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.

Crude oil prices are climbing again. $100/bbl is not impossible, if current geo-political concerns continue. And today's tightly balanced market could persist to 2010.

Housing and autos have always been key drivers for the US chemicals industry. We should be concerned if the housing market weakens further.

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”.

Consumer attitudes have shifted sharply in recent weeks. This could have big implications for chemical companies, and they need to respond quickly.

Central bankers are like generals. They seem to prefer fighting their last war, rather than preparing for the next one. How else to explain their continued reluctance to recognise that higher food and energy prices are here to stay? As a result, interest rates now need to rise more than expected. Pity those who have to forecast demand levels for 2008 Budgets

If you read the financial pages of your newspaper, everything sounds rosy. But if you turn to the news section, its all gloom. Both views can’t continue to exist alongside each other for ever. Whichever scenario comes out on top, will have major implications for the chemical industry. My own view is that this week’s Access deal for Lyondell will be seen, in hindsight, as marking the top. There could be storms ahead.

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.

Bill Gross runs PIMCO, the world’s largest government bond managers with assets of nearly $700bn. In a new commentary, he pulls no punches about what he sees as the ‘gluttony’ of the super-rich amongst the private equity and hedge fund elite. He also takes aim at the lenders who, in his view, have been ‘too meek and too passive’. He sees the end of the era of cheap debt financing, and with it the boom in M&A that has sustained equity markets in recent years.

Alchemists once claimed the ability to turn base metal into gold. More recently, some bankers seem to have been claiming a similar genius, via the magic catalyst of securitisation. These bankers no longer perform their traditional role of lending on a prudent basis to good quality borrowers in the personal or corporate sector. Instead, they simply seek to lend as much and as quickly as possible, usually in areas that they do not understand. Their aim has simply been to generate significant commission income for their bank, and personal bonuses for themselves.

The head of Germany’s financial regulator is warning that US subprime mortgage problems may be about to lead to the worst banking crisis since 1931. Yesterday, WTI crude broke through its 1980’s highs to hit a new all-time record price of $78.77/bbl, and looks poised to push on past $80/bbl. And adding to the sense of ‘retro’ is the news that debt traders have revived the 1980’s children’s TV show ‘Teenage Mutant Ninja Turtles’ as an acronym. NINJA now stands for No INcome, Job or Assets

Normally a 275 point fall on Wall Street, and a 600 point fall in Hong Kong, would make for some headlines. But this time, the media coverage has been very muted. Presumably everybody thinks it will be another '9 day wonder', and believes with Chuck Prince of Citigroup that one simply has to keep ‘dancing'. But equally, there are some quite worrying opinions now being expressed about the underlying risks that might impact us later in the year or in 2008. I thought you might like to see them:

‘What we saw last month was a toy trainset model of what is in store for us with the unwinding of the great credit bubble’. John Dizard, Financial Times markets commentator.

(NB the first and last quotes are from the Financial Times, which unfortunately has a subscription only policy for its stories, so I haven't included the link details in order to avoid frustration if you tried to click through).

An interesting thing has happened to benzene markets, which I haven’t seen noted elsewhere. According to ICIS pricing, average prices last week in Europe, US Gulf and Asia were $1053/t, $1052/t and $1040/t respectively.

And is the fact that benzene prices have only increased by 26% since July 2005, whilst Brent crude oil prices have moved 34%, also telling us something about the growing difficulty of passing higher oil prices down the chain?

Two of the largest US auto manufacturers, GM and Ford, have now followed Wal-Mart and Tesco’s lead in detecting a change in consumer sentiment. GM, after announcing particularly strong Q2 Asian and emerging market sales, added that US sales declined 7% as a result of ‘increasing fuel prices and concerns about housing’. Ford said that their US sales had declined 19% in July, and talked of ‘sobering’ economic challenges.

This is bad news for chemicals demand, if it continues. 70% of US GDP is consumer-related. Housing and autos are two major components – if they continue to deteriorate, then we could be in for a sticky patch in Q4. Those CEO’s now working on the cost leadership programmes that I proposed in mid-July will not feel inclined to relax their preparations after this news.

Yesterday, the ECB (European Central Bank) provided an unprecedented €95bn into the region’s credit markets, to maintain liquidity. Otherwise, firms would have had problems paying their bills, and employees might not have been paid their wages. This is serious stuff, and it was followed by the US Fed providing $24bn into US markets, and the Bank of Japan with ¥1trn of assistance this morning.

However, last month’s warning by the BIS (the central bankers’ bank), is also relevant. So far, as they forecast, we have indeed only seen ‘a tendency for national authorities to go it alone’. There has also been the ‘international dialogue’ between the ECB, Fed and BoJ to which they referred. But are the right institutional processes in place, in case today’s financial crisis gives more signs that it might start to impact the real economy in which chemical industry people live and work? One wonders.

All the world’s media are now carrying accounts of the ‘liar loans’ and fraud that has accompanied the growth in US mortgage lending in recent years. How did this come about?

The only problem is that the whole story may turn out to have been an illusion. The CEO of Countrywide, the largest US mortgage broker, said last month that `we are experiencing home price depreciation almost like never before, with the exception of the Great Depression'.

Credit market problems intensified last week, even though stock markets rallied strongly until Wednesday. I thought you might like to see some more comments on what is going on, from people close to the action.

Ben Bernanke, Fed Chairman, ‘wrote extensively in the 1980s about the causes of the Great Depression. He argued that the Fed could have prevented the damaging bank runs if it had provided the necessary liquidity, as he is trying to do now, thus calming depositors instead of forcing banks to turn them away empty-handed’. New York Times.

When I worked with ChemConnect in the halcyon days of the dot-com era in 1999-2000, we had a fantastic PR lady called Linda Stegeman. Linda ignored conventional wisdom about 'bundling' all your best news together to gain maximum impact. Instead, she released the stories one by one, and let them build. First Dow and Rohm & Haas investing; then BASF, BP, Borealis and Bayer; then SABIC; then Mitsui and Mitsubishi, and so on. The impact was extraordinary, particularly for a new company with neither sales nor income to report.

Linda called the technique 'rolling thunder', and I was reminded of her when I read this morning that Goldman Sachs were now having to invest $2bn to bail out their Global Equities Opportunities hedge fund. Over the weekend, the papers had been full of reports that US banks were refusing to lend to anyone without a '212' (eg New York) telephone area code, after last week's losses in Europe and Asia. But yesterday, the 'rolling thunder' of the subprime story returned to N America again.

And, of course, every time it completes a circle around the globe, it takes a new twist. First time around, it was about poor Americans losing their homes. Then it became one of central banks trying to avoid a credit crunch. What's next? Maybe what has been, until now, a purely financial story, is about to impact the real economy? As my wife commented over breakfast - '$2bn is a lot of shoes and handbags that the bankers won't be buying this autumn'.

The subprime parallel then wouldn't be with LTCM or other 'financial' problems. It would be with major disasters such as Penn Square Bank, which went bust in 1982 and nearly brought down much of the US banking system with it. A wonderful book by Mark Singer called 'Funny Money' was written in 1985, just as I arrived in Houston, Texas, to trade petrochemicals. Its dust cover reads 'For the better part of a decade, there had existed a virtually global belief: the price of petroleum and everything that depended on it would go no way than up'.

I have the feeling there may well be a similar book written in a few years time, when the dust has settled on subprime, which simply changes the word 'petroleum' for 'housing'.

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’.

Some 20 years ago, after a couple of senior management jobs, I was sent off to study for a month at the IMD business school in Switzerland.

There I spent time with Prof Jim Ellert, a noted financial analyst, who showed us how to understand a P&L and a balance sheet. He also passed on several powerful lessons about how to run, and not to run, a business.

His major lesson was about the danger of leverage. His demonstration was very simple, using standard assumptions for interest costs and tax, and stays with me today:

• No leverage. In a good year, a company's earnings might rise 30%, or fall 10% in a bad year. Return on equity (ROE) would swing from 18% to -6%. Nothing earth-shattering there.
• 50% debt: equity. Then in a good year, ROE would hit 30%, but be -18% in a bad one. Things could get tricky.
• 90% debt? In a good year, ROE would hit a fabulous 126%, but in a bad year would be -114%. The company would be bankrupt.

The seeming genius of many private equity funds in recent years has been due to nothing more than the application of high leverage during the 'up' part of the business cycle. As and when we go into the 'down' cycle, leverage will exert its same impact on the downside.

If I was a CEO preparing my cost-leadership programme for rollout next month, I would include strict guidelines about how to manage credit risks with highly leveraged customers. Cash before delivery is an excellent principle, if one wants to avoid one's own company being hit by a string of bad debts.

Some of these quotes just seemed too good to ignore…

Clearly the Fed’s move on Friday will help to improve liquidity in the financial markets, so that companies can borrow to pay their bills, and employees can get their wages on time. But will it encourage lenders to relax lending standards again? This will probably depend on whether there are any more skeletons to emerge from the subprime cupboard.

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.

The report in today's 'Financial Times' that Barclays Bank has lost 'several hundred million dollars', means that the UK has now joined every other global financial centre in suffering from the US subprime mortgage crisis. The news followed Friday's 5% drop in the value of Bank of China's shares, after it revealed it held $9.7bn of securities backed by sub-prime loans.

The question now is whether this purely financial crisis will roll over into the real economy? So far, the signs are hopeful that it won't. The latest weekly Economic Report from Kevin Swift at the American Chemistry Council actually shows a slight improvement in its running tab of positive indicators to 16 out of 20.

And outside the USA, the ACC report shows that 'global chemical industry production expanded in July', offsetting a revised decline during June. It says that the 'improvement was broad-based and was strongest in Africa and the Middle East and in Central and Eastern Europe.'

However, Kevin does caution that key US indicators such as durable goods orders and leading economic indicators may not yet be fully reflecting recent financial turmoil. Whilst the US National Association of Realtors reported yesterday that the median US house price fell in July for a record twelfth consecutive month, and is now 0.6% lower than a year ago.

At the moment, liquidity seems to be improving again in financial markets, and some confidence has returned. But as I noted on 10 August, US house prices haven't declined nationally since the Great Depression. With median wages static, and falling house prices, will US consumers decide to cut back their spending? And will lenders be happy to continue lending to them, if they need to borrow more to maintain their spending?

The subprime crisis is too recent for anyone to know the answers to these questions. But people are already beginning to return from the beach, as the summer holiday season comes to an end in the northern hemisphere. As we move into September, we may therefore begin to discover whether the Barclays news marks the end of the current financial crisis, or is a prologue to its extension into the real economy.

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?

The war of words between OPEC (the oil producers’ club) and the International Energy Agency (the rich countries energy watchdog), has intensified this week, ahead of the next OPEC Ministerial meeting scheduled for 11 September.

Claude Mandil, director general of the IEA, told Arab Oil and Gas ‘the market has become aware’ that OPEC ‘has set an implicit new objective of keeping prices at or around $70/bbl and that the organisation is trying to defend this level.’ If true, this would be a further significant increase on the presumed previous target of around $50/bbl. In turn, of course, this is a long way from OPEC’s targets of $28-30/bbl a few years ago, or $18-20/bbl a decade ago.

Mandil went on to say that the current price ‘could, as we have often said, weigh on global economic growth. It is from now that the refineries must start working harder to satisfy winter demand. We therefore need more crude oil but, unfortunately, signs from OPEC do not give us much hope of this’. These are strong words, and clearly part of a co-ordinated lobbying campaign, as Mandil’s deputy then went on to tell the Financial Times that ‘$70/bbl was too high and a threat to the world economy’.

However, OPEC’s Secretary General Abdulla el-Badri told Bloomberg ‘there's enough oil in the market, we don't know what to do with it. I assure you that if there's any shortage, we will supply more crude to the market, but I think the market is really stable at this time.’ Putting this comment in context, the Financial Times commented that ‘before the US subprime lending crisis, oil-consuming countries had hoped OPEC would raise production next month’.

OPEC is, of course, haunted by the echoes of its decision in November 1997 to increase oil production just as the Asian financial crisis began to hit demand. This took oil prices down to a $10/bbl low in 1999. They do not want to make the same mistake again. And the fact that the Chinese economy is likely to grow at high rates, at least until after next year’s Olympics’, means that Chinese demand for oil may also rise strongly, irrespective of any problems in the US.

The role of financial speculators also complicates the issue. Hedge funds have been selling oil recently to pay margin calls on their subprime investments, and if this pattern continues, then prices could fall further in the short term, irrespective of the underlying supply/demand balance. As recently as early July, as I commented at the time, hedge funds were still buying crude, and went on to drive it to a $78/bbl peak by early August, from its $51/bbl low in January.

Whatever OPEC and the IEA would like, volatility will continue to be the name of the game in oil markets for the next few months. There are just too many unknowns for consensus to develop.

I first wrote about the subprime crisis two months ago, as it began to be noticed in the press. Housing represents an important source of chemicals demand, and so it seemed to have potentially major implications for the chemical industry. Since then, it has become clear that the crisis could have far-reaching implications, if not properly handled. I therefore thought it might be useful to summarise the insights I have gained via a letter to the Financial Times, which they have kindly published this morning. I thought you might like to see it.

From Mr Paul Hodges.

Sir, There is another reason Washington should follow your excellent advice and "resist" the urge to intervene in the subprime crisis ("Subprime loans - subprime solutions", editorial September 1). This is that the scale of the problem is probably too large for any congressional action to be effective.

Even Congress would surely balk at the amount of money that this scale of intervention would require. Unfortunately, therefore, the myth behind the US housing mania is likely to become increasingly transparent, as the fallout from it widens.

Published: September 4 2007 03:00 | Last updated: September 4 2007 03:00

This week has seen more downbeat news on US auto and housing sales.

Ford said their total August vehicle sales were down 14% versus August 2006, and that their car sales were down by an amazing 34%. Toyota, who have been growing market share, said they were down 2.8% in total, and that their car sales were down 8%. GM bucked the trend with total vehicle sales up 5%, although they didn’t break out car sales, and did note there had been a ‘double digit decline in daily rental sales so far this year’. Chrysler, who mainly focus on trucks, said their sales were down 6%.

The accompanying comments to the sales figures were also concerning, with words such as ‘challenging’ and ‘competitive’ being used to describe current market conditions. Typical was Jim Lentz, EVP of Toyota, who said that ‘reduced credit tied to the subprime squeeze challenged consumer confidence this month’.

Housing is the other main driver for US chemical demand, and here the National Association of Realtors (NAR) posted a worrying 12% decline in their index of pending home sales for July, even before August’s turbulence. The NAR regard the index as a forward-looking indicator, and its fall prompted them to sound an unusually downbeat note about prospects, saying that ‘existing-home sales are likely to decline in coming months as mortgage disruptions work their way through the housing market’.

Early news on August sales from key retailers such as Wal-Mart also confirms that 'price leadership initiatives' are proving important in maintaining sales volumes. So July and August seem to be indicating that more difficult times may lie ahead. In the English countryside, the movements of migratory birds are often used as a sign of the changing seasons, although a rustic proverb reminds one that the mere sighting of ‘two swallows’ doesn’t necessarily indicate the arrival of summer.

Similarly, one does need to be cautious in predicting a downturn, based on the sighting of a slowing in retail markets over just two months. But unless there is a significant improvement in September, we will probably have to accept that the good times have already ended.

There’s an interesting indication today of the changes taking place in the Chinese economy. Bloomberg are reporting that Blackstone, the US private equity group, is to purchase around 18% of specialty chemical company China BlueStar for $500m. This will be Blackstone’s first Chinese investment, and follows the Chinese government’s $3bn investment into Blackstone in June.

The report is also interesting for the detail it provides about the way the deal has been structured. We already knew that China had decided to move some of its considerable US$ holdings into equity-type investments, via the establishment of a $200bn Sovereign Wealth Fund. The investment in Blackstone was clearly signalled as being part of a strategy to use selected Western companies to help them invest this money wisely.

And it is true, of course, that Blackstone do have a long-standing interest in chemicals. How can one forget their investment in Celanese in April 2004?

They spotted an anomaly between the ratings of chemical companies listed in Frankfurt and New York, and bought Celanese (which had 60% of its assets in the US) for $3bn. They then loaded up the company with $3.2bn of debt, before IPOing it 9 months later. According to Forbes, this meant that by June 2005, Blackstone had achieved a return of $3.1bn in exchange for its original $650m stake, whilst retaining a significant equity stake in the company.

But the structure of the deal with China is different. German investors complained bitterly after the pyrotechnics with Celanese. China seems to have played its hand much more carefully.

Blackstone may still do well, but is acting more as a ‘hired hand’ than as an individual entrepreneur. BlueStar had initially intended to raise $300m in an Hong Kong IPO, but under Blackstone this will be deferred to the end of next year (probably no bad thing given the current problems in financial markets). Blackstone will also be charged with integrating BlueStar’s French holdings (Drakker and the silicone business bought from Rhodia), before grouping the assets for a listing.

It therefore gets to do all the work, whilst paying $500m upfront for the privilege. But China National Chemical will remain the biggest shareholder in the company, and so will still reap its share of any rewards that Blackstone may generate. Whilst China’s holding in Blackstone means it will also profit from the latter’s success.

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.

OPEC are sounding a note of concern about the impact of high oil prices on the world economy. Hasan Qabazar, OPEC’s chief economist said yesterday ‘We are trying, hopefully, to reduce high oil prices, to have prices that are more conducive to economic development’.

Qabazar also emphasised OPEC’s desire to help counter any impact from the subprime downturn in the US, stating that this had put ‘some clouds’ over the forecast for global GDP growth of 5% next year. ‘We are trying to avert a slowdown’, he added, as ‘we are afraid that prices may play a part in the slowdown, and we want to avert that if possible’.

Oil traders ignored OPEC's comments today, sending NYMEX prices to a new record $79.29/bbl. They also ignored OPEC’s two agreements to increase quotas by 500,000 bbls/day, and to ‘normalise’ the basic quota in line with recent actual production (which effectively added another 900,000 bbls/day to the quota). Even the International Energy Agency’s (IEA) decision to reduce its Q4 demand estimate by 250,000 bbls/day, and its 2008 demand estimate by further 180,000 bbls/day, had no impact on the euphoria.

This does support the CGES view, mentioned here on 5 July, that players in oil futures markets are trend followers rather than leaders. Most of the ‘technical charts’ appear to show that oil prices remain in an upturn, and are poised to break $80/bbl. This supposed ‘momentum’ drives the ‘paper’ traders to buy more, encouraged by the widespread consensus that the oil price doesn’t matter any more to the world economy.

The IEA has played a key role in sustaining this idea, with its continuing forecasts of large increases in demand. So it is interesting that it has now begun to reverse itself on this critical point. Having just been in Asia, it would certainly seem that higher oil prices there are already affecting demand in those countries where subsidies don’t exist. And they are also prompting subsidising governments to review the level of support that they can afford to provide.

My own view is that the liquidity boom in financial markets and the high oil price may well have been inter-connected. The ready availability of credit meant that consumers (and governments) could borrow, instead of having to cut back expenditure as the higher costs of oil reduced their cash-flow. Now, however, we are entering a credit squeeze, and growth in US gasoline demand has already begun to slow.

Futures traders may well continue to ignore OPEC for a while, and the risk to supply from geo-political events remains very real, so one cannot discount the potential for even higher prices, if circumstances conspire together. This could make an already difficult situation worse. Higher oil prices have always slowed the world economy in the past. Their impact may have been deferred this time, but it is hard to believe that it has been avoided.

When the US subprime crisis began, we were assured by the ‘experts’ that it was only a small problem, involving a minor segment of an otherwise robust market. However, the more one read about the situation, the more untenable this view seemed to be.

Equally, we were told by other ‘experts’ that there was no danger of any spillover into other countries. Again, this reassurance began to seem equally simplistic after it became apparent that subprime loans had in fact been parcelled up and sold around the world. But even when the IKB and Sachsen banks had to be rescued in Germany, other ‘experts’ rushed to tell us that this was really due to issues relating to the German banking system.

So one wonders what these ‘experts’ will rush to tell us today, on the news that the UK’s Northern Rock bank, responsible for 18.9% of UK mortgage lending, and with over GBP 100 billion in assets, has had to rescued by the Bank of England, acting as 'lender of last resort'? Whilst we wait to be told not to panic, us non-experts are probably safe in drawing the following conclusions:

• The liquidity crisis in the banking sector is getting worse, not better. The underlying problem is that banks have been borrowing in the short-term money markets to lend long-term. This is very profitable whilst it lasts, but the US Savings & Loans collapse of the 1980’s is a reminder of how it can all go very badly wrong if short-term lending dries up.
• Banks are usually very keen to lend you money when you don’t need it, but are very quick to withdraw at the first hint of trouble. One doubts that other banks will rush to fill the void in the UK mortgage market that will be caused by whatever retrenchment now takes place at Northern Rock. So even normally well-qualified home buyers may find it more difficult to borrow in future.
• Housing has been a main source of support for the Western economies in recent years. Low interest rates encouraged more buyers to enter the market, and the laws of supply/demand worked to push up prices as a result. This allowed homeowners to release equity from their home via remortgaging, and kept consumer spending strong. This virtuous circle is now in danger of becoming a vicious circle, as lenders tighten standards to more normal levels again.

There is one ‘expert’, however, whose judgement I have learnt to trust over the years. Warren Buffett spotted the underlying risks posed by financial derivatives as long ago as 2003. He described them then as being ‘financial weapons of mass destruction’, and warned that they could end by creating ‘a mega-catastrophic risk’ for the economy. One just hopes he is not proved right.

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.

Well, now we know. Interviewed by the Financial Times on Monday, Alan Greenspan rejected the widely-held belief that central banks are now independent. Throwing aside his normal caution, the former US Federal Reserve Chairman said quite bluntly that ‘the presumption that we were fully independent and have full discretion was false’.

This is a worrying statement, as the concept of independence from political control is integral to the market’s confidence in the ability of central banks to control inflation. It is therefore perhaps not too surprising to find Greenspan also commenting in the same interview that he ‘sees oil going to $100/bbl’.

Coincidentally, on the same day, Goldman Sachs (GS) provided a potential rationale for this scenario when they issued a report that raised their 2008 oil price target to $95/bbl. They see the key driver for this increase as being the fact that ‘the oil industry has added very little new, low-cost, production capacity as it has run into technological and political bottlenecks that will likely take years to resolve’.

GS also believe that ‘costs have continued to rise, pushing marginal costs closer to $70/bbl’. If they are correct, this represents a sea-change in expectations. All through the early 1980’s, we in the chemical industry argued that with marginal production costs only $5/bbl, it was inconceivable that oil could remain at the then current level of $30/bbl in an over-supplied market.

But if Goldman’s analysis is right, then we will soon be in the opposite situation. Heavy crude now accounts for much of the world’s current spare oil capacity. Many refineries cannot process it, making effective supply/demand for lighter crudes much tighter. And in these circumstances, it is the marginal cost that will again set the price.

This could have ‘severe’ implications for polymer producers, as Goldman’s James Yong notes. He foresees a potential ‘squeeze coming from both the feedstock as well as the polyolefins side’, as feedstock costs rise just as the new Middle East/Asian capacity starts to arrive next year.

Shell and Saudi Aramco have now confirmed plans to spend $7bn to build what they term ‘the first new refinery in the U.S. in more than 30 years’. They will achieve this by adding 325,000 barrels per day (b/d) to their existing Port Arthur, Texas, facility, taking total capacity to 600,000 b/d. It is scheduled to come on stream in 2010.

Refining capacity has been tight in the US for many years, due to historically low refining profitability and environmental difficulties in siting new refineries. Both these factors have changed over the past couple of years. Post Hurricane Katrina, refining profitability has been very strong, whilst President Bush recently even offered to allocate military land to help overcome environmental issues.

When completed, the Port Arthur refinery complex will be the largest in the US, ahead of Exxon Mobil’s 562,000 b/d at Baytown, Texas. It will be able to process ‘heavy crudes’, for which refining capacity is currently short around the world, and will supply Shell’s 7700 gasoline outlets in the Eastern and Southern USA.

There are two elements of this announcement that are of particular interest to the petchem industry. The first is the degree of cost escalation now taking place in major construction projects. In April 2006, Shell estimated that the expansion cost would be around $3bn. But this has now more than doubled over the past 18 months. One assumes also that Bechtel/Jacobs will be taking much less of the risk of cost over-runs as well.

The project also confirms gasoline’s increasing importance within the major oil companies. And with new gasoline-focused refineries being planned all round the world, there is a clear danger of naphtha production becoming a ‘poor relation’. This could keep petchem feedstock prices relatively high, even after gasoline margins return to more normal levels.

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’.

Its now 3 months since we first saw the impact of the subprime crisis. At that time, the main impact was on poor Americans, who were losing their homes. Then, in August, banks stopped lending to each other, causing credit conditions to tighten. By September, central banks were fighting fires on several fronts:

• Injecting billions into money markets to improve liquidity
• Bailing out major mortgage lenders such as Northern Rock in the UK
• Cutting interest rates in the US by 0.5% to help avert recession

Their activities continue to be the focus of attention, but at the same time the American Chemical Council (ACC) have performed a useful service in a recent weekly report by reminding us that the original problem in housing is still getting worse, not better.

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As their chart shows, new home sales are now down 21% on a year ago, and existing homes sales down 12%. The inventory of new homes is at its highest level for 16 years, whilst that for existing homes is at an all-time record high of 10 months. Equally, the ACC comments that ‘the pace of monthly (house) price declines is accelerating as tightening mortgage lending standards and a slowing economy suggest the housing downturn will last into 2008’.

This does not bode well for future chemical demand in this important sector.

Coal-to-chemicals just took a further step towards becoming a major source of chemical production once again.

Yesterday, major coal producer Shenhua Energy listed on the Shanghai stock exchange, and saw its shares jump 93% to value it at $173bn. Shenhua is the world’s second largest seller of coal, after the US’s Peabody Energy, and it now becomes the world’s largest IPO this year.

This is part of a process by which huge sums of money are now being raised in China to finance industrial development. As I noted on June 22, PetroChina started the trend by successfully raising $5.6bn, to help finance its proposed 6 new ethylene cracker projects, as well as to develop new oilfields and construct new refineries.

Shenhua Energy is going down the same expansionary route. Having consolidated many of China’s coal companies over the past decade, Shenhua is now looking to invest in a range of coal, power and transportation projects. It aims to produce 200 million tonnes of coal in 2010, compared to 137 million last year, as well as 20,000 megawatts of electricity.

In addition, and critically for the chemical industry, it plans to ramp up its activity in the coal-to-liquids and coal-to-chemicals sectors. It has already partnered with Dow Chemical in planning to build a world-scale coal-to-chemicals complex in Shaanxi province. This intends to use ‘clean coal’ technologies to produce ethylene and propylene, as well as a chlor-alkali unit and a wide range of derivatives.

The chemical business started life by adding value to coal, and the impact of higher oil prices seems to be re-opening this route as an economic source of feedstock for the future. With 66 billion yuan now in the bank post IPO, nobody should doubt Shenhua’s ability to finance its ambitious plans.

The price of a product is a key factor in determining the profitability of producing and using it. And a transparent pricing structure encourages liquidity, which enables price discovery to take place more easily between buyers and sellers. This is why I have long been a supporter of the London Metals Exchange (LME) initiative to trade futures contracts in PP and LLDPE.

At the moment, pricing in the cracker and thermoplastic sector involves a long chain of players, many of whom have differing agendas and priorities. The actual producers and users of the products rarely get to negotiate prices directly with each other. Instead, the main buy-sell relationship today is often with a converter. As a result, much pricing is done on a lagged basis, so the ultimate sales price is often not known until well after the product has left the factory gate.

This ‘lag’ also creates an opportunity for playing the market. Converters, for example, can build stock if they see feedstock prices rising, and reduce it when prices fall again. But this is not a zero-sum game, as cracker operators and polymer producers then have to respond by adjusting operating rates up or down (always very expensive). Equally, unnecessary polymer imports and exports take place, as players down the chain respond to confusing signals about demand trends.

This is why I was glad to see in the MF Global daily plastics report this week that some players, at least, are now starting to hedge LLDPE and PP by using a monthly average price based on the LME prices. This is only a small step forward, but anything that makes it easier for producers and consumers to better manage their business is to be warmly welcomed.

Hopefully it will also encourage others to experiment with LME trading. As the downturn edges ever nearer, it will become increasingly vital to have an accurate picture of underlying demand. Today’s lack of transparency and liquidity in pricing will otherwise extract a major cost in terms of lower profitability throughout the value chain.

BP and Reliance Industries are both powerhouses in their own fields. BP’s new CEO, Tony Hayward, has just given his first interview in the new job. Comparing, and contrasting, his comments with last week’s AGM statement by Reliance’s Chairman, Mukesh Ambani, is very revealing in terms of content as well as tone.

Hayward’s interview in the Financial Times showed him as making a decisive break with the Lord Browne era. He believes that the company had done a ‘fantastic job assembling a great set of assets, but a much poorer job in really making them run efficiently’. He also ‘admitted that morale at BP was poor, and that the company had been failing to recognise and reward excellence among its employees’.

Over the same period, of course, BP has divested much of their petchems business via the Innovene sale to INEOS. But according to Hayward, they have still managed to ‘increase the complexity of BP’s structure’, as a result of which ‘it is so tough to get things done’ within BP.

Ambani, of course, had no need to eat humble pie. He titled his talk ‘Towards a quantum leap’, and in it he set out the major changes now underway in Reliance’s portfolio. From small beginnings with a single polyester plant, Reliance is now the world leader. And Ambani announced a move from 1.9 MT to 4.5 MT of PX capacity, in association with the refinery expansion at Jamnagar.

The site will also feature 2 MT of new olefins capacity, with further expansion already planned. Ambani explained that the petchem business now aims to ‘follow the path to global leadership set by the polyester business’. Reliance has also become one of the top 20 private upstream companies in the world, and he revealed that they are now planning to invest a further $4bn to build on the success of the past 7 years.

But even Reliance now needs to make a number of major strategic shifts. Ambani accepts, for example, that although they have been able to focus on organic growth to date, ‘acquisition’ will have to become a more important part of their growth process. He also accepts this will require a shift in mind-set, towards ‘partnership’ and more JVs of the type carried out with Chevron in the Jamnagar refinery expansion.

What is interesting about both Hayward and Ambani’s viewpoints is the stress that they lay on operational expertise. Reliance’s success to date, like BP’s in the past, has been based upon their ability to deliver. To recapture excellence in this area must be Hayward’s objective for BP, if he is to achieve the turnaround he targets.

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.

I mentioned PetroChina in the very first blog entry, when the stock was trading at $155 in New York. It seemed to me to typify the new mood of confidence that I was finding as I travelled in Asia on the 10th anniversary of the Asian financial crisis. Little did I think that just 3 months later, it would be trading at $260.

This meteoric rise in the Chinese stock market has left me feeling more than a little uneasy, as to whether confidence has now turned into pure speculation. And this concern has been amplified by news this week that legendary investor Warren Buffett has sold his entire 11% holding in PetroChina, for a $3.5bn profit. Agreeing that, as usual, he sold ‘a little too soon’, he told Fox Business News yesterday that the sale was due to his concern over valuation.

Buffett clearly feels that the best of the China stock market run is behind us, at least for the moment. It will be interesting to see how much longer the present surge can last, and what the impact will be if (when?) it tumbles back to reality.

And in the meantime, it was also interesting to see that in the same interview Buffett denied that he had ever been interested in buying troubled investment bank, Bear Stearns. He added that he was still steering clear of the housing market and US housing stocks, as ‘prices still didn’t seem low enough’. As Buffett tends to buy and sell early, this is a salutary warning that there may well be more trouble ahead for this critical area of chemicals demand.

The ‘consensus forecast’ for 2008 is very optimistic, as I commented in my post-EPCA note. It says oil will remain at $70/bbl, that debt market problems will be contained, and that petchem margins will remain at 2007 levels. This is unusual, as the consensus is normally a base case scenario, with upside and downside variants.

And since EPCA, oil has already increased to around $90/bbl. Back in early July, when it was still ‘only’ $70/bbl, I noted that it had the potential to approach $100/bbl, and this still seems a real possibility. In these circumstances, it is perhaps no surprise that we are seeing an apparent ‘boom’ in demand, as downstream consumers rush to cover themselves before product prices move higher.

I first saw this effect happen in 1979, when the industry had a record year. It was only in 1980 that we discovered that the apparent ease with which the economy had weathered a rise in the oil price to $30/bbl (around $95/bbl in today’s money), was a mirage. Could the same be happening today? I think it is worth considering very carefully as a possibility.

After all, whilst history never repeats itself, the underlying position in financial markets is clearly deteriorating. Bank of America (the 2nd largest US bank), came out with truly shocking Q3 results on Thursday, whilst on Friday Caterpillar’s CEO Jim Owens said the US was already ‘near to, or even in, a recession’. And new housing starts and US house prices were already very weak, even before the recent credit crunch.

There must surely be a real possibility that this latest upward rush by the oil price will be the catalyst 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.

If I was drawing up budgets for 2008, I would be putting in place contingency plans for just such an outcome, even whilst crossing my fingers that I would not have to use them.

I recently had the opportunity to attend a workshop organised by Pilko & Associates with leading figures from the private equity (PE) industry. It was fascinating to hear their views on how the current credit crunch is affecting M&A activity. The days when some PE players were acclaimed as geniuses simply for loading up a company with debt are clearly gone. There is a growing consensus that we are moving into a tougher climate for deals, which will probably affect M&A activity and chemical company valuations quite significantly:

• PE had lost its cost of capital advantage in M&A, with a maximum of 4/5 times leverage now being available, compared to the 8/9 times that had been common.
• Investors have also become more cautious, wanting ‘simple stories’ to support a deal, and preferring to work with known people who have good track records.
• Deal size has dropped to around $3bn - $4bn, with larger deals only being done by strategic buyers (eg major companies) who can fund via their own cash-flow.
• Valuations are therefore reducing, but PE has not yet reduced its expectations for >20% return. Bolt-on acquisitions will therefore become more common.

I also got their inside view of the US subprime crisis, where caution seemed to be the order of the day. The expectation was that this would rollover into Q4, and that even then we might not be ‘out of the woods’.

There were also a number of specific issues which have recently appeared on the radar:

• H1 saw several major deals completed, and these will take time to be digested.
• PE buyers are more wary of above ground liabilities after the Texas City refinery explosion. Issues such as process safety/maintenance spend/training are now key.
• The ‘mood music’ of management presentations is seen as critical, as whilst governance policies/systems can change quickly, cultures change more slowly.
• There is probably less sharing of HSE/EHS experience going on, due to the more fragmented nature of the industry. This is a negative step, and needs addressing.
• The majors are now imposing their own standards very quickly on new acquisitions, and taking the costs up-front as part of the deal’s overall cost.

Of course, the current problems in financial markets may all blow over in the next 6 months. But it was interesting to hear the response given to a question as to whether it would be better to issue debt now, or wait 6 months. ‘Take the pain now, and pay the extra premium’ was the advice. ‘Risk is currently increasing in financial markets, not reducing’.

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.

Oil prices last week rose to an all-time, inflation-adjusted, high in New York at over $92/bbl. Meanwhile food and commodity prices have continued their upward march. In China, the rate of consumer price inflation hit a decade-high of 6.5% in August. So why are we still seeing rates of around 2% reported in the USA and Europe?

Part of the answer is that China, like other developing countries is less energy-efficient than the West. Equally, as the world’s leading manufacturer, it is first in line to suffer higher prices for metals (the steel industry is expecting a 50% increase in the iron price next year, on top of 145% increases this year). But freight costs get passed straight on to buyers, and the Baltic Index for dry goods such as iron, coal and grains has risen 135% this year alone.

Yet current official Western inflation figures still appear benign. As I commented back in July, central banks such as the US Fed conveniently focus on ‘core’ inflation, that excludes food and energy costs. Similarly, the Bank of England now focuses on consumer price inflation (CPI) instead of retail prices (RPI). What’s in a name, you might ask? 2.1% is the answer. The new CPI registered just 1.8% in September, but the older and more comprehensive RPI clocked in at 3.9%, and is clearly on an upward trend.

Central banks also use ‘hedonics’ as a way of avoiding the hard decisions to raise interest rates when economies are over-heating. But one can’t eat or drive a mobile phone or a laptop, so although these are more powerful today than earlier models, this may not impress union negotiators when they plan tactics for next year’s wage round.

Thus there is a strong argument that investors may have been lulled into a dangerous sense of complacency. A double whammy may be just around the corner. Not only may ‘official’ inflation rates finally start to rise, just as the housing-dominated economies are slowing sharply. But chemical companies’ earnings may also suffer from margin compression if, as seems very possible, consumers prove less willing to accept the latest round of price increases.

Since posting yesterday, oil prices have moved further ahead, with WTI closing at $93.53.

I have also had an interesting dialogue with Paul Satchell of ING Bank, one of the leading chemical analysts, who has kindly allowed me to summarise his comments. Paul believes that investors have become 'dangerously complacent' about the industry's ability to cope with increases in oil prices, following the success of companies such as BASF at passing-through input cost rises since 2004.

He sees a growing danger that commodity chemical producers may suffer the same fate as specialties companies such as Ciba and Clariant, who 'seem to have suffered a major loss of pricing power'.

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.

Back at the end of August, I suggested that we had only reached the end of Phase1 of the credit crunch. I feared that it had the potential to get much worse, and to damage the ‘real economy’ where all of us in the chemical industry live and work.

This was definitely a minority view at the time, especially in financial markets. Earlier in August, I had quoted Chuck Prince, CEO of Citigroup, who expressed the prevailing mood when he said, ‘We are not scared. We are not panicked. We are not rattled. Our team has been through this before.’ We are ’still dancing’.

Yesterday, Prince resigned as CEO, following the announcement that the bank would take a $5.9bn loss on its subprime exposure for Q3. His departure followed that of Stan O’Neal as CEO of Merrill Lynch. This morning, Citi have said they may have incurred a further $11bn loss in the past month. Their shareholders are being left to pick up the bill for a very expensive period of ‘dancing’.

It is now almost certain that the current credit crisis is not going to be a ‘9 day wonder’. The problems in sub-prime apparently go too deep for an easy recovery to be possible. This is a double whammy for the chemical industry, which is already suffering from growing difficulties in passing through higher feedstock costs.

De-leveraging is an ugly phrase, and its impact on the chemical industry could be as bad as it sounds. I suggested back in mid-August that CEOs should be rolling-out ‘strict guidelines about how to manage credit risks with highly leveraged customers’. Similarly, highly-leveraged companies in the chemical sector should be conserving cash by all means possible as we come to year-end.

Christophe de Margerie, the new TOTAL CEO, has burst the bubble of complacency that has surrounded discussion of future oil supply.

The ‘business as usual’ forecasts of both the International Energy Agency and the US government assume that the world will be producing c120m bbls/day by 2030. But de Margerie said he wished to ‘speak clearly, honestly and not just try to please people’ on this topic. In his view, ‘it would be difficult to reach even 100m bbls/day’.

Yet the world is already using 85m bbls/day. And demand has been growing very fast. 5 years ago, it was only 78m bbls/day. This is because of new demand from the emerging economies such as China and India, as well as the Middle East, where oil consumption is subsidised by the government. So higher world prices have little impact on domestic demand in these countries.

de Margerie said the problem was NOT with the amount of oil in the ground. He believes that ‘reserves have never been so big’ as a result of new technology. But he DID highlight the practical problems in the way of reaching 100m bbls/day, saying:

• ‘We (in the oil industry) have been over-optimistic on geology, in terms of how much time it takes to develop reserves’
• The industry has also ‘misunderstood’ the willingness of resource-rich countries to allow production today from their best oil fields. Instead, these countries are often only offering smaller and more difficult fields to foreign investors.
• Political and security problems were also holding back supplies in countries such as Iraq, Nigeria and Venezuela. ‘We know these developments are not underway’.

Only 3 years ago, under the influence of Wall Street, the major western oil companies were still spending more money on share buybacks than on finding new sources of oil and bringing it to market. This lack of investment is about to catch up with us. In de Margerie’s view, ‘100m bbls/day is now an optimistic case’.

His conclusion is that the increasing tightness of supplies will keep oil prices relatively high in the future. This is a very worrying message for the chemical industry, which depends on oil-based feedstocks for most of its products.

1 in every 196 US households was in receipt of a foreclosure filing at the end of September, according to Bloomberg. This is a scary number for anyone who owns a house. And Quarter 4 is likely to be worse. Latest figures from the Realtors Association show September’s existing home sales down 19.1% from a year ago.

US auto markets are also getting worse. I calculate that sales of the Big 3 (GM, Ford, Chrysler) are down 7.8% this year, based on latest sales data. Market conditions have deteriorated markedly since I last reviewed industry performance in early September.

Chrysler are already offering cashbacks and lease cash on most of their 2008 range. They are also taking an axe to inventory, which fell 8% last month versus a year ago. Even so, it still stands at 84 days sales.

Chrysler are bound to be aggressive, as the new owners are Cerberus, the private equity firm. And chemical companies can’t say they weren’t warned. Cerberus have, after all, named themselves after the 3 headed dog who guarded the gates to Hell in Greek myth! (The pic at the top by William Blake gives you the general idea.)

Darryl Jackson, their VP for U.S. Sales justified the cashbacks by referring to ‘growing concerns about the housing slump… and future economic conditions’. And we can see this in the latest reports from the individual companies:

• GM reported a 6% fall in Q3 vehicle sales versus a year ago.
• Ford were down 9.5% in October.
• Chrysler were 9% down.
• Toyota managed a minor 0.5% increase (but noted that October had an extra selling day this year, so in reality their sales were also down on a daily basis)

Any US chemical company making final adjustments to 2008 budgets would be well advised to err on the downside. Domestic US markets could get very difficult next year, if core auto and housing markets don’t start to recover soon.

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.

Gazprom is becoming a player to watch in petchems.

For decades, observers have speculated that Russia might increase its petchem activity. A recent comment by Gazprom deputy CEO, Valery Golubev, seemed to bring this concept closer to reality. He said that Gazprom aimed to increase its ethylene production by 350% to 7.66 million tonnes (MT) by 2015. He also said Gazprom plastics production would rise from 400 KT to 1.7 MT in the same period.

Now Gazprom has announced a further initiative, this time with Dow. As Nigel Davis and Sergei Blagov reported on ICIS news, Gazprom and its petchem arm, Sibur, will study with Dow the potential for joint gas processing projects near the Valanzhinsk gas deposits in Russia's Yamalo-Nenets Autonomous Region, as well as a possible joint venture based on expanding Dow's petrochemical production units in Germany.

This agreement builds on an earlier MOU signed last year. And the concept seems well in line with Dow’s developing asset-light strategy for commodity businesses. Earlier this year, Dow’s CEO Andrew Liveris said that Dow could cooperate with Gazprom on the building of bulk chemical production facilities, in return for the sale of feedstock from it at a lower price. Liveris added that Dow is ‘a very advanced provider of technology. Gazprom would be able to achieve a great deal of synergy from it’.

BASF have also been talking about JV’s with Gazprom, and it is probably no coincidence that Gazprom chose the same day to announce the formation of a new JV with BASF, Gazprom YRGM Trading, which will trade gas from the jointly owned Yuzhno-Russkoye field. Earlier this year, of course, BASF’s own Solvin JV with Solvay announced a Sibur JV to build Russia’s first world-scale fully integrated vinyls plant in Kstovo in 2010.

Gazprom has been indicating since 2004 that it was interested in selling a 50.6% stake in Sibur. Dow and BASF were both said by Gazprom’s former deputy CEO, Alexander Ryazanov, to have made informal offers. Today’s announcements probably also bring this intriguing process one step nearer to realisation.

The US Congress is currently close to finalising a Bill that would aim to tackle climate change. This follows the EU model by establishing a carbon price via a cap-and-trade system, and is very welcome news.

However, there is a sting in the tail, as currently drafted. For it also calls for a border tax on carbon-intensive goods. Chemicals would inevitably be a prime target for such a tax, and ‘The Economist’ rightly devotes an editorial to attacking this concept.

Proponents of the border tax argue that it would encourage other countries to reduce their carbon footprint. It would also stop American producers being disadvantaged by the higher costs imposed by the new higher US standard. But its costs could be huge.

As ‘The Economist’ comments, not only would a ‘massive bureaucracy be needed to certify the carbon content of different goods imported from different factories in different countries.’ But the indirect cost could be even higher, as ‘such a tax would be a dangerous weapon in the hands of America’s growing gang of protectionists’.

‘The Economist’ is not prone to exaggeration. It says that if these measures are passed, America risks starting ‘a global trade war’. Chemical industry executives need urgently to get themselves up to speed on this issue. And the trade associations need to monitor developments very carefully.

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’.

Are we seeing just a dip in economic growth? Or are we at the start of a downturn that may run for months, or even years? The answer to this question lies in the US, which still accounts for 25% of global GDP, and where US consumer spending is 70% of US GDP.

Optimists maintain that central bankers have the power to stimulate the economy via interest rate cuts. And certainly, as we saw again last week, the merest hint of further US reductions is enough to send stocks soaring worldwide.

But from a chemical industry viewpoint, the answer is not so simple. Kevin Swift’s excellent weekly report for the American Chemistry Council (ACC), gives a mixed picture. November’s US railcar loadings remained strong, as export activity continued to compensate for weakness in the housing and auto sectors.

But as the chart shows, global chemical industry production growth (ex-pharma) has slowed significantly since the summer in all regions. And the ACC notes that US leading indicators are now negative, and at a level usually associated with recession.

US housing data is very worrying from a chemical industry viewpoint. Each US housing start generates an average $16k of chemical demand, according to ACC calculations. And the massive fall in building permits does not bode well for H1 demand next year

November’s figures for new and existing US home sales are just awful, compared to 2006:

• New home sales are down 24%; median prices down 13%; housing starts down 16%; building permits down 25%. Inventory is 8.5 months sales.
• Existing home sales are down 21%, median prices down 5%. Inventory is 10.8 months sales.

A further worrying sign is that in the wider economy, US inventories are increasing rapidly, adding a full 1% to US GDP growth in Q3. This is perhaps not surprising, given the recent rapid rise in oil prices. Crude was only $71/bbl in early July, when I first suggested it could reach $100/bbl, and it would not be surprising if chemical/polymer buyers have been building even more stock in recent weeks as prices rose.

The optimists may still be right, and central bankers may be able to wave the magic wand that restores us to a growth path. But with US housing/auto sales so critical for the global economy as well as for chemical demand, and with feedstocks remaining tight, it is hard to imagine that the chemical industry can now avoid a serious downturn.

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.

The UK has a proverb about how stable doors only get shut after the horse has run away. We can see this happening in the UK housing market.

The main regulator (the FSA) failed to spot the Northern Rock problem before it led to the UK’s first bank run in 140 years. Only now has it woken up, telling mortgage lenders yesterday to expect ‘market conditions to remain very difficult for a sustained period’.

It also warned that 1.4m UK borrowers face higher interest charges next year ‘which may prove too much for many of them to afford’. In other words, only now has the FSA realised that the US subprime disaster may be just about to hit the UK market, where house prices are even higher as a multiple of earnings. Apparently, they are already having to pay ‘weekly visits’ to some lenders where ‘liquidity levels’ seem too low.

The only problem with this warning is that it comes far too late. The time to stop the unsafe lending practices was when they started. Already the main UK lender (Halifax) has announced a 1.1% fall in UK house prices last month. This makes 3 months in a row that prices have fallen – and one has to go back to 1995 (when the UK was emerging from the last housing crash) for the last time this happened.

The European chemical industry will be badly hit if the UK follows the US housing decline. UK housing has been a major source of demand. And indirect demand will also decline, as UK homeowners will no longer be able to borrow against the rising value of their homes, in order to purchase autos and other consumer goods.

The risk of a global downturn is clearly increasing, as the credit crunch intensifies.

Central banks seem to have their work cut out if they are to restore normality to global credit markets. The famed head of Legg Mason, Chip Mason, who manages over $100 billion of assets, and is one of the world’s largest money managers, said yesterday that ‘credit markets are in the worst state he has seen them in his 47 years in the business’. ‘I have not seen anything like this’, added Mr Mason.

As I discussed back in August, when the current crisis began, companies with high leverage are obviously at great risk if current credit markets conditions continue. By now, many Finance Directors will have already completed their own in-depth assessments of credit risks. Sales people should therefore not be surprised if ‘cash before delivery’ soon becomes the norm for some companies. This may seem a harsh requirement, and may lose some sales in the short-term, but it is far better than standing in line for repayment after the worst has happened.

There is some interesting material on the OPEC website, following this week's Summit, which clarifies their current strategy. The key points are:

• OPEC is currently targeting inventories, not prices. Their policy is to keep OECD crude stocks within the 5 year average. OPEC says its previous production cutbacks ‘minimised the excessive overhangs that existed at the beginning of the year'. Saudi Oil Minister, Ali Naimi, added that ‘inventories (are now) at a healthy level within the 5 year average’.
• In keeping with this approach, OPEC made no comment on current prices. Instead, it focused on the issue of volatility, blaming this on ‘fear of future shortages’, ‘increasing speculation in the futures market’, ‘continuing geopolitical tensions in some oil-producing regions’ and ‘downstream bottlenecks’. This is quite different from September's meeting, when they tried to talk prices down.
• Naimi reiterated OPEC’s commitment to ‘stability and reliability of supply in oil markets’. But he also raised a warning flag over the negative impact of any Western initiatives to move away from fossil fuels, commenting that OPEC’s investment in future production increases will be ‘assuming in good faith that the demand will be there’.

OPEC, in public at least, thesefore seems much more relaxed about the impact of today’s high prices on economic growth than it was in September. Then, the IEA had suggested that OPEC was targeting a minimum $70/bbl price, compared to today’s level near $90/bbl. Or maybe, with a mild winter forecast for the US as a result of the La Nina effect, they are just hedging their bets until they next meet in February.

The major investment banks have changed their minds about the potential for Asia to ‘decouple’ from any credit-crunch induced downturn in the West.

Originally, they had believed that domestic demand in China and elsewhere would enable the Asian economy to sail ahead, no matter what happened elsewhere. I was a bit sceptical of this hypothesis, after my recent visit to the region. And now Bloomberg reports that both Goldman Sachs and Morgan Stanley have changed their minds.

Typical of the new realism is the comment from Morgan Stanley’s Chairman in Asia, Stephen Roach that ‘decoupling is a good story, but it's not going to work going forward’. He sees the region’s economy being badly affected ‘as the US slowdown goes from housing to consumption’. Whilst Goldman also now believe that ‘what began as a US-specific shock is morphing into a global shock’.

China's global manufacturing lead is focused on housing-related products such as refrigerators, microwaves and DVDs, as well as textiles and related products. These are also all areas of strong demand for chemicals/polymers.

And as I noted recently in ‘A dip or a downturn?’, it looks as though the pace of Asian growth is already slackening, as a result of the downturn is western housing markets. 2008 could well be a difficult year in Asia, as elsewhere.

A reader has kindly sent me a YouTube link to a recent British television sketch featuring two masters of satire, John Bird and John Fortune. It takes the form of a mock-interview, with Bird playing the all-wise investment banker, and explaining to Fortune how subprime happened, and what a SIV might be. Not only is it very funny, but also (as always with their work), well researched. It lasts around 9 minutes.

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.

News that UBS, the major investment bank, has had to follow Citigroup in raising new capital in a hurry, will have added to the CFO concerns I describe below. Massive subprime losses have forced both banks to raise a combined $24.5bn in the past fortnight. Both had previously said that their losses would only be modest.

According to the Financial Times, ‘strong forces are pushing up banks’ demand for capital’. It suggests they are no longer being able to ‘sit on’ bad debts, and that as a result, ‘pressure on bank capital is starting earlier than in previous downturns’. As a result, it believes that Citi and UBS rushed ‘to get in first’, before market conditions become more difficult next year.

Tonight the Fed will have another attempt at waving a magic wand to make these mounting worries go away. To judge by the Duke University survey, chemical industry CFOs, and their professional colleagues, are obviously not over-impressed with the success record so far.

In recent days, 3 respected commentators on oil markets have raised concerns about the near and medium-term prospects for oil supplies:

• Goldman Sachs has raised their 2008 WTI price forecast to $95/bbl from $85/bbl. This is driven by their expectation that cost inflation, plus continuing technological and political uncertainty, will ‘increase the price required to motivate capacity investment’. They point out that there has recently been a ‘large rise in long-dated prices to the $80-85/bbl range’.
• CIBC have pointed out that ‘soaring rates of consumption’ in Russia, Mexico and the OPEC countries will reduce their exports by 3.5mb/day by 2010. This equates to 3% of world demand. High oil prices are stimulating rapid growth in car ownership in many of these countries, whilst subsidised gasoline prices make driving cheap.
• The International Energy Agency (IEA) said yesterday that ‘we are on the eve of a new world order’ in energy, where China and India ‘now drive global energy demand’. The IEA chief economist, Faith Birol, projects 35mb/day of new demand by 2015, but worried that only 25 mb/day is currently being planned. Equally, the IEA says major energy consumers, including the USA, are doing very little to restrain demand growth.

My reading of all this is that dialogue between oil producers and consumers is starting to break down. As I noted after the OPEC meeting, even the Saudis are questioning whether they should invest the billions of dollars needed to bring major new fields on stream.

The price and availability of oil is absolutely critical to the chemical industry. Growing uncertainty around these key issues is already leading to increased price volatility, which in turn will reduce margins and profitability.

It is now almost 6 months since I started writing this blog. And I thought you might like some feedback on how it is developing.

As you can see from the green-shading on the map, it is now read in almost all of the major chemical producing/consuming areas. A high proportion of readers bookmark the site, and return to it regularly. You are also spending more time on the site, as the amount of content builds.

Certainly, there has been no shortage of issues to cover:

• Oil prices. The blog was amongst the first to suggest, on July 5, that crude prices might reach $100/bbl over the winter. At that time, the price was $71/bbl, and most forecasters were expecting a decline. The recent peak was $99.26/bbl, and the winter is not yet over.
• Credit crunch. The blog covered this from the start, just as the US subprime crisis began. And many people have kindly commented that they first became aware of its implications for the chemical industry via the blog’s commentary.
• Chemical markets have been covered extensively, with a focus on key areas such as housing and autos. These are clearly leading indicators for chemical demand, and the blog has been able to highlight potential problems before they became widely recognised.
• Regional developments. Chemicals is a global industry, and the blog has kept readers up to date on developments in all the major areas – Asia, the Americas, Europe and the Middle East.

Re-reading the blog’s Mission statement (at the top of the main page), it therefore seems to be fulfilling its role of ‘sharing ideas that may shape the chemical industry over the next 12-18 months’. We have certainly ‘looked behind the headlines’, and I have tried to provide as many links as possible to original source material elsewhere on the web.

We have also had our moments of ‘fun’ - commenting on the hedge fund trader who ‘forgot’ he owned a £80k Maserati, and on the Brazilian super-model who sparked a mini-currency crisis by revealing she preferred to be paid in euros, not dollar.

One recent change is that I am often now writing shorter summaries of issues as they develop. With 82 postings already on the site, readers can then link to more detailed background, as required. Hopefully, this makes it quicker for you to find the topics of most interest.

Thank you very much for your support and comments over the past 6 months. I’m looking forward to covering whatever 2008 may bring.

Dow has been unique amongst the world’s largest petchem companies in not being integrated upstream into oil and refining. This position will change dramatically at the end of 2008, when its newly-announced JV with the PIC subsidiary of Kuwait Petroleum opens for business.

Not only will Dow then integrate its ethylene/PE business, but it will be do so with a non-western oil company. As Dow’s CEO, Andrew Liveris, describes it, ‘the day of the NOC (National Oil Company) dominance has arrived’. The new JV will be responsible for pursuing ethylene/PE projects on its own, and will be the prime focus for Dow's Asian ambitions. Some/all of the existing PE-based JVs may also be linked to it in the future. Liveris explained that the aim is ‘to bring each one of those relationships to the table in due course’.

This deal continues Dow’s strategy of JVing its Basics business, whilst growing its technology-led performance businesses. In Basics, the aim is to anchor Dow’s technology and market knowledge with locally sourced advantaged feedstocks. Whilst the Performance businesses focus on 4 key areas – Human health, Energy, Infrastructure & Transportation, Electronics & Communication.

The deal creates a $19.1bn global JV that (if combined in due course with the existing Equate, MEGlobal and Equipolymers JVs) will create the world’s No1 polyolefins company. It will focus on plastics (PE/PP/PC/PET), and will also create the world’s largest EO/EG & derivatives company. It will have supply agreements with 3 of Dow’s crackers at Fort Saskatchewan (Canada), Bahia Blanca (Argentina), Tarragona (Spain). If combined with the existing JVs, it would have $14bn in revenue, and be largely focused on ethylene, with some aromatics involvement via polycarbonate. Dow’s other US/European crackers will remain wholly-owned.

The partners have so far concluded a non-binding MOU. Closure of the deal is expected at the end of 2008, at which point PIC will pay $9.5bn for its share of the businesses that Dow is contributing. This will provide Dow with the flexibility to move forward on the next stage of its push into a more market-facing portfolio.

Dow now plans a ‘more aggressive approach to M&A’. It will certainly have the flexibility to do this, having successfully reduced its ‘debt to total capital ratio’ in recent years from over 50% to today’s low 30%. But any prospective acquisitions will need to be aligned with the market-facing businesses, and to also meet Dow’s DCF, IRR financial metrics, as well as having a short payback period, and adding more value to earnings than a simple share buyback.

For Dow, the deal aims to preserve integration whilst mitigating cyclicality via JVs. Transfer pricing downstream will continue as today, as if they were Dow businesses. And Dow will aim to put the income from the deal ‘to better use’ in new business development. Whilst for PIC, the deal will provide 50% of the businesses that Dow is contributing, and the basis to contribute Kuwait feedstocks (eg crude/gas) to future integrated refinery/petchem projects in China and elsewhere.

Dow’s other potential JVs with Saudi Aramco, Egypt, Libya, Oman and Gazprom are all outside the new JV ‘for the moment’. And its multi-product JVs such as with Saudi Aramco will likely remain separate. Equally, the existing PS JV with CPChem will remain separate, as Dow do not see the PS/ABS area as capable of much growth, by comparison with the other polymers. Dow did however hint that they do have further plans around their existing VCM business with Shintech, but did not elaborate further.

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.

Housing, as we know, is an absolutely key market for the chemical industry, both directly and indirectly. Directly, each new house accounts for $16k of chemical demand, whilst indirectly, years of rising western house prices has allowed consumers to cash out their gains to spend on Asian imports.

Now this virtuous circle has turned with a vengeance. And the subprime mortgage crisis is turning into a game of very big numbers. Earlier this week, the European Central Bank handed over €349bn, not too many questions asked, to 390 banks. It was also revealed that the Bank of England was now liable for around £50bn in respect of the continuing Northern Rock debacle.

Now the Financial Times reveals that the US is ahead of them both, handing out $746bn in Q3, on an annualised basis. Apparently the reason the US hasn’t (yet?) suffered a major bank run is that an obscure body called the Federal Home Loan Bank (FHLB) system has stepped in to replace the lack of liquidity in mortgage-backed loans.

The sums lent by now may be even higher, because like all government bodies, data releases tend to be delayed. But we do know it raised $210bn in November alone, presumably to fund loan commitments already made, on top of the Q3 lending. Its top 3 borrowers have been Citigroup. Countrywide and Washington Mutual – and one wonders what would have happened to their balance sheets without this infusion of federal money?

The Chairman of the FHLB, Ronald Rosenfeld, summed up the dilemma facing central banks and governments across the Western world. Asked by the Financial Times what would happen to the FHLB portfolios if house prices fell by 20 or 30 per cent, he replied: "I do not know the answer, but I can tell you I do not want to hear the news’.

But, he added, if the loans weren’t being made, and ‘if house prices were to depreciate 20% to 30%, you would simply have enormous problems in this country.’

Right at the start of the crisis on 2 August, I noted that Jochen Sanio, head of Germany’s financial regulator, had warned that we were facing ‘the worst banking crisis since 1931’. Since then, public statements from the world’s central bankers have remained calm. But actions speak louder than words. And it is clear from their actions that they too must share Herr Sanio’s fears.

Its always interesting to see the news stories that are slipped out just before major public holidays, when media attention is likely to be low.

Only ICIS news seemed to spot the announcement by Moody’s that they were placing SABIC Innovative Plastics (the former GE Plastics business) on watch for a potential ratings downgrade. Yet this is a story with potentially major implications for the chemical industry.

SABIC bought the GE business in July, when it was already well known to be suffering from high feedstock costs and increasingly difficult market conditions. But Moody’s felt no qualms then about issuing a provisional Ba2 rating for the debt. Yet on 21 December, Moody’s said that Q3 results might lead to a downgrade.

The key to the story is Moody’s sudden concern over the fact that SABIC used ‘a highly leveraged funding structure', which it now believes could ‘put more pressure’ on the business. In July, this structure was the norm for chemical M&A deals. But as I noted in October, the subsequent credit crisis has caused lenders to become more risk-averse.

Nobody, least of all Moody’s, is really questioning SABIC's support for its new Innovative Plastics business. But the ratings agencies, including Moody’s, were very slow to recognise the developing problems in the banking world as a result of the subprime disaster.

By rushing out news of a possible downgrade on this debt, Moody’s are making it easier for themselves to downgrade more debt issued by less well-placed companies during 2008. They can point to the SABIC example as ‘justification’ for a tougher line. Existing borrowers should therefore prepare for similar actions, as well as higher interest payments, during 2008.

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.

Oil prices touched $100/bbl today, a new record in nominal and inflation-adjusted terms. At the same time, the US Institute of Supply Management (ISM) index signalled that the manufacturing sector ‘failed to grow in December’, with ‘industries close to the housing market struggling more than others’. All the ISM’s main indicators were negative, with inventories also reported to be moving in the ‘too high’ direction.

It is difficult to underestimate the psychological importance of oil reaching the $100/bbl level. I first identified the potential for this to happen 6 months ago on 5 July (just as this blog began), when I suggested $100/bbl could be reached ‘early next year’. But at the time, this was a distinctly minority view. The price then was only $71/bbl, and many expected it to retreat to the $50/bbl level seen at the start of 2007.

I noted on 14 July, as oil rose to $79/bbl, that leading retailers Wal-Mart and Tesco were already reporting that consumers had become more conscious of value-for-money issues. I commented that CEO’s needed to develop ‘a major cost-leadership programme’ for September rollout, in order to respond to this twin challenge of higher feedstock costs and increasing consumer price resistance.

By August, I had also become concerned that the combination of the subprime disaster and high oil prices could provide ‘a distinctly unhealthy cocktail’ for the global economy. With OPEC proposing only a small increase in oil supplies as we came into the northern winter, plus ‘weakening US demand and credit markets’, I worried that chemical company profits could well be hit.

I repeated this concern in mid-September, when prices were still at $79/bbl, and concluded that ‘higher oil prices have always slowed the world economy in the past. Their impact may have been deferred this time, but it is hard to believe that it has been avoided’.

My EPCA posting confirmed this concern. I found myself worrying that the consensus forecast was too complacent, expecting $70/bbl crude and reasonable chemical demand and margins for 2008. Instead, I suggested that the meeting ‘will mark a turning point in the petchem cycle’.

By mid-October, I was pointing out that crude had risen to $90/bbl, and worried that ‘this latest upward rush by the oil price will be the catalyst that finally causes the US consumer to cut back on non-essential spending’. I suggested that companies should develop contingency plans for a 2008 downturn, even whilst hoping these would not be needed.

By the end of October, crude had reached an all-time high in inflation adjusted terms of over $92/bbl. And I questioned the reliability of Western inflation figures that sought to portray inflation at ‘only’ 2%, despite massive increases in the prices of food and energy. I worried that we would see ‘margin compression’ in the industry, as central banks belatedly woke up to the risk that inflation might become a real problem again.

Paul Satchell, chemicals analyst at ING shared my concerns, believing that investors had become ‘dangerously complacent about the industry’s ability to cope with increases in oil prices’. Whilst TOTAL’s CEO added to my worries in early November when I reported his view that ‘increasing tightness of supplies will keep oil prices relatively high in the future’.

By December, I noted that ‘the dialogue between oil producers and consumers is starting to break down’. I suggested that ‘the price and availability of oil is absolutely critical to the chemical industry. Growing uncertainty around these key issues is already leading to increased price volatility, which in turn will reduce margins and profitability’.

During December, we had a significant fall in the price to below $90/bbl. But the experience of previous oil price surges in 1973-4 and 1979-80 was that when the rally finally ended, prices stabilised at the new, higher, level. They did not collapse. It would therefore be a triumph of hope over experience to expect the 2007-8 surge to be different. And, of course, the worst of the northern winter is possibly still to come.

S&P have quickly followed Moody’s in putting SABIC Innovative Plastics’ debt on creditwatch for a downgrade. As I commented with the Moody’s downgrade, this is not really to do with a newly discovered decline in the polycarbonate market. S&P have very competent chemical analysts, and must have been aware in August (when the original grade was announced), that Q3 was turning out to be a tough quarter, and that future profits were likely to slow.

Again, ICIS news have done a good job uncovering this story during the quiet holiday period. Most revealing is the comment from S&P analyst, Tobias Mack that ‘We expect that SABIC will likely have to offer some parental support in 2008 to protect its subsidiary SABIC Innovative Plastics from a distress scenario’.

SABIC is one of the strongest chemical companies around. In making this demand, S&P are clearly preparing the ground to put major pressure on less well-supported companies with high leverage. They are also signalling that life will be quite difficult for those still trying to finance deals completed towards the end of 2007.

My conversations over the holiday period suggested that lenders’ lawyers are already busy examining the fine print of loan agreements, even those supposedly ‘cov-lite’ with few covenants to enforce performance. Finance directors don’t want to be caught unaware, if a major downgrade is likely. They need to ensure their sales and purchasing teams are monitoring credit conditions at their customers and suppliers very closely.

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)

US autos are one of the major uses for chemicals. The ACC recently calculated that each auto contains $2441 worth of chemistry, with a wide range of companies supplying products such as antifreeze, sealants, coatings and plastics. In 2006, chemical sales to the industry were worth $32.6bn.

A downturn in auto sales is therefore not good news. As I commented in November, when reviewing Q3 sales, ‘domestic US markets could get very difficult next year, if core auto and housing markets don’t start to recover soon’.

Unfortunately, Ford CEO Mulally’s comments last night suggests that they are not optimistic about 2008 prospects. ‘Clearly, most of the parameters of our economy are associated with a real slowdown’, said Mulally. ‘Everything has deteriorated more than we expected’.

We can also see this in the newly-released sales figures for 2007. Sales by the big 4 (GM, Toyota, Chrysler, Ford) were down 5% overall versus 2006 at 11.1m, with only Toyota showing a sales increase.

• GM were down 6% in the year, with 3.9m sales
• Toyota took the No 2 spot for the first time, with a 2.7% increase to 2.6m sales
• Ford took No 3 spot for the first time since 1905, after a 12% decline to 2.57m sales
• Chrysler, now under Cerberus management, and offering major cashbacks to clear inventory, was down 3% with 2.1m sales

The only positive was that inventories do seem to have been cleared, with Chrysler reporting the lowest level going into January for 13 years. But even this good news came at a cost for the chemical industry, as it was only due to a 21% production cut in December.

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.

Reports from leading retailers such as Wal-Mart and Tesco provide the best real-time insight into what is really happening in the wider economy. It is clear from both companies’ recent results that US and some other western consumer markets are slowing very quickly. This has critical implications for chemical companies.

In the US, Wal-Mart see a ‘difficult retail environment’. Their core offering is now ‘Wal-Mart’s food performance…which helped drive traffic to other areas of the stores’. In response, their strategy is focused on ‘price leadership’, and they noted that ‘customers responded to our pricing and merchandise offerings’ over the holiday period.

Since the holiday season, US sales growth has slowed further. Tom Schoewe, CFO, said they were now seeing just 2% growth, compared to 2.6% during the holiday period. In real terms, after adjusting for inflation, this means that sales growth is now negative.

Tesco are seeing a similar pattern in the UK, reporting that sales growth is now just 3.1%. This is also negative in real terms. Andrew Higginson, Tesco’s finance director, said that ‘we have all been affected by the market, as it slows’.

Back in July, I noted that the same retailers were the first to spot that ‘consumer attitudes have shifted sharply in recent weeks’. At that time, they were reporting that price had become the critical factor, and said they were aiming to ‘lower prices by working with key suppliers’.

It is clear that core markets for chemicals - housing, autos, and now retail - are all becoming more difficult. It is therefore hard to be optimistic about the next few months. Feedstock costs are high, volumes are coming under threat from lower consumer demand, and so margins will suffer.

Back in October, I suggested that CFO’s might be wise to develop ‘contingency plans’ in case consumer spending weakened whilst banks stopped lending. It now looks as those plans will, unfortunately, be needed.

I have often wondered how the major investment banks arrive at their forecasts for long-term crude prices. Last night I found out how it is done at the biggest player, Barclays Capital.

Dr Paul Horsnell, Head of Commodities Research, said that when he started in the role in 2003, he began by keeping close to the mainstream with a forecast of $24/bbl. Since then, as the market price has risen, he has simply doubled the previous price, deducted $1/bbl, and this number has become his new long-term forecast.

So from a starting point of $24/bbl, he then moved to a $47/bbl forecast, and is currently forecasting $93/bbl. When he next revises the forecast, he expects it to go to $185/bbl.

The interesting thing was that in a room full of eminent energy economists, as well as many senior oil industry people, nobody took issue with his methodology.

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.

The new ICIS Weekly Margin report on polyethylene is a goldmine for those who want to track the fortunes of the petchem industry.

The recent issue contains good news and bad news for producers:

• The good news is that PE margins have improved during January for integrated producers as a result of lower feedstock costs, higher cracker co-product values and higher PE prices.
• However, non-integrated producers are not yet seeing much improvement, as they have not been able to fully pass on the ethylene contract price increase.
• And the bad news is that the recovery in margins is starting from a low base. LDPE margins were down a massive 47% in Q4, versus the same period in 2006, whilst HDPE margins were down 55%.

Overall, though, 2007 was a reasonable year. Margins were down 9% for both LDPE and HDPE versus 2006, but this was mainly because of the Q4 downturn. As the chart shows, there was a dramatic fall towards the end of the year. Both European LDPE and ethylene contributions (the blue and yellow lines) hit lows in December that were last seen in early 2002 and late 2005.

Producers will certainly be hoping that today’s massive US Fed interest rates cuts, combined with the proposed Bush tax rebates, halts the current slide in consumer confidence and helps volumes and margins to recover.

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.

China’s ethylene and propylene imports have surged in recent months, as the country has diverted naphtha to supply gasoline and diesel needs.

ICIS news, reporting official China Customs figures, says 2007 ethylene imports were over 400% higher at 510KT, versus just 117KT in 2006. Ethylene exports also more than halved to 50KT in 2007, from 129KT in 2006.

Altogether, China’s net ethylene balance was therefore 472KT worse than in 2006. Propylene shows the same picture, with imports more than doubling in 2007 to 728KT versus 321KT in 2006.

Strong growth ahead of the Olympics is obviously part of the explanation. As is the fact that most of the country’s major new crackers won’t come online until 2009/10. But another key factor is the government’s need to prioritise gasoline and diesel production to ensure social stability.

As ICIS news reported last year ‘China has asked Sinopec and PetroChina to beef up their gasoline and diesel output to help relieve the country’s oil shortage since October’. And they quoted refinery sources as adding that ‘Diesel is tight in China. Reduced production of one tonne of ethylene would mean adding five tonnes of diesel.’

China’s dilemma highlights a wider problem for petchems. Crude supplies look to remain tight. This is driving up naphtha prices. But gasoline and diesel demand is continuing to grow strongly in many emerging countries, as governments such as China's instead subsidise domestic consumers.

Demand for transport fuels is therefore likely to stay relatively strong, as the world adjusts to a tighter oil supply/demand balance. Those petchem producers without access to advantaged feedstock may well face a difficult few years.

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.

On my regular trip to Asia, the major news is the snowstorms battering China. These started on 10 January, and are expected to continue for at least another week.

The transportation system seems to have ground to a standstill in many areas as a result. and so essential coal and food supplies are not reaching the major cities. The NRDC reports that 17 of China’s provinces have already suffered electricity blackouts. Many factories have had to close as a result.

Premier Wen Jiabao has now gone further and called for ‘key enterprises to take social responsibility’ and shutdown their operations. The Wall Street Journal reports that 78 million people have so far been affected by the storms, with 24 deaths recorded and 107000 homes destroyed.

This will make for a miserable Lunar New Year in China, with food shortages reported. Clearly chemicals production and demand will also be badly affected.

Andrew Liveris, Dow’s CEO, commented today that Dow now have ‘a total clampdown on costs and capital expenditure’. Whilst other CEO’s told the Financial Times that ‘rising oil prices, sagging consumer confidence and the on-going credit crunch’ are causing them to put in place ‘contingency plans to protect against the expected economic downturn’.

Separately, Bill Gross of Pimco, who manages the largest bond fund in the world, has said that he doesn’t expect the US interest rate cuts and tax rebates to rescue the housing market. In his monthly client newsletter, he comments:

‘Mr. Bernanke – we have a problem. First of all these 6-7% 30-year mortgages now require a significantly higher down payment than in prior years. 20% down? Say what? Where does a 30-year-old couple get that kind of money?
Secondly, however, and just as important, what motivates a future homeowner to pay 6%+ interest for an asset that is going down in price?’

The difficulty now for CEOs and CFOs lies in judging just how deep current problems might prove, and how long they might last. Gross goes on to suggest that only the provision of ‘subsidized mortgage rates with minimal down payments’ will cause US housing markets to bottom. He suggests that this won’t happen until next year, when a new US administration is in place.

If he is right, then US chemical producers cannot look for any short-term improvement in their main market, housing. And with China in the middle of severe winter storms, demand in the Asian region is probably about to dip for some weeks. Transportation is being hit very badly, and even where chemical plants are still able to run, product is often having to be warehoused as a result. Equally, many customers are already shutdown by lack of power, as coal supplies fail to arrive.

A slowdown in both the US and China is a potentially lethal combination for chemical demand, particularly as we come into what should be the seasonally strongest period of the year.

OPEC’s decision to hold its production quota at last Friday’s meeting came as no surprise to the markets, which were busy taking prices down $2/bbl on renewed fears of a US recession. But it did produce a warning from the International Energy Agency (IEA) that OPEC’s policies ‘threaten the strength of the global economy’.

The decision also tells us something very significant about current oil market politics. Because it was only last month that President Bush had made a direct appeal to the Saudis to lift oil production. And there have only been two previous occasions when a sitting US President has failed to influence OPEC discussions via the Saudis.

The first was in 1973-4, in the aftermath of the ‘Yom Kippur’ war, which resulted in OPEC oil embargoes. The second was in 1979-80, during the Iran hostages crisis. At all other times, the relationship between the US and the Saudis has been based on the close personal linkages established at the famous Valentine’s Day meeting 62 years ago between Saudi Arabia’s King Abdulaziz and then US President FD Roosevelt.

Saudi Oil Minister Naimi was typically Delphic in his comment after the OPEC meeting, commenting that ‘supply and demand are equal, and global reserves are fine’. And it is true that the Saudis have increased their own production to 9.2mbd in response to US requests. But probably two factors caused this historic rebuff to take place:

• Pragmatic. As noted at the time of the last OPEC meeting, the La Nina weather system generally produces mild winters on the US East coast. This has happened in 2008. Equally, the severe winter storms in China (attributed by government meteorologists to La Nina), will reduce demand still further, just as it normally takes a seasonal dip.
• Politics. It is probably hard for the Saudis to force through an OPEC increase with so much political tension around the Middle East. The US threat to bomb suspected Iranian nuclear facilities is clearly creating major tension in the region, and it would be difficult, if not impossible, for the Saudis to respond to a US appeal at the moment.

Quite why, in the light of these factors, President Bush chose to issue his personal appeal must be a matter of debate. History, as well as the IEA, is warning us that its rejection implies that oil markets are likely to stay difficult for some time.

Chemical companies tend to trade on ‘open book’ terms with long-established customers. They are also supportive when those customers are facing problems in their end-markets. In a recession, these admirable qualities can become expensive.

ICIS news reports tonight that the bankruptcy of Plastech Engineered Products in the US has led to debts of nearly $5m for 4 of the major US polymer producers. Plastech was a supplier of door panels and other items to Chrysler, and got into difficulty due to the alarming auto industry downturn chronicled here in recent months. Dow are apparently owed $1.57m, Basell $1.4m, BASF $1.02m and SABIC $970k, according to bankruptcy court documents.

CFOs and sales heads need to look urgently at their terms of trade with companies in recession affected industries such as housing and autos, as Plastech will probably not be the last company to fold. For example, as I commented 2 months ago:

“I would not be surprised if ‘cash before delivery’ soon becomes the norm for some companies. This may seem a harsh requirement, and may lose some sales in the short-term, but it is far better than standing in line for repayment after the worst has happened.”

These decisions are not taken lightly, but no chemical company can afford to take losses on this scale on a regular basis. I fear that a new generation is about to learn what some of us had the misfortune to go through in 1980-83 and 1990-2. If they can learn from our experience, and avoid some of the most extreme disasters, then everyone will benefit.

Very few non-OPEC oil projects have been financed in recent years, although market prices have risen from $20/bbl to $100/bbl. This is because oil companies and banks assumed that current prices would fall back to $40/bbl, or even lower, within 3 – 5 years.

But a new reality has been dawning, summed up by Total’s CEO last year, when he commented that major production increases from today’s $85mbd ‘would be difficult’ to achieve. Now BP have also reacted. Under new CEO Tony Hayward, they will now test projects against an assumption of $60/bbl. This 50% increase reflects a growing sense that the oil price will stay higher, and for longer, than oil companies had previously expected.

Futures markets still regard this price as too low. WTI for 2009 delivery is trading today at $85/bbl, and for 2016 delivery at $88/bbl. Buyers at these prices are aware that history would suggest oil prices should tumble in a US/western recession. But they also know that most demand growth is now taking place in Asia, and this is less price-sensitive due to subsidies.

Will the change in BP’s assumptions lead to more oil appearing? BP will certainly now invest more money, but construction costs have more than doubled in recent years. So the net effect will not be large. But at least they are investing. This was something that never appealed to Hayward’s predecessor, Lord Browne. His priority was always share buy-backs rather than investment.

‘‘I despair at times at why the equity markets can’t see how serious the credit crunch is’, said one senior credit analyst at an investment bank. ‘They just trade off the day-to-day newsflow’.

This interview from yesterday’s Financial Times reminds me of last July, when I noted how financial markets seemed to have become divorced from reality.

My musing then was prompted by the fact that Access had offered $12bn for the Lyondell business. This struck me as an extraordinary amount of money. Net debt was forecast at $22bn and 5.5 times current ebitda. And although the deal has now closed, I understand that the underwriting banks have still not been able to offload the debt into the market. This is a clear sign of the problems in credit markets to which the FT is referring.

Equally worrying is the fact that Wal-Mart, probably the best managed company in the world, yesterday reported that US sales were ‘below expectations’ during January. If Wal-Mart are now being surprised on the downside, then it is clear that things are really bad in US retail markets.

The FT goes on to warn that debt markets are growing ‘increasingly pessimistic about companies’ ability to withstand the bursting credit bubble and a possible recession’. Equally, the Wal-Mart warning means that US domestic chemical sales in the first half of the year will probably be much weaker than normal seasonal trends would suggest.

The prudent course for CEOs and CFOs must be to ignore the rose-tinted glasses still being worn in equity markets. They need to review January’s performance for early signs of weakness. They also need to test current budgets against an assumption that credit markets will get worse. Unfortunately, this week’s Plastech bankruptcy is probably not an isolated event, but just the first of many.

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.

The US Fed has dramatically cut interest rates by 1.25% recently. But as it eases, so US banks seem to be tightening their lending criteria for mortgages. Present standards are the tightest recorded

Since 1990, the Fed has asked banks about their lending standards. The chart above (by Merrill Lynch) shows the results. From 1992-2006, banks were relaxing standards most of the time. And even when they tightened, it was only by relatively small amounts, with no more than 20% of the US population being affected.

But over the past year, there has been a major, and unprecedented, change. As the above chart (complied by Merrill Lynch) shows, over 70% of Americans are now finding it harder to get a mortgage. 85% of banks have tightened their standards. And the change is not just affecting the subprime market. Over 50% of banks have tightened their standards for traditional prime mortgages.

The implications of this are enormous. It means that stimulating demand, whether by interest rate cuts or tax rebates, is unlikely to significantly reduce today’s inventory of new and existing US homes, which now stands at 9.6 months. Previous demand relied on lax lending standards – and today’s tighter policies mean that previously qualified buyers cannot now return to the market, even if interest rates go to zero percent.

So in reality, trying to stimulate demand is like pushing on a string. The only way to bring housing supply/demand back into balance is to reduce supply. And as anyone who has ever traded oil products or petchems knows, the only mechanism to achieve this is a sustained period of falling prices.

The banks have clearly recognised this new fact of life, which is why they are rushing (too late, of course) to try and reduce their exposure. Unfortunately, from a chemical industry standpoint, this could help to ensure that sales to the important housing market may take months, if not years, to properly recover.

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.

The Bank of England’s quarterly survey of corporate credit conditions, published today, shows that companies are finding it harder to get credit, and that rates are rising. This is in spite of the massive liquidity injections made by the Bank over the past 6 months, and its 0.5% interest rate cut.

The Bank says that ‘lenders reported a tightening of credit supply in Q4 and expect to tighten supply further in coming months’. Equally, as shown in the chart, the Bank says that ‘the effective rate of borrowing has remained elevated, despite falls in Bank Rate'. The Bank also worries that ‘although the effective rate on new business has fallen since its peak in August, this decline may be misleading, as it is likely to reflect the fact that as banks cut back on riskier higher-rate loans, the average rate on new lending falls'.

I noted 2 months ago that CFO pessimism was increasing in the chemical sector. This week’s reports from the Fed and Bank of England will do nothing to lighten their mood.

Ratings agencies Moody’s and S&P started taking a heavy line with Sabic in December over the supposed decline in the business environment at Sabic Innovative Plastics (the former GE Plastics business). This caused me to speculate that they were preparing the ground for a more wide-ranging move.

Today’s S&P report on private equity owned companies confirms my suspicions. S&P has looked at 36 European buyouts, including some major chemical names. It compares 2007 performance with the forecasts made when the deals were being done over the past 18 months.

S&P’s conclusion are worrying. Firstly, they report that the median company missed its first year forecast for EBITDA by 5%. And if this wasn’t bad enough (given that the period was a boom time in terms of margins and earnings), they add that net debt targets at many companies were only met by squeezing capex and working capital. And they add that 20% of the companies surveyed would breach loan covenants if their EBITDA fell by 10% or less.

The Lex column in the Financial Times sums up the report, with admirable restraint, by commenting that ‘if the corporate profit cycle turns, as seems inevitable, inappropriate capital structures will leave many buyouts in big trouble’. S&P’s report suggests that worried CFOs now have to wonder whether the risk of continuing to supply such companies on open book terms is one they should be taking.

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.

The UK government has today nationalised the country’s 8th largest bank, responsible for 18.9% of UK mortgage lending.

You may remember that Northern Rock was an immediate victim of the US subprime crisis. Its funding model, based on securitisation, failed to work once lenders became more concerned about return of capital than return on capital. Since September, the Bank of England has been forced to provide GBP 55 bn of emergency funding, following the UK’s first bank run in over 100 years.

The government even employed Goldman Sachs to scout the world and seek new investors. Sovereign Wealth Funds and others were approached, but none would agree to participate in a rescue. And so a bank which had an asset value of over GBP 100 billion in August, is now dependent on government for its survival.

The absence of Northern Rock will put further pressure on the UK housing market. Northern Rock had grown via aggressive lending, providing loans at multiples of 10 times salary, more than treble historical norms. In turn, this will reduce chemical industry sales to this important sector.

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’.

US housing markets are getting worse. Today’s S&P/Case-Schiller index showed prices declined 8.9% in December. Moody’s said that 10% of homeowners (8.8 million people) had negative equity in their homes. And unsurprisingly, given this background, bank repossessions rose 90% versus January 2007 levels.

Price changes generally follow changes in volume, up or down. And so yesterday’s existing home data from the US Realtors Association indicates that we are still some distance from a price bottom. January’s sales were 23.4% below the level of January 2007. Inventory, the other major indicator, is also still moving in the wrong direction. It is now at 10.3 months, compared to 9.7 months in December.

The underlying problem is that credit availability continues to tighten. The Realtors say ‘subprime loans and other risky mortgage products have virtually disappeared from the market’. And the Fed’s interest rate cuts are having little impact on the price of credit for those able to get loans. The standard 30 year mortgage rate was 6.22% a year ago, and is now 5.76%. Had the rate followed the Fed’s cuts, it would be 3.97%.

The same reluctance to lend is now developing in the UK, following the Northern Rock nationalisation. ‘The Guardian’ reports today that lenders are focused on margin preservation as credit markets tighten, and are no longer ‘worried about market share and volume’. 125% mortgages are unavailable for new applicants, and many major lenders are now demanding 25% deposits for the first time in many years.

In the past, comments ‘The Guardian’, falls in house prices have normally been driven by rising unemployment. This time, however, the main factor is the ‘credit crunch’, which means there is a ‘lack of funds for lenders’. Until this can be resolved, chemical companies will continue to suffer from the double whammy of lower sales into the critical housing market, and higher borrowing costs.

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.

China’s move last month to charge for plastic bags has now been followed by the iconic UK retailer, Marks & Spencer.

Whilst the environmental angle is clearly important, the move also represents a reaction to higher oil prices. Plastic bags are not ‘free’ to retailers, and their cost is now escalating. Restricting this cost, whilst also gaining ‘green’ credentials, is a ‘win-win’ for them. Similarly, its a ‘lose-lose’ for polymer producers. They have to pay the higher feedstock cost, and will now have lower volumes, so unit costs will increase.

Even worse, it probably marks the start of a more general movement to restrict ‘non-essential’ uses of crude oil. Gordon Brown, UK premier, has now said the UK government will force all supermarkets to charge within a year. Other governments will no doubt follow. The benefits of plastics are not well understood by the general public, and represent a soft target. Operating rates for producers and converters will suffer as a result.

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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.

Anthony Bolton of Fidelity has been the UK’s premier stock picker for 30 years. His learnings from his ‘worst disasters’ provide an insider's perspective on how to spot a company that’s about to fail. He revealed his top 3 warning signs in the Financial Times this weekend:

‘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.

India is apparently facing its own subprime crisis. Banks have cut back on lending, as the Bank of India has caused real interest rates to rise to around 7%. Loan growth is already down 20% this year, with personal unsecured loans facing the greatest cutbacks.

ICICI, India’s largest bank, has withdrawn entirely from this sector, which was formerly growing at 40% a year. V Vaidyanathan, executive director at ICICI, said ‘we have tightened credit norms across all elements of the credit portfolio. Though the existing book is performing well, its better to be conservative’.

As a result, India’s GDP is now expected to be around 8 – 9% this year. Earlier optimistic expectations of 10% growth now look unrealistic.

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