like many readers, has become rather fond of the IeC Boom/Gloom Index since it was launched in June 2009. The aim to was to track market sentiment, and it continues to perform this task.

It also throws up intriguing parallels, and sometimes disconnects, with financial markets. As the chart shows, this month is a classic case.

The Index itself (blue column) remains deep in Gloom territory, with a reading of 2.2. This is not the lowest reading on record, which was 1.4 in January 2009. But it is matched by the Austerity reading (shown last month) which continues to work its way higher.

Meanwhile, however, the world's main stock market index, the S&P 500, is attempting a rally. So far this is making good progress (red line) towards its recent high of 1365 back in April, and is now over 1300.

We have been here before, of course, during the end-2007/early 2008 period. Then the Index was also (correctly) in Gloom territory, whilst financial markets continued to appear in good shape.

Will this pattern repeat itself this time? Or will it be the Index that adjusts to a more optimistic outlook? The fascination of the Index is that it highlights the key questions. It also, as today, provides another view to Wall Street's euphoria.

Dow Chemical is usually optimistic. 6 months ago, for example, it reported that "our transformed portfolio, underpinned by our cost-advantaged and flexible operations, is now performing at a new level."

Last week, however, Dow reported that Q4 operating rates were down from 81% in 2010 to 72%, and warned it faced "headwinds" in all segments apart from agriculture. Dow added that "times like these demand a focused approach and strong resolve, and Dow's firm operating discipline, cost control and productivity will continue throughout 2012."

Yet next day, financial markets turned euphoric, with the S&P 500 and oil prices jumping 1.5% in response to the monthly US jobs report.

Demand, as always, will determine whether markets are right to climb today's 'wall of worry'. So far this year, it has been relatively subdued, and gives no indication that either Western or Asian consumers are feeling full of confidence about the year ahead.

The chart shows market developments over the past year. Product price changes since the 29 April peak, with ICIS pricing comments, are below:

HDPE USA export (purple), down 14%. "US spot export prices are too high for most markets"
Naphtha Europe (brown dash), down 11%. "Demand from both the petrochemical industry and the gasoline sector have declined"
PTA China (red), down 10%. "Chinese fibre market has yet to resume full production after the holiday"
Brent crude oil (blue dash), down 10%
Benzene NWE (green), down 5%. "There had been an expectation that buyers would enter the market, but this has so far failed to materialise"
S&P 500 Index (pink dot), down 1%

Short-term pressures have come to dominate financial markets in recent years. In turn, they have become dominated by high-frequency trading, which frequently accounts for over 60% of all market action.

Their trading is not based on careful analysis, but on extremely fast 'black box' computing, which generates 'trading opportunities' in micro-seconds. Their power is enormous, as Friday's US market action showed in response to US jobless figures.

This is a pity, as the detail of the jobless figures themselves, and of those for personal income, provides valuable insight into the current state of the US economic recovery. As the chart shows:

• The number of US jobs (blue column) bottomed at 129m in Q4 2009
• It has since seen a slow but steady recovery, quarter by quarter
• But the current total of 132m jobs only matches that seen in 2001
• Disposable per capita income (red line) was $33.8k ($2005) in Q2 2008
• In Q4 2011 it was only $32.4k, and also lower than at the end of 2010

This is a completely different picture from anything seen in the past:

• Every 10-year period since 1939 (when jobs records began) has previously seen an increase in the number of jobs created. The past 10 years are the first time this has not happened.
• Similarly, every 2-year period since 1969 (when income records began), has previously seen a rise in real ($2005) disposable income. 2011 was the first time this has not happened.

Equally, the percentage of those unemployed for more than 6 months is at levels not seen since the Depression in the 1930s.

Of course, we can all hope that January's rather modest jobs growth finally marks the start of a major upturn. But hope is not a strategy. It is certainly not a good reason for assuming that Friday's euphoria means financial markets know something that the rest of us have missed.

The comparison with historical trends shows no sign of the strong job creation and rising disposable incomes that have powered economic recovery in the past.

Last April, China's polyester market provided an early warning signal that the current downturn was about to start. Now, it is flagging an important change in relative positions within the value chain.

9 months ago, the divergence between crude oil prices and those for the C8 chain highlighted slowing end-user demand. The chart above updates the picture since then:

• Brent (purple line) is ~150% above its January 2009 level
• PTA (red) peaked at ~130%, but is now only ~75% above this level
• PET (blue) peaked at ~110%, but is also now ~75% above this level
• PX (green) has been relatively stronger, and is 100% above this level

This, of course, is very bad news for those who have invested in PTA and PET. They are suffering value leakage in relation to paraxylene (PX) prices, rather than adding value.

The reasons are probably three-fold:

• Slow end-user demand means products close to the oil barrel have greater pricing power than those downstream
• Lower Western refinery operating rates are reducing mixed xylene production, and increasing the differential necessary to justify extraction
• A massive jump in Asian PTA capacity (primarily in China) is not being accompanied by a similar increase in PX supply

The jump in Asian capacity repeats the pattern seen in the early 2000s, when China first boosted PTA production. Fellow-blogger Malini Hariharan noted last month that nearly 11.5MT of new capacity is expected in Asia this year, whilst only 1.4MT of new PX supply is scheduled.

Major shortages, and considerable market disruption, could therefore occur if the new plants all bid for the same few available feedstock parcels. This wouldn't happen in the West, where issues of profitability would take priority. Producers would instead optimise margins by selling PX and covering their PTA commitments by purchases.

But China's philosophy is not so profit-oriented. Instead, due to the often close linkages between companies and government, the need to maximise employment can have priority. This is especially true in a year when major politburo elections are underway, and the need for social stability is strong.

Russia has been the great exception in regional chemical markets.

Normally, production growth starts at a high level, often 15% a year or more, and then slows as markets become more mature. But in Russia, output collapsed with the Berlin Wall after 1989, and growth was actually negative until the mid-2000s.

Since then, there has been a strong recovery. This makes sense from a feedstock perspective, as Russia was the world's largest oil producer in 2009-10 (as Saudi operated OPEC quotas). Oil is now setting new post-Soviet records at 10.3mbd, with gas output also increasing.

As always, the blog is grateful to Sergei Blagov of ICIS news for the data in the above chart, and further insight into some key areas:

• Production growth slowed during 2011 from 2010's very high levels
• Fertiliser output (blue line) grew 5% to 19m tonnes
• Polymers output ( red) grew 9% to 5m tonnes
• Synthetic rubber output (green) was up 5% at 1.4m tonnes

These were still strong rates by historical standards. Polypropylene was particularly robust, up 12% at 722KT: polyethylene was up 8% at 1.65MT; polystyrene was up 14% at 348KT; and PVC was up 6% at 636KT.

Mahathir Mohamad is one of the Grand Old Men of the Asian political establishment. He was Malaysian premier from 1981 - 2003, and led its rapid modernisation and economic growth. Over the period, which included the Asian financial crisis, the former colony's economy grew four-fold in real terms, and it is now the 37th largest in the world.

His comments from an Asian viewpoint to the BBC on the problems facing Europe are thus well worth noting. He suggests that:

"Europe must face up to the new economic reality. Europe... has lost a lot of money and therefore you must be poor now relative to the past. In Asia we live within our means. So when we are poor, we live as poor people. I think that is a lesson that Europe can learn from Asia."

"You refuse to acknowledge you have lost money and (that) therefore you are poor. And you can't remedy that by printing money. Money is not something you just print. It must be backed by something, either good economy or gold. I think you should go back to doing what I call real business - producing goods, providing services, trading - not just moving figures in bank books, which is what you are doing."Mahathir agreed "with a laugh" with the BBC, this was a tough message:

"We used to get tough messages from you before, remember? And now, what is the result? Sometimes you undermined our currency and we became very poor. Well, we learn from each other. We were Euro-centric before. I think it should be a little bit Asia-centric now."

China's bank lending fell 7% in 2011, following a 17% decline in 2010. As the chart shows (red column), the government is clearly trying to stabilise the position, after the panic increase in lending in 2008/2009. (January lending, impacted by Lunar New Year, was down 29% vs 2011).

Electricity consumption growth (blue line) also seems to be stabilising. It is a lagging indicator, as it takes time to expand electricity production. But the ending of subsidies for rural home appliances helped to push their sales down 33% in January versus 2011.

The reason for the government's caution is that food price inflation remains out of control. It was up 10.5% in January, reversing recent declines. In a country where 96% of the population earns less than $20/day, food prices matter a great deal.

Those analysts with a purely financial outlook seem to have missed this critical point. They have been forecasting further stimulus programmes for some months. But very little has yet happened. Instead, the government remains focused on maintaining social stability.

This is particularly important in the run-up to the major changes that will take place in politburo membership this year. Thus, instead of reductions in interest rates, the government has instead announced minimum wages will rise 13% a year until 2015:

• In Beijing, it is currently $200/month, and $140 in urban Chongqing
• The aim is for it to be at least 40% of average wages by 2015
• At present, it varies between 20%-30%, depending on region

This will boost domestic spending power. But, as we argue in our Boom, Gloom and the New Normal eBook, affordability will be the key factor. Those companies who focus on meeting the population's basic needs for food, water, shelter, health and mobility should do very well indeed.

Over the past 18 months, the main investment analysts have argued that high oil prices would have no impact on the global economy. Now, new forecasts suggest their optimism has been misplaced.

The chart above gives the International Energy Agency's latest forecast of likely oil demand growth this year:

• It has been reduced by a further 0.3mbd since January
• Total 2012 oil demand growth is forecast to be just 0.8mbd
• Global economic growth is now forecast at just 3.3%, down from 4%

Sustained high oil prices are indeed reducing economic growth, and oil demand itself, just as they have done every time in the past.

Even the idea that China would "inevitably" see strong demand growth has proved wishful thinking. The IEA forecasts just a 0.4mbd increase in China's oil demand this year. And even that may turn out to be over-optimistic, given the clear slowdown now underway.

As the blog has long feared, the chemical industry will now have to pick up the pieces, after the damage has been done:

• Today's oil and feedstock price levels mean that working capital costs are very high compared to historical levels. This reduces the cash available for product and market development.
• They also increase market volatility. The lack of inventory means small changes in demand can cause major swings in market prices, if producers or consumers have to cover supply chain problems.
• Even more critically, as we are seeing with the Petroplus refinery bankruptcy, there is a real risk of supply disruptions for feedstocks and raw materials, if key plants can no longer afford to operate.

Product price changes since the 29 April peak, with ICIS pricing comments, are below:

HDPE USA export (purple), down 14%. "US spot export prices are still too high for large quantities to be sold in many markets"
PTA China (red), down 10%. "Buying activity slowed down clearly as compared with last week because the persistently weak downstream polyester sales curtailed buying interest"
Naphtha Europe (brown dash), down 7%. The Petroplus bankruptcy led traders to build inventory in anticipation of "stronger demand from both the gasoline blending sector and petrochemical end-users"
Brent crude oil (blue dash), down 6%
Benzene NWE (green), down 4%. "Price ideas edged up in line with stronger US and Asia numbers as well as steady-to-firm energy costs"
S&P 500 Index (pink dot), down 2%

US petchem producers are planning a major boost to ethylene capacity. They now have the 2nd cheapest feedstock in the world, due to ethane from shale gas. The only question is, where will they sell their product?

Ethylene, of course, is very expensive to export. So derivatives such as polyethylene (PE) are the main way to tap export markets. Today, using trade data from Global Trade Information Services, the blog looks at the outlook for PE in the US's largest export market, China.

China should present a wonderful opportunity. Market growth has slowed to normal rates following the end of stimulus programmes. But its production is largely based on crude oil, and so is far more expensive than NAFTA's. Yet, as the chart shows:

• China's net imports from NAFTA fell 53% between 2009-11
• This was despite a major increase in their cost advantage
• The USA saw its net exports fall 51%, from 947KT to just 461KT

The reason is that China does not focus on profitability as a major driver for business. Instead, it emphasises social and political factors:

• Social. Sinopec continues to increase its own production, even though its total chemicals EBIT between 1998-10 was just Rmb84bn, compared to total chemicals capex of Rmb166bn. No Western company would invest on this basis. But Sinopec's role is to act as an utility, providing reliable supplies of raw materials to China's factories to keep people employed.
• Political. China is, however, increasing its PE imports from the Middle East (up 69%) and SE Asia (24%). The ME and China operate a 'strategic corridor' which balances China's need for energy imports with the ME's need for markets. Whilst SEA has a free trade area with China.

The result is that producers in NAFTA, NE Asia and Europe have all seen a major decline in export volumes since 2009. In turn, of course, this has led to greater competition for the USA in other markets.

Tomorrow, the blog will analyse how has impacted US exports to Brazil, currently the world's fastest-growing major market for PE.

As promised, the blog looks today at the performance of US polyethylene (PE) exporters in Brazil.

It was the fastest-growing of the major markets in 2011, as the wider economy benefitted from China's demand. Since 2008, Brazil's PE net imports have grown 78%, from 445KT to 793KT in 2011. But as the chart shows (based on data from Global Trade Information Services):

• NAFTA (red square) has seen its market share decline from 40% to 38%, despite its growing cost advantage since 2010 due to shale gas
• The reason is that China's changing market dynamics (as discussed yesterday), has led to greatly increased competition

USA net exports have grown 51% over the period, from 171KT to 258KT. Canada's exports have also increased from 6KT to 32KT. But at the same time, many more players have entered the market:

• Latin American exporters (blue line) have been the big losers
• Their share has dropped from 42% in 2008 to 24% in 2011
• The Middle East (dark blue) has jumped from 2% to 13%
• Europe (green) has maintained its position, rising from 8% to 10%
• SEA (brown) has jumped from 1% to 6%
• NEA (dark green) has increased from 3% to 4%
• India (purple) has gained a 1% share

In turn, this has led to a decrease in relative profitability. GTIS data also shows that Thailand, for example:

• Sold in 2008 at an average $1825/tonne, $100/t above USA levels
• But in 2011 it sold at $1546/t, $50/t below USA levels

Brazil's market dynamics therefore highlight the increasing challenge being faced by US exporters. Countries no longer able to sell their output to China will not simply reduce production. Instead, they will target new markets, increasing competitive pressures around the world.

Greece's debt default saga seems never-ending. And it is tempting to hope that it only matters to those suffering in Greece and the PIIGS countries (Portugal, Italy, Ireland, Greece, Spain).

But a look at auto sales trends since 2005 gives a different picture. As the chart shows, based on ACEA data, sales in the 5 PIIGS countries have seen a sharp decline since the crisis began:

• 4.8m autos were sold there in 2007, 31% of total EU sales (blue column)
• Only 2.9m were sold in 2011, a fall of 39%
• Italy's sales (green line) were down 30% to 1.7m
• Spain's (red) were down 50% to 0.8m
• Portugal's (orange) were down 24% to 0.2m
• Greece's (purple) were down 65% to 0.1m
• Ireland's (brown) were down 52% to 0.1m

It is also clear that further declines are inevitable, as earlier stimulus such as 'cash for clunkers' is replaced by austerity programmes. Those losing their jobs in the public sector, or seeing their pensions reduced, will suffer a permanent loss of purchasing power.

Even more worrying is that a vicious circle is now underway. Jobs are starting to go in the private sector within the PIIGS, and amongst EU companies who supply there, further damaging the sales outlook:

• Italian auto maker, Fiat, sold 928k cars in 2011, versus 1.2m in 2007
• France's PSA, the EU's 2nd largest manufacturer, sold 1.6m versus 1.9m
• Renault COO, Carlos Tavares, has suggested current price wars could lead to a major bankruptcy
• He added "you cannot continuously be in the red. Somebody some day has to pay for it."

Already PSA has announced 6000 job cuts, and said that production needs to be cut short-term to conserve cash-flow. Whilst
Fiat CEO Sergio Marchionne has warned that Europe needs to "cut 10% - 20% of its car manufacturing capacity".

January was not a great month for auto sales in the 3 major markets of the USA, EU and China. These amount to over 50% of global auto sales, and are a key indicator of underlying consumer demand.

As the chart shows, sales were just 3m (red square), down from 3.2m (green line) in 2011:

• China's volumes were down 17% to 1.2m from 1.4m
• EU fell from 1.04m to 0.97k
• Only the USA saw a rise to 0.9m from 0.8m

Of course, China's sales were much slower than last year due to the Lunar New Year taking place earlier than in 2011, and combining with the Spring Festival. But even so, China's auto industry is only forecasting 8% growth this year - in line with the 6% seen in 2011. This is well down on the 33% and 49% increases seen during the stimulus period.

It is also difficult to be optimistic about EU sales, with auto companies forecasting sales declines of 6% or more this year. Whilst sales growth forecasts in the USA will be tested by today's high gasoline prices.

This time last year, the petchem industry stood on the edge of an unseen precipice. Life seemed good. Prices were racing ahead and demand appeared buoyant. But in reality the buyers were only buying forward to protect margins, whilst end-user demand was slowing fast.

This year, the blog fears, we may be about to take one step forward.

As last year, the evidence comes from ICIS market reports. The highly experienced Linda Naylor last week reported buyers commenting as follows in European polyethylene and polypropylene markets:

"'We expect an increase for ethylene in March, so we are buying our full contracted volumes in February, and also in January, even though our demand is poorer than we expected. That way, we won't have to buy so much in March."

"'Our demand is below what we expected but we are taking our full contracted volumes to be able to have a buffer next month."

Similar warning signs are reported by Becky Zhang in China's ethylene glycol markets, and Helen Yan in Asian butadiene:

"'The market is full of offers and this [has worsened the] bearish sentiment', a major regional trader said. China's port inventory reached a historic high of over 750KT, with increased import volumes arriving from all over the world. This is almost exceeding China's maximum storage capacity of around 800KT."

"'BD prices are higher than BR and this is not sustainable,' another synthetic rubber producer said."

The chart shows how prices for the benchmark products have seen 3 major rallies since 2009. These followed the 3 major stimulus packages.

Today's rally began with Q4's US Federal Reserve's $400bn Operation Twist programme. It is clearly much weaker than those which followed the March 2009 and August 2010 quantitative easing programmes.

Product price changes since the 29 April peak, with ICIS pricing comments, are below:

HDPE USA export (purple), down 11%. "Offers for re-exports from China were heard at lower prices than offers from the US Gulf"
PTA China (red), down 11%. "The current supply and demand balance as well as volatile external markets did not support a solid upturn"
Naphtha Europe (brown dash), down 7%. "Vitol continued its naphtha buying spree, taking 5 cargoes after it bought eight cargoes last week"
Brent crude oil (blue dash), down 5%
Benzene NWE (green), down 4%. "Continued buoyancy on crude and energy numbers counterbalanced by lower demand."
S&P 500 Index (pink dot), no change

An excellent new report from Citi's commodities team suggests the US supply/demand balance for crude oil is undergoing fundamental change.

Importantly, they also argue that the concept of 'peak oil is being buried', and add:

"The belief that global oil production has peaked, or is on the cusp of doing so, has underpinned much of crude oil's decade-long rally".

US OIL MARKETS
As Citi note, the arrival of shale oil in the USA and the associated liquids from shale gas, is now "leading the US to be the fastest growing oil producer in the world".

The Citi chart above provides dramatic evidence for the first assertion. It shows that the US has become a net exporter of refined oil products (gasoline, diesel, jet fuel etc) for the first time in 60 years. The scale of the turnaround is also important. The US imported 2.5mbd in 2005, but exported 360kpd in H2 2011.

Citi argue there is little reason to expect this trend to change. Not only is more oil being produced all the time, but US demand is also declining:

• On production, the key is developments in states like N Dakota, where companies are applying shale gas drilling techniques to shale oil deposits
• On demand, Citi share the blog's view that higher prices reduce the ratio of oil demand growth to global GDP growth. Higher auto fuel standards, the attractiveness of shale gas, and increasing use of ethanol will also reduce oil demand

Citi thus expect the US "to achieve energy independence this decade". This has been long-delayed since the goal was announced by then President Nixon in reaction to the 1973 oil crisis. But not only are the tools to achieve it now available, but also the political will.

PEAK OIL DOUBTS
The concept of 'peak oil' was originally invented in 1956 by a Shell geologist, M King Hubbert, and gained credibility from its accurate forecast that US oil production would peak between 1965-70. However, as the blog noted last year, Hubbert's other forecasts were less successful. The USA produced 7.5mbd in 2011, rather than just the 1.5mbd he expected.

The major influence of the peak oil story has been in commodity markets.

As we noted in chapter 3 of 'Boom, Gloom and the New Normal', pension funds and others have been sold the idea that oil and other commodities represent a 'store of value' whose prices will always keep rising. Thus they have continued to buy, even though demand is falling and inventories are comfortable.

The major impact of the Citi argument is initially on US markets. They therefore expect the recent disconnect between WTI and global markets to continue.

Yet now the 'peak oil' theory is being challenged, the door is also opening for other countries to exploit the large deposits of shale gas and shale oil that exist outside the USA.

The US S&P 500 is the most important stock index in the world. It contains 500 different major companies, in a wide variety of industries, and has been calculated since 1957.

There has never been a day when all 500 stocks moved in the same direction. This is not surprising, as good news for one company or industry can often be bad news for another.

Until June last year, there had only been 5 days when 490 of the stocks moved together, after an external event such as the 9/11 tragedy.

Yet in just the second half of last year, according to the Financial Times, there were 6 days when 490 stocks all moved together. This is the 'correlation trade' in action. And as the chart above shows, the correlations extend across markets and include oil prices.

The reason is the rise of high-frequency trading. These are computer 'black-boxes' which are programmed with complex algorithms to trade vast numbers of contracts on a micro-second by micro-second basis.

They account for 70% of all US equity trading. But they do not exist to perform the usual function of financial markets, which is price discovery. Nor do they provide liquidity, as the boxes only trade when they choose.

Now a major new study shows how this "computerised trading has created a new world, one where the usual rules don't apply, populated by algorithms and only dimly understood by the people who made them".

The study looks at 5 years of recent trading history for the S&P 500. And it looks at it in detail - at below the 950 millisecond level, which is where the high-frequency trading takes place. It also notes that speeds are increasing all the time:

• One new computer chip built specifically for high-frequency trading can prepare trades in 0.000000074 seconds
• A £200m ($320m) transatlantic cable is being built just to shave 0.006 seconds off transaction times between New York City and London

It is very hard to see what value this trading provides, except to the owners of the 'black boxes'. And even they are at risk, as we saw during the so-called 'flash-crash' of May 2010, when the computers went haywire and their trades had to be cancelled.

But it is very easy to spot the problems. Correlation trading means that no individual market knows what it is trading. So the fundamentals of supply and demand become irrelevant.

Thus, as we are seeing to our cost today, oil prices continue to rise even though demand is falling. And investors think that the global economy must be doing well, because financial markets seem strong.

Oil prices are poised at a critical point. As the chart shows, the recent rally has taken them to the top of the triangle formation that has built up over the past decade. Players now need to decide if they are confident enough to push prices into higher ground.

A lot of different reasons have been advanced for the rise. But most of them are 'stories' rather than reality. They may fool pension funds, but not serious traders:

• There is no major surge in demand, as in 2008
• Inventories are also at reasonable levels
• Saudi is pumping 10mbd and has promised to keep the market supplied
• In euro terms, oil prices are at record levels and EU demand is falling
• The US is a net exporter of oil products for the first time in 60 years
• China's demand is slowing, with retail prices 36% above 2008 levels

The real reason, as the Wall Street Journal noted yesterday, is the liquidity provided by the Federal Reserve to the high-frequency traders.

However, the Iran issue is separate from this and represents a real threat. If the Strait of Hormuz was blocked, then oil exports would suffer, and shortages could easily appear.

Prices could then jump higher, perhaps to $150/bbl, as suggested by Vitol CEO Ian Taylor this week. But Taylor said this was not their base case, noting that the idea of prices going above the record $147/bbl was "unlikely, but it is possible".

We have, of course, also been in today's situation before, in the summer of 2008. Then the blog famously suggested, against all conventional opinion, that prices "could easily fall $50/bbl to $100/bbl" if diplomacy worked. And fall they did.

The blog would not therefore rush to 'go long' at today's high prices:

• It is over 2 months since Iran first made the threat
• Governments and major companies have all prepared contingency plans
• Today's price levels are already causing demand destruction

Equally, from a purely commercial viewpoint, the blog suspects Iran may have to cut prices to achieve sales. China, Japan and India have every incentive to exploit their position as the only major markets left open to Iran. And as oil importers, they have no downside from doing this.

The only prudent course, as the outcome is essentially unknowable, is to hedge both possible outcomes:

• Most companies will by now have put hedges in place against higher prices, as part of their contingency plans. If oil now heads higher out of the triangle, then they have covered this risk.
• If prices fail to break higher, then their next step might instead be to use today's higher prices as a platform for opening new hedges to guard against the downside risk

The Wall Street Journal carried an interesting opinion piece on Friday, assessing current market conditions from the viewpoint of the film character, Forrest Gump. Gump's key insight is that "Stupid is as stupid does". Thus the Journal noted:

"Oil staged its last price surge along with other commodity prices when the Fed revved up its second burst of "quantitative easing" (QE) in 2010-2011. Prices stabilized when QE2 ended. But in recent months the Fed has again signaled its commitment to near-zero interest rates first through 2013, and recently through 2014. Commodity prices, including oil, have since begun another surge." And it went on to add:

"Fed officials....want to take credit for easy money if stock-market and housing prices rise, but then deny any responsibility if commodity prices rise too, causing food and energy prices to soar for consumers. They can't have it both ways, as not-so-stupid Americans intuitively understand when they buy groceries or gas. This is the double-edged sword of an economic recovery "built to last" on easy money rather than on sound fiscal and regulatory policies."

ICIS' Truong Mellor sums up the consequences as far as petchem markets are concerned when he notes with regard to benzene that:

"The push and pull of opposing factors - the upstream bullishness versus the slower end-use demand as well as the sense that the market is currently overheated - is also adding to the confusion."

Europe and the USA are not the only regions where the Fed's QE policies are destroying demand. China has record retail prices for gasoline and diesel, and ICIS reported a polyester producer commenting this week:

"General demand is not recovering as well as expected. We are at a very difficult position now: sales are slipping while inventory are increasing".

All the key sentiment indicators are telling us that financial markets are at a cross-roads. The critical number is 1370 on the US S&P 500. This was the peak of the last rally, and coincided with the blog's launch of its Downturn Alert on 2 May. Friday's close was 1366. A rise above 1370 would also mark a recovery to market levels not seen since June 2008.

The chart shows product price changes since then, with ICIS pricing comments below. It shows how stock and oil markets continue to move together, whilst downstream markets have proved increasingly unable to pass through the higher prices due to demand destruction:

HDPE USA export (purple), down 11%. "PE prices were stable in Asia, amid weak demand and high feedstock costs"
PTA China (red), down 11%. "Mounting polyester inventories have restricted the purchasing power of polyester makers in the physical and futures markets"
Benzene NWE (green), down 5%. "Sentiment has softened this week with lower demand from the phenol and cumene sectors."
Naphtha Europe (brown dash), down 4%. "Reduced supply, resulting from refinery maintenance and shutdowns, is easily able to meet soft demand"
Brent crude oil (blue dash), down 2%
S&P 500 Index (pink dot), no change

China's economic growth has become more and more unbalanced over the past 10 years, as we discussed in chapter 6 of Boom, Gloom and the New Normal. Its domestic consumption is now only around a third of GDP, compared to 50% a decade ago. Instead, the leadership has focused on achieving growth via exports and infrastructure investment.

THE SHORT-CUT HAS BECOME A DEAD-END
This 'short-cut' to higher growth is now looking more and more like a dead-end. Exports are falling, as the ageing Western babyboomers cut back their spending. Whilst the surge in bank lending has often led to purely speculative activity, such as the housing market bubble.

Now, not for the first time, China's leadership are flagging that they may move away from their GDP-driven policies. Bloomberg report premier Wen may announce a GDP target of less than 8% in his National People's Congress speech on 5 March. The problem is that the move, if it comes, may well be 'too little, too late' to put China back on course.

Wen himself recognised the issue 5 years ago, when he described the economy as being "unstable, unbalanced, uncoordinated and unsustainable". But hard choices were deferred when the financial crisis hit in Q4 2008. Instead, lax lending made the problems worse, not better.

Policymakers discussed a possible new approach at December's economic work conference, which highlighted that "the country is poised to make some significant policy changes". As Yi Xianrong of China's Academy of Social Sciences noted then:

"The country has shown more determination than ever to shy away from any enormous economic stimulus packages in an endeavor to decelerate its fast pace of GDP growth".

FIVE KEY RISKS TO FUTURE GROWTH
'Better late than never' is probably the sensible response to this potential policy change. But unwinding the legacy of the previous past decade will not be easy, and creates 5 major risks:

• China's current policy saw its share of global exports hit 10.5% in 2011, up from 8.8% in 2007. Replacing this volume, and the jobs it created, will not be easy
• Similarly, its wasteful infrastructure investment, which rose to 48% of GDP in 2011 from 42% in 2007 means money has been spent which cannot be recovered
• China's new short-cut to help boost consumption is to increase wages by 13% a year. But this will reduce profit margins and jobs
• It is also difficult for any country to manage a smooth transition on such a scale. There is a strong risk that the uncertainty created may reduce future investment spending
• Finally, there is the really big risk, that China may hit the 'middle income trap' we described, and simply fail to make the transition required

THE WORLD BANK'S WARNING
This latter risk is not just the blog's concern. Yesterday, the World Bank and China's Development Research Center (DRC) published their major China 2030 report which warned explicitly that:

"China's growth is in danger of decelerating rapidly and without much warning. That is what has occurred with other highflying developing countries, such as Brazil and Mexico, once they reached a certain income level, a phenomenon that economists call the 'middle-income trap'."

The chart above, from the Wall Street Journal, highlights the scale of this risk. The blue columns show GDP/capita pre-1970 in countries including China, Thailand, Malaysia, S Korea and Japan. The orange column updates this to the 2007/9 average. Some countries have clearly done very well. Korea, for example, has moved from having a GDP/capita of only 10% of US levels to almost 60% today.

Following Korea's example will not be easy for China. The blog was a regular visitor to Korea in the 1987-92 period, when a key part of this transition took place. It saw major political change taking place, as ordinary people were allowed to vote for their president in a direct secret ballot. This will not be happening later this year in China, when President Hu is expected to be replaced by Vice President Xi.

Yet as Sir Arthur Lewis' work has shown, political change of this kind is essential if the economy is to continue to grow. Equally, China's 'one child policy' means it has no choice - it cannot continue to rely on cheap labour, and has to become more capital intensive.

The World Bank/DRC report highlights the key question. Can China manage this transition? Equally, it warns that "A sharp slowdown could deepen problems in the Chinese banking sector and elsewhere, and could prompt a crisis".

The New Normal involves three major transformations in the nature of consumer markets:

• The increasing size of the New Old 55+ age group in the West
• Too many young people struggling with higher unemployment
• Large number of people moving out of poverty in the developing world

These are the great opportunities for future growth, if our economy can be adapted to serve their needs. Chapter 9 of our new 'Boom, Gloom and the New Normal' e-book looks at the implications for chemical manufacturing.

Today, and in the future, we need to focus on the megatrends which will drive future demand growth.

In the fields of water and food, we should focus on reducing the amount of waste, and the output that is lost when product is moving to market.

In developing new products and services for the over 55s, we should focus on core needs, such as food, water, health, shelter and mobility.

This will enable us to 'do more with less'. We will reduce carbon footprint, and enable output to be afforded by the maximum number of people.

These changes in market drivers will have a profound impact on how, and where, products are manufactured.

Manufacturing processes will need to change in many companies as we transition to the New Normal. Quality will matter more and more as we move away from the 'throwaway society' of the past couple of decades.

So will approaches such as Process Intensification. This involves reducing the size of chemical and plant equipment, and can often enable companies to lower capital and operating costs whilst reducing waste.

The chemical industry has long been an enthusiastic champion of the importance of Quality management. It was one of the first to appreciate the importance of the concept of the 'learning organisation' that was originally brought to the West from Japan.

But in the early 2000s, the Quality movement seemed to stall. Many of the people who had launched this revolution retired. More worryingly, some companies began to forget that Quality was a process, and had to be reinforced by senior management at every possible opportunity.

Now, we need to relearn that having the right corporate philosophy is the critical starting point. This includes a focus on benefiting wider society, good leadership, and on rooting out inefficiencies through getting everybody involved in processes and problem solving.

Chapter 9 will hopefully help companies to ensure that manufacturing delivers the competitive advantage that is required as we transition to the New Normal.

FREE DOWNLOAD OPTIONS FOR CHAPTER 9
Click here to download a 2 page summary of the Chapter .
Click here to download the full Chapter
Click here to view the 6 minute video with Paul Hodges