Chemicals & The Economy

2 July 2007 marks the 10th anniversary of the Asian financial crisis, which began with the devaluation of the Thai baht. Visiting the country 10 years later, the situation has changed quite dramatically from those panic-stricken days.

Yesterday’s "swings in financial derivative prices were so extreme that they implied scenarios in which the core of the global liquidity system suffers a serious assault", according to JP Morgan, the investment bank. Watch out, if current US sub-prime mortgage problems turn into a more general “flight from risk”.

The US dollar has been falling steadily in recent weeks. It is particularly weak against the euro, having fallen almost 5% since January. OPEC countries buy much more from the eurozone than from the US, and the OPEC President has said they are ‘concerned’ about dollar weakness. We probably need to start monitoring oil prices in euros as well as dollars.

The past two Thursdays have seen extraordinary things happen in financial markets.

We are not yet at the point where the real economy, in which we all live and work, is necessarily going to nosedive into recession. But a few more Thursdays like these will certainly test its robustness. We could well be close to finding out, as the old English nursery rhyme says, that ‘Thursday’s child has far to go’.

It used to be said that ‘if the US sneezes, the rest of the world will catch a cold’. Well, the US is certainly sneezing as a result of its subprime financial crisis, but the rest of the world doesn’t seem to be taking too much notice, as least so far.

When we look back on the events of 2007, this major initiative may well be seen as being one of its key developments.

You may remember that the Chairman of Sinopec, Chen Tonghai, suddenly resigned last June. This prompted plenty of discussion about whether there had been a disagreement with the government over the level of subsidies paid to keep domestic oil product prices low.

Now, this morning, China’s Finance Minister, Jin Renqing, has also quit. There are suggestions that this reflects rising official concern over accelerating Chinese inflation and the surging stock market. The timing is also a surprise, coming as it does just 6 weeks before the 5 yearly Communist Party Congress, and is sure to prompt questions about possible policy changes.

However, according to AFX News, there is another side to the story, and the two resignations are linked. They quote a report in Hong Kong’s Ming Pao newspaper that says ‘Jin was sacked after he introduced a woman to Chen’, and she then became Chen’s mistress. They add that ‘the relationship between Jin and the unnamed woman was unclear’.

The role of Finance Minister in China is fairly critical in today's global economy, as is the Chairmanship of Sinopec. One waits to see whether more will emerge about whether policy, or personal, reasons were behind these sudden departures. Do any readers have more information that they could share with us?

One of the benefits of writing this blog is that it provides the opportunity to research behind the headlines, and better understand what is really happening. Friday’s US payrolls report, which showed the first loss of US jobs for 4 years, is a classic example.

Nobody in the chemical industry should have been too surprised by the report. Dow’s CEO Andfrew Liveris was already emphasising, when reporting Q2 results, ‘continued weakness in the North American housing and automotive sectors’. BASF Chairman Jürgen Hambrecht similarly anticipated ‘large variations (in growth) from region to region’. Hambrecht added that the main risks to the world economy were ‘the renewed significant rise in the price of oil, the weak U.S. dollar, and tension in conflict areas around the world.’

It is also noticeable, as Bloomberg reports, that Fed Governors themselves are not joining the chorus from Wall Street and US Presidential candidates for big US interest rate cuts. On Thursday, when they must have known the payroll news, both Thomas Hoenig of the Kansas Fed, and Dennis Lockhart of the Atlanta Fed, said they hadn't seen sure signs of a housing spillover into the broader economy. St. Louis Fed President William Poole and the Dallas Fed's Richard Fisher added that the effects of the turmoil so far were unclear.

After Friday’s report, the IMF’s MD, Rodrigo Rato, agreed that there was ‘a serious crisis,’ and confirmed the Dow/BASF view that US growth is slowing. But his concern was quite different from Wall Street’s, as he went on to warn that that the real problem is that ‘systemically important banks may face constraints in extending credit.’

I share Rato’s view that the current US subprime lending crisis is about concerns over return of capital, not return on capital. Would cutting rates encourage lenders to lend more? Probably not. It might well make them more reluctant, by reducing their potential reward. It might also weaken the dollar, as overseas investors looked for higher returns elsewhere.

Over the past decade, as I argued earlier this year in the Financial Times, central bankers have too often confused being ‘market-friendly’ with being ‘friendly to markets’. Today, Philadelphia Fed President, Charles Prosser, lines up alongside his colleagues in trying to avoid this trap. He argues in a Hawaii speech that ‘disruptions in financial markets can be addressed using the tools available to the Federal Reserve, without necessarily having to make a shift in the overall direction of monetary policy'.

Will the Fed give in next week, and give the crowds what they want? If they do, they may well end up adding to the very problem they are trying to solve.

Extraordinary events have taken place in the UK since my posting on Friday:

• A bankrun took place on the 8th largest bank, Northern Rock, with lines of depositors queuing for hours outside its branches all over the weekend and Monday.
• Faced with this, the UK Finance Minister was forced to announce that the government would guarantee all deposits in the bank, regardless of size. Previously, savers would have received a maximum of £31,700 in the event of default.
• Shares in Northern Rock closed below £3 last night, having been over £12 as recently as February.
• Shares of the other two banks that have fuelled the growth in UK subprime lending, Alliance & Leicester and Bradford & Bingley, have also fallen heavily since Thursday. A&L fell 30% yesterday as the storm intensified.

On 12 July, I wrote that ‘the problems in the US subprime mortgage sector…have the potential to become a global hurricane’. The problem now is that, unlike a normal hurricane, this one seems to gather more force each time it touches down.

As I noted on 14 August, it started with ‘rolling thunder’ and its main impact was on poor Americans, who were losing their homes. Then, as it circled again, central banks were in the eye of the storm as they tried to avoid a credit crunch. I forecast that if they failed, the next impact would be on the real economy, as housing and autos have been a mainstay of chemical and polymer demand in recent years:

• The construction industry boomed in those economies where housing markets have been strong.
• ‘Equity release’ provided consumers with more money to spend on chemical-intensive purchases such as autos
• In turn, chemical demand surged in the export-oriented, emerging economies of Asia.

Since July 14, I have been advocating that CEO’s should develop ‘a major cost-leadership programme’, ready for the end of the summer vacation. Unless the US Federal Reserve can pull a rabbit out of its hat at today’s meeting, it will now be time for this programme to be rolled out.

A week ago, I wrote that it would be important to see if ‘the US Federal Reserve can pull a rabbit out of its hat’ at its meeting later that day. The dust has now settled on its 0.5% Fed Funds rate cut, and one can see that short term liquidity has certainly been improved, although at the cost of weakening the US dollar.

Equally, US 2 year rates today are virtually unchanged from a week ago, at 4.05%. The same is true for 5 and 10 year rates at 4.30% and 4.63% respectively. This indicates that the main effect of the Fed’s cut was only to improve liquidity in the short-term money markets. In turn, of course, this encouraged the restoration of overnight and 3 month lending between banks, and also enabled stocks to rally.

The other main impact of the cut was to weaken the US dollar. Against the euro, the dollar had been trading above 0.72 euros, but it is now below 0.71 euros. It also dropped marginally against the yen, from around 115 yen to 114 yen, even though there was a political vacuum in Japan due to Premier Abe’s surprise resignation. More surprisingly, the Canadian dollar is now trading above parity with its US cousin, for the first time in over 30 years.

This consistent pattern of US dollar weakness suggests that the Fed’s move has disturbed overseas investors. They have been financing the US deficit for some years, and so an overnight retreat into euros or yen would still seem unlikely. But Asian and Middle Eastern holders of dollar assets are clearly feeling more nervous than a week ago.

Overall, then, the Fed probably achieved its main short-term goal, of restoring liquidity to the markets. But in so doing, it has opened up new questions about its commitment to fighting inflation, and therefore caused investors to question its underlying commitment to a strong dollar.

And back in the ‘real economy’, today’s Case-Shiller index showed record US house price falls in July, even before the credit crunch hit in August. It must therefore now be time for chemical companies to start battening down the hatches, and rolling out the cost-leadership programme that we began to discuss here in early July.

Dow CEO Andrew Liveris has spelled out very clearly his concerns about the impact of the US subprime crisis and high energy prices. He said that last week’s Fed Funds cut ‘flirted with danger’ in terms of the risks it took with inflation, although it was clearly necessary in order to tackle other problem areas.

Liveris’ comments echo those made here in recent weeks, and are striking for their clarity. Speaking to a Credit Suisse investment conference yesterday, he said that ‘the jury is out as to what next year will look like’ and added that:

• ‘The trend line in US housing is still in the wrong direction – it will be the end of next year before we see any flicker of improvement'.
• There is a real fear that the US housing crisis and high energy prices will ‘more than trickle over into consumers’ spending’
• ‘The future of the US ethylene industry is uncertain’. He believes that recent private equity deals are 'being done on a run for cash basis’, and that it is ‘almost impossible to compete on the basis of $6/MMBTU gas’ versus $2/MMBTU in the Middle East.

Liveris has been warning of potential problems in housing and autos for a year. Yesterday’s presentation made it clear that recent developments have only added to his concerns about the economic outlook.

It seems likely that this week’s European Petrochemical Association annual meeting in Berlin will mark a turning point in the petchem cycle.

Looking back over 2007, Boy Litjens, CEO of Sabic Europe, told ICIS@EPCA that performance this year had been ‘excellent’, and that they would ‘definitely report the best results ever’. He was also hopeful about the outlook for 2008, but thought that 2009 onwards might prove to be ‘difficult years’ for the industry.

Litjens went on to add, however, that ‘I am realistic enough to say that somewhere in 2008 and 2009 the economy is going to turn down’. But in his view, the pressure from new Middle Eastern and Asian capacity won’t really begin to be felt ‘until the fourth quarter’. So the key issue is whether demand begins to turn down before this.

The views that I picked up on this issue over the 4 days were mixed. The US market definitely seems to be weakening, and although European and Asian demand is still robust, industry margins are coming under pressure:

• There seemed no doubt in the minds of US delegates that the US housing market will get worse (some thought a lot worse) before it bottoms. This means there will be a lot less demand for chemicals/polymers in this important sector.
• However, US producers were encouraged by the decline in the US dollar, and hoped that this would enable them to compensate for lower domestic sales via increased exports to Asia, and Europe.
• European producers generally saw demand continuing to be strong, although many noted that the major downstream buyers were taking a more aggressive stance on pricing.
• Asian delegates, particularly those from China and India, remained very confident. They see strong demand in their domestic markets out till at least 2010.
• Feedstock pricing and availability was a major concern for everyone with whom we spoke. The volatility seen during 2007 is expected to continue, and this makes margin forecasting much more difficult.

It used to be said that ‘if America sneezes, the rest of the world catches a cold’. My sense from our EPCA meetings is that we may find ourselves needing to rewrite this phrase, if housing and subprime problems do tip the US economy into recession next year. This might cause us to discover instead that ‘when America catches a cold, the rest of the world sneezes’.

There has been a noted change of tone from leading policymakers in the past few days. Gone is the jaunty confidence that the world economy is ‘fundamentally sound’. This has been replaced by a sense that debt market problems may have a wider impact than first expected.

US Treasury Secretary, Hank Paulson, typified the new tone when warning this week that the US subprime problem will ‘continue to adversely impact our economy, our capital markets, and many homeowners for some time yet’. His downbeat assessment was all the more remarkable as it followed his success over the weekend in establishing a $75bn ‘superfund’ to help support the asset-backed commercial paper market.

Instead of spinning this fund as the answer to recent problems, Paulson seemed to be going out of his way to reduce expectations about a quick recovery. This also seems to be the approach being taken by the IMF, which has cut its forecast for world growth and warned that the US$ may still fall further.

The IMF is still forecasting a relatively strong year in 2008, with 4.75% GDP growth compared to 5.2% this year. But it commented that ‘the risks to the outlook look firmly on the downside, centring around the concern that financial market strains could continue and trigger a more pronounced global slowdown’.

Equally, its comment that ‘the weakening dollar was part of a normal process of economic rebalancing’ is likely to raise concerns in parts of Europe, and Asia, that the US is quietly pursuing a policy of ‘beggar my neighbour’ via currency devaluation.

The new note of realism by policymakers is very welcome if it leads them to debate robust solutions to the present crisis. But if frankness merely leads to argument, as we saw most notably in 1987, then those finalising the 2008 budget process in chemical companies may need to anticipate more turbulent times ahead.

The Bank of England correctly predicted in April this year that the risks associated with US subprime lending had increased, that credit risk monitoring was poor, and that markets should be prepared for liquidity to dry up in parts of the financial sector.

It must therefore, as the Financial Times said, ‘have required some restraint not to write “we told you so” at the start of the Bank’s latest report this week on Financial Stability’. This report updates its analysis, and does not provide much comfort about the near-term outlook. It concludes that:

• Lenders will become even more nervous about asset valuations if any further problems emerge in the US subprime and housing markets
• Highly-leveraged companies, including those involved in recent buyouts, could suffer from a tightening in credit availability, as banks have to absorb formerly off-balance sheet loans back onto their books
• Equity markets (in both industrialised and emerging economies) are vulnerable to any downward revision in global growth prospects
• The US$ may also be vulnerable to a downwards correction if recent changes in investor sentiment to US securities persist

The Bank believes that the cause of the recent problems was ‘a long-standing “search for yield” in financial markets – a desire by investors to maintain high returns in a low interest rate environment’. Its view is that ‘a repricing of risk was long anticipated and necessary’.

But it goes on to add that ‘the scale and breadth of the transition have caught market participants and the authorities by surprise’. It also suggests that players have become complacent, and ‘afraid to stand against the tide for fear of losing market share’.

Its warnings echo those made in early summer by the central bankers’ bank, the BIS, which I covered on July 3 in ‘4 risks to the world economy’. And judging by the Bank's tone in this week’s Report, we should remain on our guard in the coming months for signs that further problems are developing in financial markets.

What are the key questions that need to be asked when discussing any budget or strategy proposal? I have just found the answer, from a master in the field.

Sir Maurice Hodgson is recognised as one of the greatest ICI Chairmen. Under him, the company became a truly global leader, moving away from its ‘imperial’ heritage. His stepping stone to this job was in 1965, when he became ICI’s first strategic planner, and in this role he developed the concept for the whole chemical industry.

As he describes it, Hodgson decided that there were ‘3 very specific questions’ that the ICI Board needed to address:

• Where are we going if we don’t change?
• Where would we rather be going?
• How do we need to change to get from one to the other?

Unfortunately, this first question, in my experience, is almost never asked these days.

Today's ‘default’ position is that the status quo is assumed to be optimum and viable, unless concrete evidence is produced to the contrary. The beauty of Hodgson’s question is that it turns this assumption on its head.

Its ‘default’ position is that the risk of NOT changing is potentially quite high. This provokes quite a different debate, as it forces a discussion to take place on how the future might be different from the past.

Today would be an excellent time to put Hodgson’s questions to the test. As I wrote on 22 October, the consensus forecast for next year is very optimistic. And so, rather than assuming that 2008 will look much like 2007, it might be very revealing for a Board to have an open debate about where the business might be going if indeed, as many now believe, a US recession is just around the corner.

In turn, this would allow debate on Hodgson’s other two questions to take place whilst there is still time for contingency plans to be prepared. Otherwise, there could be a real risk of the company losing control of its own destiny, if circumstances do turn out to be more difficult than is currently expected.

Gisele Bundchen, the world’s richest supermodel, has joined the list of those who refuse to be paid in US dollars. As a Brazilian, she has had plenty of experience to help her recognise a depreciating currency.

According to Bloomberg, she even insisted that a recent contract with US-based Proctor and Gamble for ‘Pantene’ hair products should be paid in euros. Her twin sister, Patricia, explained that ‘we don’t know what will happen to the dollar’.

In terms of common sense, Gisele seems streets ahead of Parisian hedge fund manager Bertrand des Pallieres. You may remember he featured in the blog last August, for his ability to forget that he owned an £80k Maserati, which had been illegally parked near Knightsbridge in London, and towed away.

At the time, I expressed the view that one might not want to ‘trust your money to someone who found it difficult to look after his own car’. But Gisele certainly gets my vote. I shall continue using her shampoo with renewed confidence.

Our annual European conference, organised with ICIS, always provides an excellent opportunity to gain a snapshot of industry views as we move into a new year. At this week’s event in Antwerp, Belgium, the prevailing mood was uncertainty, for the first time since 2002:

• Oil prices are high, and volatile. This makes it difficult to plan ahead with any confidence.
• Feedstock markets are in a perfect storm. Shell described the major pressures on refiners, which have kept naphtha markets tight, and prices high.
• End-user demand may be weakening. Artenius and Scott Bader see increasing difficulties in passing through higher feedstock prices to end-users.
• Credit worries are increasing. Our financial speakers from ING and Barclays Capital both warned that the sub-prime crisis is far from over.

Petchems have had a great run since 2003. It is not at all clear that this will continue into 2008. Our delegates are probably very wise to be developing contingency plans, in case the next few months turn out to be the start of the long-awaited downturn.

English children have a card game called ‘Beggar my Neighbour’, where the aim is to win all the cards from your opponents. Central bankers seem to be learning its rules, and applying them to currency trading. OPEC’s weekend summit showed it is clearly worried that it will have a losing hand if oil remains priced in US$.

US exports have been booming recently, whilst imports have been falling, as can be seen from the chart below produced by the American Chemistry Council (ACC). In a recent note, the ACC estimated that US chemical exports are up 18% versus last year, whilst imports are down 6.7%. As a result, the US trade deficit in chemicals has fallen from $6.7bn to just $0.6bn through September.

In the background is 2007’s 16% fall in the value of the US$ against a basket of currencies. This is making it much easier for US-based chemical companies to boost exports, and so compensate for the housing/auto-led sales decline in their own domestic market. But the US’s trading partners are now expressing unease.

Last week, Japanese PM Fukuda followed the European Central Bank in complaining about the soaring value of the yen versus the US$. Whilst UK central bank governor Mervyn King explicitly warned that the UK pound would need to fall, in order to close the UK’s £7bn/month trade deficit in goods.

Now OPEC has joined the chorus of dissent. Ignoring a warning from Saudi Arabia that any currency discussion might cause the US$ to ‘collapse’ (a warning that was ‘accidentally’ broadcast to the media!), OPEC members pointed out that in euros, their average netback is actually lower in euros this year than in 2006.

Any move by OPEC to price oil in a basket of currencies, rather than the US$, could cause major feedstock cost increases for the global chemical industry, as well as disrupting US chemical exports.

Fluctuating currency values look set to be another cause of uncertainty about the prospects for 2008.

Wen Jiabao, the Chinese premier, spent his trip to Singapore yesterday expressing concern over the fall in the US$. ‘“We have never been experiencing such big pressure. We are worried about how to preserve the value of our reserves,’ he said.

In a separate interview, Mr Wen then went further, stating ‘We will increase the flexibility of the renminbi exchange rate and gradually achieve its convertibility on the capital account’.

Clearly Mr Wen is amongst those who have woken up to the rules of ‘Beggar my Neighbour’ that I described yesterday, when commenting on currency markets. It will be worth watching closely to see if, and by how much, the renminbi starts to rise in the next few weeks.

The consensus viewpoint is an easy way of keeping up to speed on a variety of issues outside one’s daily experience. But the signs are that the consensus may be leading to complacency, when it comes to the assumptions being used to finalise 2008 budgets. There are a number of areas where some new thinking is required:

• Oil prices. Many companies are already having to revise up their budget assumptions, now that crude is approaching $100/bbl.
• Housing markets. It was said that US prices would never fall on a national basis. But they have, and other key markets (UK, Spain, France) look weak.
• Inflation. After 10 years of Great Stability, central banks were widely believed to have inflation under control. This looks increasingly unlikely today.
• US $. This was supposed to stabilise or strengthen, but is now declining quite rapidly against the Yen (109 as I write), and the euro (0.67).
• Leverage. This was thought to be ‘a good thing’, forcing managers to ‘make assets sweat’. But it also makes it easy for companies to go bust in a downturn.

The current consensus may still be right, that 2008 will be a relatively good year for the industry. But core areas for chemical demand such as US housing and autos are already looking quite difficult. Financial markets are also growing more nervous. And when things go wrong, the decline is often quite sudden, leaving little time to think.

Time spent now on preparing contingency plans, in case there is a downturn, may well prove a good investment.

A recent Financial Times article commented on the 93% correlation this year between changes in the ¥ / € rate and global stock market movements. It showed that during 2007, whenever the euro has risen against the yen, stocks have also risen, and vice versa. This could be interesting background info for anyone who dabbles in shares.

This analysis also prompted me to have a look at the chart above, showing the yen/dollar rate. It is a good proxy for US chemical exports to Asia. And as you can see, there has really been quite a dramatic shift since July. The dollar peaked in late June at 124 yen, and now only buys 108 yen. That’s a 13% fall in 5 months.

And the rate of fall has been increasing. In mid-October, the dollar bought 118 yen. So it has fallen 8% in 6 weeks. No wonder that Japanese and Chinese premiers are concerned, as I described earlier this week. If this continues, we will soon be approaching the 102 yen level, which has served as the bottom of the dollar’s trading range for over 10 years.

Companies who have been profiting, or suffering, from the dollar’s recent fall will no doubt be paying great attention to its progress over the next few weeks. A fall below 100 yen would take us into uncharted water, and seriously worry other countries, such as those in the Middle East, who currently tie their currency to the dollar.

Its been a while since we had an old-fashioned currency crisis. One might be just around the corner.

Its 2 months since I was last in Asia. It is clear that earlier optimism about the region’s resilience in the face of a possible US recession in 2008 has begun to disappear.

Typical is the comment by Kanit Saengsubhan of the Thai Fiscal Policy Institute. He sees Thai growth in 2008 falling below earlier 5% government projections ‘if the US sub-prime mortgage crisis deteriorates further’. And he voiced uncertainty over just how severely Thailand might be hit. ‘In a moderate case, economic growth in the next year could stand at 4.5%, he commented. ‘If the situation becomes more severe, chances are that growth will be less than 4.5%.’

Asian chemical demand is critically dependent on the West. The Asian Wall Street Journal pointed out on Friday that ‘Chinese “exports” often aren’t very “Chinese” at all. The mainland is still largely an assembly point for other countries’ parts’. Thus the current boom in Asian chemical demand is underpinned by an expected 30% increase in this year’s EU-China trade deficit to $253bn (€170bn), and a further rise in the US-China deficit above last year’s $232bn.

As I wrote post-EPCA, we may well be about to discover that ‘when America catches a cold, the rest of the world sneezes’.

There’s a very interesting article in Barrons (the premier US investment magazine) today. It compares current efforts by Treasury Secretary Paulson in trying to cap US mortgage rates with President Nixon’s ill-fated introduction of a US wage/prices freeze in 1971.

Barrons points out that non-US buyers are already being hit by major write-downs in the value of their US subprime holdings, and adds that ‘now, the interest may be less than promised’.

It is concerned that this weakening of creditors’ rights will discourage global investors from sending their savings to the USA. And it wonders ‘what impact will that have on the current credit crisis? On the dollar? And the status of the US as financial capital of the world?’

US housing conditions are bad enough already. If Barrons is right, the proposed ‘cure’ may end up by making the situation worse, not better. This would not be good news for chemical sales into this important market.

CFOs are paid to worry, but their worries seem to be increasing quite rapidly, according to the results of the quarterly CFO survey by Duke University/The Economist. This showed:

• Record pessimism about the US economy, with US CFOs worrying about ‘weak consumer demand, high fuel costs, rising labor costs and credit markets’.
• European CFOs are ‘dramatically more pessimistic’, and expect employment to fall 0.6%
• Asian CFOs are still optimistic about growth, but almost all CFO’s with Western multinationals said they were being told to increase revenue growth to compensate for slower Western growth.
• A third of Asian CFOs see Chinese growth as likely to slow, whilst 61% of Chinese CFOs expect a US recession to hurt their firms.

Credit market worries are particularly painful for US CFOs, with around half saying that credit has become less available, and that they have experienced an increase in the cost of credit. A third of European CFOs have seen the same impact. US CFOs also noted an increase in ‘hardship withdrawals’ by employees from their 401K savings account, as a result of a need to make mortgage payments or avoid personal bankruptcy.

Yesterday the European Central Bank opened its doors and lent €349bn to 390 banks seeking to shore up their reserves position for year-end. Will this help solve the credit crunch? Writing today in the Financial Times, their excellent banking editor (Gillian Tett) is doubtful. She worries that ‘the banks know something nasty that we don’t’, and that this is causing them to hoard ‘cash to an extraordinary degree’.

What does this mean for the chemical industry? Firstly, of course, it will add to CFO concerns about their ability to obtain reasonably priced loans, as I discussed last week. There are already reports of major M&A deals in the chemical sector being unable to raise long-term debt due to current market conditions.

Secondly, it seems to add to the uncertainty over the outlook for 2008. As one banker told me recently, the worry about Q1 is that auditors will not only find further problems in the lending books of some banks, but also find holes in the balance sheets of some companies, who had put subprime investments (knowingly, or unknowingly) into their reserves.

Helpfully, Gillian Tett has separately summarised the 3 major scenarios that describe how the current crisis might play out next year:

Consensus. The US narrowly escapes recession. US housing and banking markets stabilise in Q1, and there is little spillover into the rest of the economy, although auto sales growth and jobs growth decline. Emerging markets continue to boom, helping to balance slower Western growth.
Muddle through. The credit crunch slows global growth. Western economies come under pressure, and high levels of debt reduce corporate and individual flexibility. The US$ remains under pressure, as investors reallocate portfolios to other currencies.
Downturn. Today’s credit worries spread. Banks severely restrict lending as their current business model of securitising loans to 3rd parties stops working. They also suffer losses in other consumer areas (eg credit cards). A US recession leads to a second wave of financial turmoil, as highly indebted companies go bust.

What worries me about the consensus view, as with the consensus on oil prices that I discussed in October in ‘Budgeting for a downturn’, is that it is not a true base case. It is easily the most optimistic scenario. The other outcomes are both downside cases in terms of the 2008 outlook for the ‘real world’ in which the chemical industry operates.

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

Bloomberg reports today that China’s yuan has now risen 12% against the US$, since the dollar peg was scrapped in July 2005. And the rise is accelerating, with the currency up 6% so far this year.

Significantly, China’s Commerce Minister Chen Deming said that the yuan’s rise ‘fits China’s economic needs’. A strong exchange rate will help to keep China’s inflation in check. This is now at 6.9%, an 11 year high. But it is a mixed blessing for Asian chemical companies, as although they (and other regional exporters) will obtain higher netbacks for their exports to China, they may also find themselves having to compete harder against domestic suppliers.

The dollar has rallied a bit in December to around 113 yen. US corporate buying traditionally supports the dollar in December, as companies finalise their accounts for year-end. But this is still a 9% fall versus its June high of 124 yen. As I noted last month, there is still a worrying potential for a dollar fall below 100 yen in the New Year, once these seasonal influences are out of the way.

For the chemical industry, much depends on whether the US economy goes into recession during 2008. The signs are not encouraging, with even former Fed Chairman Alan Greenspan believing it is a 50:50 chance.

So how would any recession impact the current credit crisis? Writing in the Financial Times their banking editor, Gillian Tett, provides one answer. She has an excellent track record, as I have noted before, and in her forecast for 2008 she points out that current $100bn losses in the banking system could easily grow by a further $200bn if the housing slowdown leads to credit card and commercial property defaults. She then adds:

‘The nightmare scenario, however, is one in which risky companies start to default on their loans. Thankfully, there is no sign of this occurring yet. But if the US economy goes into recession, the chance of corporate defaults will rise - which could produce more losses for banks, and thus a second chapter in the credit crunch story.’

Finance Directors will also have taken note of Chrysler CEO Nardelli's comments recently to employees that the company is 'operationally bankrupt' and likely to have to sell assets quickly to raise funds. A policy of close monitoring of customers' financial solvency would seem to be a sensible precaution, gicen the uncertainties around.

I noted in late November that China’s policy towards its currency might be changing.

Now we have evidence of this change, with a rather spectacular 0.9% rise in its value versus the US$ last week. This was the largest weekly gain since it was de-pegged against the $ in July 2005. And it seemed to result from a desire by the Chinese authorities to boost the currency in order to help get inflation back under control.

If China is really changing course in terms of the renminbi's value, then we can certainly expect to be living 'in interesting times', as the Chinese saying goes, in the next few months.

A reader has kindly sent me an interesting analysis from Richard Bernstein, Chief Investment Strategist at Merrill Lynch (ML)*. He argues that ‘the Fed can lower interest rates quite a lot, but they will likely have minimal impact on the economy unless credit creation grows’.

Bernstein says their research indicates that US credit availability is now very tight. This leads him to conclude that ‘the Fed’s policies might be extremely impotent’ and akin to ‘pushing on air’. He adds that ‘lower interest rates do not always spur credit growth’, and points to the example of Japan for the past 15 years.

I noted back on 9 September that the then IMF head. Rodrigo Rato, had also warned that reducing interest rates might make the situation worse, not better. Rato argued that the real problem was that ‘systemically important banks may face constraints in extending credit.’ Four months later, it seems even more likely that the current lending crisis is about concerns over return of capital, not return on capital.

This analysis had led me to question whether ‘cutting rates (would) encourage lenders to lend more?’ I concluded that the answer was ‘Probably not. It might well make them more reluctant, by reducing their potential reward. It might also weaken the dollar, as overseas investors looked for higher returns elsewhere’.

Unfortunately, developments over the past 4 months seem to suggest that my concerns were correct. Key US chemical markets such as housing and autos have got worse, not better, whilst the US$ has weakened.

Another round of US rate cuts is widely expected this month. Although the Fed is undoubtedly well intentioned, ML’s research suggests that their actions may, in this crisis, be doing more harm than good.

(* I can’t link to this report, but will be happy to send a copy to any interested reader)

Reaction to $100 oil has been swift. Yesterday, the Chinese State Council decided to freeze the prices of oil products, natural gas and electricity, as well as public transportation. A measure of the government’s concern is that the meeting to approve the freeze was attended by premier Wen Jiabao.

Chinese inflation is now at 6.9% and the Council noted that ‘China faces relatively large pressures of further price increases (as) prices of crude oil, grains and other primary products are still rising on the international market’.

So as expected, $100 oil prices are already having an impact on psychology. The Chinese government has been most aggressive in searching for new sources of oil imports. But even they are now starting to worry about the implications of unlimited consumption of oil and oil-based products.

Earlier this week, the State Council also announced a decision to ban ultra-thin plastic bags, and to charge customers for thicker plastic bags. China uses around 3bn plastic bags a year, which requires 37m bbls of crude per year. But even if the ban is totally successful, it will save less than two days of total oil consumption.

If major energy importers such as China have decided to prioritise oil use, and have started by banning plastic bags, what other petchem products will be next affected? And if other countries follow this lead, what will be the impact on petchem demand generally?

Financial investors are already quite disruptive in crude oil markets. And their influence is set to grow this year. That’s the message from surveys by Barclays Global Investors and JP Morgan. $120bn is now invested in commodities as a class, with oil a major target. Even your own pension fund may be about to invest, or to increase its exposure, after the stellar returns posted in 2007.

As a result, crude oil prices are becoming more volatile. Over the past month, they have been over $100/bbl on several occasions. Yet they were below $90/bbl on 18 December, and are currently back around $93/bbl. This is a major issue for petchems, making pricing and margins most uncertain.

Nothing has changed since mid-December in the ‘real world’ of oil supply/demand to justify this recent volatility. The mild weather forecast for the critical NE USA area seems to have been accurate. There have been no new geo-political tensions.

The cause is simply the behaviour of financial players. As I noted back in July, these do not set underlying trends. Rather, they jump on them after they have developed. The ‘weight of money’ then exaggerates any minor changes in either direction.

Worryingly for petchems, this influence seems likely to grow in 2008. The US pension fund, Calpers, is poised to invest $13bn (5% of its $250bn portfolio). It sees oil markets as a good ‘hedge’ against inflation and slowing stock markets. Calpers adds that ‘we believe energy will offer investors opportunities in coming years’.

In Europe, JP Morgan found that 31% of major investors were planning to invest in commodities this year. Belgium, Netherlands, Germany and Austria were particularly keen, with only France having zero interest. Europe is following the US pattern, with the largest Dutch pension fund ABP increasing its investment to 3% of its portfolio, matching Hermes (the UK’s largest fund).

There is little point in petchem producers or consumers trying to stand against this wave of new money entering the oil markets. And with a profits downturn probably already underway, it is instead important to ‘lock-in’ margins as much as possible. Companies routinely ‘hedge’ their currency exposure these days. Use of the LME futures contracts may well need to become a similarly essential tool.

The OECD produces useful leading indicators each month, which try to capture turning points in the global economy. Its industrial production indicator is very relevant to chemicals, as 85% of demand comes from this sector.

The latest outlook is summarised in Kevin Swift’s ACC report. The blue line is actual global industrial production, whilst the red line represents the OECD’s indicator. This is based on OECD countries plus the 6 main non-OECD countries. Kevin comments that November’s indicator ‘showed a marked deceleration’ versus previous data.

In terms of individual OECD countries, the indicator suggests a downturn now seems to be underway in the US, Germany and the UK, with Japan, France, Canada and Italy slowing down. China and Brazil are still expanding, Russia is improving, but India now appears to be weakening.

I had the opportunity last night to learn current thinking within the oil industry on the current outlook for oil markets, by attending the annual lecture of the British Institute of Energy Economists, kindly hosted by BP.

A year ago, at the same event, the crude price was $51/bbl. Last night, the headlines were ‘major fall in oil price to $91/bbl’. This captures the extreme volatility that now exists in oil markets, and which makes life an absolute nightmare for anyone who buys or sells oil-based chemicals.

The consensus emerging from the discussion was that markets will remain strong, and that the activity of speculators will continue to create volatility. High oil prices are not likely to stimulate new supply in the short-term, as most reserves are in areas that are difficult to access due to politics or geography. Equally, demand will continue to grow in the Middle East and Asia, due to massive government subsidies on domestic prices.

Stock markets are usually good indicators of future economic conditions. Their savage downturn since the start of the year suggests that investors now feel a growth slowdown is almost inevitable.

Barrons (the major US investment paper) today highlights another very worrying development. It notes that ‘selling rallies aggressively is (now) more fruitful than buying every little dip’. This marks a complete change of behaviour by investors. Barrons suggests that the rationale is that now ‘overshoots tend to occur on the downside’ rather than on the upside.

The basis for the argument can be seen in the chart, which plots the relative performance of 5 main indices (the German DAX, UK FTSE 100, Shanghai Composite, US S&P500, Japan Nikkei) over the past month. All are down by around 15%, with Japan down over 20%.

These are major losses by any standard. Particularly at this time of year, when seasonal influences are strongly positive. And although rallies have taken place, these have soon given way to further falls. Last Friday, for example, news of the Bush stimulus package led to a major intra-day rally in the US, but the market still closed down. And today, more selling has taken place in Asia and Europe.

Unless something changes quickly, this synchronised downturn would imply that we are now in a fully-fledged global bear market. Strong rallies do occur in bear markets, just as corrections happen during bull markets. But they cannot disguise the fact that the overall trend has become negative.

In turn, this would suggest that chemical companies should not expect either that consumer demand will recover quickly, or that Asia will successfully ‘decouple’ its economy from western markets. They should also be very careful about credit risks, as if the economy does go into a slowdown, company defaults will rise.

CEOs seem to be following CFOs in worrying about the impact of the credit crunch and debt crisis. The annual CEO survey by PwC of 1150 executives shows that fears of a downturn now top their list of concerns.

US CEOs are much less confident than a year ago, with only 35% now ‘very confident’ about the short-term outlook. West European CEOs are also downbeat, with only 44% very confident about short-term prospects and just 36% confident about growth over the next 3 years.

This CEO gloom is based on a variety of factors that relate strongly to the chemical industry – the sub-prime mortgage crisis, the credit crunch, rising energy prices. It mirrors the record pessimism shown by CFOs last month in The Economist survey which (as I noted last month), found them worrying about ‘weak consumer demand, high fuel costs, rising labor costs and credit markets’.

The PwC survey is not all gloom, as it does reveal a striking difference between CEO attitudes in the western and emerging economies. PwC reports that ‘CEOs in Asia, Latin America and CEE are more confident’ than last year, and comments that this shows a belief that ‘their booming economies could insulate them’ from problems elsewhere.

However, PwC issue a mild health warning over the results, as the survey was taken at the end of last year. Since then, CEO confidence has probably declined, following recent financial turmoil. There are also growing doubts, as I discussed in December, about whether emerging economies really can ‘decouple’ from the West.

The credit crunch and associated debt crisis has elicited an unprecedented response from the International Monetary Fund (IMF). Today, the head of the IMF, Dominique Strauss-Kohn, told the Financial Times that the new IMF economic forecasts would ‘show a serious economic slowdown that needs a serious response’.

Just last autumn, the IMF was calling for ‘continued fiscal consolidation’ in the USA to reduce the budget deficit. Now, however, M Strauss-Kohn said he not only approved the US tax cut package, but also called on other countries to develop ‘a new fiscal policy to answer this crisis’.

Behind the IMF’s change of direction is a recognition that lower interest rates on their own ‘will not be enough to get us out of the turmoil we are in’. As I noted back on 7 January, many experts now believe that cutting interest rates is like ‘pushing on air’.

This is because the problem is not one of stimulating demand via interest rate cuts, but of trying to encourage lenders to resume lending. In this environment, lower interest rates may actually make matters worse, by reducing lenders’ incentive to lend.

Policy makers are therefore stuck between a rock and hard place. Higher rates might well encourage more lending, but would bankrupt all those many highly-geared people and companies who have borrowed beyond their means. The new head of Merrill Lynch, John Thain, has already ‘predicted that the problems in mortgage markets will spread to credit cards and consumer loans’.

If the IMF is right, then chemical industry sales to key consumer markets such as housing and autos look set to come under further pressure. Contagion from the growing crisis in financial markets may well now start to spread into the 'real economy' in which we live and work.

I noted last month that China seemed to have changed policy with regard to the renminbi. Since then, its rise versus the US$ has accelerated, as shown in the above chart from Merrill Lynch (ML). Since August, it has been rising at an annualised rate of 13%.

ML’s explanation is that the government is having to relax credit controls as the economy slows. The recent snowstorms have further loosened policy. Yet with wage inflation now at 18%, something needs to tighten and so the exchange rate is being allowed to rise. ML say 'it is possibly the fastest sustained appreciation' since the PRC was founded in 1949.

ML suggest that the increase will continue, and that it will cause Asian interest rates to rise in sympathy, as well as Asian exchange rates. Outside Asia, the impact will be to export inflation to N America and Europe, as China’s export prices rise in $, € and £ terms.

This is good news for chemical exporters to China. But at a macro level, it means that the ‘virtuous circle’ of the past decade, under which China exported deflation, is well on the way to reversing itself. In turn, this will eventually limit the ability of Western central banks to cut their interest rates to try and stave off recession.

Its not normally a good sign when chemical industry bosses feel the need to cheerlead on the outlook for the economy.

Dow’s CEO Andrew Liveris therefore caught my attention at Davos, when he told CNBC that talk of recession was ‘over-reaction’. Particularly when he then corrected himself, adding that what he had meant to say was ‘I won’t say there won’t be a recession – but there’s an over-reaction’.

This week, BASF Chairman Jürgen Hambrecht has taken up the role of cheerleader. Interviewed by the Financial Times, he revealed that he was ‘sleeping well at night.’ He conceded that in some industries related to housing and the consumer there was ‘a little bit of inflection’ from credit problems. But overall he was serenely confident, adding ‘why should there be a big, big crisis? I can’t see this happening’.

Unfortunately, his compatriot Peer Steinbrück, the German finance minister, was less upbeat over the weekend. Speaking after the G7 finance meeting in Tokyo, Steinbrück said the ‘G7 now thought subprime losses could reach $400bn’. This is quite an increase from the original $50bn estimate made by the US Fed. It also implies $280bn of write-offs are still to come, as total losses revealed to date are ‘only’ $120bn.

China has been a major source of price deflation for the past decade. It is now the world’s leading manufacturer of a whole range of products from microwaves to DVDs. And the rest of the world has benefited from the lower prices that it has provided.

But not any more. The attached chart from the ACC’s weekly report shows that import prices from China into the USA increased by a record 3.3% in January. The trend is also worrying. For years, import prices were falling at around 1% a year. Now they are on a steep upward path.

I noted last week that the renminbi is now rising at an annualised 13% rate, whilst Chinese wage inflation is running at 18%. This implies that import prices from China could continue to rise over the next few months.

There’s an interesting article on Bloomberg, suggesting that the US Fed’s dramatic interest rates reductions are ‘driving Asia’s governments back to controlled economies’.

Its argument is that by cutting rates, Bernanke is ‘limiting his Asian counterparts’ ability to curb inflation'. It goes on to argue that Asian banks cannot now raise domestic interest rates to restrict demand, as a ‘widening spread between US and Asian borrowing costs draws more foreign money into the region’, causing asset bubbles to appear.

The same effect will occur if they allow their exchange rate to rise too quickly versus the dollar. And Asian central banks certainly don’t want to encourage a repeat of the US housing bubble in their own countries. So they are instead being forced to impose price controls on essential goods, in a bid to restrain inflation.

As I noted on 10 January, China froze the prices of oil products, natural gas and electricity, as well as public transportation. 5 days later, just as the Fed embarked on its 2nd round of interest rate cuts, it added price controls on grain, cooking oil, meat products, milk, eggs and LPG. The rationale can be seen in today’s announcement that inflation hit 7.1% in January, the highest for 11 years.

The problem, of course, is that domestic price controls (which also now apply in many other Asian countries for similar reasons), reduce the incentive to cut back on consumption as world prices move higher. The same is true for oil and gasoline prices, which are subsidised across Asia and also in many OPEC countries.

Thus the law of unintended consequences applies. These subsidies mean that supply and demand will be much slower to rebalance. So the net effect is that as the Fed reduces rates to try to avoid a severe US recession, it is indirectly causing global food and energy prices to rise. And in the end, if inflation starts to spiral out of control, rate increases may become essential, even in the US.

Quietly, oil has moved back to the $100/bbl level.

This is quite different from January, when it first hit the magic $100/bbl number. Financial players had jumped on the trend from November as crude rose above $80/bbl, and then wanted to ‘get out at the top’. Their thinking was that a US recession would reduce demand for oil, and so prices would fall. Now, however, more fundamental forces seem to be taking prices higher, and causing the 'shorts' to cover their positions.

The problem for the chemicals industry is that this purely speculative behaviour creates additional volatility. And with $120bn already ‘invested’ by financial players in commodities, much of it in oil, companies must assume that ‘speculative volatility’ will increase.

The behaviour of financial players is not the only uncertainty currently driving oil prices. Apart from the impact of geo-political issues such as Iran, Nigeria and Venezuela, four key questions will influence the direction of oil prices in 2008:

• Does OPEC care that higher oil prices will damage the western economy? In the past, the answer would have been ‘yes’, but recent signs (their decision to ignore President Bush’s plea for lower prices last month) imply their thinking may have changed.
• Can net non-OPEC supply increase as much as expected this year? Production from existing fields in Mexico and the N Sea has recently been decreasing faster than expected. This means more new oil has to be produced, to make up the difference.
• Will Asian and OPEC countries continue to subsidise oil products? If they do, then higher world prices will have no effect on the countries where fastest demand growth is taking place.
• Will financial players and pension funds see oil as a hedge against a falling US$? Some are already viewing the ‘US recession’ argument from a different angle, and believe it will force the Fed to cut interest rates back to 1%, causing the US$ to fall further.

The downturn in the global economy has been impacting chemical margins since the summer. Profits have been hit, as key customer industries such as housing, autos, and retail became more price conscious. Demand has also been slowing, as higher oil prices acted as a tax on Western consumption. Now feedstock volatility is likely to increase, due to the growing influence of financial players. CEOs and CFOs therefore need to ensure that proper risk management tools are in place to protect margins.

BASF Chairman Jürgen Hambrecht sounded confident last week, following their annual results.

2007 sales were €58bn (up 10% on 2006), and income from operations was €7.3bn (up 8%). However, Q4 saw sales up just 1.6% at €14.7bn, and income actually down 3.4% at €1.6bn.

The main culprit in Q4 was chemicals. Sales were marginally down on 2006 at €3.4bn (partly due to the impact of extended plant turnarounds), but income fell 50%. Unsurprisingly, N America was the problem region, with sales down 11% and income down 64%. BASF was clearly hit very hard, as one would expect, by higher feedstock costs and the downturn in housing and autos.

However, BASF was supported by a solid performance from its oil and gas business, where their main partner is Gazprom. The sector accounted for only 18% of 2007 sales, but contributed 41% of total profit. This was a very good performance given the strength of the euro, as the $7/bbl increase in the average price of Brent translated into just a €1/bbl increase for BASF.

The sector’s Q4 performance was excellent. BASF faces a headwind in its gas business when prices are rising, as it takes time to pass on these increases to customers. (Of course, it benefits from the same effect when prices fall). But although oil and gas sales were flat at €3.1bn, they still contributed €800m and represented 50% of total Group income.

BASF are continuing to reshape the portfolio, and hope to complete the styrenics sale within a few weeks. This would follow previous petchem divestments (eg Basell), and the acquisition of late-cycle businesses (eg Engelhard). BASF’s low debt ratio is also a strength as the credit crisis worsens. Whilst its Verbund strategy of highly integrated sites provides cost leadership, which is always critical during a downturn.

Chemicals and plastics will probably cause increased problems for BASF in 2008. But oil prices are already well above BASF’s budget figure of $78/bbl. So its perhaps understandable that Hambrecht felt able to tell the Financial Times he is currently still ‘sleeping well at night.’

Wheat prices rose 25% yesterday, the biggest one-day rise ever, as Kazakhstan imposed restrictions on wheat exports.

The rationale for today’s rising prices is three-fold:
• US farmers have shifted land over to corn, to meet increased ethanol demand, and US wheat inventories are forecast to hit 60 year lows
• Emerging countries are now eating more meat, because of growing prosperity, and so more grain is required to feed livestock
• Financial players see ‘soft commodities’ such as wheat as representing a store of value, versus weak currencies such as the US$

Inevitably increases of this magnitude will feed through into higher inflation. In turn, longer-term bond rates will increase. Chemical company CFOs were already facing problems from the credit crunch. Higher food and energy prices can only make these problems worse.

Its not often that one gets clear statements from central bankers. Today’s comment from the Bank of England’s Deputy Governor that the credit crunch was ‘an accident waiting to happen’ is truly remarkable for its clarity. She also gives the best one sentence summary that I have seen on the background to today’s credit crunch. :

‘The US housing crisis has acted as the trigger for an overdue correction in financial markets, after a long period of plentiful liquidity during which risk premia of all sorts had become unduly compressed, asset prices had become detached from reality, financial innovation had run ahead of risk management, and unsound business models had led to a deterioration in credit monitoring and, in some areas, underlying credit quality.’

She summarised it as ‘the largest ever peacetime liquidity crisis’.

The blog has been following the debate over ‘decoupling’ with some interest. With the US going into a downturn, it is critical to understand whether Asian chemical markets will follow. Until recently, they have been buoyant, allowing US companies to make up for some of the decline in their domestic markets via exports. But I suggested back in December that this would probably not last.

Today’s news from Japan tends to confirms my scepticism. Factory output fell 2% in January. Bloomberg reports this was because ‘a deepening US slump weakened demand for cars and electronics’. Even worse, companies expect output this month to slide a further 2.9%. March may be better, as inventories will have been worked off.

Japanese central bankers can do little to stimulate the economy, with interest rates near zero. Governor Fukui said last week that ‘a deeper slump in the world’s biggest economy (the US) would have adverse effects on the emerging markets that Japanese exporters depend on’. With the US$ weakening as well, markets seem likely to get increasingly tough for Asian chemical companies.

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'A vicious circle now seems to be in place again, where a lower dollar inspires raw material prices to rally, which in turn increases worries about inflation’. This was how strategists at BNP Paribas summed up the US Fed Chairman’s two days of testimony to Congress last week.

For the last 20 years, every Chairman and US Treasury Secretary has paid at least lip service to the concept of ‘the strong dollar’. Hank Paulson repeated the mantra on Thursday. But Bernanke did not once mention the phrase to Congress. Currency and commodity traders were quick to take the hint. The $ dived to new lows against both the euro and yen. Oil prices also jumped to new record highs.

A 2nd stage of the financial crisis that began last August now seems to threaten. The 1st stage was the discovery that US houses (and those in several other western countries) were no longer worth the price that had been paid for them. This led to a collapse in house-building, and a general tightening of global credit markets.

Now, the Fed sems to be encouraging the $ to fall, with Bernanke commenting that this would have ‘the benefit of stimulating exports’. But as Barrons, the influential US investment magazine noted, this policy carries the risk of creating an ‘inflationary maelstrom’. Just as in 1973, they added, oil producers may get ‘tired of parting with their precious petroleum for depreciated dollars’.

The combination of lower economic growth, tighter credit conditions, and commodity/feedstock price inflation is potentially a toxic cocktail. Some companies selling into buoyant agchem markets will have no problem overcoming it. But others face a more uncertain future.

‘If it walks like a duck, and quacks like a duck, then its a duck’. This simple logic probably best sums up Warren Buffett’s position on the current state of the US economy. ‘By any commonsense definition’, said Buffett yesterday, ‘the US is in recession’.

Buffett is the world’s leading investor. And key evidence from a chemical industry perspective supports his conclusion. US vehicle sales fell 10% in January, after a terrible 2007. Housing starts are 50% down on earlier peaks, and US house prices are falling nationally for the first time since the Depression. As Buffett added, ‘most people (are) experiencing recession’, and ‘their net worth (is) heading south’.

Buffett’s warning about the US$ was also worrying, with his belief that it ‘is going to get weaker over time’. Last year, the lower $ allowed US chemical companies to compensate via increased exports for slow domestic markets. But the $'s latest fall means that it is now challenging the ¥102 level, which has held for over a decade.

Equally, investors search for a reliable ‘store of value’ is causing them to chase commodity prices higher. Speculative long positions on NYMEX crude oil rose 50.4% last week, as financial players rushed to exit the US$. Many expect crude to hit the $110-$115/bbl level shortly.

OPEC today decided to hold oil production at current levels, even though prices are at a level which clearly threaten economic growth. They even recognised this risk in their statement, ‘highlighting the economic slowdown in the USA, which together with the deepening credit crisis in financial markets, is increasing the downside risks for world economic growth and, consequently, demand for crude oil’.

Normally, faced with this outlook, OPEC would have flooded the market with crude, in order to bring prices down and help support the world economy. Clearly their priorities have changed, and we appear to be back to the difficult times of 1973/4 and 1979/80, when OPEC similarly held production whilst the world economy went into a downturn.

OPEC’s statement seems to reflect a growing hostility towards the US over a number of issues, including the weak US$ (as noted by the New York Times). Saudi Arabia, the leading OPEC moderate, clearly feels let down by the lack of progress in the Middle East peace talks. And OPEC also decided to support Venezuela’s ‘sovereign rights over its natural resources’ in its dispute with ExxonMobil, calling on EM to hold back from further legal actions to support its claims.

Faced with this background, chemical company planners need to rethink their crude oil scenarios for the year. I argued back in October that the consensus $70/bbl forecast looked too optimistic. Now, with OPEC taking a hard line, and western investors starting to panic over the value of the US$, we are in uncharted and potentially dangerous territory.

Central bankers are slowly recognising that inflation is becoming a serious problem. But their responses differ. So chemical companies will find it harder to predict interest and exchange rate policies.

China announced yesterday that inflation had soared again last month, reaching 8.7%, versus the government target of 4.8%. Part of the increase is clearly due to the effects of recent major storms. But with the US Fed likely to cut rates soon, China remains in a difficult position. If it increases interest rates, then the currency will rise further, making it a target for ‘hot money’. If it doesn’t, then inflation (particularly in food and energy) will continue to rise.

Meanwhile, Bloomberg has analysed developments in US fixed income markets and suggests that bond traders now believe that the US Fed is about to ‘lose control of inflation’. Since 29 February, the yields on US Treasury Inflation-Protected Securities (TIPS) have been negative. Buyers are apparently prepared to give up ‘real yield today’ for the security of inflation-proofing in the future.

Against this background, it is perhaps not surprising that traders pushed up crude prices yesterday to a new record of $107.91/bbl, as they continued to search for a ‘store of value’. US natural gas prices have also strengthened recently, and are now over $10/MBTU.

The US$ had now fallen through the ¥102 level, which has held since 1995, and went straight to the psychologically important ¥100 level. The dollar peaked 9 months ago at ¥124, and so it has now fallen 19%. This is dramatic by any standards. I forecast back in November that an ‘old-fashioned currency crisis’ could be just around the corner. With the dollar falling against both the yen and the euro, I think this crisis has probably now arrived.

My other recent forecast, that crude would hit $110/bbl, has taken only a week to occur. Yet a month ago, crude was 'only' $90/bbl. Part of the rise was caused by speculators having to unwind short positions, but there is also increasing interest in call options at $150/bbl. I have even heard people talking seriously about the chance that $200/bbl could be seen before the end of the year. As I commented after the OPEC meeting, we are now ‘in uncharted and potentially dangerous territory’.

The Financial Times this morning reports that the US Fed fears that ‘the economic downturn in the US could turn into a deep and protracted recession of the kind that plagued Japan’. Clearly based on interviews with senior Fed officials and other policymakers, the two articles (one for the European edition, and one for the US) provide a remarkable insight into the Fed’s current thinking:

The US$ took a major tumble yesterday, as traders decided the Bear Stearns news meant there was little risk of central bank intervention. Against the Japanese yen it fell almost 2.5% during the day, closing at ¥97.35, as shown on the chart. It also fell 2% against the Swiss Franc to SwFr 0.98, and continues to hit new lows against the euro.

The $ is now at its weakest since 1971 on a trade-weighted basis. This will have a major impact on chemical company results:

Winners will be those who buy feedstocks in dollars, and sell in hard currencies such as the euro, yen or SwFr.
Losers will be those who buy in hard currencies, and sell in dollars

US exporters are likely to do well as a result. But one should expect to hear cries of real pain from the losers as Quarter 1 results are reported.

The New York Times has an excellent feature today that aims to explain how ‘US sub-prime mortgages could take out the whole global financial system’. I know that many readers found the Bird/Fortune video on the subject very useful last December. So I thought you might like to know about this new analysis.

The Times reporter called a number of senior figures on Wall Street, asking them the simple question ‘Can you explain this to me?’ After they had finished, he often then asked ‘Can you try again?’ He concludes:

• The US had a housing ‘bubble’, which is now going ‘bust’
• Massive leverage meant that even small losses led to equity wipe-outs
• All ‘busts lead to panics’, which can cause ‘long, deep, economic downturns’
• ‘Unprecedented’ actions are now being used to try and restore confidence

Volatility has been rising in the crude oil and feedstocks markets. This is because individual players have completely different strategies. In turn, this makes it difficult for chemical companies to forecast short-term feedstock costs. It also makes it difficult to maintain margins.

Last Monday, crude reached a new high of $111/bbl. Then, as the scale of the Bear Stearns collapse became apparent, it fell over $10/bbl. Currently, it is trading around $100/bbl. A number of different rationales have been put forward to explain this sudden fall:

• Many commentators have taken it as a sign that the US recession will reduce demand, causing prices to weaken. Latest EIA figures show a rare, if minor, 0.1% decline in gasoline demand over the past month.
• Other analysts have pointed out that last week’s wild swings in equity markets caused major losses for many investors, requiring them to meet margin calls by selling out their positions in commodities.
• They have also added that Bear Stearns’ Proprietary Trading Group had been very active in crude oil futures, and it was likely that its positions had been sold quickly once its collapse had been confirmed.
• Equally, others have argued that crude’s recent strength was due to US $ weakness, as investors used commodities as a ‘store of value’. They now expect the US $ to strengthen, reducing their attractiveness.

All of these analyses probably have some element of truth in them. Over the longer-term, prices will be set by the fundamentals of supply and demand, which in turn will be influenced by geo-politics. But last week’s ‘perfect storm’ of events illustrates just how complex it has become to forecast day-to-day market action in crude oil markets.

Those who liked my earlier posting about Margin calling, might like to look at the new online Financial Times page devoted to subprime jokes. For example, 'What's the definition of an optimistic investment banker?' 'Someone who irons 5 business shirts on a Sunday night.'

It also mentions the prospect of a new breakfast cereal being launched, ‘Credit Crunch’. One hopes this won’t be served along the RiverWalk at San Antonio during next week’s NPRA meeting.

Readers will know that I am a great admirer of Gillian Tett’s analyses of banking issues in the Financial Times. Today, she has another thought-provoking article, this time on the emergence of Iceland as ‘the world’s first country run like a hedge fund’. The article is worth reading in itself, but also for the question that it raises in conclusion. This is whether the leverage used in recent years by some banks now means that they are ‘not just too big to fail, but also too big to rescue’?

China is well worth watching at the moment. Quietly, away from the headlines, the Shanghai stock exchange has been collapsing. It is now down 44% since its October peak, and fell over 5% on Wednesday.

This matters to the chemical industry for two reasons:

• The immediate cause of Wednesday’s fall was news that Sinopec and PetroChina lost money in January and February. Their shares fell over 8% as a result. This shows the level of ‘subsidy’ now being offered to Chinese consumers following the government’s decision to freeze oil product prices in January. It turn, this subsidy delays any rebalancing of demand (as I noted on Wednesday), putting more pressure on western consumers.

• The collapse itself indicates that the Chinese ‘growth story’ may be about to take a break. The government has been raising interest rates very steadily, because of worries about ‘over-heating’ in the economy, and rising inflation. The stock market is forecasting that these measures will work, and that we may well see a major slowdown after the Olympics. This would be extremely serious as China was the powerhouse behind the recent boom in global chemical demand.

Of course, stock market collapses do not always lead to economic downturns. But they are often linked. The establishment of contingency plans for dealing with a global slowdown is fast becoming an urgent priority for chemical industry managements.

The US Fed’s decision to keep cutting interest rates is causing a major change in Asian investment behaviour. This will slow world economic growth quite significantly, and is bad news for chemical industry sales. It also means that the informal Bretton Woods II system of currency management has broken down.

The IMF now sees a 25% chance of a world recession this year, in which global growth would fall below 3%. Its base forecast is just 3.7%, compared to 5.2% before the credit crunch began. Sales growth for most chemicals is tied to GDP growth, so companies should expect volumes to come under pressure as global growth slows.

‘The sharp drop in housing starts and the developing credit crisis will flow into the cracker business’, according to Shell Chemical’s CEO Stacy Methvin. She added that ‘the housing crisis is more far-reaching than anyone anticipated’.

Similarly, BASF is now more cautious about the potential impact of the US recession on its petchem business. Peter Cella, VP petchems N America, told ICIS news that the ‘impact thus far has not filtered down to demand for our products (but) it could be coming. There could be a delayed effect three, six, nine months out that we’re just not seeing yet.’

The ACC’s weekly report also notes that JP Morgan’s global Manufacturing Index has slipped to its lowest level since May 2003, as America’s recession impacts the rest of the world. As the ACC comment, ‘so much for decoupling!’

If you would like to read my article in this week’s ICB, on the importance of contingency planning, please click this link

The weekend’s finance minister meeting in Washington DC seems to have been quite different from its predecessors. Not only did they apparently have an ‘informal brainstorming session’ at one point, but they also found themselves confronted with two major and on-going crises:

• We have to ‘put food into hungry mouths’ commented Bob Zoellick, President of the World Bank. He added that “throughout the weekend we have heard again and again from ministers in developing countries and emerging economies that this is a priority issue.”
• At the same time, the rich countries wanted to focus on the global credit crisis. According to the New York Times, some Western finance ministers ‘appeared to be self-conscious about how much of the attention at the meeting has focused on the global credit crisis, while there was less focus on the problem of feeding the world’s poor’.

I remarked back in July that central bankers were in danger of ‘fighting their last war, rather than preparing for the next one’. And I questioned ‘their continued reluctance to recognise that higher food and energy prices are here to stay’. Equally, in a letter to the Financial Times in September, I suggested that the scale of the subprime crisis was much greater than generally accepted, and that the sums of money required to stabilise the situation would require “‘a buyer of last resort’, such as the Federal government, to emerge".

The problem is the slowness with which central bankers are waking up to these seemingly obvious truths. For this reason, one must applaud Dominique Strauss-Kahn, the new IMF MD, for pointing out the risks of further delay, even at the risk of seem to over-dramatise. He noted that ‘the food crisis posed questions about the survivability of democracy and political regimes…(and) sometimes those questions lead to war’.

Russia is the world’s 2nd largest oil producer. And it has been the main source of increased crude production in recent years. Its output rose 58% between 1999-2006, from 6.2mbd to 9.8mbd. Now Lukoil’s VP, Leonid Fedun, has told the Financial Times that he thinks 2007 output will be ‘the highest he will see in his lifetime’. He also believes that Russian oil production may now follow the sharp declines seen in the North Sea and Mexico.

Singapore is one of the global economic success stories of recent decades. Its sovereign wealth fund, GIC, is one of the world’s largest fund management companies, with assets of over $100bn. And GIC has already been active during the early stages of the credit crunch, investing $18bn since December in supporting cash-calls from Citigroup and UBS.

GIC's views on the outlook for the Asian/world economy are therefore of great interest to the chemical industry. Unfortunately, the message is not the one that we would wish to hear. Speaking today to its 500 employees, deputy chairman Tony Tan warned that `We could be facing a recession which is longer, deeper and wider than any recession that we have encountered in the last 30 years'.

He added that ‘as banks continue to deleverage, cutting down on their lending activities and causing contraction in credit supply, the prospects for the U.S. economy and possibly even the world economy are fraught with considerable downside risks.’

OPEC used to believe that its fortunes were tied to the health of the global economy. But as I noted last month, its current policy is more reminiscent of ‘the difficult times of 1973/4 and 1979/80’.

The evidence for this statement is mounting. Saudi Oil Minister, Ali Naimi, said recently that the Kingdom has ‘no plans’ for further expansion of oil supply beyond 2009. This means that current capacity will peak at 12.5mbd. From a petchem viewpoint, it also means there will be no more ethane availability, beyond current allocations, as Saudi ethane is all associated gas.

Further evidence comes from King Abdullah himself. He was reported by the official Saudi news agency as saying "I keep no secret from you that, when there were some new finds, I told them 'No, leave it in the ground, with grace from God, our children need it'." This follows the historic rebuff by the King of President Bush’s personal appeal in February to increase oil production.

This week, OPEC’s President Chakib Khelil went still further. He told the Financial Times that oil prices ‘are high due to the recession in the United States and the economic crisis, which has touched several countries, a situation that has an effect on the value of the dollar. Each time the dollar falls 1 per cent, the price of the barrel rises by $4 and of course vice versa’.

The chemical industry is already struggling to pass through current oil prices, which are increasingly looking like a ‘bridge too far’. Many still hope that they will soon fall back to the $70/bbl that was the common budget assumption. I suggested back in October that this assumption was ‘very optimistic’. Now Khelil is warning that ‘oil prices could hit $200/bbl’.

Anthony Bolton’s investment column this weekend contains another nugget of wisdom. Coincidentally, it is linked with Archie Norman’s ‘tip for management’ which I quote below.

Bolton is the UK’s most successful fund manager. And he certainly shares Norman’s sense about the need to be humble. In fact, he goes even further, commenting that in his experience, ‘On average, you will be wrong at least two times out of five – half the time because an investment thesis proves to be incorrect, and half the time because something changes’.

He goes on to list some of the main things that can change. All of them will be familiar to commercial people in the chemical industry: ‘movement in interest rates or currencies; a change at the industry level – such as increased competition or new legislation; a new product fails to work as well as expected; a price war breaks out in a key market’.

Bolton’s caution seems particularly sensible today. As I commented in ICB last month, contingency planning has gone out of fashion in recent years. But given the current high level of uncertainty in the world economy, focused on the issues that Bolton highlights, it probably needs to assume a high priority in any CEO’s agenda.

I noted back in February that China is no longer exporting price deflation, and is instead causing global prices for commodities and manufactured goods to rise. A reader has now kindly sent me an interesting report from Credit Suisse, commenting on the potential inflationary impact of new labour laws in China. This is particularly important for the chemical industry, given the volume of foreign investment that has taken place in China.

It features the above chart, showing how wages have increased by 70% since 2004. And its analysis claims that the new Labour Contract Law, in operation since January, will increase manufacturing costs by a further 15%-20%. CS argue that this under-reported measure raises China’s labour rights to international standards, requiring extra pay for overtime, employer contributions to social and pension funds, and severance pay.

CS note that the new law is part of a package of measures aimed at stimulating domestic demand and reducing export-dependency. VAT export rebates were lowered three times in 2007, whilst corporate tax rates for Foreign Direct Investors are being raised from 15% to 25%. They argue that as well as increasing global inflation, the new measures ‘will also affect margins of many listed foreign companies using China as a production base’.

Please contact me at phodges@internationalechem.com if you would like a copy of the report.

Headline interest rates are set by central banks. But the ones that we actually pay, as consumers or companies, are set by the banks themselves. And most of these are based on LIBOR - the London Inter-Bank Offer Rate - which is the main benchmark for $347 trillion of borrowing around the world. Now it seems the LIBOR rate is likely to rise by 30 May.

The background to this is slightly complex (details below), but the implications are enormous. Lending rates for 6 million US homeowners are likely to rise as a result, for example. Today the LIBOR system was discussed in the UK Parliament, and it seems a new system is likely to emerge by 30 May. Based on the evidence so far, this could increase actual lending rates quite significantly, by up to 0.30%.

Increases in Russian oil supply have played a major role in balancing world oil markets, at a time when other non-OPEC sources such as the N Sea have been declining. Production rose from 6.2mbd in 1999 to 9.6mbd by 2006. But as I noted last month, there are signs it may now have peaked.

The reason for this is perhaps to be found in a comment by Leonid Filimonov, former USSR Oil Minister, in this month's 'Petroleum Review' . He said that from 1998, Russian oil "companies were focusing on the 'easy fields', racking up tremendous production gains, leaving only the 'difficult fields' for the future".

More recently, under Putin, Russia has become much more professional in its marketing of crude. According to the Financial Times, he has re-established central control of Russian crude sales by supporting the growth of Gunvor, a Geneva based trading house now responsible for an estimated $70bn worth of Russian oil sales this year. This has helped to support oil prices, by comparison with the previous free-for-all, and is credited with helping to 'reduce the discount between Russian Urals and western Brent'.

European isomer players may recognise some of the names involved in Gunvor, as it owes its origins to the Kirishi refinery, a regular PX/OX producer for many years. Kirishi is, of course, close to St Petersburg, where Putin was formerly Mayor. And according to the FT, the relationship is still maintained via a common interest in judo, with Putin and Gunvor boss Gennady Timchenko both members of Moscow's Yavara Neva club.

Sinopec is now losing 3000 yuan ($425) on every tonne of oil product sold, due to China's price freeze, according to Sinopec spokesman Chen Ge yesterday. And this is on top of official government subsidies paid to Sinopec, which rocketed to $1bn in April. This was more that the entire subsidy paid in 2007. And it will be higher still in May, as the government's subsidy was based on April's $98.60/bbl purchase price.

The government has massive foreign exchange reserves, of course, and there are no signs that it is preparing to relax the price freeze. Sinopec Chairman, Su Shulin, told Sinopec's annual meeting yesterday that 'it is hard to say' when the government may allow diesel and gasoline prices to rise. In fact, the higher the price for crude, the more difficult it would be for the government to act - particularly with inflation already at a 12 year high, at over 8%. So demand will continue to grow unchecked by market forces.

This is bad news for petchem producers and consumers, who are already struggling to pass on current record feedstock levels.

Dow today announced that it is raising prices for 'all of its products by up to 20 percent - depending on their exposure to rising energy, feedstock and transportation costs - and will review all terms to all customers'. Dow CEO, Andrew Liveris, said that Dow's 'first quarter feedstock and energy bill leapt a staggering 42 percent year over year, and that trajectory has continued, with the cost of oil and natural gas climbing ever higher."

Liveris added that "the new level of hydrocarbons and energy costs is putting a strain on the entire value chain and is forcing difficult discussions with customers about resetting the value proposition for our products." Dow thus follows Rohm & Haas in taking extraordinary steps to try and mitigate current feedstock prices. The company estimates that its $8bn bill for energy and hydrocarbon-based costs in 2002 will rise to $32bn this year, if present trends continue.

As I commented back on 2 January, 'it would be a triumph of hope over experience to expect the 2007-8 surge (in oil prices) to be different' from those that one remembers from 1973-4 and 1979-80. Then, we did exactly as Dow are doing now, and raised prices as an act of desperation. I would like to believe that the next stage of the story will somehow be different this time from previous experience, but as I have been warning since the blog started last June, a major downturn in chemical demand looks increasingly likely.

For those who are interested, my New Year Outlook from 2 January is available via the January archives, and is also attached to this posting ....

Central bankers had it easy over the past decade. Now they are going to have to earn their money. Inflation is rising rapidly, and growth rates are falling. But unfortunately, as I first noted back in March, they still seem to have differing ideas about what policies will best counter these twin challenges.

Every now and then, a few interesting quotes come along, which seem to recent summarise developments, and set the tone for the next few months. Recent days have been a good example of this process at work:

'The era of cheap energy is over, as oil production isn't rising fast enough to meet demand amid a lack of spending'. Tony Hayward, CEO, BP

'A public backlash against high (oil) prices in China could have an adverse impact throughout the world'. Zhang Guabao, China's delegate to the G8 Energy Ministers' meeting

'It is not clear if the rest of the world is going to continue to fund the US current account deficit at current levels of exchange rates'. Malcolm Knight GM, Bank of International Settlements (the central bankers bank)

'The banking system might simply revert to the role of a utility, which is the way things were before the great deregulatory tide began in the 1970's'. John Plender, senior financial columnist, Financial Times.

I noted earlier this year that China was now exporting inflation, rather than the deflation of the past decade. Working in Asia again this week, one can see a major change in attitudes is now underway. Rising food and energy prices are having an enormous impact, and Asian governments are clearly nervous about the potential for greater political unrest.

Therefore many have instead introduced subsidies of one type or another. In addition, central banks have allowed real interest rates in every major country to turn negative. For example, China's real borrowing rate is now -1.03%, as inflation is higher than the benchmark interest rate. Across the region, rates average 6.75%, well below average inflation of 7.5%.

Governments fear that raising benchmark interest rates would push up currency values, and damage exports. But many are still keen to cool their domestic economies. So they use other levers instead. This week, for example, China raised the deposit rates for banks to 17.5%, forcing banks to cut back on loans to companies and individuals. India followed, raising its rate to 8%, and Vietnam, Indonesia, Philippines and Pakistan also raised rates.

The result was a major fall in stock markets. China's benchmark index, the CSI, plunged 15%, the biggest fall on record, and is now down 44% for the year. Benchmark Asian indexes also fell around 7% on the week. And the Chairman of Morgan Stanley Asia, Stephen Roach, warned that the world was 'in denial' about the likelihood that Asia would now start to export 'stagflation' (stagnant growth, plus inflation). Stagflation last occured in the 1970's. This time, he argued, 'it will be made in Asia'.

Chemical companies, faced with rising feedstock costs and the prospect of lower volumes, might well argue that it has already happened.

The US has now confirmed what oil traders have been suspecting - that Israel is preparing for a bombing raid on Iran's alleged nuclear facilities. According to Bloomberg and the New York Times, around 100 Israeli aircraft took part in a full-scale training exercise in early June. The distance it involved, 900 miles, is apparently 'about the same distance between Israel and Iran's uranium enrichment plant at Natanz'.

Its now a year since the blog started. Since then, 213 postings have appeared. It is now read in 72 countries and 620 cities (shown above). Most encouragingly, readership continues to steadily increase. Since January, it has risen a further 301%.

The blog's aim is to identify 'the influences that may shape the chemical industry over the next 12 - 18 months', and to 'develop useful insights into the key factors that will drive the industry's future performance' . So a first birthday is a suitable moment to assess its success:

The central bankers' bank (the Bank for International Settlements) is not very impressed with its members' efforts over the past year. Readers may remember that the BIS Report last year explicitly warned of the problems that were about to occur in world financial markets. This year's Report expresses its disappointment about what central banks did in response:

European refining margins are falling, as the US's need for gasoline imports reduces. Margins have reached a 4 year low of minus $6.21/bbl, according to Bloomberg. And the problem is likely to get worse, as the US moves towards greater self-sufficiency in gasoline via refinery expansions and increased biofuels usage.

This trend could have important implications for European petchem producers, who are currently suffering from an inability to pass through today's high naphtha prices.

Andrew Sentance of the Bank of England has issued a very clear analysis of current oil and commodity price movements. It rejects the view that these have been primarily caused by speculators. Instead, it points to increasing demand, and lack of supply, as the main causes of today's higher prices. The slide above sums up his case, showing recent increases in non-OECD oil demand in light blue, the OECD increase in dark blue, and supply increases in purple.

Pimco, the world's largest bond investors, are worried about rising inflation. Their main concern is that many Asian and Middle Eastern countries had 'anchored' their currency to the US$. 'With that anchor gone', they comment, 'due to the US Federal Reserve's focus on preventing the US financial system from falling into a depression-style downward spiral, many countries find themselves anchorless'. They regard this as 'wholly inappropriate for emerging markets that are growing in aggregate around 7%, and whose inflation has picked up to double digits in many cases'.

BASF have now reduced their 2008 GDP forecast from 2.8% to 2.4%. This may sound a small amount, but it means it is now in line with the Global Downturn Scenario set out in our Feedstocks for Profit Study. Previously, it had been just below our Base Case Scenario. CEO Jurgen Hambrecht still sounds confident, commenting that the world 'will still continue to grow respectably, even if not as fast as in the last two or three years'. But he cautions that BASF now think the 'wave-like effects of the subprime crisis' will last 'at least until H1 2009.

A year ago, the noted investment analyst, Jeremy Grantham, described the credit crisis as a 'slow motion train wreck'. The Financial Times has now updated the metaphor to describe what has happened since. It notes that train crashes happen more quickly than economic ones, and that there are pauses before the next carriage hits the one in front. It believes this explains how we have since 'moved from crisis to crisis, with rallies in between, as participants persuade themselves that the worst is over'.

Its conclusion is not encouraging for chemical companies. It expects that the problems in banking, housing and consumer markets will continue to play out 'in very slow motion'. As a result, it warns that 'we may have much longer to wait until the final impact has juddered through the train'.

Housing is a vital market for chemical companies. It boomed in the US and other Western countries as credit standards were relaxed between 2003-7. Now it is at the centre of the credit crunch. Martin Feldstein, Harvard economics professor, and the man who chairs the Board that determines the duration of US recessions, is clearly very worried. Writing in the Financial Times today, he summarises the outlook as follows:

'The US economy is sliding into recession. Employment, industrial production and real incomes are declining. Monetary policy has little traction because of the dysfunctional credit markets and the collapse of housing. The fiscal policy of tax rebates failed to achieve a significant impact on consumer spending. The economy will continue to decline and the financial markets to deteriorate unless a policy is adopted to stop the downward spiral of house prices.'

Anyone preparing budgets for 2009-11 will need to include a Downside Case that covers what might happen to demand, and margins, if house prices do continue to fall.

Many readers have been out of the office during August on a well-deserved break. I am therefore highlighting below the main postings over the past month, in the hope this will help them to catch up quickly on key developments - please click on the highlighted title if you want to read the original posting:

• Oil prices were still close to $150/bbl in early August, but the blog again warned they could easily slip towards $100/bbl in the absence of any military action on Iran. Since then, they fell to a low of $112/bbl.
• Change, challenge, complexity. We published a major Study on the outlook for the petchem industry over the next few years. The post also contains a link to my feature article in ICB, summarising its key conclusions.
• US housing and auto markets continued to slow. US house prices fell again, and the number of new housing starts reduced. BMW warned on the outlook for 2009.
• GDP forecasts were cut by BASF. The UK's Finance Minister said the global economy was at a 60-year low, and China's minister referred to the need for economic restructuring.
• The credit crunch continued. Warren Buffett memorably referred to 'the nudist beach on Wall Street' where those bankers who had been 'swimming naked' were now being exposed.

All in all, reading through these headlines makes me think that August was probably a good month to go away. Welcome back, if you have just returned!

Pimco, the world's largest bond fund, have repeated their belief that we are facing a 'Minsky moment', named after Hyman Minsky (pictured). His insight was that a long period of stability, such as that experienced over the past decade, eventually leads to major instability.

This is because investors forget that higher reward equals higher risk. Instead, they believe that a new paradigm has developed, where high leverage and 'balance sheet efficiency' should be the norm. They therefore take on high levels of debt, in order to finance ever more speculative investments.

Eventually, however, a 'Minsky moment' occurs. Earnings from the new investments prove too low to pay the interest due on the debt. Confidence in the 'new paradigm' disappears and, with it, market liquidity. Investors find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid. In turn, this prompts a rush for the exits. Prices then begin to drop quite sharply, as 'distress sales' take place.

Pimco argue that housing markets were the first to experience the 'Minsky moment'. Now it is occurring amongst those who financed the housing boom. Pimco's forecast is that this process will continue. They believe we are now 'moving through this progression backward, with asset prices falling, risk premiums moving higher, leverage getting scaled back and economic growth getting squeezed'.

'A disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance,' according to the US Federal Reserve last night. As a result, the US government now owns 79.9% of the nation's largest insurer, in return for providing an $85bn loan.

Does this new 'rescue' mark the end of the problems? Former EPCA speaker, Martin Wolf, is not optimistic in the Financial Times today. He sees 4 major areas where 'excesses' need to be unwound:

• 'The fall of inflated asset prices to a more sustainable level
• De-leveraging of the private sector
• Recognition of resulting financial sector losses;
• Recapitalisation of the financial system'

He adds, that 'making all this worse will be the collapse in private sector demand, as credit shrinks and wealth falls'.

Another day, another rescue. This time on the other side of the Atlantic. HBOS, the UK's largest mortgage lender, with a 20% market share, announced this morning that it was being rescued via a merger with the Lloyds TSB bank. The deal was brokered by the UK government. UK Finance Minister, Alastair Darling, told the BBC that without the deal, HBOS's future 'was very bleak indeed'.

As readers will remember, Darling rather surprised financial markets last month by suggesting that today's economic times 'are the worst they've been in 60 years'. But his assessment has now been confirmed by former US Fed Chairman, Alan Greenspan, who says it is a 'once-in-a-century' financial crisis. Greenspan added that it must have 'a significant impact on the real economy globally, and I think that indeed is what is in the process of occurring'.

Alan Greenspan's comments (below), led the blog to investigate how the world's major stock markets had moved since their recent peaks. All, as shown in the chart, are now in bear markets. Stock markets often forecast economic developments 6 - 12 months ahead, and so this represents a negative indicator for future chemical demand.

Also significant is the globalised nature of the decline. Germany and Japan peaked first in July 2007, followed by the US, UK and China in October. They were followed by India in January 2008, then Russia and Brazil in May. This pattern seems to confirm the blog's long-standing concern that we may now be facing a multi-year global slowdown, as the financial excesses of the 2003-7 boom are unwound.

Does the US Treasury read the blog? Just hours after the chart below was posted, rumours began to circulate of a major government initiative to try and stabilise financial markets.

The proposal now before Congress to authorise the spending of $700bn to bail out Wall Street contains just 849 words. It avoids the need to go into further detail via its suggestion that the Treasury Secretary should simply have unlimited authority to act as he 'deems necessary'. But 5 key questions are bound to be asked over the next few days:

What is the likely total cost? The headline number is currently $700bn, plus the $50bn spent on Friday to insure money market funds. But, of course, there is also the estimated $200bn cost for bailing out mortgage giants Fannie and Freddie, in addition to the costs of the earlier Bear Stearns bailout and of the $100bn tax rebate in May/June. So already the sums involved are more than S Korea's total GDP ($939bn).
Is this a 'done deal'? No. The Wall Street Journal (WSJ) notes that House Speaker Nancy Pelosi has already said 'the Democrats will insist on adding measures to protect taxpayers and tighten regulation of the industry'. They also want more help for homeowners threatened with foreclosure. So the cost is bound to rise - the Savings and Loans bailout took 10 years (1989-99), and cost more than double the original $50bn estimate.
How will the money be spent? One suggestion is that the Treasury will purchase the assets via reverse auctions. This leads the WSJ to comment that 'the government may find itself in a quandary: Does it pay more than fair-market value for hard-to-assess distressed assets, putting taxpayers on the hook for any losses? Or does it drive a hard bargain, buying for pennies on the dollar? The latter approach would further hurt financial institutions, since they would have to write down the losses and take additional hits to their balance sheets.'
Who will pay the bill? The proposal calls for US national debt to rise by a further $700bn, to $11.3 trillion. There is no suggestion that taxes will rise - instead, the government will borrow more. Global interest rates will therefore end up being higher than would otherwise have been the case. And as the blog noted in September, financial institutions are already deleveraging thier balance sheets. So this new government borrowing will 'crowd out' borrowing by companies and consumers, forcing them to cut back, and further slowing the economy.
Will it solve the crisis? The WSJ notes that the proposal only deals with one-half of the current problem. 'A revival of the credit markets and a bottoming of the housing market are keys to a revival' it comments. 'The government's debt plan may reduce the level of fear in the market, enabling the credit markets to operate properly. But such a plan wouldn't do anything about the excess supply of homes and the large number of mortgage borrowers in dire straits.'

The blog has given up counting the number of US banks that have failed in recent weeks, away from the headlnes. Ken Lewis, CEO of Bank of America, predicted last month that half of all US banks would fail, and he is well placed to know.

Bank rescues are also rising across Europe. The German government last night supported a €50bn ($68bn) rescue for Hypo Real Estate, the country's 2nd largest real estate lender. Whilst France's biggest bank, BNP Paribas, took control of Fortis Bank in Belgium and Luxembourg for €14.5bn after a government rescue failed. Germany also followed Ireland's example in guaranteeing bank deposits, to avoid further bank runs this morning.

Against this dreadful trans-Atlantic background, the UK government is moving to address one of the fundamental issues. The Financial Times reports today that Finance Minister, Alastair Darling, is considering a taxpayer-funded 'recapitalisation of Britain's banks' as part of 'some pretty big steps which we would not take in ordinary times'.

Darling impressed the blog in August with his realisation that the 'global economy is at a 60-year low'. His move mirrors the successful Swedish response to a similar banking crisis in the early 1990's, which was also caused by a bursting property bubble.

This model only allowed the strongest banks to survive, and GDP still fell by 5% over 3 years. But its use of government money for selective recapitalisation is now viewed 'as one of history's most successful financial system bailouts'.

The UK is to invest £50bn ($85bn) to rescue its major banks, via part-nationalisation. In addition, it will provide unlimited amounts of cash via loans. The aim is to try and unfreeze the UK's banking system, which has been on the verge of collapse. Unlike the USA, there is no disagreement amongst the major parties over the need for the rescue.

In fact, the initial defeat of the US bailout bill last week, seemed to spur a sense of 'this mustn't happen here' amongst UK politicians. A new consensus is also beginning to form about the relative roles of government and markets. As summarised by Michael Skapinker in the Financial Times, this is based on the principle of 'the markets where possible, government where necessary'.

The International Monetary Fund (IMF) has now increased its estimate of total sub-prime losses to $1.4 trillion, versus $945bn in April. It estimates banks will need to raise $675bn in new capital. And Dominique Strauss-Kahn, the IMF MD, has called for the major economies to respond to the credit crisis with 'a collective commitment by authorities to address the challenges directly'.

The annual IMF meeting of the world's finance ministers takes place this weekend in Washington DC. This would be the perfect opportunity for such a collective commitment to be made. Chemical company executives will certainly share Strauss-Kahn's view that 'the time for piecemeal solutions is over'.

The German word 'Zeitgeist' describes 'the ethos or mood' of a select group of people. Back in January, the blog noted a change underway in the financial zeitgeist. Today's Wall Street Journal, normally a cheerleader for the financial community, provides a further example. After reviewing the losses to her personal portfolio, and considering how current financial market events compare to those at the start of the Great Depression, Karen Blumenthal writes:

'For more than a decade, I have gone to my local elementary school to tutor. There I spend time reading with children who own no books of their own, whose families can't afford school supplies and who have never been to a dentist. For the price of 45 minutes a week, I return to my desk feeling as wealthy as any one person needs to be'.

As the blog predicted, Iceland has been forced to call on the IMF for help. Finally, the country's leaders have recognised that their $20bn economy couldn't support the level of debt built up during the 'go-go' years. The pity is that it took them so long to recognise reality - and by then, any chance of avoiding disaster had long since disappeared.

Winston Churchill, a long-standing friend of the USA, once irritably but acutely observed that 'one can rely on America to get to the right conclusion, when all other options have been exhausted'. So, hopefully, it will prove with the financial crisis.

Tonight, Bloomberg and the New York Times are reporting that US Treasury Secretary Henry Paulson 'is planning to buy stakes in a wide range of banks within weeks, as the credit freeze increasingly threatens to tip the U.S. economy into a deep recession'. The cost being talked is $200 - 300bn.

This has to be the right thing to do, via the purchase of preference shares. But the sum talked sounds too little to the blog. After all, the UK government is investing at least $87bn in its bank purchases, in a much smaller economy.

The purchases also need to happen much more quickly than 'within weeks'. The US$ has just slipped below ¥100: $1, and as the blog noted last November, any sustained fall below this level 'would take us into uncharted water', and create the potential to add a currency crisis to the banking and housing crises already underway.

Many new readers have turned to the blog, to better understand what is happening in the financial world, and to chemicals demand. They might like to start with the 7 September posting, which forecast the current collapse: 'The price of all assets will go down'

Also, here is a list of recent postings:
Financial crisis
US to follow UK in buying bank shares
'Incompetence and denial'
Iceland calls in IMF
Europe, N America, China cut interest rates
The zeitgeist continues to change
The time for piecemeal solutions is past
UK part-nationalises its major banks
The Swedish model
Bailout bill passes, Wall Street falls

Housing crisis and chemical demand
Credit crunch causes demand destruction
Auto markets face 'outright collapse' in 2009
'Demand and prices in free fall'Blue skies disappear
US car sales plummet, house prices fall again
Shell's priorities for the gathering economic storm
Akzo halts share buybacks

And finally, for those who would like a break from it all:
A satirical look at the banking crisis

It is nearly time for the blog's annual forecast of chemical industry prospects. Of course, past performance is not necessarily a guide to future outcomes. But it is one of the better guides that we have. So before publishing the forecast next weekend, it makes sense to assess the blog's credibility by looking back at last year's outlook.

This was titled 'Budgeting for a downturn'. It took issue with the then current consensus, suggesting that this was 'very optimistic' in its belief that 'oil would remain at $70/bbl' for the year, that 'debt market problems would be contained', and that 'margins will remain at 2007 levels'.

It argued instead that there was 'a real possibility' oil prices would reach $100/bbl, and noted the alarming parallels with 1979-80, when apparent petchem demand increased (due to stock-building ahead of likely prices increases), whilst actual end-user demand collapsed. It also worried that 'the underlying position in financial markets is clearly deteriorating', and that 'new housing starts and US house prices were already very weak'.

Its main concern was that 'the latest upward rush by the oil price will be the catalyst that that finally causes the US consumer to cut back on non-essential spending. Equally, the continuing problems in the banking sector may well turn off the tap of consumer, and maybe even corporate lending'. It concluded that 'if I was drawing up budgets for 2008, I would be putting in place contingency plans for just such an outcome'.

The whole aim of the blog is to 'share ideas about the influences that may shape the chemical industry over the next 12 - 18 months'. The blog hopes that its 2008 forecast achieved this aim, and enabled readers to better prepare for today's more difficult economy.

The moment the blog has long feared has now begun to happen. Celanese chairman David Weidman said on Tuesday that acetic acid prices in Asia had dropped sharply in recent weeks. "Basically, orders just stopped", he added. It is almost certain that this moment will now be repeated in other product areas and in other regions, particularly as customers will be aiming to keep working capital low for year-end reasons.

The blog warned a year ago in Budgeting for a Downturn that this cycle was probably underway. And earlier this month, in 'Demand and prices in free fall' it suggested that the 'Hodges moment' (cf last month's 'Minsky moment' in banking markets) was about to arrive.

The 'Hodges moment' is when everyone in the chemicals value chain suddenly realises that they have been living in a parallel universe. Whilst they have been building inventory in advance of future oil price-related increases, demand in the real economy has been collapsing.

Now, the task is simple. Those of us who had the misfortune to be around in 1980, at least know what needs to happen next. Supply and demand need to be rebalanced to today's lower level of demand as quickly as possible. The blog also hopes that its recent 'Budgeting for Survival' will provide a helpful scenario for those seeking to 'test' their thinking in today's difficult market conditions.

The blog first raised this issue last December, when noting that global chemical industry production growth had already "slowed significantly".

At that time, it questioned whether "central bankers will be able to wave the magic wand that restores us to a growth path". And it warned "it is hard to imagine that the chemical industry can avoid a serious downturn". The above chart, based on Kevin Swift's must-read weekly report for the ACC, shows how serious the situation has now become.

• Asia Pacific growth has fallen from 10% in June 2007 to 3% in August
• Central/Eastern Europe has crashed from 10% to -3%
• Latin America growth has fallen from 3% to zero
• Western Europe has fallen from 3% to -1%
• N America has gone from zero to -3% in September

The Middle East is the only robust region, where new capacity based on advantaged feedstocks has caused growth to increase from 5% to 13%.

World chemicals growth is usually close to GDP. So it is ominous that growth had fallen from 5% to 1%, even betore the current Crash. This must further impact demand and credit availability. The blog therefore believes that the industry needs to prepare for a serious and extended downturn.

Sometimes markets move because of sentiment, sometimes because of fundamentals. Sometimes (luckily rarely), because of blind panic. The latter is what we are seeing at the moment. Investors suddenly feel they MUST sell - whether because they need the cash, have completely lost confidence, or because their family and friends are advising it.

Whatever the reason, markets then crash. But these moments, contrary to popular belief, do not come out of the blue. After the blog itself was caught in 1987, it learnt to read the warning signs, and to move aside as the moment of maximum danger approached. Thus it was able to forecast on 7 September that 'The price of all assets will go down'.

Deleveraging, which caused today's panic, will still be with us once markets stabilise again. This matters to the chemical industry, as it tells us whether we are in a dip, or a downturn.

The US Federal Reserve used just to manage monetary policy for the 12 'districts' of the USA. But now, it is going global.
First, it opened unlimited "swap lines" with other G7 countries through the European Central Bank, the Bank of England and the Bank of Japan, as well as the Swiss National Bank. Then, last week, it did the same for Brazil, Mexico, New Zealand, Singapore and S Korea.

Those countries within the new "swap lines" can borrow from the USA in their own currencies - so the Fed takes the exchange rate risk. This is also something that has never happened before, and highlights just how seriously the Fed regards current problems in the world financial system. As Bloomberg comments, "5 years from now, Fed Chairman Ben Bernanke will be regarded either as brilliant or reckless for so directly reaching around the globe".

Sen. Barack Obama duly won a landslide victory in yesterday's US Presidential election, but will not take office until 20 January.

I suggested last month in ICB, that "this delay, at such a critical moment, is not good news for chemical companies or for their customers".

The blog therefore congratulates the new President, and expresses its hope that he will find a way to move forward on tackling the key economic issues. 11 weeks would be a long time for a policy vacuum to exist on these at the heart of Washington DC.

UK interest rates have just been cut by 1.5% to 3%. They were last at this level in 1955.

The Bank of England had been very concerned about inflation, currently at 5.2%, compared to a target of 2%. But the Bank now sees no danger from inflation in the future. Instead, it is warning that there is "a substantial risk of undershooting the inflation target".

The Bank also noted that "since mid-September, the global banking system has experienced its most serious disruption for almost a century". It added that "there has been a very marked deterioration in the outlook for economic activity at home and abroad". And it expects that "the availability of credit to households and businesses is likely to remain restricted for some time".

Earlier, the European Central Bank had also recognised that inflation was no longer a major concern, when it cut rates by 0.5% to 3.25%.

"Our normal customers have no orders to place with us, and our credit department won't let us sell to others who might want to buy". The blog was given this plain-spoken assessment of current chemical market conditions by one of the majors yesterday.

Coincidentally, US Fed Governor Kevin Warsh was making one of his rare speeches, analysing today's "unprecedented levels of volatility and dramatic financial market and economic distress". He concluded that "we are witnessing a fundamental reassessment of the value of virtually every asset everywhere in the world".

Warsh is one of the few central bankers who tried to warn of coming problems. He pointed out in April that "liquidity should not be mistaken for capital". Now, he sees companies and investors being forced to reassess "seemingly benign risks - credit, liquidity, counterparty, and even sovereign risks". As a result, credit controllers are refusing to allow sales to be made unless they are sure the invoice can be paid.

The G-20 was created in 1999, after the financial crises that had hit emerging countries from 1997 onwards. It includes the G7 group of major industrial companies, plus the main emerging economies, including the BRIC countries (Brazil, Russia, India, China). Its ministerial meeting this weekend became a preparatory session for its first-ever Heads of State meeting in Washington on Saturday, with the aim of developing "concrete policy outcomes".

Encouragingly, China used the occasion to announce a $586bn stimulus package, to be spent by the end of 2010, focusing on rural development and infrastructure programmes. As Zhou Xiaochuan, governor of the People's Bank of China, noted "if China can maintain domestic demand, its helpful for global stability". The BRIC countries also announced measures to promote trade flows between themselves, in an effort to compensate for lost exports to the West.

The background to these efforts is a forecast from the International Monetary Fund that world growth in 2009 will be at a recession level of 2.2%, and less than half the 5% seen last year. The IMF also forecasts that "output in the advanced economies (US, Europe, Japan) will contract" next year. This would be the "first annual contraction since 1945", and be "broadly comparable" to the major recessions of 1975 and 1982.

The blog's forecasting record is reviewed in ICIS Chemical Business this week. Click here if you would like a copy. The blog's aim is to "highlight relevant information for the busy executive, and to provide relevant and actionable analysis of key issues". The article particularly notes the blog's willingness to challenge consensus forecasts.

The blog has warned for over a year that the chemical industry faced a global downturn. It has developed a good track record on forecasting movements in oil prices, and it also forecast the global financial crisis in early September under the heading 'the price of all assets will go down'.

A few months ago, Russia's economy seemed to be recovering from its problems in the late 1990's. High prices meant oil revenues were increasing, and the currency was strong. Now, the combination of the oil price collapse and the credit crunch has reversed the position. Yesterday, the central bank was forced to raise rates to 12% to slow the rouble's fall.

ICIS news reported this month that some planned petchem investments have already been postponed. Russia is also the world's 2nd largest oil producer. But as the blog noted in May, the easy gains in production have been made. Now, only "the difficult fields" remain to be exploited. Without cash, Russia's oil production will slow even faster, setting up more feedstock problems for the chemical industry in the future.

The Financial Times series on surviving the downturn focuses this week on CFOs. It includes advice from Feike Sijbesma, CEO of DSM, who suggests that "you need to see how creditable your debtors are, very quickly", and advises that "maintaining a good relationship with your creditors and banks is also critical".

The Key Tips from the article are worth considering by any CFO:

• Cash is king. Monitor it daily.
• Be visible. Raise your profile in the company.
• Rethink bonuses. Make them focused on cash generation.
• Stress test. Will oil prices stay at $50/bbl? Will we see deflation?
• Strike a balance. Be tough, but don't overreact.

CFOs have a vital role in preserving the financial health of the business. They need all the help and support they can get, at this critical time.

Andrew Liveris, Dow CEO, has consistently warned that we are facing a major recession. Today, in a Bloomberg interview, he spells out the need for "radical actions" to "take out capacity".

He notes that Dow's volumes are down 10%-20% this quarter, and expects this to continue into H1 next year. And he forecasts that "we could be looking at a couple of years of trough and severe correction".

Liveris says that Dow's prices for PE and PP have fallen 40% since September. And he warns that "holding prices in the commodities is going to be near impossible in the next 3 to 6 months". He adds that demand is falling in all the major regions of the world simultaneously. "To see a global contagion of this order of magnitude, I think that is what we are currently living, and that is probably unprecedented,'' Liveris said.

Liveris' view is that plant closures of older and higher-cost plants are inevitable. Otherwise, the industry will find itself operating at "less than 80% of capacity as demand declines". He expects that "Dow and others, I think, will be taking some radical actions to take out capacity".

As the blog argued last month, survival is the key priority at the moment for many chemical companies. CEOs and Boards need to focus on developing and implementing major change management programmes as quickly as possible.

The first-ever G-20 meeting of Heads of State was a relatively quiet event, without the presence of President-elect Obama. Two main areas seem to have been discussed:

• Regulatory reform, where finance ministers have been given until the end of March to work out new rules for the world's financial markets
• Fiscal stimulus, where the International Money Fund (IMF) proposed countries should co-ordinate a stimulus of up to 2% of GDP via tax-cuts and spending

The scale of the current crisis means that it is going to take many months to put together a sensible and deliverable strategy for recovery. This will also require co-operation amongst all the major economic powers. The G-20 is certainly the right body to take this type of initiative, rather than the G8. The blog hopes that it is up to the task.

An interesting note from PetroMatrix highlights the close linkage that has now developed between changes in the Dow Jones Industrial Average and WTI crude oil prices.

The chart, showing market action on Thursday, makes the point very clearly.

PetroMatrix's analysis suggests that "the correlation across asset classes remains very strong and there is little diversification of sentiment or of asset fundamentals".

Japan has an ageing population. Since 1990, it has relied on exports to boost its economy.

Yesterday, official figures showed industrial production is now being badly affected by the global recession. Output fell 3.1% in October, and a 6.4% decline is expected in November.

Observers forecast the September - December period could see an "unprecedented" total fall of 12%. And unfortunately for the chemical industry, auto production was worst-hit last month.

A vicious cycle is clearly now underway, whereby lost exports will lead to major job cuts, and further reduce consumer spending. Japan's economy minister, Kaoru Yosano, also warned this would increase "deflationary pressure on Japan's economy".

In September, the blog wondered whether "China's interest in remaining the manufacturing capital of the world may be starting to wane". Yesterday, Lou Jiwei, the chairman of China's sovereign wealth fund (China Investment Corporation) confirmed the new focus on domestic growth. He suggested that "if China can do a good job domestically, that is the best thing it can do for the world".

Lou's statement echoed last week's comments from President Hu Jintao that "difficulties in the global economy threaten to undermine growth in China". Lou also added that major losses in their western financial investments (for example, Blackstone down 82% since they bought at $29.60/share), meant they "do not have the courage to invest in financial institutions because we do not know what problems they may have".

Asian chemical demand is tied to GDP/capita growth in the West, not to domestic needs. So China's new focus means much slower growth in local chemical demand. As the blog warned a year ago ,"decoupling (of the Asia economy from the West) is a good story, but its not going to work going forward".

Sometimes a headline says it all. Today's in the Financial Times, "Markets braced for big European rate cuts", showed just how far we have travelled since the first signs of global financial crisis in August last year. Then, a co-ordinated round of interest rate cuts would have sent stock markets soaring. Now, they are taken as a sign of underlying weakness. Deflation, as the blog discussed in October, is now the real concern.

The downturn is starting to impact politics all over the world. As an example, take the recent sequence of events in Canada:

• In October, Prime Minister Harper increased his vote, but still ended 12 seats short of a majority, after calling an early General Election
• Last week, the opposition parties united against his economic policy, and called for a confidence vote in Parliament.
• In response, and for the first time in Canada's history, Harper won the Governor-General's approval to suspend Parliament for 7 weeks.

China has just reported its first fall in exports for 7 years. These were still growing at 19.1% in October, but fell 2.2% in November. The suddenness of the downturn is also shown in the import figures, which were down 17.9% versus 2007.

The numbers confirm the blog's long-expressed fear that China, and the Asian region, will suffer badly from the global downturn. Their relatively low levels of GDP/capita means that domestic growth rates immediately stall, as soon as exports dry up.

There is now general agreement that we are in a global recession. The World Bank's new 'Global Economic Prospects' report expects global GDP growth of only 2.5% this year, and just 0.9% growth for 2009.

This is well below the 3% level that signals recession. And the Bank also forecasts that world trade will contract in 2009, for the first time since 1982.

The key question is therefore how long this recession will last? The blog's research has highlighted 4 main scenarios:

V-shaped. The optimistic view is that recovery is just round the corner. But this seems unlikely, given the headwinds of the credit crunch and looming over-capacity in many key chemical products.

U-shaped. This is the blog's base case. It implies the recession bottoms in 2010/11, and then begins to recover. Early decisions to close high-cost plants, and cancel unnecessary new capacities, would also be required.

W-shaped. This is often seen in serious recessions. Severe destocking leads to an apparent early recovery, as the value chain restocks. But demand then slips back again, before properly recovering.

L-shaped. This is the worst case scenario, as it implies demand could fail to recover by 2011, and might instead remain at a low level. This would mirror Japan's experience post-1990.

The blog's view is that it would be very optimistic for companies to plan on the basis that this recession will be V-shaped, as in 2002/3 and 1997/8.

Instead, it shares the view of a senior BASF executive, who has reportedly said he had "hoped it would be a U-shaped recovery (as in the early 1980's and 1990's), but now thinks it could become L-shaped".

Japan went through its "bubble years" in the 1980's, with the Nikkei index peaking at 39000 (versus 8664 today). The blog well remembers standing in front of Tokyo's Imperial Palace in Tokyo in 1988, when its land was said to be worth more than all of California.

Since then, housing and stock market bubbles have occured in many other countries. Whilst Japan was picking up the pieces, after its bubble burst in 1990.

In his first interview today, the new Bank of Japan Governor says they found no "magic formula" that could "spare economies the pain of dealing with the excesses that led to the bubble in the first place". He adds that "alarm bells should have gone off when the global economy was growing at an unsustainable 5% from 2003-7".

The result, he warns, is that "the economic cost is so huge", fiscal stimulus or low interest rates will make little difference. In Japan, for example, "the cumulative drop in property prices was 60-80%". The uncomfortable lesson from Japan, he says, is that "the economy will have to grind out the excesses - high house prices and unsustainable household debt - that inflated the bubble in the first place".

The blog has been searching the websites of the major central banks, such as the IMF, World Bank, Federal Reserve and Bank of England, for research on the history of credit crises. Several readers, including Paul Noble of Parsons Brinckerhoff, have also kindly forwarded helpful studies.

The most comprehensive study that it has found analysed 33 banking crises between 1977-2002 and concluded:

• The average length of each crisis was 4.3 years
• The median loss of GDP was 7.1%
• Major crises (such as today's) caused GDP losses of at least 10%.
• GDP losses can double if the banking crisis leads to a currency crisis

The studies also suggest that lack of effective government action (eg depositor guarantees and liquidity support) causes even greater GDP losses. The US Depression led to 30% of GDP being lost.

Another key message from the research is that even "successful" government intervention comes at a high price. This is because it causes banks to lower their risk profile in two key ways:

• They prefer to hold government debt rather than make corporate loans
• They only lend to the very safest borrowers

This change in risk profile means that government intervention has the side-effect of breaking the process by which banks provide credit for the real economy. Inevitably, therefore, credit crunches are deflationary.

History's lessons on the likely course of today's crisis are thus not encouraging. Governments will initially find it easy to borrow, but face the risk of a currency crisis if foreign lenders begin to suspect they will never be able to repay the money borrowed. Companies however, will find it more difficult to borrow, as banks "de-risk" their balance sheets.

Consumers therefore face an increased risk of unemployment, and so will tend to save more, rather than spend money. In turn, this will reduce demand - further pressuring companies, and government's ability to provide fiscal stimulus.

The blog is now 18 months old. It has a truly global readership, and as shown in the above map, is now read in 1244 cities and 89 countries.

Its aim has always been to identify 'the influences that may shape the chemical industry over the next 12 - 18 months', and to 'develop useful insights into the key factors that will drive the industry's future performance'. So today is a suitable moment to review its development:

Economic events. The blog has been widely recognised for its success in forewarning readers of the global financial crisis. This was most obvious in its posting of 7 September, titled "The price of all assets will go down", which was written 2 weeks before the Dow Jones began its fall from 11,200 to a low of 7500. Its insight does not depend on economic models, but on its willingness to identify the key facts and let them speak for themselves.

Chemical industry growth and margins. The blog's prime interest is in understanding the trends that will drive chemical demand and profitability. Thus it follows developments in housing, autos, oil prices and the financial markets on a daily basis. Over time, this enables it to identify patterns of cause and effect. Thus its 2008 Outlook was titled 'Budgeting for a Downturn', and warned that "the consensus forecast for 2008 is very optimistic". Its more recent posting on 19 October, giving its 2009 Outlook, was titled 'Budgeting for Survival'.

Oil and feedstock prices. The blog's prime focus has been to stress the likely volatility of oil prices. This is due to tight supply/demand balances, which mean that small fluctuations around the core 85mbd level can lead to large changes in prices. This insight enabled the bog to forecast ever-high oil prices until July, when it was virtually alone is suggesting that oil prices "could easily fall $50/bbl to $100/bbl" in the absence of any military action on Iran. It then built on this success by forecasting that a further fall to $70/bbl was likely, followed by a warning on 4 November that "a $20-$30/bbl range for crude, albeit temporarily, would not be impossible". WTI's $33.87/bbl mid-December low justified this caution.

Summary. The aim of the blog is to identify key changes in the wider landscape, as early as possible. As a natural optimist, I would prefer these to be positive changes. Unfortunately, however, the last 18 months have instead proved to be full of warning signs. I hope that reading the blog has provided you with valuable insights into the underlying issues. And I will do my best to ensure that it continues to helps you prepare for the problems that we now face.

Early last year, the blog flagged up a warning from Gillian Tett in the Financial Times that Iceland could go bankrupt, as its banks were "too big to rescue". Yet at the time, the United Nations had listed it as having "the highest standard of living of any country" in the world. Unfortunately, however, Iceland's 'wealth' was all based on leverage, and in October the banks failed, causing the Icelandic currency to become virtually worthless.

Readers will also, of course, remember that last autumn's financial crisis originally started with a few, seemingly isolated, banking problems over subprime. So they will understand why the blog is taking recent concerns over the future stability of the eurozone quite seriously. Nobody is suggesting that Germany, for example, is at risk. But two developments signal that the situation could become serious:

• Yesterday, S&P downgraded Greece's credit rating, due to its high debt levels, and may downgrade Portugal, Spain and Ireland
• Bonds issued by Greece, Spain, Portugal, Ireland and Italy are now yielding record amounts versus the German benchmark

The core of the issue is whether any of these countries may be forced either to devalue against the euro, or to leave the eurozone entirely. The implications for the chemical industry would, of course, be enormous if this happened. After Iceland, however, it is clear that nothing can be ruled out, if the 5 governments do not quickly start to put their house in order.

Asia is hard-hit by the downturn in the Western economy. Today, China said its Q4 GDP had grown just 6.8%, the slowest level since 2001. This led premier Wen Jiabao to say the outlook for jobs was "very grim". It also increased speculation that China will devalue the renmimbi, which would increase trade tensions within Asia and with the USA.

The root cause is a decline in exports, which account for 37% of China's GDP. Japan's exports are also suffering, down 35% in December. Taiwan saw a 40% drop, whilst S Korea's industrial production is now declining at the fastest rate since 1975. In turn, this has very worrying implications for petchem producers. Many Asian countries send 50% of their production to China, to be re-exported as manufactured goods to the West.

Meanwhile, the outlook in the West is still getting worse. Housing is a key driver for chemical demand, and today the US government announced that total 2008 housing starts were just 904,000, down 33% from 2007 levels, and the lowest annual rate since records began in 1959. December housing starts were even lower, at only 550,000 on an annualised rate.

China faces a difficult outlook, after the collapse of its main export markets in the West.

Interviewed by the Financial Times today, China's premier, Wen Jiabao, sets out a pragmatic list of "forceful" actions that are now underway. Most are Keynesian measures, aimed at putting money in the pockets of those who are most likely to spend it quickly:

• 74m low-income people have received spending subsidies
• Pensioners of state-owned companies have been given supplements
• 12m teachers have been given salary increases

In addition, Wen is planning to introduce a "fairly comprehensive social safety net", with further money being spent on medical care. Subsidies for small-engine cars are being introduced, and technology spending is being increased. Plus, of course, $400bn has already been allocated to increased infrastructure spending.

Wen was also relatively outspoken, for a top Chinese official, about the causes of the downturn. Dismissing suggestions that China's savings had caused the current recession, he noted that "it is completely confusing right and wrong, when those countries that have been overspending, then blame those that lent them money for their spending".

Last August, the blog noted that politicians were beginning to wake up to the scale of the current crisis. There are still many politicians (and businessmen) who still hope we are facing just a 'normal recession'. But last week, IMF head Dominique Strauss-Kahn told a Malaysian audience that "advanced economies are already in a depression".

Now a senior UK politician, Ed Balls, formerly an economic adviser to the Prime Minister, has warned that "the reality is that this is becoming the most serious global recession for, I'm sure, over 100 years as it will turn out." He added that "we now are seeing the realities of globalisation, though at a speed, pace and ferocity which none of us have seen before".

Yet again, as in October, 'buy on the rumour, sell on the news' has been the financial markets' reaction to the latest efforts to solve the financial crisis. A 5% fall on Wall Street last night, in response to the Geithner plan, tells its own story. The blog is also unconvinced that this further $2.5 trillion will solve the problem.

Back in September/October, it raised 5 questions about the spending plans. None have yet been properly answered. And crucially, for the chemical industry as well as for the economy, nothing has yet been done to solve the root cause of today's problems, namely "the excess supply of homes and the large number of mortgage borrowers in dire straits".

Today, however, former Treasury Secretary Brady has put forward a plan to address this issue. Brady was the man who gave his name to the Brady bonds, issued during the first Bush administration to resolve Latin American banking problems. He has a good track record, and the blog agrees with his diagnosis and proposed solution. His plan focuses on the two key issues that are currently depressing the US economy:

Deleveraging. Brady argues that this process has to be eased. One key step would be to abandon 'mark to market' accounting. This creates a vicious circle, whereby today's low value becomes the norm tomorrow. In turn, this destroys the banks' capital base, forcing them to further reduce lending, and causing more bankruptcies.

Foreclosure. As Brady notes, you can't begin to rescue the US financial system without first confronting the mortgage problem. His first step would be to make a realistic calculation of the "true scope of the problem". At the moment, neither the public nor the financial markets believe that this has been done.

The essence of Brady's plan is that the authorities need to get a handle on the amount of money that needs to be written off, as a result of the reckless lending that took place in the housing sector. People then need to be given support to help them stay in their homes, rather than being pushed onto the street, leaving their property to become derelict.

At the same time, the financial system needs to be given time to begin to repair itself. The US Treasury will need to pick up the tab, and the US taxpayer will end up paying the bill. But as Brady says, quoting General George Patton, " a good plan, violently executed now, is better than a perfect plan executed next week".

China plans to increase petchem production as a way of stimulating its economy. According to the China Daily, the government intends to allocate 400bn yuan ($58bn) from its fiscal stimulus to accelerate the implementation of petchem expansion plans. Bloomberg adds that the givernment could approve plans next week to increase "tax rebates for the exports of some petrochemical products". In addition, refiners will gain increased subsidies, allowing them to support downstream pricing.

This news is a disaster for other Asian petchem producers. China has been the main export market for NEA/SEA countries in recent years, accounting for up to 50% of output. This demand has already been reduced by the West's recession, as production has slowed in China's manufactured goods sector. Now, the use of subsidies will make China's own production even more competitive in the short-term. Whilst the decision to accelerate capacity increases will increase regional and global over-capacity in the medium term.

In December, the blog noted that Japanese policymakers saw clear parallels between the mistakes they made during the 'lost decade' of the 1990's, and those being made today in the USA and other Western countries. The New York Times now has a fascinating article on this subject, which notes that:

"The Japanese crisis of the 1990s and early 2000s had roots similar to the American crisis: a real estate bubble that collapsed, leaving banks holding trillions of yen in loans that were virtually worthless. Initially, Japan's leaders underestimated how badly the real estate collapse would hurt the country's banks. As in the United States, a policy of easy money had fuelled both stock and real estate speculation, as well as reckless lending by banks.

"Many in Japan thought that low interest rates and economic stimulus measures would help banks recover on their own. In late 1997, however, a string of bank failures set off a crippling credit crisis. Prodded into action, the government injected 1.8 trillion yen into Japan's main banks. But the injections -- too small, poorly planned and based on little understanding of the extent of the banking sector's woes -- failed to stem the growing crisis."

It adds that "One reason Japan's leaders were so ineffectual for so long was their fear of stoking public outrage. With each act of the bailout, anger grew, making politicians more reluctant to force real reform, which only delayed the day of reckoning and increased the ultimate price tag."

Depressingly, the NYT concludes that, "so far, the Obama administration's plan avoids the hardest decisions, like nationalizing banks, wiping out shareholders or allowing banks to collapse under the weight of their own bad debts." Denial, however, is not a viable policy, and the NYT notes that "in the end, Japan had to do all those things".

US fund managers Comstock Partners reported a 50+% gain on their flagship Capital Value Fund in 2008. The logic behind their out- performance is summarised in the chart, which depicts their belief that we are now in a global cycle of deflation. Their analysis is that this cycle:

• Began with a rise in savings in emerging countries such as China, which then funded over-investment locally whilst also supporting excess consumption in the West.
• In turn saw twin excesses appear, of debt, and manufacturing capacity. These then led to the generalised weakness in pricing power now impacting chemicals and other major industries.

Some countries, such as the UK, have already responded to recent developments by devaluing. The pound is down 23% versus the US$ since September, and 13% versus the €. The risk is that we now see a round of competitive devaluations, as other countries also try to support their exports, and reduce import penetration.

Logically, countries should instead be focused on closing capacity as fast as possible, to avoid the menace of deflation. This would, of course, be very painful in terms of immediate job losses. But the risk, as Comstock suggest, is that we may end up seeing a rise in protectionism to protect employment, with governments imitating the 1930s by introducing tariffs and other beggar-my-neighbour trade policies.

Past performance, as we all know, is no guarantee of future performance. But there seems to be sufficient evidence for Comstock's analysis to make the blog concerned that they may just be right.
The blog is an active private investor, and may have a financial interest in any shares, securities and trading strategies mentioned.

James Baker was Treasury Secretary to President Reagan. When he says that the US is "repeating Japan's mistake by viewing our banking crisis as one of liquidity and not solvency", the blog listens.

His prescription is stark: "we should divide the banks into 3 groups - the healthy, the hopeless and the needy". And he suggests policymakers should "leave the healthy alone, and quickly close the hopeless. The needy should be re-organised."

Baker also argues in today's Financial Times that "this crisis demands a pragmatic, comprehensive plan. We simply cannot continue to muddle through it with a Band-Aid approach." And he goes on to echo former Treasury Secretary Brady's concern that policymakers have not yet realised "the true scope of the problem".

Its not just the World Bank that is concerned about the outlook for East Asia. Today, Moody's (the ratings agency) says it has a negative outlook for the petrochemical sector over the next 12-18 months. It concludes:

• "In response to weakening global demand, Asia Pacific's petrochemical companies are rapidly shedding inventory and delaying their procurement of feedstock, which has amplified the sector's current down-cycle.
• "The negative outlook in the Asia-Pacific petrochemical sector reflects petrochemical manufacturers' deteriorating margins, which in turn result from weak demand, a slowing economic environment, and new capacity coming online