Chemicals & The Economy

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.

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.

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.

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.

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.

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.

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

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

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

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

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

‘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.

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

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

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

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

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

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

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

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

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

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

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

This matters to the chemical industry for two reasons:

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

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

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

There is an extraordinary main feature in this week’s Barron’s, the leading US investment magazine.

This analyses the dramatic 391 point rally in the Dow Jones Industrials Index on 1 April. It describes this as ‘a spectacular exercise in the absurd’, and claims that the root cause was an April Fools spoof sent out that morning by a very prominent bearish commentator.

Doug Kass (known as the Bear who Never Sleeps) sent out an April Fools note in which he suggested the Dow would soon hit 56,000, after a 26% rise in 2008. He also joked that foreign buyers would now rush to buy up foreclosed US properties, oil prices were about to fall 50%, and that there would be no US recession. Barron's claims that these views were picked up by many foreign news media (who probably did not understand the April Fools concept), as well as hundreds of ‘investment websites’.

Was this really the cause of the rally? Who knows? But for Barron's to write about it so prominently suggests that they are convinced.

A month ago, I suggested that oil prices 'seem set to move higher in the short-term, with $125/bbl now being talked as a target'. Readers were hopefully not too surprised, therefore, to see prices for Brent and WTI close at this level on Friday night.

One of my longer-term forecasts also seems to be coming true. Back in October, I was a rather lonely voice when I suggested that the 'consensus (chemical company) forecast is very optimistic...expecting oil will remain at $70/bbl, that debt market problems will be contained, and that petchem margins will remain at 2007 levels'.

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

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

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

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

Chemical companies are still getting used to the idea that crude is trading above $100/bbl. For many of them, this was a complete shock, as many had believed the consensus view and budgeted for a $70/bbl average in 2008. Now, however, worse news is in prospect as forward prices have been racing away this week. 2016 oil contracts yesterday traded just under $140/bbl for the first time.

The picture above shows the global reference chart from the International Energy Agency (IEA). They expect oil demand to continue to increase, driven by growth in China, India and other emerging economies. Higher oil prices don't affect this growth, as countries such as China have imposed price freezes on oil products, as I noted back in January. Equally, OPEC countries also subsidise oil prices, with many selling gasoline at 10c/litre. As a result, last week's IEA forecast is for demand in these countries to grow 4.9% this year.

There are some close parallels between the airline and chemical industries. Both are very capital intensive, use oil as a key raw material, and are heavily dependent on operating rates as a driver of profitability. Therefore one probably needs to pay close attention to news that American, historically the strongest US airline, has announced it is 'retiring' jets in response to rising fuel prices. Whilst British Airways has warned that its entire operating profit for this year might be wiped out.

Recent statements from senior airline executives also have an ominous tone to them for chemical industry managers. Jean-Cyril Spinetta, CEO of Air France-KLM has said 'air fares would have to rise' and 'admitted the increases could hit demand for air travel'. Willie Walsh of BA had an even bleaker outlook, commenting that 'we're going to see people fail'.

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

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

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

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

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

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

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

The US price for natural gas has risen faster than crude so far this year. It is already up almost 65%. Rising coal and oil prices have encouraged power generators to switch to gas, whilst lower Canadian exports and a tight global LNG market have helped to push prices higher. Increasing demand for ethanol will also require 1bn cu ft of extra gas supply, between 2008/9, according to Merrill Lynch. US producers can be forgiven for feeling battered, with their costs rising and the domestic market hit by lack of demand from the housing and auto sectors.

Monday, Monday, can't trust that day
Monday, Monday, sometimes it just turns out that way
Oh Monday morning, you gave me no warning of what was to be

These 'Mamas and Papas' lyrics certainly sum up Monday this week:

• Oil prices went to another record high, just under $140/bbl, as traders worried about the falling US$ and the risk that an attack on Iran might not be far away
• A leading US economist suggested that the next 18 months might parallel the 1988-92 US real estate crisis, 'when more than 1000 banks and 1000 thrifts failed'.
• ICIS' Nigel Davis highlighted the suggestion from Citigroup analysts that the chemicals industry was also'heading for crisis' due to its inability to pass through recent feedstock cost increases

John McCain, Republican Presidential candidate, is making waves in the US political scene with his suggestion that the ban on offshore drilling for oil might need to be lifted. Barron's, however, notes rather ironically that in fact, drilling is already underway off the Florida coast. It points out that 'Cuba is allowing Chinese energy companies to drill for oil and gas in the Gulf, less than 90 miles (145km) from Florida'.

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

Oil prices at $140/bbl caused plenty of debate in Bangkok this week at our Asian conference (jointly organised with ICIS). Delegates also heard from Reliance's President of Fibre Intermediates, Rajen Udeshi, on the potential for a new commodities 'Super Cycle' to be underway.

Discussing the above chart, he pointed out that the industrialisation of China and India might well cause the same disruption as the industrialisation of Europe and the USA in previous centuries. 'China and India have a combined population of 2.1bn, which is one third of the world population', he added. 'That is a lot of buying power'.

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

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

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

Oil price movements are now dominated by the Iranian nuclear issue.

Last month, they jumped $10/bbl to $146/bbl as news leaked of Israel's training exercise against Iran's nuclear sites. I've since talked to someone who was on holiday in Southern Greece at the time, and he says it was an amazing sight - the sky was apparently filled with planes.

Early last week, prices fell $10/bbl as news agencies headlined Iran's leader saying 'There won't be war'. But his actual comments made it clear that he wasn't backing down. Rather, he was arguing that the US/Israel were bluffing, and calling the threat of an attack a 'joke'.

And then prices rose $10/bbl again. First, Iran fired missiles which it claimed could reach Israel. Then the Jerusalem Post carried reports from the Iraqi Defense Ministry that the Israeli air force had been using US bases in Iraq in further training exercises.

I suggested at the weekend that the Iran issue had the potential to move oil prices by $50/bbl either way. Since then, prices have fallen $20/bbl to $130/bbl, on news that the USA and Iran will meet tomorrow for the first time in nearly 30 years. If they reach agreement on the nuclear issue, oil prices will almost certainly fall further, as the threat to exports via the Strait of Hormuz is removed. Alternatively, if diplomacy fails, any bombing by Israel of Iran could easily cause prices to soar to $200/bbl.

Maintaining price hedges against both outcomes therefore seems the right strategy for chemical companies, given this uncertainty. If prices do fall further, working capital will take a major hit, as stocks are revalued downwards. Current price initiatives will probably also collapse. Equally, if bombing does take place, and oil prices jump in response, it is most unlikely that these higher costs will be quickly recovered in product prices.

There seems to have been no response from Iran to the 2 week deadline set by the US and Europe on the nuclear issue. Over the weekend, Iran's President, Mahmoud Ahmadinejad said 'the Iranian nation would not retreat one iota from its rights.' Earlier, Israel's deputy Prime Minister, Shaul Mofaz, had also taken a hard line, claiming that Iran was simply pursuing a strategy of 'buying time', and adding that Israel believed 'Iran will reach enrichment capability' by 2009.

Although such statements may be a cover for more substantive discussions in private, the rhetoric is not encouraging. Mofaz added, for example, 'it's a race against time and time is winning'. Early last month, when oil prices were at $150/bbl, I suggested that they could easily slip to $100/bbl if diplomacy worked. Equally, I worried that they could rise to $200/bbl if military action took place, and Iran blocked oil exports through the Strait of Hormuz. Hedging against both possible outcomes still seems a prudent strategy for chemical companies to adopt.

I noted last month that German industrial production fell 2.4% in May, and that Chancellor Angela Merkel was expecting 'a significant fall' in economic growth for 2009. This fall now seems to be already underway. Industrial output fell by a further 2.9% in June, and for the seventh month in a row - the longest period of decline for nearly 20 years. German officials are also indicating that GDP fell by around 1% in Q2.

The specific problem in Germany is a lack of export orders. In Spain, the economy is also facing recession, as housing market problems spread to the wider economy. Manufacturing output fell 9% in June, and H1 industrial output was down 3.1%. As a result, the Bank of Spain is now forecasting GDP at 0% for 2008.

A multi-year global downturn seems more and more likely, as the major Western economies all appear to be running out of steam simultaneously.

OPEC's oil output hit an all-time record in July at 32.8Mbd, due to higher volumes from Saudi and Iran. The Saudi increase to 9.55Mbd was in line with their pledge at the Jeddah summit in June to raise output to 9.7Mbd. But the Iranian increase appears to have been a one-off, as the country sold off stockpiles that had been built up whilst refineries underwent seasonal maintenance. And on the demand side, Chinese consumption continued to boom, rising above the 8Mbd level for the first time to reach 8.3Mbd in June.

According to the International Energy Agency's latest monthly report, some demand destruction is now taking place in Western countries, as a result of higher oil prices. It notes that 'even if retail prices ease, it seems unlikely that motorists who have purchased smaller cars will revert to gas-guzzling vehicles'. But the IEA still expects global demand to grow by 790kbd this year, as emerging countries and OPEC continue to subsidise domestic oil product prices.

This morning, the blog is awarding itself a pat on the back. This is because, almost alone, it forecast in mid-July that oil prices 'could easily fall $50/bbl to $100/bbl' in the absence of any military action on Iran. And it had the courage to repeat this comment on 4 August.

It added that if prices 'fall back, then working capital (stocks etc) will take a massive hit'. This forecast also seems to have come true. The whole supply chain appears to be filled with product, bought on the basis of a consensus forecast of $200/bbl oil by Xmas. This surplus may well take weeks, if not months, to clear properly.

The only 'relief' would be if oil prices suddenly rose again. But whilst OPEC agreed yesterday that the market was 'over-supplied', they formally agreed just a minor cut of 520kbd, effectively re-establishing the 'official' quotas. If OPEC had cut further, they would have risked a real shortage in Q4, as stocks now need to build in front of the northern winter.

Another major blog forecast has been that 2007-8 was shaping up to be a repeat of 1979-80. It first stated this view last October. It worried that, as in 1979, the consumer would initially appear to absorb a major rise in oil prices. Then, as in 1980, it would become apparent that this had been 'the catalyst that finally causes the US consumer to cut back'.

US and Chinese stock markets were making record highs when this forecast was first made. But the blog worried that 'the continuing problems in the banking sector may well turn off the tap of consumer, and maybe even corporate, lending'. Nearly a year later, stock markets are well off their highs, and the latest news from the financial sector indicates that the blog's concern may prove well-founded.

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

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

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

In early August, the blog noted that politicians were beginning to recognise the seriousness of the economic situation. First, China's finance minister Liu He warned that 'an economic restructuring was inevitable'. Then the UK's finance minister said the 'global economy was at a 60-year low', and France's Prime Minister added that the world was facing a 'very, very serious global economic slowdown'. Last night, US President Bush joined the chorus, warning that 'our entire economy is in danger'.

No doubt Congress will now try again to approve some form of bailout for the US banking system. And stock markets may well rally, at least briefly, in relief. But as the Wall Street Journal comments this morning, the underlying issue behind the crisis is that 'homes were grossly overpriced, fueled by binge borrowing. For that to correct, prices must return to more affordable levels'. And it adds that even with a bailout, 'it isn't clear home prices will rise. They could simply stagnate.'

This is a critical issue for chemical companies, given the importance of housing markets for chemical demand. And a new report today suggests they are getting worse, not better. Prices are now falling in 21 of the 33 countries monitored by Global Property Guide. A year ago, only 5 countries were in a downturn.

As the blog suggested 10 days ago, CEOs could be well advised 'to start preparing contingency plans to survive a major economic downturn'. The chances of this occurring remain 'uncomfortably high'.

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

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

Collapsing housing markets are creating major problems for chemical companies worldwide. Now JD Power, the leading auto industry research firm, is warning that 'the global auto market in 2009 may experience an outright collapse.' They add that 'while mature markets are being impacted more severely than emerging markets, no country or region is completely immune to the turmoil'. 2008 sales are already weakening:

• They forecast US volumes will be down 16%, with any recovery 'more than 18 months away'
• China's growth will be down to 10%, versus 24% in 2007
• India will grow just 5%, versus 16% last year
• Europe will be down 3% overall, with W Europe down 8% and growth in E Europe 'slowing considerably'.

CEOs will need to revisit their Downside scenario in the 2009 Budget, and check once more that it really is robust in the face of such forecasts.

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

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

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

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

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

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

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

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

Sir Fred Goodwin, CEO of RBS, was one of the poster boys of the new banking model. Along with his peer group, he preached the virtues of the 'efficient balance sheet'. Equity was for wimps. The blog warned over a year ago that the 'seeming genius' in recent years of people such as Sir Fred '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.'

This morning, Sir Fred is gone. So is Sir Tom McKillop as Chairman - a very talented and friendly man, but out of his depth when he moved from running AstraZeneca to chairing the 'go-go' bankers at RBS. Instead, Gordon Brown is now effectively the blog's bank manager, as the UK government will end up owning 60% of RBS in exchange for a £20bn ($35bn) capital injection - twice its recent market capitalisation.

Financial markets currently seem to be discounting the end of the world. So it would be no great surprise if the recent panic was replaced by a more balanced outlook. But the unusual feature of this recession is that the banks have already gone bust, even before the 'real economy' has turned down. So unfortunately, as the blog warned early last month, this probably means that deleveraging still has a long way to run.

Futures markets are taking an increasingly gloomy view of oil demand. And over the past 2 weeks, the volume of NYMEX contracts to sell crude at $50/bbl has soared 50-fold. But so far, as the blog expected, physical prices have stabilised at the $70/bbl level in advance of OPEC's emergency meeting on Friday.

Current OPEC President, Chakib Khelil, today indicated OPEC will probably cut production, in stages, by between 1 - 2 mbd. This would be a bold move, just before the US elections. But many OPEC governments simply cannot afford further price falls, if they are to balance their budgets, and so they may well decide they have to take the political heat.

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

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

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

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

Two main factors weigh on oil markets. The first, as PetroMatrix note in their latest weekly report, is that speculative players in virtually all commodity markets are being forced to deleverage their positions, and so "the bottom will be dependent on the end of the firesale". The other factor is the continuing fall in demand. OPEC's own expectation, following its 1.5mbd production cut, is that global recession means the current "fall in demand will deepen, despite the approach of winter in the northern hemisphere".

The risk is that all this uncertainty over future demand levels and prices starts to reduce future supply. A new draft study from the International Energy Agency suggests the world needs to replace 9.1% of current production every year, as existing fields reach the end of their life. As the Saudi cabinet warned on Monday, "continuation of investment" is therefore vital for the "safety and growth of the world economy".

The blog has been thinking about last week's leaked report from the International Energy Agency (IEA). This said that the world needs "to invest $360bn each year until 2030 to replace falling oil production and increase supply". The IEA based this sum on a new analysis of 500 oilfields, which showed the current depletion rate was 9.1% every year, and 6.4% even if companies invested in more wells at each field.

This means that the world is currently losing nearly 8mbd each year of current oil supply due to depletion, more than double the previous 4% assumption. Even the 6.4% rate means 5.5mbd of new oil needs to be found each year, just to keep supply stable. And, of course, demand has been growing in recent years, due to industrialisation in emerging economies in Asia, the Middle East and Latin America. This demand growth means more oil has to be found.

And there is another aspect to the issue. This is that OPEC countries, who produce 44% of the world's oil, are facing major problems from the global recession. According to Bloomberg, Dubai's government-controlled companies owe "at least $47bn, more than Dubai's GDP". The money has been borrowed on the back of a huge property boom, and the expectation that tourist numbers will double to 15 million by 2015. Other oil producers, including the 2nd largest, Russia, are in similar difficulties.

This would suggest that oil prices need to rise, on a permanent basis, in order to encourage exploration and production. Equally, oil producers need higher prices if they are to balance their budgets, and avoid social unrest. But at the moment, with destocking underway around the world, prices are instead under downward pressure. OPEC has already had to announce cuts of 1.5mbd, and may be forced to announce more, just to try and stabilise prices at today's $60/bbl.

Oil prices will probably remain under pressure whilst the current period of destocking continues. But after that, they could easily spike quite sharply, even if underlying demand is actually quite slow, as OPEC is likely to be cautious about raising production once more. And longer-term, today's relatively tight supply/demand balances may well continue. Ongoing price volatility, and a global recession, will make it difficult to fund the large investments that the IEA says are needed.

ICIS is reporting today that Shell sold open spec naphtha to Cargill at $267 CFR Japan, for the first half of January. Normally the naphtha: crude ratio is around 9.5: 1. But with January Brent at $66/bbl, the ratio is now just 4:1. The blog can safely say we have never seen it this low before. And naphtha is not the only oil product facing a glut, with Petromatrix commenting that US refinery margins are currently "under extreme pressure".

With Reuters reporting that Saudi Arabia is cutting oil exports by 900,000 bpd, Cargill's purchase is logical. But the fact that a well-informed player such as Shell was selling, makes the blog slightly wary. If refiners are forced to cut runs for December, then it would be hard for OPEC to cut its own production quickly enough to compensate. In that case, a $20 - $30/bbl range for crude, albeit temporarily, would not be impossible.

TOTAL have adopted a very clear strategy for surviving the downturn. The results statement today particularly highlights their success in strengthening their balance sheet. Net debt to equity now stands at just 15.4%, whilst they are "maintaining a high-level of liquidity and divesting non-strategic holdings".

TOTAL also see a need "in the short-term" to adjust oil "supply to lower levels of demand". But they "reaffirm their view of higher oil prices in the medium to long term, supported by a tight supply-demand balance".

Their view is supported by a report in today's China Daily. This features calls from leading analysts to increase China's storage from its current 30 days of supply, and "take advantage of today's low prices to build more oil reserves".

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

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

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

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

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

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

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

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

I gave an interview to ICIS radio at EPCA in September, in which I warned that the destocking process would go through two phases:

• The first, which took place during Q3, was when companies destocked in response to the falling oil price, to a more "normal" level of stock
• The second, which would occur in Q4, as companies destocked further on discovering that end-user demand was actually lower than "normal"

Two months later, Peter Salisbury has just documented in ICIS Insight the disastrous impact of this second phase, which is now taking place as forecast. Hundreds of millions of dollars has now been wiped off the value of chemical companies' inventory.

The interview was highlighted in the blog, and I just hope that readers took the appropriate action in time, and have not suffered the full pain.

Current market conditions are causing problems for everyone in the chemical industry. But as the blog has long feared, they are particularly testing those companies with higher debt levels. On Friday, Moody's announced a downgrading of the Corporate Family Rating of Lyondell Basell Industries to B3 to B1, and said the outlook "remains negative".

Yesterday, INEOS asked for "a waiver on its covenants". As the Financial Times reports: "The highly indebted chemicals group is struggling with a loss on its large inventory of oil following the decline in petrochemicals prices. It is also feeling the knock-on effects of a rapid deterioration in the housing and automotive sectors, two big users of its products."

The FT says that INEOS currently has €7.3bn in net debt. Q3 EBITDA was reportedly 20% down at €402m, causing INEOS to ask for the waiver for the next 6 months "whilst we wait for the mists to clear". The FT adds that INEOS will present a new 5 year business plan to its bankers by April, and could consider selling assets to reduce leverage.

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

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

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

Regular readers of the blog will know that it believes price movements in benzene have great predictive power. This is due to the fact that benzene is one of the oldest of the major chemicals, and has the widest industrial usage. Thus in March, when benzene prices hit a "ceiling", the blog noted this was indicating "that the outlook for commodity petchem profitability has also weakened".

Now, benzene is giving us another clear signal. Today's actual crude price is close to $50/bbl. Yet benzene's current $250/t price implies a crude price of $16/bbl (assuming the usual formulae of an $80/t conversion margin to naphtha, which in turn should be 10 times the crude price). And although anything is possible in today's markets, it is highly unlikely that OPEC would allow a $16/bbl price to continue on more than a temporary basis, unless we are entering a massive global slump.

Today's benzene prices are therefore giving us another clear message. Producers are selling on a firesale basis, because they have to clear inventory, in order to meet year-end cash targets. Last March, benzene was telling us that profitability was about to hit a ceiling. Now it is telling us that we are getting close to the floor.

Surprisingly, our 7th European conference this week in Cologne (co-organised with ICIS), was one of our most successful. Delegate numbers were down, as companies cut travel budgets. But those attending said they had gained much more, than if they had stayed in the office.

For a start, there was the opportunity to share experiences, and put today's problems in context. My colleague, John Keeley, focused on the scary nature of today's demand slump when opening the conference. But he also reminded delegates that one must remain pro-active. His "yes, we can" approach became the key theme of the event:

• Pierre-Emmanuel Goffinet of GTIS showed how companies could use trade statistics to better understand what is happening in their markets
• Phil Allen of GEMS outlined new marketing tools to maximise profit by better understanding customer needs
• Wood Mackenzie suggested that the coming gasoline glut created an opportunity for producers to obtain cheaper feedstocks

Delegates also came away with a real insight into current problems in financial markets. Nigel Davis of ICIS insight analysed the factors behind the current collapse in demand. Whilst Paul Satchell of ING, who had correctly warned last year that the crisis had hardly begun, focused this year on the problems caused by lack of visibility down the value chain.

Summing up the 2 days, I said that I hoped the New Year would see a welcome recovery in demand. Factories will reopen downstream, and customers will need to rebuild inventories. But I warned that this would provide only temporary relief, with housing and autos in recession.

My advice was therefore to use the next few weeks to develop, and implement, robust plans to survive an extended downturn.

Last March, the blog supported Warren Buffett's statement that "by any commonsense definition, the US is in recession". I also wrote an article for ICB in April, "Building your defences", to suggest how companies could develop contingency plans to deal with the "real threat" of recession.

At the time, government figures did not support Buffett's claim. But today, the official US body responsible for dating recessions has formally declared that the US entered recession last December.

As the blog expected back in May, when quoting Mark Twain's famous line "Lies, damned lies and statistics", Buffett's call has turned out "to have been right, after all".

The chart presents a sobering view of recent stock market performance. It shows (courtesy of chartoftheday.com) the Dow's performance in the first year of all bear markets since 1900. Since its 2007 peak, the Dow has fallen more than in any other bear market, even more than in 1929.

INEOS is the world's 3rd largest chemicals company. Its €7.29bn debt burden ($9.2bn) means that it is also Europe's largest issuer of high yield debt. This is an unfortunate combination, given today's chemical markets.

Last month, INEOS was forced to ask its lenders for a waiver on its debt covenants. It offered to pay a 0.5% upfront fee for the waiver, plus an ongoing fee of up to 1.25%. Its lead bankers, Barclays and Merrill Lynch, offered their support immediately, but other investors have been cautious.

Bloomberg reports that INEOS has a number of US lenders, and says these are used to receiving much higher fees in return for covenant waivers. S&P data shows US companies paid an average 2.40% so far this year. And according to Reuters, "the markets' reaction shows that investors remain unconvinced that the company will be able to solve its problems by the end of May and avoid a full balance sheet restructuring".

Reuters adds that investors' concerns are also shown by the fact that insurers have recently required payments of "€7m upfront to protect €10m of the company's debt against default". INEOS senior debt has been trading around 50% of face value, whilst its junior debt has traded below 20% of face value.

INEOS has warned of an expected €400m loss on inventory write-down, if oil is $60/bbl at year-end. It announced a management restructuring of its European Olefins and Polymers businesses, and is taking a number of measures to reduce costs and improve working capital. John Reece, INEOS CFO, has also reassured investors that "the Group as a whole can produce significant profits and cash flows even at the bottom of the cycle".

Decision-time for the 233 members of INEOS's banking syndicate is 9 December, when the waiver request is likely to receive majority approval. Reports suggest, however, that the company may well have to pay an extra 0.5% in fees.

Having no risk management systems in place may be better than having the wrong systems in place. That seems to be one of the lessons from the recent financial meltdown.

The reason for this apparent paradox is that awareness of risk makes people cautious. But if they wrongly believe that all risk has been removed, then this can lead to over-confidence and potential disaster. Two recent articles highlight this issue:

• Paul Ray of ICIS kindly sent me The risks of risk management.pdf" by an expert in quantitative finance, which shows why banks failed to anticipate the credit crunch, despite employing thousands of highly qualified mathematicians to quantify risk for them.
• Prof Nassim Taleb (author of 'The Black Swan'), calls on companies and investors to boycott banks and business schools that employ the widely-used "value at risk" methodology, which he believes is fatally flawed.

Both authors believe that managing risk is not just a financial exercise, but also requires an understanding of human nature. It is well-known, for example that an unfortunate side-effect of building safer cars is that people feel more confident, and some may drive too fast as a result. This is bad news if you happen to be a pedestrian, and the driver fails to spot you crossing the road. Unfortunately, this has been the outcome in the financial world, as a result of flawed thinking on risk.

George Soros is one of the most successful investors in recent decades. The blog came across today a report of Soros' graphic description of the dangers of having too much debt in a business, or personally:

"Leverage was like driving along a straight, clear freeway with a sharp spike pointing from the centre of the steering wheel to an inch or two above your chest. All would be fine if the road and the traffic continued as they were, but any sudden application of the brakes would stab you through the heart."

The current credit crunch is, of course, equivalent to the "sudden application of the brakes" to which Soros referred.

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

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

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

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

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

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

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

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

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

The chart, taken from the weekly ACC report, shows just how badly chemical production has been hit in recent months:

N America. This region has been worst affected, with volumes down 12% in November versus 2007.
W Europe/CEE. Both regions were down 3% in October versus 2007
Asia/Latin America. These regions are just positive, with 1% growth.
Middle East. This region remains strong, with 14% growth, as new production based on advantaged feedstock comes online.

Overall, world growth is now a negative 1.9%, confirming that we are in a global recession. And core sectors for chemical demand such as housing and autos are still in decline. The blog therefore fears that the news on production will get worse, probably a lot worse, before it gets better.

Prof Nouriel Roubini has long been correctly bearish about the economy, and was one of the first to highlight the deflation risk. In a new interview, he sets out his thoughts for 2009, and concludes:

"I don't believe we are going to be in a depression - but we could end up like Japan that had essentially economic stagnation for a decade with deflation. You know, the "L"-shaped recession.

"At this point, the "U"-shaped recession could turn into an "L"-shaped recession if we don't fix the financial system, and the credit crisis becomes worse and if we don't get a massive fiscal stimulus. So, a lot depends on our policy reaction. If our policy reaction is appropriate, by 2010 there will be some recovery of growth.

"The only risk is that the recovery of growth could be so weak that it feels like a recession even though we are technically out of it. So there is a risk of something like a Japanese-style, multiyear economic stagnation. I would not rule it out, but it is not my benchmark scenario.

"I think there is a one-third probability it will end up that way, but a two-thirds probability that we will end up in a severe, two-year-long recession. And that would be by any standard the worst recession that the U.S. has experienced in the last 60 years."

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

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

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

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

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

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

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

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

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

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

In early October, I forecast that we were about to revisit "the scariest moment of my 30 year chemical career", adding that:

"The moment the blog has long feared, and warned about, may be about to arrive. It appears that we may be about to revisit 1980, when for some weeks it seemed that demand for many petchem products had simply stopped."

I also repeated this forecast in an EPCA interview with ICIS radio.

Sadly, the coming results season is likely to demonstrate that my forecast was all too prescient. INEOS have already announced inventory holding losses of €1bn ($1.3bn) in Q4.

As I wrote in October, "If your Board would like to talk about the current situation, and to discuss how to manage it, please contact me. I will be happy to use my experience to try and help."

OPEC Oil Ministers, meeting today, have achieved 80% compliance with their announced production quotas. This is much higher than normal, and owes a lot to the hard-ball tactics played by Saudi Arabia, the world's leading oil producer, in initially allowing prices to slip to a $32/bbl low.

The blog forecast in January that OPEC would be successful in stabilising prices "around the $35 - $45 range". And as the Barrons chart shows, this range has since held, in spite of major speculative attacks from financial players trying to push prices either below $30, or above $50/bbl.

Saudi has also made no secret of its desire to push prices back to a $75 - $100/bbl range in due course. But as OPEC noted last week, the global economy is in a "terrible situation". OPEC expects a 1mbd fall in demand during 2009, whilst it and the International Energy Association expect consumption to average only around 84.5mbd.

Uncertainty over OPEC's ability to maintain the current range is therefore likely to continue, especially as quota compliance from Iran, Nigeria and Angola is only at 51%, 54% and 15%. Equally, this means that prices are likely to remain highly volatile. Even the core $35 - $45 range implies nearly 30% swings, whilst over 50% is entirely possible if prices overshoot on the downside towards $30 and then recover towards $50.

Source: Chartoftheday.comUS house prices remain on a "downward path" according to today's latest S&P Case-Shiller house price index. S&P report that in terms of nominal prices (including inflation), "average home prices across the US are now at similar levels to late 2003". In 'real terms' (after excluding inflation), the picture is even worse.

According to the above chart from ChartOfTheDay, "a home buyer who bought the median priced single-family home at the 1979 peak has actually seen that home lose value (1.6% loss)". COTD adds that "the median priced home has moved back to the top of a trading range that existed from the late 1970s into the mid-1990s".

Leaders of the G-20 represent 85% of the global economy, and 65% of world population. Set up by Finance Ministers after the Asian crisis in 1997/8, they first met at Heads of Government level in the USA last November. Sadly, although their communiqué was filled with earnest promises, few of these have since been enacted.

Most critical for the chemical industry is the outlook for global trade. This is now seriously threatened. The above chart from the OECD shows trade fell 24% in Q4, more than in 1975, and is forecast to fall at similar levels for Q1 2009. And as the World Bank has already documented, protectionism is on the rise - with 17 of the G-20 countries having introduced new measures since the November meeting.

The blog is always optimistic, and so it hopes that the meeting will provide an opportunity for world leaders to put aside the rhetoric and focus on the real issues. These are:

• Is fiscal stimulus the way to go? If so, how should it be done? The US has already committed $12.8 trillion (versus total GDP of $14.2 trn). Is this money well spent, or simply storing up more debt for the future?
• How far should governments go in combating the downturn? Are we, as the blog speculated in October, getting to the point where the principle becomes "markets where possible, governments where necessary"?
• What should be the future role of regulation and central banks? What changes need to be made to the global financial system? How should they be implemented?
• What happens if things get worse, not better? The consensus view is that the economy will 'naturally' recover at some point. But as the blog discussed in December, an L-shaped downturn is certainly possible.

These are big issues, and the blog does not expect immediate answers. But much time has already been lost, as politicians (and some industry leaders), denied that a crisis was underway. Hopefully, tomorrow's discussions will finally start to move policy in the right direction.

Today saw further anecdotal evidence of speculative crude oil buying. A senior manager at the Port of Rotterdam told Bloomberg that oil inventories were the highest he had seen since he began work there in 1985. Rotterdam can hold 75 million barrels. Whilst there are also reports of tankers at anchor along the UK's southern coast, supporting the idea that land storage is filled close to capacity.

Meanwhile, the US Energy Information Agency reported US crude inventories rose for the 8th straight week. As the chart shows, these are well above the normal range, and 18% above this time last year. EIA also said total US oil product demand was down 6.8% in the past 4 weeks versus 2008. Refinery operating rates slipped to only 82.7%.

BASF, the world's largest chemical company, said today that they see "weak demand for chemical products" continuing through 2009. In response, plants and sites "will be closed or sold where necessary". These are clear statements about the outlook, backed up by commitments to take action.

Yet volumes and prices in financial markets are rising, as traders "look through to the recovery". Nowhere is this more evident than China where, as the chart shows, April volumes in Linear Low Density Polyethylene (LLDPE) soared to 77 million tonnes, 3 times total annual world production. In turn, prices rose 21% over the month.

CEOs have some tough decisions ahead of them. Do they follow the BASF example, and start closing capacity? Or do they listen to the siren voices of the traders, promising that all will soon be back to normal?

The blog continues to believe that fundamentals matter in the end. Key chemical markets such as construction, autos, and electronics seem to be stabilising. But they show no signs of real recovery. BASF are making the right decisions, difficult though these are.

In July 2007, the US Federal Reserve warned that "credit concerns were spreading" and estimated that total bank losses due to US sub-prime loans could reach $100bn. Yet now, after the conclusion of its "stress tests", the Fed says total bank losses could reach $600bn.

In most companies, a 6-fold change in a key financial assumption would prompt concern that the underlying issue was not being properly addressed. But this has not happened at the Fed, which says its new tests have still focused on residential lending (including sub-prime). The potential impact of a serious economic downturn has been ignored. Only minor losses have been assumed from corporate lending.

This omission also means that the Fed is able to forecast a very sharp recovery in bank earnings of $415bn over the next 2 years. It is therefore able to reduce the banks' requirement for extra capital to $75bn. Without this heroic assumption, many of the banks would already be insolvent, as they would have to raise $185bn - a clearly impossible figure.

How does the Fed expect this wonderful recovery to occur? Conveniently, it assumes that the banks will be able to charge higher interest margins on their loans to corporate and personal borrowers. But in the blog's view, this policy is simply a short-term 'fix', and will make the overall economy worse, not better.

US unemployment, according to Friday's figures, is already at 8.9% - the peak rate in the 1974/5 downturn. And private sector payrolls are now falling at an annual rate of 4.7%, worse than at any time since 1958. This is therefore exactly the wrong time for banks to be charging higher margins on their loans. Bankruptcies will increase as a result.

The Fed's focus is still on the needs of the financial economy, as defined by Wall Street. It is ignoring the developing problems in the wider 'real economy' on Main Street, where chemical companies (and many others) are battling with lower volumes and margins.

This makes it likely that, before too long, the Fed will be back to announce even higher estimates for loan losses, as the banks are forced to make further write-offs, this time in respect of corporate bankruptcies.

Many thanks to everyone who signed up for yesterday's Webinar. We ended up running two sessions, due to demand. I hope you found it stimulating and helpful. My thanks also go to Nigel Davis for chairing it, and to Alan Tyler and the ICIS team for organising the whole event.

If you would like a copy of the slides, or have any further questions, please contact me at phodges@internationalechem.com

The high level of speculation accompanying China's apparent economic revival worries the World Bank. "Until we see a recovery in private investment, it's hard to get too excited about the future," according to David Dollar, the Bank's country director for China, at a Beijing seminar today.

Dollar added that "private investment, the main driver of growth, was 'way down' in Q1". And this view seems to be confirmed by a report from China's own National Audit Office into the impact of the government's stimulus programme. This says that "some bank funding is getting stuck in the pipeline, instead of flowing to the real economy", and may have been used to "buy stocks or speculate in other assets".

My fellow-blogger, John Richardson noted recently that net lending fell 70% in April versus March, due to such government concerns. In turn, this could cause problems for those Western polymer producers who have benefited from China's recent surge in import demand. LLDPE volumes on the Dalian futures exchange are certainly slowing, with "only" 42 million tonnes traded so far this month, versus 71 million tes in April.

My fellow-blogger, Barbara, cleverly spotted this week's 'Global Traders Summit' in Singapore. Had this blog been there, it would have mentioned the latest, apparently fool-proof, way to determine stock market turning points, based on bankers' interest in adultery.

According to Bloomberg, the Illicit Encounters website has a major increase in traffic when either the market collapses, or has a sudden rise. Apparently, when markets are up, traders "think they can have an affair because they feel they can get away with anything. When the market hits the bottom, they are looking for a way to relieve the pressure."

The site first came to the blog's attention in December, when the Financial Times reported on its rather lucrative business model - a male membership fee of £119/month ($190). Now it appears to have forecasting potential too.

The 3 most popular posts in May were:

Dow, Ineos focus on debt issues
Rotterdam oil storage running out of space
Green shoots likely to be yellow weeds

The blog will be celebrating its 2nd birthday at the end of the month. I would welcome your comments on what you value about it, and what you would like it to cover in the future. Please either post these below, or email them directly by clicking here.

Markets are driven by two factors, sentiment and fundamentals.

Fundamentals can be followed by analysing hard data. In chemical markets, for example, key areas include new housing starts, auto sales, industrial production, Asian exports, etc. This data can also be used to make forward projections.

However, sentiment is equally important, as it tells us what markets think is going to happen next. Sentiment can often contradict fundamentally-based forecasts. Usually it involves financial players, often using price charts to time their entry and departure.

Today, many markets are clearly being ruled by sentiment. In oil markets, for example, Deutsche Bank analysis suggests speculative involvement is back to levels seen last July, before the market crashed. So it is important to better understand how sentiment is changing.

Thus today, the blog is launching its new "Boom/Gloom Index©", shown above. This is calculated using data from the Financial Times, showing the number of times the words "boom" or "gloom" appear in its columns each month. The FT has been chosen, rather than Google or a more general search mechanism, so as to best reflect sentiment in financial markets.

The Index (blue column) starts from July 2007, when the blog began. It peaked in October 2007, when US, UK and Chinese stock markets peaked. It then shows sentiment recovering in H1 2008, when commodity markets were very bullish. And since January it has been rising strongly, as oil and stock markets have been strengthening.

June's figure is estimated from the first 10 days of the month. It shows we are now close to October 2007's Boom levels. This is possibly a warning sign of at least a temporary peak. The chart also shows a potential cause of the rally in sentiment, namely the extraordinary rise in mentions of the phrase "green shoots". This is shown on the right-hand scale, in green.

The blog welcomes your comments on the index, and will update it regularly, particularly when sentiment is a particularly powerful influence on markets.

The blog is now 2 years old. Its readership is very loyal, and continues to grow. 64% of current readers bookmark the blog, and read it regularly. And it is now being read in 2088 cities and 111 countries - versus 1244 cities, and 89 countries, 6 months ago.

Its regular readership is also very international. The UK, USA, Germany, The Netherlands, Turkey, China, India, France, Japan and Singapore make up the Top 10 countries. Other major chemical producers including S Korea, Italy, Brazil and Saudi Arabia all feature in the Top 20.

The blog aims "to share ideas about the influences that may shape the chemical industry over the next 12 - 18 months", and so it focuses on:

• The major companies
• Key consumer industries, including housing and autos
• Economic data such as GDP, industrial production and exports
• Developments in oil and financial markets

553 posts have been made in total, with 147 written in the past 6 months.

The blog is also aware that English is a 2nd language for many readers, who speak 46 different first languages. Even so, a long-standing American colleague told me recently that he sometimes had to look up the meaning of words via Google. I will try harder to keep it simpler in future.

Thanks you very much for your continued support.

Last month, the blog introduced its new Boom/Gloom Index, designed to track sentiment in financial markets. The chart above now updates it to reflect the whole of June.

The Index has continued to move up, and is close to the levels last seen in October 2007. Equally remarkable is the performance of the Green Shoots Index, which has hit another all-time high. There is little doubt that the performance of the two indices is related. Investors clearly want to believe that recovery is 'just around the corner', even though there is little hard evidence to support this belief.

Chemical companies have done well in exploiting this improved sentiment. Dow managed to raise nearly $10bn to repair its balance sheet, via asset sales and equity/debt issues. Ineos are well on the way to agreeing new covenants with their lenders. Neither looked easy to achieve before the market began its March rally.

Now, of course, comes the hard part. Will the current restocking process turn into a real recovery? The blog maintains its doubts, and fears the green shoots may wither to become yellow weeds.

If you want a loan, go to China. That's the message from the chart, courtesy of Credit Suisse, which shows the staggering growth in bank lending since the start of the year. Now, even the People's Bank of China is starting to get concerned.

Lending so far this year has reached $1trn, equal to a quarter of the country's annual economic output. $223bn was lent in June alone, as local banks scrambled to meet government targets by the end of the quarter.

This is not an academic issue, as far as the global chemical industry is concerned. As a senior executive from a N American company told my fellow blogger, John Richardson, "I keep returning to the fundamentals and cannot understand why prices have risen so steeply since mid-February."

But what would you do, if the government offered you a cheap loan, and you saw the oil price was rising? Would you buy polymer, and store it? Just as US homeowners took subprime loans at cheap rates and bought houses they couldn't afford, on the basis that prices couldn't fall?

The blog hates to be a party-pooper. But it is growing increasingly worried by the 'China story', and continues to fear that it will all end in tears.

Natural gas is a major feedstock for US chemical producers. So the problems caused by the rush to buy a fund that "invests" in the natural gas futures market, are a concern.

Olivier Jakob of Petromatrix has been warning for some time that the UNG fund was becoming too large. Investors have been so keen to bet on rising commodity markets, that it now represents 70% of open interest in the nearby futures contracts! As a result, the market itself has become dysfunctional, and UNG is being forced to close some of its positions.

The UNG problem is another example of rampant speculation in financial markets. When this happens, it usually ends in tears

This year, China has been the one place in the world where almost anyone can get a loan. But now, it seems policy is about to change.

Zhang Jianguo, president of the 2nd largest bank, China Construction, has announced a 70% cut in H2 lending to Rmb 200bn ($29bn), "to avert a surge in bad debt".

Zhang also confirmed the blog's own worries about the speculative bubble that has developed, saying that "we noticed that some loans didn't go into the real economy and feel that some industries are expanding too rapidly".

The latest OPEC monthly oil report paints a bearish picture of the market. It expects OPEC to supply 28.4mbd in 2009, down 7.5% from 2008 levels. And it forecasts more of the same for 2010, expecting to supply just 28 mbd.

Its analysis suggests that "the market is still fundamentally weak amid ample stocks of crude and products". And it notes that "US oil consumption is still showing a massive reduction". However, it says China saw "strong growth" in June "after a devastating contraction in Q1", and India is seeing "significantly higher growth".

OPEC notes that recent high levels of oil price volatility "indicates the increasing sensitivity of oil prices to conflicting economic signals". Its own view is cautious, suggesting that "expectations for a strong recovery (in the US economy) may still be premature".

Monsoon rainfall accounts for 60% of farm irrigation in India, Asia's 3rd largest economy. This monsoon season, it has so far been about 2/3rds of the 10 year average. Last week it was 56% below normal.

Although agriculture accounts for just 17% of the economy, the lack of rainfall will also damage the whole rural economy, which has remained robust through the economic crisis. It accounts for more than half of India's domestic consumption, and so total GDP will probably reduce by 1% - 2%.

Industrial production has been strong recently, up 7.8% in June versus 2008, even though exports fell 28%. But as Finance Minister, Pranab Mukerjee noted Friday, although "the economy has started moving slightly, other problems may come from adverse impact of scanty rainfall."

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

Demand has stabilised, but companies saw no sign of major upturn when reporting HI results. More questions were asked about China's apparent boom. The manipulation of 'operating earnings' to meet analyst expectations reached a new peak amongst S&P 500 companies. GDP in the west made a statistical recovery, as destocking ends, although a weak monsoon is hitting India's GDP.

End-user industries have also stabilised. Auto sales rebounded due to government subsidies, but capacity cutbacks continued, whilst a rise in foreclosures has increased US house sales.

Oil markets remain sentiment-driven and out of line with fundamentals. Benzene prices have dropped $300/t since the blog suggested they were signalling a chemical market peak. The Boom/Gloom index turned cautious, whilst US natural gas markets remain confused.

Bank lending is greatly reduced versus the Boom period, and Gillian Tett suggested their plumbing systems were still blocked. China's banks started to worry about a speculative bubble.

Consumption trends are focusing on cost and sustainability rather than innovation, with P&G introducing a Basic brand. Auto makers drive for higher fuel efficiency creates a feedstock opportunity for chemical companies, as does the need for improved irrigation systems in Asia.

Political issues will need careful attention when companies produce SWOTs in future, as politicians start to focus on real rather than financial engineering.

Prof Mintzberg had good advice for managers on coping with interruptions.

A key rule for any successful trader is that high volume is always bullish, and low volume is negative. The blog first learnt this when trading oil products in Houston, on secondment from the UK in the 1980's. And it has proved an invaluable guide ever since, in a wide range of markets.

The rationale for the rule is simple, namely that (a) more people join in a rally as it strengthens and (b) the end of a bear market is signalled by a "give up phase", when volume rises as people finally lose faith in recovery. In turn, this sets the scene for a new trend to emerge.

Thus the chart above carries a fairly clear message. Trading in linear low density polyethylene (LLDPE) on China's Dalian futures exchange leapt earlier this year, just as benzene prices also surged. By April, Dalian was trading 80 million tonnes - 4 times total annual world production. But August's trading was down 58%, whilst benzene prices have also fallen.

Clearly, the "smart money" feels that it is now time to move on, having made a healthy profit. In turn, this confirms the blog's growing sense that the speculative price rallies of the past 6 months, in commodity and financial markets, may now be coming towards an end.

Last year, OPEC meetings led to newspaper headlines. But today's session in Vienna seems to have slipped off the radar. Yet the oil market remains as important as ever to chemical companies.

As the chart shows, the prime driver for oil prices (blue line) is still the financial market. Traders continue to believe recovery is "just around the corner", but other factors include worries about the strength of the US$ and a desire to own a tangible asset in times of uncertainty.

From an OPEC point of view, though, concerns are mounting:

• OPEC understands that the world economy is fundamentally weak, and that this represents a potential threat to current price levels
• Recent higher prices have led to more cheating on quotas - from a peak of 80% compliance, OPEC are now down to just 68%
• Russia has broken ranks completely and is now exporting more oil than Saudi Arabia (7.4mbd versus 7mbd)

In addition, a new 'joker in the pack' has appeared with China's announcement this week , that it supports those companies who face huge losses incurred last year on derivatives contracts when oil prices plunged. China Eastern airline, for example, said in January it faced a loss of $900m on jet fuel contracts, but seemingly now claims the contracts "may be void, invalid or unenforceable".

The chart suggests that oil prices are now plateauing. Whilst normal winter restocking, and Wall Street's bullish trend, may hold them at this level, the downward pressures continue to mount.

Pity your poor CFO. As well as keeping cashflow positive, they are also coping with major US$ volatility. In July 2008 it was trading at $0.63: €1, but then rose 43% to $.80: €1, before declining 28% to $0.68: €1 today.

The catalyst for this volatility seems to be oil price movements. As the chart shows from a new report by the James A Baker III Institute (kindly forwarded by my fellow-blogger John Richardson), there has been an 82% inverse correlation between the US$ exchange rate index and changes in crude oil prices since 2001.

The reason is that tighter crude oil supply/demand balances have led to higher oil prices. As a result, US oil imports cost $331bn in 2008, and were 47% of the US trade deficit, versus just 19% in 2002. So last year's collapse from $147/bbl in July to December's $34/bbl was good news for the US$. But this year's recovery to $70/bbl has caused a further US$ fall.

Adding to the CFO's problem is that 2009's price movements have been purely speculative, as traders 'look through to economic recovery". OECD crude oil inventories have actually risen steadily, from 52 days in June 2008 to 57 days by December, and then to 62 days by July 2009. Equally, today's US distillate stocks are the highest since 1983, whilst European heating oil stocks are at an all-time record.

Nothing is certain in life but death and taxes. But with refining margins now only $3.42/bbl, a fall in crude prices back towards $40/bbl would not be too surprising. CFO's probably need to consider whether to hedge against this possibility, and the problems it could cause - not only with year-end inventory, but also via a "surprise rally" in the US$ as well.

Destocking is now well underway in crude oil markets. This is focused on the vast amounts of floating storage that built up in H1.

According to a Financial Times analysis, April saw 56 ships being used for storage, versus a normal level of 5 - 7 vessels.

29 ships are still in use today, with c50-60 mbbls in store. But the price incentive for this storage has disappeared, with future month prices only c$5/bbl higher than spot. As the chart shows, this 'contango' had reached nearly $24/bbl earlier in the year, allowing traders plenty of margin to sell forward on a risk-free basis, as floating storage costs just 50-60c/bbl.

The first stage of the destocking process caused oil prices to stabilise around $70/bbl. Now, though, there are signs that the next phase could take prices lower, as a major increase in demand seems unlikely. As Petromatrix note, September's US auto sales are likely to be the lowest of the year, now the scrappage scheme has ended.

China's perceived demand has been the major driving force behind the rallies in financial and commodities markets this year. It has also attracted large volumes of polymer imports. But this wishful thinking ignores the fundamental issue that China's economy is relatively small (just $4trn in a world economy of $60trn) and is 104th in terms of GDP/capita ($3k, versus $46k in the USA).

Instead, traders have focused on the opportunity to make easy money, with at least 50% of the government's $1trn lending package estimated to have been used for speculative purposes. As the blog has noted, the Dalian futures markets has been a focus for some of this activity - at its peak in April, 80 million tonnes of LLDPE was traded, versus total world annual demand of c2 million tonnes.

Since then, the bubble has begun to deflate, and September's volume continues this trend. It was down 63% from April, at 29 million tonnes, whilst PVC trading volumes crashed the same amount in just one month. Volume still has a long way to go to return to more "normal" levels, but the trend (blue line) in the chart is clear. No government, not even China's, can continue to lend 25% of its annual GDP every 6 months.

2010 should be a better year for the chemical industry, as demand grows in line with a recovery in global GDP.

But a quick V-shaped return to the 2003-7 Boom years in terms of volumes/margins seems unlikely.

Governments will worry about budget deficits, and may well scale down support for critical end-uses such as autos and housing. Equally, major amounts of new capacity, planned during the Boom years, will start to come onstream in the Middle East and Asia.

In effect, therefore, 2010 will be a year of transition to a 'new normal'. The blog expects global GDP growth rates to average around 2.5%- 3% for the next few years, the 1980-2000 average. This will be a significant reduction from the 3.5%-4% levels seen in the Boom years.

The rationale for this change is that we will start to see a rebalancing of the global economy. The West will see lower consumption, as people rebuild their savings, and borrow less. In turn, this will mean lower export demand for the emerging economies. The outcome will be a more sustainable world economy, but it will be a difficult journey.

Growth Forecasts. Most chemical markets are mature, and growth rates are therefore tied to GDP. The blog would therefore suggest that companies review their forecast growth rates for individual businesses in the light of their expectations for global GDP growth. One of the problems of the Boom years was that arbitrary growth rates (often of 5% or more), were assumed for many products. This also led to a perception that major amounts of new capacity were needed to meet this assumed demand. A more realistic view of demand would highlight potential problems of over-capacity, and perhaps encourage companies and governments to address the problems this will bring.

Demand. On a global basis, chemical output is now back at 2006 levels, having lost 3 years of growth. If GDP now grows as the blog expects, then demand from key sectors such as construction/housing, autos and electronics should improve next year. But the impact of government stimulus measures will make for a bumpy ride. The end of specific measures will cause major falls in perceived demand, whilst new stimuli will create short-term upward fluctuations. Excellent supply chain management will therefore be required, and Boards will need to keep a very careful eye on underlying trends.

Protectionism. Unemployment is set to become a key political issue in the West, as economies adjust to the 'new normal'. Hopefully, it should peak in 2010, but is unlikely to quickly return to previous levels. Arguments about the 'export of jobs' will therefore increase, and lead to a rise in anti-dumping activity. In turn this will cause job losses in emerging economies. Chemical companies will need to keep a close eye on the political arena, as they operate in a complex value chain, and may not otherwise appreciate the potential impact of a development in a key supplying or consuming industry.

Credit issues. A recovery in demand puts great strains on cash-flow, and many companies go bankrupt as a result. This could be a particular problem in the current recovery, given the underlying fragility of large parts of the banking system. CFOs will need to institute robust monitoring mechanisms, and be prepared to keep customers on 'cash before delivery' terms if they have grounds for concern. New customers represent a particular risk, if their credit history is weak, even though their promised volume may be attractive.

Oil prices. These are likely to remain volatile in 2010, as speculative price movements linked to traders' bets on the US$'s value will continue. Neither $100/bbl, nor a return to $40/bbl, would be a great surprise on a day-to-day basis. But underlying supply/demand balances may well remain weak in 2010, in spite of the expected economic recovery. Thus we might see prices coming under more pressure during 2010. $50/bbl might be an average price, in the absence of major geo-political events.

Overall, the blog expects 2010 to be a transition year. Full economic recovery is unlikely to take place much before the 2011/13 timeframe. But the return of economic growth will offer companies the opportunity to identify likely future market needs. Those that focus on this new reality, rather than simply hoping for a quick return to the Boom years, will position themselves for future success.

The blog's new Budget Outlook is an independent view of the key issues which will impact chemical sales and margins in 2010. Previous Outlooks have stimulated much debate within the industry. We are therefore proposing to run a free 1 hour Webinar next week for blog readers, on Thursday 29 October at 15:00 GMT (16:00 CET, 11:00 EDT, 19:00 Dubai).

The format will be a 30-40 minute presentation, followed by online discussion. The Webinar will be hosted using Microsoft Live Meeting. If you would like to join the Webinar for the presentation, please click above, and use entry code w@\!7{F For audio you will need to dial +44 1452 584201, conference code is 4389561610

If you wouild like to obtain a PDF copy of the presentation before the Webinar, please email either Simon.Robinson@icis.com or myself, adding 'Chemicals and Economy Group' in the subject line of the email. Colleagues and business partners are also very welcome to join the Webinar.

The blog should award itself a pat on the back, now its May forecast of $80/bbl crude has come true. And it is pleased to maintain its 100% record in forecasting the direction and level of oil prices.

But it still regrets the lack of substance behind the so-called 'correlation trade' between oil, the US$ and the S&P 500. Like all good trading ideas, this could have some truth in it: if oil was fundamentally strong, then the US$ should weaken (due to the extras costs of oil imports) and companies in the S&P 500 might expect a return to growth.

Unfortunately, as they say in Texas, "this dog don't hunt". Crude oil stocks have been at record highs for months, due to lack of demand. And there is no indication that western companies expect a quick V-shaped recovery in top-line revenue growth. Moreover, $80/bbl oil puts great pressure on a fragile world economy, and will cause demand destruction.

Equally, as Olivier Jakob of Petromatrix notes, "this is a very technical market, and technical markets fall as fast as they rise". Barring any geopolitical surprises, a return towards $40/bbl seems very possible.

Oil prices will be one of the key issues discussed in the blog's free Budget Outlook webinar next week (details yesterday). If you would like to register, please email simon.robinson@icis.com or myself, with Chemicals and the Economy Group in the subject line.

Gillian Tett, the blog's favourite financial journalist, highlights today the rampant speculative behaviour in financial markets around the world.

Quoting a senior banker, she notes that "highly leveraged short-term trades are back in vogue". She adds that "traders feel stupid if they don't leverage up".

The basis for the speculation is that "central bankers have poured huge amounts of money into the system that is frantically seeking a home, because most banks simply do not want to use that cash to make loans".

The results can be most clearly seen in China, where mainland property prices have soared 73% so far this year. Even the property bubble in the West never saw prices rise more than 30% in a year.

The blog shares her "sense of foreboding" about how it will all end.

The BBC had a very interesting interview last night with Warren Buffett, the world's most successful investor and wealthiest man.

Buffett stakes out a clear position on the relative unimportance of financial services in the economy, and on whether there is a need to "motivate" bankers via large bonuses:

• "The idea that people who move money around are some favoured class strikes me as getting pretty far away from where we should be".
• "Its infuriating for people to see nobody going to jail (as a result of the financial disasters) and a lot of them instead walking off with tons of money at a favourable tax rate".
• "The very liquidity of stock markets causes people to focus on price action, and turns what should be an advantage into a disadvantage".
• "It is productive output, and the stream of income that the asset produces over time, that one needs to look at".
• "I've been in the right place at the right time, and I shouldn't delude myself that I am some sort of superior individual as a result of this. I've been lucky, and its fair enough that a lot of that should go back to the people who got the short straws in life."

Excerpts from the interview can be seen by clicking here.

The purpose of liquidity in financial markets is to enable price discovery. But when super-fast computers take over the trading, that purpose disappears. Instead, we have today's "correlation trading".

Olivier Jakob of PetroMatrix demonstrates this with the above chart, which shows Tuesday's detailed trading patterns in WTI and the Dow Jones Index. Clearly, they are simply trading in tandem on momentum, with no regard for real fundamentals or market sentiment.

This creates a very high risk scenario for chemical companies. As Jakob notes, we are now in "a situation where no single market knows exactly what it is pricing". Real supply/demand balances for crude oil are irrelevant to these computers, and the traders who drive them.

But, at some moment, probably not too far away, fundamentals will reassert themselves. Higher oil prices destroy demand. Already, consumer confidence is falling, even whilst stock markets (normally a positive driver) move higher.

Prudent CFOs and business managers should be alarmed by what is happening, and take the necessary avoiding action. It will all end in tears.

"Buy on the rumour, sell on the news" is the classic indication of a weak market. A lack of follow-through buying reveals that market action is not supported by fundamentals, but only by sentiment and momentum.

Friday's 2.8% fall on the US S&P 500, in reaction to Thursday's positive US GDP number, was therefore a clear sign of underlying weakness. Equally, the new IeC Boom/Gloom Index (above) shows no increase in sightings of "green shoots". And the Frugal Index has actually risen.

This conclusion is supported by the generally cautious tone of recent company results. The chemical industry is a well-known leading indicator for the global economy. If a real upturn was underway, the major western companies would have noticed it by now.

A key driver for the rally in crude oil markets has been the increase in China's demand. The assumption has been that this confirms economic growth is recovering strongly.

Crude oil imports have certainly been rising since Q1, and have recently averaged 500kbpd more than 2008. Refinery runs have also been higher.

However, new analysis by Petromatrix shows that much of this increase is flowing into oil product exports, not domestic demand. As the chart illustrates, China was importing large quantities of diesel/gasoline in the run-up to the Olympics. Now, as the new refining capacity starts up, it has become a major exporter of both diesel and gasoline.

Petromatrix conclude that China's increased refining capacity has effectively therefore "shut down refining capacity in OECD Asia", rather than feeding domestic demand. It also worries that as more refineries come online in both China and India, their output will also be exported and compete with existing "refining capacity in the Atlantic Basin".

The new World Energy Outlook from the International Energy Agency (IEA) spells out two major challenges. It:

• "Identifies higher oil prices, coupled with the downturn in oil sector investment, as a serious threat to the world economy, just as it is beginning to recover".
• Suggests that "a profound transformation of the energy sector" is required, to achieve the Copenhagen goal of restricting greenhouse gases to 450ppm of CO2 equivalent.

OPEC is also now concerned about potential demand destruction at today's high oil prices. A year ago it cut output dramatically, as the financial crisis hit. But it is now tacitly encouraging more production. Quota adherence is just 61% today, versus 89% in March.

Most significantly, Saudi Arabia allocated increased supplies to Asian refiners this week. And Oil Minister al-Naimi "maintained that price extremes in the low and high ends are not sustainable", and made clear that he favours increased control of commodity exchanges to reduce today's, trader-inspired, high levels of volatility.

On the Copenhagen agenda, the IEA noted that "energy efficiency is the largest contributor, accounting for over half of total abatement by 2030 (whilst) low-carbon energy technologies also play a crucial role." This represents both a problem and an opportunity for the chemical industry.

Increased energy efficiency will require increased investment, which will not be easy in today's financial climate. But it will also drive increased use of chemicals and polymers in key industries such as housing and autos. Similarly, the process engineering skills that support the chemical industry will be vital for successful development of low carbon technologies.

Leading indicators are useful reference tools, but sometimes they can also mislead. The chart above, from the ACC's excellent weekly report, seems to provide a good example of this problem.

The blue line shows the official Leading Indicator for the OECD area plus the 6 major non-OECD countries. It suggests that a strong recovery is underway. Yet actual global industrial production (the red line) is only showing a very weak recovery.

The problem is that the OECD Indicator has to use "expectation-dependent" indicators such as share and commodity prices. These have been on a roll recently, as financial investors bet on a V-shaped recovery. But as the blog has noted, at today's levels, factors such as higher crude oil prices can actually slow down recovery, rather than support it.

The irresponsibility of some parts of the global banking system continues to upset the blog.

First, there was news that several banks are planning to award themselves huge 'bonuses', based largely on their trading success.

Yet the money they are using for this trading has mostly been provided by central banks and governments. And it was supposed to have instead been used to support lending to companies and individuals.

The blog completely fails to see the social value in what has been achieved as a result. This trading may have been profitable for a few banks, but it has created increased volatility in currency and commodity markets, and higher prices for key products such as crude oil.

And now comes news in today's Financial Times that US Treasury bills are now paying negative rates of interest. The FT says this is because banks are wanting "to polish their balance sheets for the year end". Once again, the cash being lent out by central banks is instead being used for selfish purposes by the recipient commercial banks.

How can it be sensible for governments to allow this type of activity to continue? The chemical industry is a $3trn business worldwide. Maybe it is time for its leading CFOs to express themselves more publicly on the problems being created by some banks, and set out what needs to be done to solve them?

Oil markets are looking increasingly uncertain as we come to year-end.

One example of this is a new survey of floating storage by oil brokers, Gibson. This found 42 ships in use, up from the 29 seen in September. Normal levels are just 5 - 7 vessels. Another is OPEC's weaker discipline on quotas, which is now just 61% versus 89% in March.

Equally, Petromatrix note that floating stocks of oil products are also rising, with distillates storage having risen 500% in 2009 to 90mbls. And they note that floating stocks already cover all the forecast oil demand increase for 2010. As a result, refinery margins will therefore continue to be under pressure for some time.

Petromatrix also note that the floating storage represents production that has been 'brought forward' in advance of actual demand. They therefore warn that if/when financial markets tire of the "correlation trade" (selling the US$, buying crude), traders may look for a "quick exit", and put oil and product prices under pressure.

The numbers to watch seem to be $1.50 : €1.0 on the $ : € exchange rate, and $80/bbl for crude oil. Currency traders seem to find it difficult to push the euro above this level, causing oil prices to also retreat.

The above chart, courtesy of trade data experts GTIS, shows the extraordinary leap in China's polyethylene imports this year.

They have surged 63% January - October in 2009 (blue bar) to 6.7 million tonnes versus 4.2 MT in 2007 (green bar) and 2008 (orange bar). Many countries have seen massive rises. Iran exported 404kt vs just 48kt in 2008; S Korea 1.2MT vs 800kt; USA 830kt vs 510kt; Saudi Arabia 678kt vs 420kt; Russia 209kt vs 52kt, Japan 464kt vs 237kt; Brazil 151kt vs 6kt.

These are not 'normal' increases. Some volume compensated for the 6% fall in H1 production. Recycling also fell earlier this year due to low prices for virgin material. But China's own production is now expanding as the major new integrated refining/petchem projects come online. The real support has come from the government's stimulus efforts, and speculation linked to the rising price of crude oil.

Will this support continue? It seems unlikely that the government can afford to add a further $1.3trn of loans into its $4.3trn economy next year. Regulators are already worrying about the potential for rising levels of bad debts. And crude prices might well fall, once currency markets tire of the "correlation trade".

The 'China effect' has been very positive for polymer sales this year. The blog worries next year may be more difficult.

In difficult times, the industry looks to the major companies for their advice. And they certainly provided this at our 8th European Conference (co-organised with ICIS),

Shell's Jonathan Forbes-Lane, European GM, focused on the "gale-force recession" now underway. He expected "prices to stay volatile and unpredictable because they were being pulled in opposing directions by fluctuations in consumer demand and feedstock supply". He also noted that Shell had "taken a creative approach to customers' credit risk by agreeing shorter payment terms, linking buying and selling contracts, or allowing customers to move from contract to spot pricing".

BASF's Jaroslaw Michniuk, Group VP, warned that "expansions in the Middle East mean there will be more interpolymer competition in the near future". He also highlighted the need for older-established businesses "to become even more innovative by focusing on new and still-expanding markets".

Reliance's Rajen Udeshi, President of the polyester chain, focused on the importance of "strong integration as a tool for ensuring its own economics". He believed that markets would become more regional in future, noting that Reliance was now "responsible for 3% of India's total GDP, and was also a substantial exporter within Asia".

The blog's own presentation highlighted lessons learned during previous downturns, particularly 1980-4. It warned against the dangers of "a purely short-term approach, as this will see companies in a vicious circle which will close down their options for the future". Please click here to download full reports of the presentations from Bloomberg and ICIS.

The momentum-driven rally in financial markets has slowed recently, with many now in temporary trading ranges. And this is reflected in December's IeC Boom/Gloom Index (above). The Index (blue column) has been steady since June.

Underlying fundamentals show no sign of improvement. The 'green shoots' index (green line), which tracks expectations for a quick economic recovery, peaked in June. It has now fallen for 5 months, and is almost back to February's level.

Equally, the frugal index (red line), has been rising slowly since May. This probably reflects consumers' increasing focus in the real economy on 'needs' rather than 'wants'.

The American Chemistry Council's excellent weekly report contains some potentially good news on the outlook for Q1 demand.

Its detailed analysis of US polymer markets (above) suggests customers are currently reducing their inventories. CFO's presumably assume that the main impact of the housing/auto stimulus programmes is now finished, and are no doubt keen to keep working capital under control for year-end.

Thus October's end-user demand (blue line) was around 100kt higher (230 m lbs) than actual product supplied (red line). This continued the Q3 trend, when consumers reduced inventory by c70kt (150 m lbs) a month. It is quite likely this destocking will continue through December. But then the situation could change, as consumers should need to restock ahead of the usual Q2 demand peak in autos/construction.

In turn, 2010 might therefore see the industry return to its normal seasonal pattern, with a strong H1, followed by a slow Q3 holiday season, and then a final burst of activity in October/November before the Xmas break. Demand forecasting would become easier, and inventory levels could be better aligned with market needs.

The main risk to this scenario lies in crude oil markets. The blog continues to worry that today's $80/bbl price is driven by the 'correlation trade' (sell US$, buy oil and the S&P 500) and not supply/demand fundamentals. If financial markets tire of this trade, and oil prices weaken, then renewed destocking in the value chains is a real possibility.

China's Dalian polymer futures market continues to have a major influence on regional, and global, polyethylene markets. But November's trading volume was lower than a year ago, at 25 million tonnes. This is the first negative annual growth since volume took off in June last year.

Last month, the blog noted a comment from LyondellBasell COO, Ed Dineen, that China's polyethylene (PE) market seemed to be following crude oil prices. And the chart above certainly provides support for this theory. It shows LLDPE prices (red dotted line) beginning to shadow crude oil prices (blue line) from July 2008, just after Dalian volumes began their meteoric rise from 100kt/month to April's record 80 million tonnes.

Normally, one would expect LLDPE supply/demand balances to have their own separate impact on pricing. In H1 2008, for example, LLDPE prices fell, even though crude prices were rising. Thus the chart does highlight a clear risk that part of China's massive import demand this year for PE may be linked to speculation on crude oil prices, financed by the government's massive lending programme.

We will only find out for certain, if indeed crude prices do slip from today's levels. But if the blog was a major player in PE markets, it would certainly now try and hedge this risk as far as possible.

For most of this year, the banks' trading houses have been earning vast sums of money promoting the "correlation trade" (sell the US$, buy crude oil, gold and equities). As a result, around 150mbbls of oil and oil products is now in floating storage, with much more on land.

Next year, the same traders and brokers might well decide there was more money to be made from promoting a different trade. They might argue, for example, that the world economy was still too fragile to afford $80/bbl oil, and instead suggest oil should be sold, not bought.

These things happen. But they can cause problems for those who have to budget forward. Governments dependent on oil revenues, for example, find it difficult to simply 'turn off the tap' on spending, just because prices on the NYMEX futures exchange have fallen.

This is behind Mexico's decision to hedge its entire crude oil output for 2010 at $57/bbl after costs. All 230m bbls have been hedged, as a follow-up to 2009's successful hedge at $70/bbl. This added $5bn to government revenues in H1, a critical sum for any organisation.

Hedging often gets a bad name, when it is used to describe a trading activity. But as Mexico's Finance Minister, Agustin Carstens, noted ""We want this as an insurance policy. If we don't collect any resources from this transaction, it's OK with us. That would mean the oil price had remained above $57 a barrel".

The blog suspects that Mexico's $1bn insurance premium for its hedging strategy may again prove money well spent in 2010.

OPEC's Angola meeting lasted just 70 minutes yesterday. Before the session, Saudi Oil Minister al-Naimi noted that prices were at their target level of $70-$80/bbl, and called this "a perfect price".

However, the underlying supply/demand balance remains fragile. As the chart from Nomura shows, current OECD oil/product inventories are well above normal levels. Whilst today's high prices have tempted many OPEC members to increase output above their production quota.

Quota compliance is now down to c60%, compared to 80% in H1, when prices were below $50bbl. Nigeria is pumping 1.96mbd (quota 1.67mbd), Iran 3.78mbd (3.34mbd), Venezuela 2.24mbd (1.99mbd). Equally, geo-political issues are less important, at least temporarily. Hostilities in the Niger delta are greatly reduced, whilst Iran's nuclear ambitions have also moved off the front pages.

OPEC's own statement also showed it remains aware that supply is well ahead of current demand levels, noting that "it is not yet clear how strong or durable the recovery might be" and adding that "the world (was) still faced by shrinking industrial production, low private consumption and high unemployment".

The blog is now 2.5 years old. Readership continues to grow, both within the chemical industry and its investment community. It is now read in 121 countries, and 2735 cities, versus 89 countries and 1244 cities a year ago. Readers are also very loyal, with 23% reading it twice a week.

Its readership covers all the major areas of chemical production. The UK, USA, Germany, Netherlands, Turkey, China, India, France, Singapore, Belgium make up the Top 10 countries, with Japan, S Korea, Italy, Brazil, Saudi Arabia and Russia all featuring in the top 25. English is a 2nd language for most readers, who speak 55 different first languages.

The blog aims "to share ideas about the influences that may shape the chemical industry over the next 12 - 18 months", and so it focuses on:

• The major companies
• Key consumer industries, including housing and autos
• Economic data such as GDP, industrial production and exports
• Developments in oil and financial markets

698 posts have been made in total, with 142 written in the past 6 months.

The blog's annual Budget Outlook continues to attract strong interest. This year's, 'Budgeting for a New Normal', was also the subject of a well-supported Webinar, and will shortly be published as a White Paper.

Thank you very much for your continued support.

Extended downturns, of the type that we are now suffering, generally mark a transition period from one set of business conditions to another.

I look at what might be in store for us during this transition, in this week's edition of ICIS Chemical Business. The analysis focuses on the key areas in the chart - Restructuring, Supply Chain, Technology, Financial Size and Commercial.

It suggests that companies need to balance today's immediate priorities with future needs, under the motto 'Think about tomorrow, and act today'. I hope you find it helpful.

The Financial Times' Investment Editor argues this week that "there is no point in forecasting stock market performance to the last digit".

Instead it presents 3 scenarios for 2010:

• Standard Bear Market. This view suggests that the current rally is "the normal adjustment after a market crash". After the rally ends, we will then see "a decade of trading in a range", with money to be made "by traders rather than long-term investors".

• Great Panic. This suggests 2007-9 was merely a "panic". Now "the risk of disaster" has gone, there is a "buying opportunity" for investors, and "profit opportunities for companies, as they can cut costs more easily".

• Second Great Bust. The downside fear is that whilst "cheap government money rescued markets" last year, this caused a "credit bubble" in China, and meant "the US put its credit rating on the line". The likely "next event will be a market disaster", taking us below 2009's lows.

The FT has sympathy with all 3 scenarios, but suggests the odds favour the Bear Market view at 60 - 70%. It gives a 10 - 20% probability to the upside and downside views.

It says its prefered measures of stock market value, Tobin's Q and the cyclically adjusted price/earnings ratio, both show markets are now overvalued. The FT therefore concludes that "it is still a very risky world".

Blog readers have a wide range of interests.

That is clear from the list below of the Top 10 posts in 2009.

It also confirms the complexity of the chemical industry, and its fascination.

In alphabetical order, it is as follows:

• Bubble, bubble, toil and trouble
• Companies remain cautious on the outlook
• "Green shoots" likely to be "yellow weeds"
• IEA warns on economic downturn, lower oil demand
• 'It's the price that matters': Wal-Mart and Tesco signal a major change in consumer priorities
• New US auto fuel standards provide chemical companies with major opportunities
• OPEC worries about weak oil market fundamentals
• Rotterdam oil storage running out of space
• Russia's chemical production tumbles
• The nudist beach on Wall Street

Interestingly, the list includes 2 'classic' posts from 2007 and 2008, which are obviously still valued by many readers as reference points:

• The insight from Tesco and Wal-Mart which pinpoints the moment at which consumer priorities began to shift from 'wants' to 'needs'
• Warren Buffett's then controversial views on financial markets, just before they began to implode.

Pity your poor Purchasing Director this week. They know the West is having a cold winter, but they have done their analysis and can show you slides, such as the one above from Petromatrix, that indicate the US has the highest stocks of distillates since 1999. In addition, the world has 75mb of distillate in floating storage. So there is no shortage of product.

So why are oil prices above $80/bbl?
• Is it because crude oil is somehow short, or gasoline? No. We have high stock levels for these as well, plus plenty more in floating storage.
• Is it instead because higher prices are needed to justify sufficient E&P investment in finding more oil for the future? Perhaps, but then we have to ask the related question, namely 'what level of global GDP growth can be maintained if oil is going to be $80/bbl or higher'?

Or to put the issue another way, can industries such as chemicals successfully pass through such prices, and maintain previous growth levels? We all know, after the experience of 2007-8, that the perception of today's high prices being easily absorbed is not the same as reality. Purchasing managers are virtually forced to buy forward, if they see higher prices round the corner. But this doesn't mean their sales colleagues can sell the same volume, or maintain the same margins.

And in reality, as will likely become clear as and when prices fall again, high oil prices (as we first saw in 1973-4, and 1979-80), in fact cause demand destruction. They effectively act as a tax on the general population, who have to heat their homes, and travel to work and the shops. This gives them less to spend on other products and services.

So, then, why are oil prices so high? The answer is very simple - 'money talks'. As the Wall Street Journal notes this weekend, banks "including Citigroup Inc., Bank of America Corp., J.P. Morgan Chase & Co. and Morgan Stanley are offering levels of borrowing--known as leverage--that they haven't provided in more than two years". But this money is not flowing into loans to industry.

Instead, its going straight into trading activity in financial markets. And in so flowing, it has the remarkable effect of creating the illusion of recovery, as outsiders look at high oil prices, and assume that demand levels must have recovered. This could become a very dangerous assumption indeed, if it becomes shared by policymakers.

CEO's are now preparing their comments on 2009 performance, and the 2010 Outlook. It would be very helpful indeed, if they included a paragraph that noted what is happening in oil markets, and questioned why this is being allowed to continue.

The Dalian polymers future market had a strong end to 2009. As the chart shows, Linear Low Density Polymer volumes (blue line) jumped to 44 million tonnes. The new PVC contract saw the same volume.

But there are growing signs that this may prove a 'last hurrah'. The government is clearly starting to worry about the impact of speculative excess from its major loan/stimulus package last year:

• Today, the central bank raised deposit reserves by 0.5%, which starts to reduce the amount banks can lend
• It has also begun cracking down on banks' off-balance sheet loans, the 'hidden loans' that don't show up in official figures
• Premier Wen Jiabao has pledged to tackle "excessive" house price rises, after they rose 5.7% in November alone

China's rise to become the world's leading exporter in 2009, overtaking Germany, also means the government will come under more pressure to let the currency rise.

In turn, these measures may start to slow China's demand for polymers. This has been a major boost for hard-pressed Western companies, facing slow domestic markets. But with the China Daily now carrying stories about how young people can't afford to marry, because of high apartment prices, it is clear that policy changes are round the corner.

Sometimes, a picture is worth 1000 words. That's the case with this photo (used by most of the world's major news media), showing President Obama with former US Fed Governor Paul Volcker by his side.

Volcker's re-emergence is the first real sign of a serious shift in policy towards the financial sector. And the blog is thoroughly delighted with his return. It summarised Volcker's key arguments last month, when suggesting that current policy "continued to confuse being 'market friendly' with being 'friendly to markets'".

There is absolutely no reason why banks should be allowed to maintain the "pervasive conflicts of interest" that Volcker describes. Equally, Volcker's belief that "we need to produce more, finance less" is a powerful message of support for people working in the chemical industry value chain. As one senior industry figure told the blog, "It's a mega change in the history of lending. No more big balance sheets and implicit Government 'insurance' to prop up flaky lending".

The oil market rally seems finally to be running out of steam. For months now, it has been driven by the 'correlation trade', whereby Wall Street traders sell the US$ and buy crude oil. But as the chart shows, the two lines have now begun to diverge.

Fundamentals have clearly started to affect the €:$ rate, as real-world concerns about the Greek economy no longer make the euro a one-way bet. The blog suggested in November that traders would find it difficult to push the euro above $1.50 : €1.00. As the blue line shows, it has since retreated quite significantly, and is now around $1.39.

The monthly average crude oil price (black line) is now at the $80bbl resistance level. And in futures markets, where Forward supplies trade, a major change has taken place. In H1 last year, the contango between the current month and the future month was extraordinarily high at $20/bbl.

This gave traders the ability to store oil offshore and make a certain profit. But now, the contango has almost disappeared. Forward prices for May are only $1bbl higher than the current month, not enough to allow traders to store oil offshore profitably. So they may now start bringing all 150mbls of floating oil back onshore again. If they do, there seems little to stop oil moving back to $40bbl, apart from geopolitical events.

As the blog has argued before, this kind of volatility is exactly what the chemical industry does not need, with the economy already so fragile.

SOURCE: WWW.CHARTOFTHEDAY.COMUS consumers were responsible for 16% of total world GDP in 2008. But their spending is taking a battering from the combination of high unemployment and high oil prices. Both are reducing end-user demand for chemical products.

New government estimates suggest US employment has fallen by 8.4m jobs since the downturn started in December 2007. Total unemployment was 1.4m higher in December 2009 than previously reported.

These are staggeringly bad figures, particularly when one considers the major financial stimulus programmes that were put in place in early 2009. And as the chart shows, from ChartoftheDay, job losses in this downturn are far worse than the average during recessions. They are 3 times worse than the average loss (blue line).

Equally, downturns between 1950-2000 had typically already begun to actually add new jobs again, and had already recouped all the jobs that had been lost. This is a major contrast with today (red line), where the most optimistic interpretation is that the job loss total may have peaked.

Sadly, this was all predictable, although politicians seem to have preferred to ignore the evidence. Back in December 2008, the blog noted detailed Bank of England analysis of 33 banking crises between 1977-2002 which concluded:

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

And their forecast of the likely course of today's crisis still seems valid:

• Governments have initially found it easy to borrow, but now face the risk of a currency crisis if foreign lenders begin to suspect they will never be able to repay the money borrowed.
• Companies continue to find it more difficult to borrow, as banks "de-risk" their balance sheets.
• Consumers face an increased risk of unemployment, and are tending to save more, thus further reducing demand.

One can only feel sorry for China's government leaders. A year ago, they faced 23m unemployed, as their export markets collapsed in the West. In order to avoid major social unrest, they opted to unleash what the Wall Street Journal called "one of the biggest credit expansions in history". $1.4trn was lent during 2009, in a total economy of only $4.2trn. In addition, there was a stimulus programme worth $580bn.

Of course, some of this money will have been spent wisely. But it is unlikely that the required number of financially sound projects could have been found in such a short space of time. A considerable amount must have gone to fund speculation. As the above chart shows, the statistics from the Dalian futures exchange confirm this suspicion, as LLDPE volume (blue line) rose from 20m tonnes to a peak of 80m tonnes by April.

More recently, volumes have begun to slow as the government now tries to reverse course and avoid major asset price inflation. January saw only 28m tonnes traded. And this month's volume may be lower, with the Lunar New Year holiday beginning 3 weeks later (14 February). Yet there is still little evidence that China's main Western export markets (which accounted for 37% of GDP in 2007) are about to stage a full recovery.

Iran has begun storing crude oil offshore again, according to Bloomberg, as demand in its major market, Japan, enters a seasonal slowdown. It has 6mbd on ships in the Persian Gulf (equal to 19% of current storage for the WTI contract at Cushing in the USA). Another 2 ships also seem to be being used for storage off Malta and Benin.

Meanwhile, Morgan Stanley (MS) have confirmed the blog's suspicion last week that traders might start to bring more offshore crude onshore, as the contango narrowed. MS suggest as much as 25% of floating storage might now be coming ashore. This was no doubt partly responsible for the dramatic 8% fall in crude prices towards the end of the week.

The contango reflects buyers' willingness to speculate on higher prices in future months. But the future price has to be high enough to cover the costs of storage, and the time value of money. As of today, the trade looks unattractive, with March futures contracts selling at $74bbl, and August at just $76bbl. Thus the blog continues to suspect that prices could easily move lower, if more traders decide to cash in their current profits. As Petromatrix comment, US stocks are now 15mb above last year's high levels, whilst demand is down, and yet oil prices have doubled.

CFO's have a lot to think about currently. Volatility is rising in currency and oil markets. Plus credit risks on previously safe 'sovereign' debt markets are also increasing.

Today, for example, there are new concerns that investors in Dubai World's $22bn debt may lose 40% of their investment.

Equally, current problems in the eurozone over Greece's debt may well spill over into Spain, Portugal and even Italy - where debt levels are also high.

Recent history would suggest these problems represent a one-way bet for speculators. Ever since George Soros famously 'broke the UK£' in 1992, it has been assumed that markets rule. But this is only a recent development. When the blog started work in 1976, for example, it was only allowed £50 for each business trip abroad, due to capital controls.

Now, John Dizard in the Financial Times warns that "sooner rather than later, European officialdom will impose higher taxes, credit restrictions and transaction barriers aimed at global macro traders", and "shock measures that force the unwinding of politically undesirable trades".

Of course, such moves in defence of the euro are not on the agenda today. But Dizard has a record of being proved right over time. And if they did occur, CFOs might wake up one morning to find they now have significant amounts of money locked away in the wrong place.

Prudent CFOs will therefore no doubt want to consider the potential impact of capital controls, where they next update their risk management strategies.

OPEC's meeting wrapped up quickly yesterday, with Saudi oil minister Ali al-Naimi once again saying oil prices today were "beautiful".

This highlights sentiment's ability to take prices in the opposite direction to fundamentals. For certainly, on fundamentals, OPEC should have had a difficult session:

• Quota compliance is now down at c50%, with Bloomberg estimating OPEC production at 26.8mbd last month, versus the target of 24.9mbd.
• Global oil stocks are 15% above normal levels at c60 days, versus the typical historical level of c52 days.
• OPEC's own analysis suggests that 2010 is likely to see "a decline in the demand for OPEC oil for the 3rd consecutive year".

But financial markets remain convinced a strong V-shaped economic recovery is underway. They also believe that China's oil demand will increase for domestic consumption, in spite of data showing China's oil imports are increasingly being used as the basis for exporting oil products - which is a zero sum game within the Asian market.

Interestingly, however, blog's own sentiment indicator, the Boom/Gloom Index, has been stable now for c6 months. And this parallels the oil bulls' own inability to push prices much above today's $80/bbl level, in spite of continued talk that they should be nearer $100/bbl.

Will this stability continue? The key issue, perhaps, is now the one of demand destruction. US gasoline prices are at $2.80/gal, their highest level since Q4 2008. And high energy prices also typically reduce consumer's discretionary spending - which in turn usually lowers chemical and polymer demand.

On a fundamental basis, such a combination of lower demand and high stocks would not normally be a recipe for rising or even stable prices.

"Crude oil is (now) more than just a physical product", according to NPRA Chairman William Klesse. As he noted, "Today there is ample crude in the world, and crude is not at $80/bbl because of physical markets".

This was a strong statement from the head of the US National Petrochemical & Refiners Association, at the start of the annual meeting in San Antonio. As he added, the reason behind the price hike is that crude has become "a financial product".

The chart, from the Financial Times, shows the reason for his concern. Last year, European pension funds alone "invested" €21bn ($29bn) into commodity funds, particularly oil. This was a 145% increase on the 2008 figure, with minimum 60% growth expected this year. This flood of money hiked oil prices 78%, even though demand growth was poor.

Now, however, as the FT notes, there is growing "alarm" amongst the investment community about the relatively poor results they obtained. The "investors" who held the fund for a year made just 17% by December, not 78%. The reason was that they "invested" in futures markets, which were in contango (where the months ahead are priced higher than today's spot price).

Thus although oil prices rose, each month the "investors" lost most of the gain, as the future contract came closer to actual delivery. Instead, the bulk of the gain went to those who launched the commodity funds, or those who actively traded the futures markets.

These highly-paid "investors" failed to understand the simple truth that commodities trading is a zero-sum game - you win, I lose. Or as Goldman Sachs' CEO Lloyd Blankfein told the US Congress earlier this year 'when Goldman sells a security that subsequently goes up (i.e., on which the other party makes money), "we wish we hadn't sold it".'

Meantime, as Klesse noted, it is the petchem and refining industries that has to cope with the end result - an oil price that is currently very over-valued in relation to the laws of supply and demand.

In December, the blog suggested that "2010 might see the industry return to its normal seasonal pattern, with a strong H1, followed by a slow Q3 holiday season, and then a final burst of activity in October/November before the Xmas break".

The chart above, from the excellent American Chemistry Council's weekly report, provides welcome evidence that this may indeed be happening. The red columns show destocking/restocking down the main polymer value chains. Clearly Q4 saw destocking for year-end reporting reasons, with consumers drawing down inventories by 110kt (250m lbs) a month.

But January and February saw this trend reversed, as customers restocked in advance of expected better demand from key industries such as auto and construction. The ACC estimate this led to inventory builds of 75kt (165m lbs) in January, and 25kt (55m lbs) in February. As a result the trend line (black) has become positive for the first time since 2006.

Much is now riding on Q2 demand. We cannot expect a V-shaped recovery of demand back to levels seen in the 2003-7 Boom. But we should hopefully see an improvement versus Q2 last year, even though today's high levels of crude prices will act as a "tax" on discretionary expenditure by causing consumers to focus on higher transport/heating costs.

China's demand has been the main driver for the global chemical industry over the past year. And prices on China's Dalian polymers futures exchange have been a key indicator of the boom. But now, the rally seems to be running out of steam. The key signs are in the above chart:

• At the end of January, the linear low density polyethylene (LLDPE) contract (red dotted line) was trading at 11210 yuan/tonne, whilst WTI crude oil (blue line) was $73/bbl.
• But by the end of March, the LLDPE contract had fallen to 11010 yuan /tonne, whilst WTI had risen to $84/bbl.

There are probably three main causes for this decoupling:

• New ME/Chinese polymer capacity is starting to arrive
• Today's high oil prices are starting to cause some demand destruction.
• New government credit controls are reducing speculative demand.

Certainly, the Dalian futures trend matches the recent downturn in Asian HDPE margins. As the ICIS Polymer Margin report shows, integrated North East Asian (NEA) margins peaked at $464/t in February. Last week, they were back at £413/t. And standalone HDPE margins are now in negative territory.

The chart above, from the insightful Petromatrix report, highlights the on-going divergence between the bullish sentiment driving prices, and the fundamental reality of crude oil markets.

It totals US stocks of crude oil and the main products (gasoline, distillate and jet kero), by year. And it shows very clearly that stocks in 2010 (red line) and 2009 (light blue) have been much higher than in the 2005-8 period. As Petromatrix comment:

• "Stocks remain at multi-year highs", even though last year's major destocking has now finished.
• "There is no stress on the supply system because OPEC is gently lowering its compliance to quota as demand gently comes back".
• US Gulf "crude oil imports are at the highest level in 12 months.

They conclude that current prices "put the demand recovery at risk". And they also note that "the extreme spread between crude and natgas also means that petchems will switch as much as possible from petroleum based to natural gas based feedstocks", causing further demand destruction in the short-term.

The blog's early career, as a petchems trader in Houston, taught it to look out for moments when prices in one market start to diverge from those of a related product. These can often provide advance warning that a trend change is underway.

Thus it is fascinated by the above chart, from commoditycharts.com. It shows US crude oil prices (black line) since December, versus the S&P 500 (red line) and natural gas (green line). Oil and the S&P 500 have continued to move together, as they have for over a year. This has been a self-supporting trade, where higher oil prices provide evidence that a strong recovery is underway, and vice versa.

But natural gas prices have clearly diverged over the past few weeks. They peaked, as normal, in December-January, but are now down 21% versus early December. And in recent weeks, oil has also begun to struggle to keep up with the S&P. It has only risen 1.5% over the period, versus a 7.75% S&P increase.

Lower prices are excellent news for US gas-based chemical producers. And they should continue to be weak. Gas inventories are currently 12% above the 5 year average, and Bloomberg suggests they could reach record levels over the summer as new supply comes online.

Of course, as the blog noted last week, oil also has poor fundamentals, with US stocks well above normal levels. But Wall Street analysts remain bullish, based on "technical" signals. So it will be interesting to see whether declining natural gas prices do now indicate a trend change.

A year ago, China's Dalian futures exchange was hitting its peak, in terms of polymer volume. The Linear Low Density Polyethylene (LLDPE) contract saw 80 million tonnes (blue line) traded in April. This was more than 3 times total annual world production.

But as the chart above shows, volume last month was 'only' 21MT - still high, but down 74% from the peak. A number of other signs also show that the 'China story', which has supported chemical, commodity and financial markets for the past year, may be coming to an end:

• LLDPE prices (red line) are down 4% versus the end-February peak, even though crude oil prices have risen 8% over the period
• Prices on the Shanghai stock market are down 6% over the same period

Plus, of course, the government is now scaling down its massive lending programme - the underlying support for all these markets.

They say that you learn more from your mistakes than your successes. In the blog's case, it will never forget the mistake it made when it began to build a long position in early May, soon after arriving in Houston, Texas. It was expecting product to go tight as the US gasoline season began on Memorial Day, at the end of May.

This was a completely wrong judgement. The scale of the US market means refiners have to move gasoline out of their systems before Memorial Day, if it is to reach the service stations in time. Luckily, a few kindly souls from the industry taught the blog the error of its ways, and little harm was done to ICI's P&L.

The memory of that near-miss was triggered this morning when looking at the above chart from PetroMatrix's valuable report. They note that US gasoline stocks (red line) are now "at an all-time record high" for this week in the year. Equally, stocks are actually building, rather than falling. I doubt this has ever been seen before in May.

The reason, of course, is the demand destruction being caused by today's high prices. US oil stocks have been building at 1.1mbd for the past month, whilst the Mastercard survey is showing a 1.1% decline in gasoline demand versus 2009. If the blog was trading now in Houston, it would be very nervous indeed about holding a long position.

Sell in May and Go Away" is the oldest rule in stock market investment. This week has certainly provided further support for it:

• The major Western stock markets are down c8%
• The major emerging markets are down between 4% - 13%
• Crude oil prices are down 13%

This May panic may well also mark the markets move into their 3rd, and most destructive phase. As originally identified by Merrill Lynch's analyst guru, Bob Farrell, "bear markets have three stages - sharp down, reflexive rebound, a drawn-out fundamental downtrend".

Greece, of course, and its debts, has been the catalyst for this week's panic. And the chart above (from the Bank of International Settlements), highlights the core problem. European banks have collectively lent $2663bn to the 5 euro countries at most risk of default, the PIIGS (Portugal, Ireland, Italy, Greece, Spain).

The vertical axis identifies the debt held by each country, showing that France has lent $79bn to Greece, and Germany $46bn. As my fellow blogger, John Richardson has noted, "if the whole of Greece suddenly vanished into the ocean, it wouldn't make that much of a difference to the global economy...including chemicals". Nor would Portugal, or Ireland.

But Spain and Italy combined are 6% of the global economy, with GDP of $3.6trn. Between them, they owe $1.8trn to banks in the rest of the EU. If markets become seriously worried about the prospects for economic recovery, then they will clearly be near the top of everyone's concerns. US banks, for example, have $3.6trn of loan exposure to Europe.

This suggests the world economy is now approaching a cross-roads:

• In one direction lies economic recovery, as argued by Larry Summers, US economics chief. His view was that government stimulus would provide, like a 3-stage space rocket, the "escape velocity" to stabilise the major economies and encourage consumers to begin spending again
• The blog, however believes with Pimco (the world's largest bond fund managers) that we face a "new normal" of lower spending and less debt.

As we move into Budget season, Boards will start to debate their outlook for 2011-3. Clearly they will hope, with Summers, for better times. But prudence suggests they should also plan for a less favourable, Pimco-type Scenario. Markets may well rally again short-term. But if Bob Farrell's analysis is right, the third phase of the Crisis still lies ahead.

On 6 May, the blog warned that "it would be very nervous indeed about holding a long position" in crude oil. And as the chart shows, its fears were well-founded. Since 4 May:

• WTI has fallen 19%, and $16/bbl, from its $86/bbl peak
• The euro has also fallen 8%, and 6c, versus the US$

The suddenness of the change highlights the extremely short-term nature of today's financial markets, where so-called 'high-velocity trading' now accounts for up to 75% of daily trading volumes.

This trading often has an average holding period of just 11 seconds, and makes no effort to understand market fundamentals. Instead, it uses high-speed computers to capture fractional changes in bid-offer spreads. And, of course, it creates the potential for extreme volatility, when markets suddenly readjust to the real world.

For months, markets have been trading positively on the assumption of a V-shaped economic recovery. This has focused on perceived strong growth in China, and led to expectations of a tight oil market. In turn, as noted in the blog, this has driven the 'correlation trade' where the US$ weakens as the cost of its oil imports increases.

Now, the basic flaw in this assumption has begun to appear. China's growth is slowing, whilst Europe is heading for budget cutbacks and austerity. Key elements of the US recovery, such as housebuilding permits, are also looking less than certain. If markets had focused more on fundamentals, none of this would have come as a surprise.

Instead, the chemical industry, and others who live in the real world, will be left to pick up the pieces. The rise of the US$ is already causing concern in China, as it makes its exports less competitive. Equally, falling oil prices may well encourage destocking down the chemicals value chain, just as we come into the seasonally weak Q3 period.

The blog has sometimes despaired of the cheer-leading and wishful thinking of too many leading policy-makers. As I argued in the Financial Times in March 2007, before the Crisis began, "they seem to confuse being market-friendly with being friendly to markets".

It therefore welcomes the realism being shown by the UK's new coalition government. Today, David Laws, Chief Secretary in the Treasury, argues that "we are moving from an age of plenty to an age of austerity in the public finances". And coincidentally, Nobel Prize-winning Paul Krugman suggested yesterday that most Western countries aren't really like Greece, but "are looking more and more like Japan".

The blog's own chart above, showing the relative movements of the US S&P 500 index, and Japan's Nikkei 225, illustrates Krugman's point:

• The black line and axes show the % monthly changes (basis September 1985) in the Nikkei 225, to 2004
• The red line and axes show the % monthly changes (basis September 1995) in the S&P 500, to today

The chart shows the parallel market tops in November 1989 for the Nikkei, and in August 2000 for the S&P 500. It highlights a remarkable parallel, first noted by market guru Alan Shaw in Barrons in July 1998, and this continued until early 2003.

The parallel then disappeared, before re-emerging briefly last year. And the recent market falls may well be a first sign that the two lines are reconnecting again. The rationale for the parallel is simple, that Japan and the West both face the problem of an aging population, with Japan's demographics being some 10 years ahead of the West's.

The difference since 2003 can also be explained by this "cheer-leading" by Western policy makers, who have tried to maintain perpetual growth in their economies. Every time markets dipped, their response has been to cut interest rates and inflate speculative financial bubbles,.

With a G7 government instead now talking about an expected 'Age of Austerity', chemical company Boards will clearly want to revisit their planning Scenarios. They need to ensure their strategies are robust enough for them to be confident of surviving a continuing Downturn.

China's Dalian futures market has been the global centre of speculative polymers trading for over a year. It traded an amazing 80 million tonnes of LLDPE in April 2009, as excitement built. And volume (blue line) remained positive on a year-on-year basis until January. But since then, comparisons have been negative:

• February's volumes were down 50% versus 2009; March was down 38%; April was down 74%; and now May was down 46%.
• Volumes on the new PVC contract are also lower, at just 7 MT in May versus 44 MT in December.

Equally, pricing (red line) has been on a declining trend since February, even though crude oil prices rose strongly until April. This divergence is also a warning sign, as it suggested traders were beginning to question the physical market's ability to pass-through ever higher prices.

For the moment, both the bulls and the bears can still present an argument for their case. But the bulls need a quick recovery in volume, if prices are not to remain under pressure.

A year ago, the blog launched its IeC Boom/Gloom Index. This was based on the concept that markets are driven by both sentiment and fundamentals. And whilst fundamentals can be understood by analysing hard data (eg auto sales, housing starts), it is equally important to understand sentiment, and what markets think will happen next.

Analysing the Index's performance (blue column) over the past year, it seems to have done its job. It has certainly reflected the positive sentiment that propelled most financial markets into major rallies. Equally, its inability to regain pre-Crisis levels since October 2008, indicates that some investors remain more doubtful.

It has also tracked mood swings. A year ago, many in financial markets were focused on signs of the 'green shoots' of recovery, and were expecting government stimulus programmes to create a quick V-shaped recovery to the levels seen in the 2003-7 Boom period.

The 'green shoots' measure (green line) captured this mood. Since then, worries that we might face a more 'frugal' world have surfaced, and these have now led to a fear that we may be moving to a world of 'austerity'. The blog's dictionary defines this as "severe simplicity, lack of luxury".

Austerity has therefore being added to the chart (red line), replacing frugal. This sentiment increased dramatically during May, as sovereign debt problems grew in Southern Europe. It will be interesting to see whether it proves to be just a temporary concern, or longer-lasting.

The blog's White Paper, 'Budgeting for a New Normal', proved enormously popular when it was published earlier this year. ICIS therefore suggested that it would be useful to update it, 6 months later.

This Update is now published. It looks at the current state of the global economy, six months on, and then covers the outlook for key chemical markets such as construction/housing and autos, as well as the latest views expressed by chemical companies themselves on the outlook.

Please click here if you would like to download a free copy.

6 months ago, the blog suggested that normal seasonal demand patterns could resume in 2010. And it optimistically forecast "a strong H1", on the basis that "consumers should need to restock ahead of the usual Q2 demand peak in autos/construction".

This optimism was based on the American Chemistry Council's excellent analysis of polymer demand, which indicated a likely turn in the inventory cycle. And the ACC's latest report (above) shows inventories (red line) have indeed risen sharply, ahead of demand (blue line). In turn, of course, this has led to a welcome improvement in company results.

The blog also suggested that we would then see a "slower Q3 holiday season", and this still seems a likely outcome. But it also worried about the risk from crude oil pricing, and the 'correlation trade'. And this has become a greater worry in recent weeks, as prices have tumbled.

The problem is that too many pension funds have rushed to invest in crude oil, based on a belief in an eternal boom in China. This has led to bumper profits for the trading and storage community, as storage tanks around the world have been filled with oil and oil products.

But now prices are beginning to fall. And worries are appearing about the pace of growth in China, as the government seeks to cool overheated housing and construction markets. There is therefore a real prospect that prices could continue to fall to $60/bbl, as the funds realise their mistake.

If this happens, then we may well see an element of destocking down the value chain, in addition to Q3's seasonal weakness.

The Baltic Dry Index of freight costs (for iron ore, grains and coal) follows changes in global demand for bulk shipping. As such, it is an important leading indicator of future economic activity, and chemicals demand.

The blog first noted Index movements in October 2007, when this was accurately forecasting the H1 2008 boom. In May 2008, the Index then began a 90% fall that preceded the H2 collapse. Now, as shown in the chart above from Bloomberg, it is again flashing a warning light.

The Index bottomed last October, as companies cut back on inventories ahead of year end. But it then moved up sharply, before the seasonal weakness in Q1 (when shipping conditions are poor). But in the last month, its rally since March seems to have collapsed. The Index is now back at the October lows.

The FT notes that "the fall in freight rates reflected a gloomier outlook for the global economy". An analyst with ICAP, the broker, added that in their view "the Chinese are tightening seriously. We're not very positive on the short-term global outlook".

Darwin hit it on the nail when he wrote in 'Origin of the Species' that "Unless profitable variations occur, natural selection can do nothing".

His message is echoed today by US Fed Governor Kevin Warsh, one of the few policy-makers who deals in reality rather than wishful thinking.

Warsh sets out to "debunk some popular truths that have become part of the crisis narrative"::

• "Subprime mortgages were not the core of the global crisis, they were only indicative of the dramatic mispricing of virtually every asset everywhere in the world".
• "The volatility in financial markets is not the source of the problem, but a critical signpost."
• "Excessive growth in government spending is not the economy's salvation, but a principal foe."
• "The European sovereign debt crisis is not upsetting the stability in financial markets; it is demonstrating how far we remain from a sustainable equilibrium."
• "Turning private-sector liabilities into public-sector obligations may effectively buy time, but it alone buys neither stability nor prosperity over the horizon."

Warsh believes we delude ourselves if we think today's problems are essentially "a series of unrelated, unpredictable, unfortunate financial shocks" and due to "bad luck".

He concludes by arguing that instead of continuing to focus on short-term 'fixes', "we should take the necessary measures to ensure that our economy is strong over the long term".

Two months ago, on 8 May, the blog suggested that 'Sell in May and Go Away" was likely to prove good advice this year. Since then, most major stock markets have fallen dramatically, with the S&P 500 down by 9%.

The proximate cause of the blog's pessimism then was the onset of the Greek/eurozone crisis. And this, of course, is still getting worse not better. But from a chemical industry viewpoint, it is the chart above, and its implications for H2 demand, that is the real worry at mid-year.

China has been the mainstay of chemical industry demand for over a year. Now, it appears that both of its key drivers are reversing:

• The government is cutting back on its stimulus programme, with lending down 31% versus 2009 levels, as it worries about soaring property prices and social unrest
• Speculators are slowly realising that oil markets are over-supplied, and crude oil prices are now off 12% from their early May peak.

In turn, these two events have caused problems for Asian polyolefin markets. Speculators had taken full advantage of China's lax lending policies to invest in oil-related product areas. As a result, trading in linear low density polyethylene (LLDPE) had soared on the Dalian futures market.

This can be seen in the above chart. It highlights how WTI crude prices (blue line) and LLDPE (red dotted line) had, most unusually, been trading virtually in parallel. Now, however, this relationship has broken down.

And now it is emerging, as long feared by the blog and other observers, that polyethylene (PE) inventories have indeed been driven by this speculation in crude. As my fellow blogger, John Richardson, notes this week, "Sinopec's stock levels are reported to be at 700,000-800,000 tonnes compared with the usual 500,000 tonnes".

He adds that this is due to Q1's high level of PE imports, which reached 865KT in March, versus a 2009 average of 610KT. And this was in spite of a 100KT increase in China's domestic production to 800KT.

With China's auto sales falling 5% in June versus May, it seems unlikely that the torrid pace of stimulus-inspired demand growth will continue into H2. Equally, even the doziest pension fund will start to ask itself whether its 'investment' in crude oil futures has really provided the hoped-for diversification versus equity markets, when both are down similar amounts.

Some Iranian PE has already been re-exported from China, as the smarter traders seek to cut their losses. And if crude oil continues to fall towards the blog's expected $60/bbl, then a further slowdown in demand can be expected, as the value chain destocks. As they say in football, 2009 could then easily become a 'year of two halves', where the seasonal upturn in H1 gives way to a much more difficult H2.

As promised on Saturday, today's post looks in more detail at the major change taking place in the relationship of propylene to ethylene prices.

When the blog joined the chemical industry in the 1970's, propylene was often regarded as a disposal problem by many cracker operators. They ran their plants to produce ethylene, which was both the highest volume and the highest priced product.

Accurate historical pricing data only goes back to 1978, and is European-based. The chart (based on the annual average propylene price versus ethylene) shows that then, propylene was only priced at around 60% of the ethylene price. This value-leakage led producers to focus development effort on propylene derivatives, particularly polypropylene.

Their effort paid off in the 1980's. The combination of propylene's lower price relative to ethylene, and its increasingly higher quality, led to better volumes. And so propylene was normally able to sell at between 70% - 85% of the ethylene price on an annual average basis.

But in the mid-2000s, propylene's relative price increased again. This was due to increasingly tight ethylene and benzene markets, which prompted some converters to seek alternatives to polyethylene and polystyrene. In turn, this helped propylene's growth rate to move to 1.2 x global GDP, versus the 1.0 x level of ethylene.

Now 2010 has seen propylene move to parity pricing with ethylene. This raises important questions for both producers and consumers:

• Should producers invest in more on-purpose production, such as metathesis and propane dehydrogenation? Some major volumes are now coming online in the Middle East and Asia, but perhaps more is needed.
• What will happen to refining rates? Around 30% of propylene is currently produced from this source, and so volumes have been reduced by the reductions in operating rates discussed on Saturday. Will these volumes return? And what might be the impact of China's heavy investment in new refinery-based propylene production?
• Will propylene derivatives be able to compete successfully at today's higher prices? Moves to higher auto efficiency in the USA, for example, will mean replacing steel and glass with lighter weight products - so perhaps polypropylene and polycarbonate won't need to be very price-sensitive in such applications?
• Can converters afford to change their machinery to use less propylene? Undoubtedly the new Polymer Parks in the Middle East will focus on polyethylene, as this is the main product from the local crackers. But with today's lower margins, the financial basis for a purchase of new equipment may not be sufficiently robust for current users to justify a move.

As noted on Saturday, this is an unprecedented situation, and we have no guide from history as to how these issues will resolve themselves. But the blog believes it would be very dangerous for companies to ignore them, and simply assume that the world will soon return to the pricing basis of the 1980s - 90s.

Paraxylene (PX) has been a great petchem success story over the past 30 years. This 4th post in the blog's series looks back at its history, and discusses how its future may develop.

It is hard to remember that back in the 1970s, DMT (dimethyl terephthalate) was the main polyester material. But the superior properties of PTA (terephthalic acid) led to dramatic growth for polyester and hence in PX demand. More recently, major growth in the use of PET (polyethylene terephthalate) for bottles has further increased demand.

This growth was even more remarkable when set against the sourcing problems associated with PX. It required xylene (or toluene for MSTDP), to be 'bid away' from gasoline, and the octane pool. This was very difficult, as refiners would never allow gasoline stations to run short, whatever the alternative value into PX.

The blog spent several years experiencing these problems at first hand with ICI, then the No 2 PTA producer - first in the UK and then in Houston, Texas. A period of low prices often meant refiners simply stopped xylene extraction. This led to PTA producers placing a high priority on security of supply issues, rather than absolute price.

More recently, however, the blog suspects that markets are moving more in favour of PX producers. As the chart above shows, PX normally trades at a spread of $200/t - $350/t versus naphtha. And whilst the spread continues to have 10 year 'peaks', it has recently been far less volatile than benzene.

Lower Western gasoline demand should lead to improved toluene and xylene availability. And so, whilst benzene is becoming less of a genuine market, PX is moving in the opposite direction. It may, after all these years, finally develop a genuine supply/demand balance of its own, only partially related to gasoline.

The latest in the American Chemical Society's 6 monthly 'Chemicals and the Economy' webinar series took place last week. It was moderated by former ACS President, Bill Carroll, of Occidental Chemical, and again proved very popular.

ACS reported high levels of satisfaction from participants. Comments included: "This speaker is one of my favorites." "This was a very useful topic!" "Very informative, very interesting, very sobering, very good presentation. " "Presentation had great depth, in short time. Easy to understand graphics w/ presenter's help." "Excellent seminar, very up to date. Thanks!"

If you would like to view the 1 hour webinar (you can fast-forward!) please click here.

The US Institute for Supply Management (ISM) has also released an article summarizing the content of the latest White Paper for their chemical industry members. Please click here to read it.

The US Federal Reserve and the American Chemistry Council (ACC) have joined the blog in expressing concern about the outlook for the US economy. And as the chart above of the US S&P 500 shows, financial markets have continued to weaken since the blog's advice on 8 May to "sell in May and go away".

The latest minutes from the Fed's monthly meeting show it worries that the economy may take up to 6 years to fully recover:

"Participants generally anticipated that, in light of the severity of the economic downturn, it would take some time for the economy to converge fully to its longer-run path as characterized by sustainable rates of output growth, unemployment, and inflation consistent with participants' interpretation of the Federal Reserve's dual objectives; most expected the convergence process to take no more than five to six years."

It also highlighted the real risk of deflation emerging:

"Some participants judged the risks to the outlook for inflation as tilted to the downside, particularly in the near term, in light of the large amount of resource slack already prevailing in the economy, the significant downside risks to the outlook for real activity, and the possibility that inflation expectations could begin to decline in response to low actual inflation. A few participants cited some risk of deflation."

As Al Greenwood notes in ICIS news, this week's data also showed that "US capacity utilisation for manufacturing fell to 71.4% in June, down from 71.7% in May. From 1972-2009, the average was 79.2%."

The American Chemistry Council has also raised a yellow warning banner in its latest weekly report. Chief Economist Kevin Swift notes:

"The economic reports were generally negative this week. Retail sales, industrial production, trade, and the regional business surveys all disappointed. There was potentially good news, however, in that initial claims for unemployment insurance fell to a two-year low."

"Overseas, the recovery of industrial production appears to be slowing, with the year-earlier comparisons in the Eurozone, China and India, for example, still strongly positive but moderating. This confirms earlier signals emanating from the purchasing manager reports and composite leading indicators. A second half slowdown or soft patch is clearly in order. It's not clear yet if this is a metamorphosis into a double-dip or not. The risks, however, are clearly rising."

The blog would strongly advise Boards to consider developing a Downside Scenario in respect of their Budgets for H2. It hopes, like the ACC, that the economy will maintain H1's improvement. But there are growing signs of renewed economic weakness in all major Regions. Companies without a detailed contingency plan could be badly hit.

As the chart above from Petromatrix shows, total US stocks of crude, gasoline, distillate and jet kero this year (red line) remain very over-supplied in the short term, by comparison with previous years.

A major reason for this is the move by pension funds to adopt long-only positions in the commodity future markets, in the belief that crude markets are fundamentally tight.

However, this week the Financial Times summarises a timely new study of commodity markets, by Prof Joelle Miffre of Edhec Business School. This argues that investors need instead to understand the difference between:

o Backwardation, "when commodity producers are more prone to hedge than commodity consumers", and the future price is lower than today's
o Contango, "when commodity consumers outnumber commodity producers, leading to excess demand", and the future price is above the current value

They recommend that "to earn a positive risk premium, investors should take long positions in backwardated markets and short positions in contangoed markets".

The team's research suggests this strategy would have earned the investor a commodity risk premium of 12% a year between 1992-2008. Whereas the long-only strategies currently followed by pension funds earned only 2% a year. Edhec therefore concludes that "passive long-only strategies as advocated by traditional indexers perform less well".

Undertaking fundamental analysis of a market can be a tedious business. You have to try and understand what uses the product might have, and the alternatives for the feedstocks. You might even have to look at inventory, and forecast future supply/demand levels.

Luckily, however, for the modern financial investor, these sad disciplines have been resigned to history. Instead, one merely has to look at the 'correlations' with designated key markets. And, of course, a helpful figure from one of the major investment banks is always on hand to provide guidance and support.

Nowhere are the benefits of modern trading more evident than in China's Dalian future exchange, on the linear low density polyethylene (LLDPE) contract. Players there have no need to read boring stories in ICIS news about inventories being 30% - 50% above normal. Or to study purchasing manager reports that suggest demand is slowing.

No, they simply need to understand that the crude oil price is going up, along with the US S&P 500. Then, as shown in the above chart, they can pile in with their orders and take monthly volume (blue line) to an all-time record of 92 million tonnes - a mere 4 times annual global production. 'Sentiment Rules OK', as the graffiti used to say.

Trust the boring old blog to have to point out a potential flaw in the argument. As its friend, and Asian expert, John Richardson notes, "there is now a significant gap between (prices of) more expensive domestic material and cheaper imports".

He also quotes a leading industry figure as warning that "It used to be that we had two markets in Asia - China and the rest of Asia, but now we have three - Dalian, China and the rest of Asia, which is causing a lot of confusion." And this party-pooper adds that he is "really worried about the 100 KT of LLDPE that is in Dalian warehouses right now."

This producer is clearly of the old school, who worries about such minor details as who is going to buy high-priced product when demand is slowing?'. Luckily for the new style of investor, and the profits of the investment banks, nobody listens to such boring stuff on Dalian any more.

The blog has been revisiting the Bank of England's 2008 analysis of the likely impact of the financial Crisis.

This reviewed 33 banking crises between 1977-2002 and found that:

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

The study also found that it was initially easy for Governments to borrow, but that (like Greece this year) they faced the risk of a currency crisis if foreign lenders began to suspect they would never be able to repay the money borrowed. Companies would also find it more difficult to borrow, as banks "de-risked" their balance sheets.

Meanwhile Consumers faced an increased risk of unemployment, and so tended to save more, rather than spend money. In turn, this reduced demand - further pressuring companies, and government's ability to provide fiscal stimulus.

As a result, whilst government intervention could mitigate a crisis, the study found that credit crunches are deflationary.

18 months later, it appears (to the blog, at least) that we are following the text-book pattern. Clearly this is still not the consensus view. But helpfully, the Wall Street Journal has provided 5 useful investment tips for dealing with deflation:

Stocks. It notes that "deflation is generally bad news for stocks, since a period of falling prices and weak demand tends to weigh down corporate earnings and, therefore, share prices". However, it says that companies that dominate an industry can do well, as might those "with plenty of cash, low debt, steady dividends and products that people will buy even in tough economic times".
Bonds. The WSJ suggests that "in a deflationary environment, longer-term government bonds tend to do well. As investors rush to the safety of Treasuries, yields drop and prices jump, resulting in higher total returns". However, "inflation-linked securities could lose value in a period of sustained deflation".
Cash. It notes that "cash is king in a deflationary world. While investors may not earn much interest, cash gains in value as prices fall".
Hard Assets. It suggests that "deflation generally means falling prices for commodities, real estate and other hard assets. But as with stocks, investors shouldn't write off the category altogether. Gold, which many investors consider an inflation hedge, also can be a useful deflation-fighting tool. The government tends to respond to deflationary concerns by printing money, which in turn can spark fears of inflation and drive up the price of the metal. Gold is a hedge against financial stress."
Debt. It notes that "deflation generally isn't kind to debtors" as the value of the debt remains steady, whilst prices generally are falling.

Anyone who followed supply/demand balances might look at the above chart from oil analysts Petromatrix, and conclude that crude oil markets should be relatively weak today. It shows that US oil stocks are only 2.2mb below the record level seen in September 1990, and have grown by 83mb since March.

But this is not the view taken by those operating in financial markets. They see a bullish story, and oil prices actually rose on the news. Amrita Sen, of Barclays Capital, was typical in telling clients that "the long wait for oil prices to break past $80 has finally come to fruition, as sentiment aligns with fundamentals".

Sen also claimed that "actual demand data had finally started to perform strongly and consistently". But the blog is slightly puzzled as to how an 83mbd rise in inventory in the world's largest market could be viewed as bullish, especially when other markets also seem to be slowing. China's oil imports, for example, fell by 150kbpd in July versus 2009.

Petromatrix also report that tanker "rates in crude oil are at the lowest level of the year". Rates on the major Arabian Gulf - Japan route have fallen 50% since June, and are now at, or below, operating costs. And whilst tanker rates can fall for many reasons, they don't usually crash 50% when demand is strong.

The only rational explanation is that oil markets are in a speculative mania. This, as we saw during the US housing mania in 2006/7, means that players become blind to the underlying state of demand. Instead, they focus on what other traders are doing. And in oil markets, as Mike Fitzpatrick of MF Global notes, "upward momentum is still vibrant".

One day, maybe soon, fundamentals will burst the bubble. And the blog's worry is that when this happens, and the momentum players finally panic and try to sell in a falling market, it will be the users in the chemical industry who have to pick up the pieces.

Yesterday, the blog worried that oil prices were well out of line with fundamentals. It argued that momentum trading, highlighted by MF Global's energy VP, Mike Fitzpatrick, had created a speculative mania.

Today, it looks as though Fitzpatrick might agree. Quoted in the Financial Times, he notes "As fundamentals come more into focus, it would suggest that there is less real support for oil prices than recent valuations would imply".

The blog couldn't have put it better.

Current financial and chemical market volatility is a bonanza for good traders, as it gives them more opportunity to take positions, up or down.

However, having traded on behalf of a chemical major in Houston, Texas, the blog knows from personal experience that not all traders get all their positions right, all of the time.

It therefore thought it might be helpful to provide some definitions of trader-speak, heard recently, to help clients interpret their comments:

"The outlook seems pretty clear to me" = I've taken a long position, but I'm having second thoughts about it. What do you think?

"It's true that the market is not in good shape. But it's not all bad either" = I've got a long position, and I can't find any way of offloading it.

"Its slightly worse than we anticipated, but its consistent with leading indicators" = I've got a short position which is in the money, but this might be the time to sell.

"Not every product is heading south" = I've got a short position, and I'm hanging on to it till things really fall apart.

"Nobody could have forecast these developments" = My boss is thinking of firing me, and hiring someone who knows what they're doing.

More examples will, of course, be very welcome.

Oil markets are an accident waiting to happen for the chemical industry. Oil inventories around the world are close to record levels, with the IEA (International Energy Agency) reporting they are over 61 days of demand. Equally, as the Petromatrix chart above shows, they are at record levels in the USA (the world's largest market), and still climbing.

The major investment banks, of course, are still able to make easy money by selling the story of "demand from emerging markets and limited growth in supplies" to gullible pension funds. So it is no surprise that sentiment in the futures market continues to ignore the fundamentals.

But the risk/reward ratio for a bet on oil at $90/bbl in Q4 is starting to look pretty thin. Prices peaked at $83/bbl in early August and in spite of another bullish report last Monday, were down $9/bbl (11%) by the end of last week. So the risk of a price collapse to $60bbl or lower is clearly increasing, and is certainly now above 25%.

If it happened, then clearly OPEC would quickly cut production again. But this would be shutting the stable door after the horse has bolted. So destocking, as we saw in Q4 2008 - Q1 2009 and in 1980, could again become a serious problem for the major chemical industry value chains.

Thus, if the investment banks lose their battle to support oil prices, then the chemical industry may well be left to pick up the pieces.

With the Chairman of the US Federal Reserve saying the outlook is "unusually uncertain", its time to summon the chemical market genie.

Of course, rubbing the lamp is not always successful. And if the genie does arrive, one can only ask 3 questions.

So rather than risk wasting them, the blog has learnt to spend the first question in asking him to decide the other two questions.

And this is what the genie said:

"They should be obvious, even to you, blog. Ask me what is happening to the US economy? It dominates the global economy, as you have written many times".

So I asked, and the genie answered, laughing:

" You have wasted a question. You already know what is happening to the US economy. It is heading back into the downturn, now the stimulus programmes are ending.

"In Q3 last year, GDP grew by 1.6%, and by 5% in Q4. But then it slowed in Q1 to 3.7% and now Q2 is estimated at just 1.6% again. But I can understand that you have been hoping a proper recovery might be underway, particularly after the industry has had such a strong H1."

Thank you, O genie, I replied, and so what should be my second question? The genie sighed, and I thought for a moment he was going to disappear back into his lamp.

"Ask me about the US housing market? You surely know that this used to be a $35bn chemical market in 2006, when there were 2.2m housing starts? But you can start by answering my two-part question:

"So, said the genie, the rich aren't buying. And as 23% of all homeowners owe more on their mortgage than the home is worth, and sales in July were an all-time low of just 276k annualised (worth just $5bn), then this major market will provide little support for future chemical sales"Chastened, I waited for him to reveal my 3rd question.

"Again, it is obvious", he replied. "Even you have been writing about it since February 2009. Ask me about the potential impact of deflation."

"But if I can interject, O genie, all the commentators suggest that we are in a 'bond market bubble' and that we should really worry about inflation?"

At this, the genie laughed for a very long time.

"You amuse me, blog", he finally replied. "So I will allow you this extra question. Ask all of your friends if they have read an article about this so-called 'bond market bubble'? And then ask them if their own pension fund is now even 50% in long-term G7 government bonds? You will find there is indeed a bubble in articles about a 'bond market bubble', but very few people actually own them".

So the genie then answered his 3rd question, reminding the blog of an analysis in Barrons, the US investment magazine.

"Today, if you're a Western baby-boomer (born between 1946-64), you now need to save $1.42 if you want to have $2 in 10 years time, with interest rates at 3.5%.

But when rates were at 7%, you only needed to save $1 to achieve the same result.

"Now, blog", he then added. "You wrote about the baby-boom generation only last week. You can surely see why they are beginning to panic about their future income level in retirement?

"If their baby-boomers stop spending and start saving, which they must do to protect their retirement income, then clearly global chemical market growth rates cannot go back to the levels seen before 2008."

And with that, the genie disappeared back into his lamp, leaving the blog to ponder on the implications of his answers for chemical sales in the rest of 2010, and in future years.

The Petromatrix report is currently a must-read for anyone seeking to understand what is really happening in crude oil markets.

Its latest issue analyses China's demand. It suggests this is not as strong as the bullish investment banks on Wall Street might wish.

China's refinery runs are certainly rising, as its new major capacity comes online. And its own oil production in July was up 250kpd versus 2009. But its oil imports appear to have peaked, with July's 1mbd lower than in June, and slightly below 2009 levels. In addition, oil product imports are now falling, as domestic production increases.

Thus, as the chart shows, China's total imports of crude oil and products were actually 441kpd less in July (blue line) than in July 2009 (red). They were only 640kpd higher than in July 2008 (yellow) and just 478kpd above July 2007 (green). Pretty clearly, this slow growth in total domestic demand does not justify today's very high crude oil prices.

The figures also suggest that China is keeping its own refinery operating rates at a high level by replacing imports with domestic production. As such, it poses a real threat to other integrated refiners/petchem producers across Asia. If they have to cut refinery runs to compensate for China's higher production, then petchem feedstock supply will suffer.

Many readers have been taking a well-deserved break over the past few weeks. As usual, therefore, the blog is highlighting key posts during August, to help you catch up as you return to the office.

August has been surprisingly busy:

Force Majeure reports show worrying increase highlighted the worrying rise in force majeures, which may be linked to cutbacks in training, and maintenance spend.

US consumer demand growth stalls. The US economy seems to be heading back into the downturn, as the stimulus programmes end, with unemployment still high, housing starts at all-time lows and GDP slipping.

5 tips for surviving a period of deflation covered advice from the Wall Street Journal on managing a personal investment portfolio.

Speculative mania continues to drive oil markets. The impact of futures market trading disguises the weak fundamentals of the oil market, and has also been driving speculative activity on polymers in China.

US junk bond issue hits record as GDP slows worried that investors were piling into high-yield corporate bonds, just as the slowing economy was increasing their risk.

Lower refining rates support EU petchem margins described how lower oil product demand, and hence refining rates, was reducing naphtha availability, and so helping to keep petchem markets tight.

The" real bottom line" in the Financial Times featured the blog's letter to the FT.

Oil markets are now in their longest-ever period of contango. This is when prices for future months are higher than current levels. According to Bloomberg, they have now been in contango for a record 656 days.

Keeping a barrel of crude in a tank on land costs 60 - 70 US cents/month, whilst hiring a supertanker costs $1.50/month.

So this is clearly excellent news for the blog's friends in the storage and shipping industries, as well as in the trading community.

But a comparison with the previous record period of contango (640 days between October 2005 and July 2007), reveals the lack of logic behind the current speculative mania. Then, global crude oil consumption was rising rapidly from 82.2mbd in 2004 to peak at 85.6mbd in 2007, according to BP's authoritative Statistical Review. But last year, demand was back at 84mbd, and is clearly still being hit by today's high prices.

Where is the need to store record levels of oil and oil products, with this level of comfort in supplies? Especially as in the short-term, oil inventories are already rising still further as Western refineries shut for routine maintenance before the winter arrives. US operating rates are already down to 87% from July's 91.5%, for example.

In addition, in terms of petchem feedstocks, OPEC has been rapidly increasing its NGL output. The International Energy Agency estimates this will rise 600kpd in both 2010 and 2011, to total 5.9mbd. It notes this volume will represent "7% of global oil output, up from negligible levels in the early 1990s".

One day, crude oil markets will shift their focus back to these fundamentals of supply/demand. The blog used to think this correction could see prices slip back to $60/bbl. But now, with the mania having lasted so long, it is beginning to fear they could easily fall back to $40/bbl. This would be very painful for those in the real world of the chemical industry.

The past fortnight has confirmed the strong linkage between Dalian futures trading, and financial market speculation.

Dalian prices (red line) for linear low density polyethylene (LLDPE) rose steadily in early September, as traders bet on higher crude prices. They had gained RMB 600/t ($90) by last Wednesday.

But then rumours began flying that China's interest rates would be increased at the weekend, to help curb rising inflation. Prices immediately dropped RMB 305 ($45/t), as traders dived for cover, mirroring Thursday's 1.5% fall on the Shanghai stock market.

Dalian's trading volume (blue line), over 6 MT/day at this month's peaks, gives it major influence on physical market pricing. Yet, now the excitement has died down, it is clear that nothing much had changed in the fundamentals of the polyethylene market to justify either its earlier rise in prices, or the sudden fall.

It has become, as my fellow-blogger John Richardson noted recently, an Alice in Wonderland market where financial speculation rules.

The blog remains very concerned that, overall, the economic policies adopted during the current Crisis are leading the world economy to the worst possible outcome. This outcome is totally predictable. Indeed it has been predicted by reputable experts for some years. Yet most policymakers still seem intent on dealing with symptoms rather than causes.

As evidence for this argument, the above chart first featured in the blog 18 months ago. It was developed by Comstock Partners, but many others identified the same logic. And sadly, we continue to move through exactly the cycle it defines:

• Originally, China/Asia boosted savings and investment, whilst the West ran up huge debts in creating demand to utilise this investment eg in housing, autos.
• Equally, the West created huge over-capacity in services, particularly financial services, in order to recycle Asia's savings into Western debt.
• Inevitably, the world then reached a position where this excess capacity led to growing weakness in pricing power - causing the Crisis which is now with us.

Did Western policymakers stop at this point, and ask themselves what was happening? Not as far as the blog has observed. Instead, they focused on short-term measures such as stimulus programmes to boost demand, in the mistaken belief that the problems were caused by a lack of market liquidity, rather than solvency.

The EU's efforts to avoid debt default by Greece are just one example of this. Equally, Germany's weakening of the new Basel bank capital rules to avoid problems for its bankrupt state banks. Or, indeed, the Obama administration's apparent belief that their stimulus programmes would produce 'escape velocity', with the US consumer quickly returning to full spending mode.

Meanwhile in Asia, China has begun quietly devaluing versus the trade-weighted average of partner currencies, spending $1bn a day in the process. It has also been forcing up the value of the Japanese yen, buying $12bn of government bonds in June-July.

China's premier, Wen Jiabao, has also ruled out any "drastic appreciation of the renminbi" against the US$. Noting that China's factories receive only $6 for each $299 iPod sold, he warned, "you don't know how many Chinese companies would go bankrupt. There would be major disturbances. This is the reality."

Yet in the USA, the administration seems increasingly keen on a 'weak dollar' policy, to support its desire to double US exports over the next 5 years.

Now, Japan has publically signalled the move to the next stage of the Crisis, with its decision to competitively devalue, to try and maintain its exports. Its export-driven economic model simply can't survive with the yen above ¥95: $1.

As before, this short-termism clearly cannot work long-term. With world trade no longer expanding, nobody is now able to take on the role of 'importer-of-last-resort' that has been adopted by the USA and Western Europe in recent years. Instead, the politicians are all mindful of the increasingly protectionist mindset of their electorates, with unemployment at high levels.

So the stage is now being set for the next phase of the Crisis, namely protectionism and tariffs. The first signs are already beginning to appear. And they will undoubtedly increase in volume next year, if the major developed economies (Europe, N America and Japan) continue to stagnate. These regions, after all, do account for two-thirds of global GDP.

In the meantime, more and more governments are planning to further reduce demand by imposing austerity programmes, in the mistaken belief that their previous policies have delivered economic recovery. The outlook therefore does not seem very optimistic, even to the blog.

Peter Lynch, who managed Fidelity's Magellan Fund in its great days, once remarked that "the futures and options markets are a giant transfer payment from the unwary to the wary".

This has certainly been the case in oil markets over the past 18 months. The sale of futures contracts to pension funds and others, has taken prices far above anything justified by fundamentals, and made a considerable profit for those selling these contracts.

The issue, of course, from the chemical industry viewpoint, is whether this situation will change any time soon?

To answer this critical question, we probably have to turn to so-called 'technical analysis', which is widely used by those trading both commodities and currencies. It focuses on trying to identify behavioural patterns, not supply/demand fundamentals, and then applies these to current conditions.

Thus the above chart, from Petromatrix, is a warning that a possible major price move lies ahead. It charts the weekly range of WTI in recent months. And it shows a 'triangle' is being formed, highlighted by the red 'resistance line' at the top, and the green 'support line' at the bottom.

The triangle has been building since May, and suggests that 'bulls' have run out of steam in trying to push prices higher, whilst 'bears' have not gained sufficient momentum to take them lower. Quite often, the end of such a tug-of-war produces a major price move, up or down, as one side capitulates.

The blog will therefore keep an eye on developments, to see if the triangle pattern helps forecast future price movements on this occasion.

Investors on Wall Street are no longer bothering with the boring detail of company performance.

That's the conclusion from a new study by Barclays Capital, on the correlation between movements in the S&P 500 and individual stocks.

Instead, they are piling into the 'correlation trade', as high-speed computers now often account for over 60% of daily trading.

Until 2006, the daily correlation between stocks and the index was just 27%. It was only in exceptional circumstances, such as the Iraq War in 2003, that correlation rose to 60%.

Since then, correlation has become the name of the game. It was 80% at the height of the financial crisis, and again in Q2 during the European debt crisis. And it is still high today, at 74% in August and 60% today.

According to the Wall Street Journal, "such high correlation levels were seen previously only during the Great Depression". The blog, not being a fan of correlation trading anyway, likes the sound of that parallel even less.

This week's ICIS Chemical Business includes the blog's article on the changes taking place in global markets for ethylene, propylene, butadiene, benzene and paraxylene. These have a potential impact on buyers and sellers all the way down the various value chains.

The article updates the blog's major series on these issues in the summer, and also links to the demographic changes now underway in the West. It suggests that "prudent producers and consumers might want to develop a Scenario-based approach to future planning, that includes further development of the analysis set out".

Please click here to download a free copy of the article. And please click here to see the YouTube interview with Will Beacham, ICB deputy editor, which explores some of the key issues in more detail.

Business models have been changing over the past decade in the chemical industry, as illustrated in the above chart.

Initially, the dotcom era began to put pressure on former 'specialty businesses', as customers discovered they were paying over the odds for technical support that was no longer required. The internet made it much easier to obtain low-cost supplies (often from Asia) of the molecules they required.

Then high oil prices pressured the former 'commodity' businesses, as it became more difficult to pass on these higher costs down the various value chains. And in turn, this has led the majors to implement strategies that prioritise site and business integration as a way of mitigating the problem.

Thus Steve Pryor, ExxonMobil Chemicals president, told EPCA last year that businesses need to be "tightly integrated to maximise the value of every molecule and minimise costs". And now Shell's Ben van Beurden, Shell's chemicals EVP, has told ICIS's Nigel Davis that even the phrase "refinery/chemicals interface" represents an out-of-date concept.

Van Beurden went on to explain that in Shell's view, "as long as you have an interface, you have a problem". And thus the chemicals business needs to focus instead on becoming the "highest profitable hydrocarbon upgrader". By this, Beurden said its role was to enable the company to "capitalise on low-value and other refinery streams and add value to the whole".

These are major changes in business models, which take time to implement. But as they become more apparent, so it will become clear that the chemicals landscape is undergoing a profound change from that which has applied over the past 30 years.

Warren Buffett, the legendary US investor once cautioned that "over time, markets will do extraordinary, even bizarre, things."

We are certainly living through such times today.

In August, the US S&P 500 Index fell 5%, as investors worried about the end of stimulus packages, and the return of banking problems in Europe. The IeC Boom/Gloom Index mirrored this fall, sinking back to its post October 2008 lows.

These fears came true came true last month, as the weaker European economies faced record levels of interest rate spreads; Ireland warned the rescue of Allied Irish Bank might cost a third of GDP; and the US Federal Reserve said it might resume Quantitative Easing (QE2), due to its worries about the US economy.

In response, the US S&P 500 rallied 9%, with the Boom/Gloom Index (above) tracking it once again as sentiment turned bullish.

"Extraordinary, even bizarre", might seem a good description of events.

The issue is our old friend, liquidity. As the SEC report into May's 'Flash Crash' shows, the high-speed traders who now dominate financial markets couldn't care less about underlying economic reality. To them, as BofA Merrill Lynch commented, "QE2 = the Bernanke Lifeboat for the equity market". All the boys with the big computers care about is that the US Federal Reserve might soon sponsor another tidal wave of liquidity.

They expect this to trigger renewed fears about the potential for rising inflation. In turn, they hope this will drive the value of the US$ lower, and cause renewed buying of commodities such as crude oil. Its the perfect opportunity for them to max out on bonuses in time for Xmas.

But once the party has ended, and the computers have been shut down for the night, it will be the real world of the chemical industry that will have to pick up the pieces.

The blog's former ICI colleague, Tom Crotty, aptly summarised the mood of most petchem players at this week's meeting in Budapest, Hungary, when telling ICIS' Nigel Davis that "2011 is a very tough call to forecast".

Crotty is this year's president of EPCA (European Petrochemical Association), and it was clear from the blog's discussions that uncertainty is the key factor in current petchem markets. In particular, people have different viewpoints based on their geographic location:

• Asian, Middle Eastern and Latin American players have had a good year, supported by China's demand. They hardly recognise that a recession has been underway, but worry China may slow next year.
• European players have seen tight markets, with feedstock supply limited by refinery cutbacks, as I describe in the above interview with ICB's Will Beacham. But they worry that government cutbacks and austerity programmes will hit demand next year.
• US players have also been supported by Asian demand, and domestic stimulus spending. But the upcoming mid-term elections, and lack of clarity over future economic policy, create their own uncertainty.

In addition, there is the strange case of crude oil prices.

Petchems always do well when these rise, as players build inventory down the value chain (as in 2007-H1 2008). And as in 2008, the blog fears that today's high prices will also choke off demand, as they reduce discretionary spending.

Equally, oil prices have not been supported by tight supply conditions. Inventories of crude and oil products are at near-record levels. It is only the efforts of financial players, selling the US$ and buying commodities such as oil, that has led to today's $80+ levels.

Scenario planning seems essential when looking forward to the 2011-12 Budget period, with companies faced by extreme levels of uncertainty over future demand levels, government actions, currency movements and feedstock prices.

The blog will take up this issue in more detail, when presenting its annual Budget outlook later this month.

Natural gas markets, so important in relation to chemical feedstock availability and pricing, are undergoing major change as we transition to the New Normal.

The Middle East, which had been in surplus, is now moving to a more balanced position in some countries, such as Saudi Arabia. But the USA, which had expected to need increased imports, may instead become a major exporter.

Middle East. The blog was speaking at the World Refining Association's annual conference in Bahrain earlier this week. And it was clear from its discussions with leading players that Saudi Arabia is having to re-evaluate gas usage strategies, to take account of competing end-user demands, as well as overall energy supply balances.

The supply position has thus changed significantly since the blog first visited the region in 1996. Then, everything was in surplus, and multiple investment objectives could be achieved, such as providing good financial returns whilst also adding value to a natural resource and providing local employment.

Today, as noted by McKinsey's Christian Gunther in Bahrain, choices will have to be made between competing priorities. Should gas replace diesel as a power station fuel, for example? Equally, should gas users pay the exploration costs for finding non-associated gas?

USA/Global. Meanwhile, over in the USA, "a supply revolution" has taken place, according to Shell CEO, Peter Voser. Voser told a London conference yesterday that a much more favourable global picture is emerging for gas reserves, due to shale gas and liquefied natural gas (LNG).

He noted that the US now has "over a century's supply" of natural gas at current consumption levels. Yet, just a few years ago, it was thought that "domestic gas production would decline". And including LNG supplies, the International Energy Association estimates the world has enough "gas in the ground for 250 years at current production rates".

In turn, of course, changes of this magnitude create both problems and opportunities for the chemical industry. Shell VP, Jeremy Bentham, spelled out some of the opportunities at last week's EPCA meeting in Budapest:

• He noted it was now economic to produce US shale gas at between $3 - $5 MMBtu, compared to the previously assumed minimum cost of $6 MMBtu.
• He also revealed that US producers were "queuing up" for export licences, based on using the terminals recently constructed for LNG imports.

Working through these issues will be a complex process. And it is made no easier by the current divorce between oil and gas prices. Oil has 6 times the energy content of natural gas and, as the chart above shows, the two normally track each other quite closely, with oil 6x gas prices.

But with financial markets currently powered by liquidity rather than fundamentals, oil prices (blue line) are now 20 times US gas prices. Does this mean gas prices (red line) might treble to $12/MMBtu? Or might oil fall back to $24/bbl? Or will current relationships continue?

The honest answer, is that nobody knows. We have simply never seen conditions like this before.

The blog's argument that oil prices are now being entirely driven by financial market speculation has won support from one of the main state oil trading companies.

ICIS news reports that the CEO of SOCAR Trading (State Oil Company of Azerbaijan Republic) claimed that the "rise in crude and other commodity prices, resulted principally from the speculation of banks". And he went on to argue that "fundamentals would indicate that the price of crude should be around $30/bbl."

Speaking at the Asia-Pacific Petroleum Conference, he justified this claim by pointing out that "paper trading on the NYMEX and ICE exchanges in 2010 was worth $25,000bn, compared with just $2,000bn for physical oil". And he noted that "although crude prices had risen, OPEC spare capacity still stood at around 6m bbl/day".

Azerbaijan produces 1mbd of oil, and SOCAR believes that today's high oil prices are positive for the world economy, as they "cushioned resource-rich developing countries, including Azerbaijan, from the worst effects of the crisis". The blog strongly disagrees with this view, which ignores the impact of high oil prices in reducing discretionary spending (and therefore chemical demand) in the rest of the world.

But SOCAR's clear statement does give a clear indication of the downside risk to oil prices, should the QE2 lifeboat party ever end.

The blog will publish its annual Budget Outlook for 2011 next weekend. And so as usual, its now time to review last year's Outlook. Past performance may not be a perfect guide to future outcomes. But it is one of the best that we have.

The 2010 Outlook was titled 'Budgeting for a New Normal', and it argued that over the next few years:

"We will start to see a rebalancing of the global economy. The West will see lower consumption, as people rebuild their savings, and borrow less. In turn, this will mean lower export demand for the emerging economies. The outcome will be a more sustainable world economy, but it will be a difficult journey."

Today, this still seems to be an accurate view, particularly the sense that it will be a "difficult journey".

The blog's 2008 Outlook 'Budgeting for a Downturn', and its 2009 'Budgeting for Survival', meant it was one of the few to forecast the Crisis. Last year, however, the blog was more positive about the outlook than most forecasters, expecting that "2010 should be a better year for the chemical industry, as demand grows in line with a recovery in global GDP".

It also correctly balanced this optimism by warning that there would be no "quick V-shaped return to the 2003-7 Boom years", and suggesting that:

"Governments will worry about budget deficits, and may well scale down support for critical end-uses such as autos and housing. Equally, major amounts of new capacity, planned during the Boom years, will start to come onstream in the Middle East and Asia."

This led it to fear that "unemployment is set to become a key political issue in the West". Unfortunately, this has also been proved correct. So have its concerns that the expected recovery in demand would put "great strains on cash-flow", and that speculative bets on "oil prices linked to traders' bets on the US$'s value will continue".

However, although it identified this latter factor, it clearly underestimated its likely longevity, with oil so far averaging around $75/bbl versus its suggestion that "$50/bbl might be an average price". The blog will keep this lesson in mind when posting its Outlook next weekend.

The blog's aim is to 'share ideas about the influences that may shape the chemical industry over the next 12 - 18 months'. It hopes that its 2010 Outlook again helped readers to better prepare for today's more difficult economy.

If you only read one newspaper article this year on the economic outlook, then the blog would recommend Martin Wolf's recent analysis 'Why America is going to win the global currency battle'.

Wolf is a former EPCA speaker, and he sets out very convincingly the rationale for the US Federal Reserve's planned move to restart printing money again (the QE2 Lifeboat policy). As he says:

"To put it crudely, the US wants to inflate the rest of the world".

Wolf argues that the Fed's QE2 policy will encourage asset price inflation in financial markets (stocks, commodities etc). The belief is this will spur US consumer spending and promote growth in the real economy. Higher US inflation will also devalue the US$, thus reducing the 'real' value of the US's enormous debt.

Equally, of course, the article highlights Fed's real fear that the USA may be following Japan's deflationary path since its financial and real estate bubbles burst 20 years ago. The chart above shows this danger very clearly:

• The bottom axis is the percent change in the Nikkei 225 Index (purple line) from September 1985
• The top axis is the percent change in the S&P 500 Index (red line) from September 1995
• The S&P line is lagged by 8 months, so that it peaks in 2000 in line with the Nikkei's all-time peak in 1990.

It shows how the Fed began inflating like mad in 2003 - focusing on the housing market - as the S&P followed the Nikkei's downward path after the dot-com bust. The resulting Crisis, however, then brought the two lines perilously close again in 2009. Thus the Fed is clearly very worried that this summer's 'soft-patch' may signal that the USA is reconnecting with Japan's fate.

The blog, does, however, disagree with Wolf's overall conclusion, that the Fed will inevitably win this battle. Wolf believes that its policy will force China and other emerging economies to allow their currencies to rise sharply, or risk higher inflation and over-heating in their domestic economies. This will then allow the US to increase its exports, and also help to rebalance the US economy.

But he overlooks the impact that the lower US$ and higher commodity prices will have on US domestic demand. Higher oil and food prices, brought on by the 'QE2 Lifeboat party', are just as likely to cause further declines in US consumer confidence, and cut into the discretionary expenditure that drives growth in the real economy.

The problem, of course, is that the Fed is certainly powerful enough to engineer a short-term boom in asset values. This is what we have been seeing with the 15% rise in the S&P since August, when the Fed began briefing on its proposed policy. But can it really 'win', as Wolf believes?

In the blog's view, this just adds to the general uncertainty over likely future demand levels, that was so evident earlier this month at EPCA. And it is therefore yet another reason why the blog plans to title its Budget Outlook this weekend, 'Budgeting for Uncertainty'.

When elephants fight, those around them need to be cautious. And this is the prospect for 2011-13, as the Western countries try to force the BRICs (Brazil, Russia, India and China) to export less and import more, the so-called 'rebalancing' strategy.

Thus Budgeting for Uncertainty seems the right title for the blog's annual Outlook for the chemical industry.

Key factors that will contribute to this uncertainty include:

• The USA is aiming to rebalance the world economy by forcing the BRICs to reduce exports and instead focus on expanding domestic demand. This proposed rebalancing represents a major change from the past 20 years of export-driven development by the emerging economies, and will not be achieved overnight.

• Europe is making a 180 degree shift in policy, by abandoning previous efforts to stimulate its economy. It is instead planning to achieve budget balances by reducing spending and increasing taxes. It is also lining up alongside the USA in hoping to increase its exports to the BRICs, whilst reducing imports from them.

• The BRICs themselves are between a rock and a hard place. They were not the cause of the financial Crisis, but they are the ones on whom the major burden of adjustment may fall. The principal instrument of change will be the exchange rate, as the West aims to force China and others to revalue their currencies quite sharply.

These macro factors clearly raise more questions than answers. Even the issue of timescale is unclear, with the US suggesting it might take a full Budget cycle of at least 3 years for real changes to be observed. Plus, of course, there is absolutely no guarantee that the West will get its way, or that the whole exercise may not end in tears.

On the other hand, everything might go extremely well, with a renewed burst of co-operation as seen immediately after the Lehman collapse in Q4 2008. If the G20 Group of the major economies really worked together, then chemical demand could easily be stronger, rather than weaker.

The blog's view is that Scenario planning is the only solution when faced with so many different variables. The idea is to establish a Base Case, and then develop Upside and Downside Cases which are reasonable projections of what might happen if everything went very well, or very badly.

The blog's own effort to help kick-start this process is shown above:

BASE Case. This suggests we will see global GDP growth of 3%, with oil staying in the $60 - $80/bbl range of the past 18 months. We will still see financial market volatility, but no major collapses. It is the classic 'muddle through' type of Scenario.

UPSIDE Case. This assumes that the G20 achieves a 'grand bargain' to rebalance the world economy, allowing GDP to grow at above 3.5%. Inflation would probably become a major issue under this Scenario, causing oil prices to move above $80/bbl.

DOWNSIDE Case. Instead of increased international co-operation, countries put their own interests first and adopt beggar-my-neighbour policies. GDP growth would probably fall to 2.5%, and the oil price below $60/bbl, with the banking system under major strain as Deflation took hold.

The slide also suggests a number of 'Jokers' that companies may want to consider. These include changing demographics, such as the ageing of the Western baby-boomers. And, of course, one can never ignore the potential impact of geo-political events, such as a bombing of Iran's nuclear plants, or new tensions with N Korea.

Of course, it would be possible to simply adopt a Base Case Scenario, and assume that this will work out. But the chances of this occurring are probably less than 50%, so it would be highly risky. Instead, the blog would strongly recommend businesses to adopt a version of the above framework, using their own ideas for Base, Upside and Downside Scenarios.

By adopting this process, businesses can then test out key assumptions in advance. They can also develop mitigation strategies, in case events begin to diverge from the Base Case view. As always, the blog will be very happy to advise on the process, if this would be helpful.

2010 has been a suprisingly good year for many companies. We can certainly hope that current performance will continue, but hope is not a strategy.

Scenario planning will give businesses the chance to adopt the wisdom of the Scouting movement. Its motto, 'Be Prepared', seems the best possible approach in today's increasingly uncertain New Normal environment.

As promised, the blog is today looking at a key European consumer trend, as part of its Budget Outlook week. 70% of chemical sales are consumer-related, so changes in these trends are very important.

Earlier this month, it shared a platform in Bahrain with Thibaut Eissautier, Chief Procurement Officer of McBride, Europe's leading own-label producer of household and personal care products. 81% of his purchases relate to chemicals, from packaging materials through to the actual ingredients.

He noted that Europe has the highest global penetration of own-label goods (those supplied to supermarkets under their own label). And it has risen 10% since 2007, with one in six products now own-label in the household care sector. He outlined 5 key trends driving this trend:

• Value for money. "Consumers are more price-sensitive than ever".
• Simplicity. They "want less complicated life-styles".
• People, not things. They increasingly "prioritise what is important in life, such as family and friends", and often only "enjoy small moments of indulgence", which they prefer to achieve via "bargain-hunting".
• Values. Sustainability, carbon footprint, trustworthiness and performance are key for many consumers.
• Local. Convenience/express stores and online options are therefore gaining ground versus hypermarkets.

Most of these trends are quite different from those of the past 20 years, when affluent European consumers often defined themselves by the car they drove, or the house they owned. They therefore add a further element of uncertainty, when it comes to forecasting future chemical demand patterns.

An unnatural calm continues to dominate crude oil trading. Prices may move up or down by $2/bbl or $3/bbl a day, but then they always return to where they started, between the upper red line and the lower green one.

The blog has kept its promised eye on developments, since this trend of 'trading in a triangle' was spotted by Petromatrix last month. It also applies, as the chart above shows, to trading in the Brent oil contract in euros/bbl. And it has continued even with the US Fed's QE2 Lifeboat policy about to start.

Thus there is still the potential for the sharp move, up or down, that technical theory would suggest, if either bulls or bears finally come out on top.

One of QE2's major aims is to drive down the value of the US$, and increase inflation. And in turn, of course, this is supposed to force investors into chasing so-called 'riskier' assets. Thus they should buy commodities such as crude oil, as a supposed 'store of value'.

The interesting thing, however, is that this promised vast flow of liquidity has indeed pushed up equity markets, and some commodities. But as the triangle shows, its positive impact on oil has been balanced by others' sales.

Crude oil prices were already far too high, of course, relative to either today's supply/demand balance, or natural gas prices. But they could still have gone higher. After all, as the eminent economist Keynes warned, 'markets can remain irrational, longer than you can remain solvent'.

So today's unusual calm in global oil markets, is perhaps trying to send us a message about future developments. The blog will continue to watch, with interest.

China's Dalian futures market has been attracting world headlines recently, with its status as China's leading market for chemical futures being confirmed. As such, one would expect its pricing for the two major polymers traded, LLDPE (linear low density polyethylene) and PVC, to follow similar patterns.

But this seems not to be the case. The LLDPE contract has boomed recently, offering punters a chance to bet on the direction of oil prices in high volume. It traded 46 million tonnes last month, around twice total annual global output.

Yet PVC, a higher volume product globally, and in China, traded just 1/10th of this volume. And as the chart shows, its price (red line) actually fell last month, as the physical market failed to pass through higher oil prices (blue).

This highlights, of course, the more speculative nature of the LLDPE contract. Anyone using it as the basis for pricing physical product, therefore needs to keep a close eye on what happens next to crude oil prices.

Last week, the blog repeated its warning that crude oil was preparing for a big move, either up or down. And prices then jumped 7%, to a two-year high of $87.49/bbl. So the 'triangle formation' proved its predictive power again.

As the above chart shows, from Petromatrix, the driver behind the move was the Large Speculators on the Futures markets (ICE and NYMEX). In anticipation of the US Fed's QE2 Lifeboat programme kicking off, they:

• Bought a further 12.5m bbls, about 15% of total daily consumption
• Took Speculative length to an all-time record high

2010 (blue line) has seen more Speculative buying than any previous year. Net length is now ~150mbbls, versus March 2008's peak of 115mbbls (green line).

At the same time, of course, the world is seeing near record levels of physical stock. And OPEC's own forecast last week suggested global demand in 2011 would only equal 2007's level. Even in 2014, OPEC expects to have over 6mbbls/day of spare capacity.

In the short-term, however, the Speculators rule, not these fundamentals. So the most likely outlook for chemical markets for the rest of Q4 is that:

• Speculators will continue to buy oil futures and sell the US$
• In turn, this will force chemical company purchasing managers to buy forward
• CFOs will probably allow inventories to increase, given good cash-flow

In turn, this should lead to a strong end to the year, as far as chemical volumes are concerned.

Of course, it is possible that the US Fed will be proved correct. It might happen that a lower US$, and higher commodity prices, will restore Western consumer confidence and banish current debt worries. But the blog would not invest its own money on this basis.

It fears it is far more likely that we are in the middle of yet another speculative bubble. Whilst oil prices are rising, underlying demand is almost certainly weakening. Once again, as in the mid-2000's, the Fed's misguided policies are treating symptoms, rather than causes.

The US Fed's new QE2 Lifeboat programme designed to raise asset prices got off to a bad start last week, with most stock markets falling, rather than rising. It has also begun to run into major opposition from advisors to the new Republican-dominated Congress, with an open letter published Monday in the Wall Street Journal and New York Times that suggests:

"We believe the Federal Reserve's large-scale asset purchase plan (so-called "quantitative easing") should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed's objective of promoting employment."

Equally, the above chart from the American Chemistry Council (ACC) weekly report shows diverging patterns of economic growth across the major economies. It notes that the OECD's main Leading Indicator for the world economy (blue line) is now slowing quite fast. And the ACC add that the leading indicators for

"Brazil and China continue to point strongly downwards, edging below the long‐term trend and implying that the level of industrial production will fall below its longer‐term trend in these two economies."

Creating more liquidity, as the Fed plans, does not do anything to tackle these key issues. In the meantime, by having caused oil and other commodity prices to soar, it has created added uncertainty as regards chemical industry prospects for 2011.

In one of its first posts, at the time of the ill-fated Access deal for Lyondell in July 2007, the blog highlighted the strange divergence that had developed between the front pages of the newspapers, and their business coverage:

"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. "

Today, the same disturbing trend has returned.

• The €90bn ($125bn) Irish bailout, for example, is very clearly bad news. As the blog noted back in May, Europe's banks have lent $495bn to Ireland, more than twice the €182bn at risk in Greece. And, of course, next in line are Spain (€792bn) and Italy (€961bn).
• Equally, the US housing markets remains very difficult. Already the government has committed $188bn to keep the two main lenders (Fannie Mae and Freddie Mac) alive. And there are few signs of any real improvements as we head into the seasonally difficult winter months.
• Plus, most importantly of all for chemical demand, China's economy is moving into an enforced slowdown, as the government worries about soaring inflation - up from 3.6% to 4.4% in just one month. Price controls are likely on key foodstuffs, whilst interest rates have already begun to rise to cool the real estate bubble.

Yet the financial pages are full of optimism about the economic outlook. Most remarkably, there seems a consensus that interest rates will need to rise dramatically. Almost all commentators warn that inflation is about to soar, due to the strength of the economic recovery now underway.

As in 2007, the blog begs to differ. The chart above, from the New York Times, shows the parallel between Japan's core inflation rates (green line) after its housing bubble burst in June 1991, and US inflation (blue line) since its housing market peaked in June 2006.

October's US core inflation was a record low of just 0.6%. The previous low was 0.7% in February 1961. And, as always, the blog believes that the major retailers are a far better indicator of what is happening in the real economy, than financial markets. Thus it believes Wal-Mart's announcement that it intends to follow a "price-leadership" strategy virtually guarantees US inflation rates have further to fall.

If Wal-Mart are right, then financial markets must be wrong in their assessment of the underlying state of the US economy. And in turn, this has critically important implications for chemical companies. Lower oil prices, and destocking down the value chain, are serious risks if today's sunny optimism in financial markets starts to be seriously challenged.

Q3 showed no real improvement in European cracker operating rates (OR%). As the chart shows, based on APPE data, these remained at 82% for the Q1 - Q3 period. Of course, this is much better than the 76% OR% seen in 2009, but it would not normally be a matter for celebration.

However, the 'silver lining' identified by the blog back in August has continued to support margins. EU refinery operating rates remained low because of the increasing gasoline surplus. And so there was little pressure to increase cracker operating rates. In addition, there were further force majeures, helping to restrict over-supply.

However, the latest IEA data on refinery OR% indicates these are now rising. This would make sense, as Europe's refineries are primarily diesel-driven, and so rates usually increase as winter approaches. The scale of refinery operation dwarfs that of petchems, so producers will have to remain on alert for relatively small changes to have a major impact on their business.

But for the moment, the silver lining remains very welcome.

The obvious is rarely a winning strategy in commodity markets. Too many players have inside knowledge to allow anyone to profit from their own position.

But now and again, interesting trends do emerge from following how the major players are positioning themselves. Thus the above chart from Petromatrix provides a valuable insight into the different views being taken on oil markets by the Swap Dealers and the Large Speculators.

As it shows, the net length taken by Swap Dealers (green line) is now at a record low. These are the commercial dealers (eg Goldman Sachs), who have recently been producing daily reports forecasting $100/bbl crude. But they also act for the commercial players - the major oil companies. And so it seems most likely that it is these who have been hedging forward their positions.

Thus almost uniquely, the Large Speculators (red line) now hold all the net length on the US futures markets. These are hedge funds, who have been busy buying crude oil on the famous 'correlation trade', arguing that a lower value for the US$ means higher commodity prices as a store of value.

Initially, their buying caused the recent 7% rise out of the 'triangle shape'. But prices then drifted lower, as producers decided to lock in $80/bbl. And as Petromatrix note, this could cause problems for the Speculators, as producers may not simply close winning positions for a small gain.

The Speculators will clearly continue to try to push prices towards their beloved $90 - $100/bbl range. But if they fail, and prices start to move towards $70/bbl, then there is a clear risk the hedge funds will panic, and in so doing take prices down towards $60/bbl.

The styrene business has been increasingly difficult in recent years:

• CD and video sales went online, removing the need for polystyrene (PS) packaging
• Prices for the main feedstock, benzene, leapt in the mid-2000's, due to US gasoline market changes, forcing convertors to look at alternatives such as polypropylene
• Recycling became an essential part of the packaging 'offer', leaving PS behind
• Increased POSM/SMPO capacity meant styrene prices came under pressure

And one could go on.

The result has been, as discussed at our Conference last week, that the two 'inventors' of styrene, BASF and Dow, felt forced to establish new business models. Dow sold Styron to Bain Capital for $1.6bn earlier this year. BASF announced it would 'carve-out' its business as Styrolution from January 2011. And separately last month, Nova announced they would sell their share of the current INEOS Nova styrene joint venture to INEOS.

Now comes news that Styrolution will become a BASF/INEOS joint venture. Unlike Styron, it will not include the 'sexier' parts of the portfolio - such as expandable PS (widely used in insulation). Nor will it own the Nanjing activities in China. But, assuming anti-trust clearance, it will still be a €5bn ($6.8bn) business and large enough to control its own destiny.

Clearly Styrolution, like Styron, will have to do things differently in the future, if it is to regain a reasonable level of profitability. But both Roberto Gualdoni and Chris Pappas, the CEOs of the two new businesses, have solid track records in the petchem industry, and good teams alongside them.

The blog wishes them well, and hopes they succeed triumphantly.

China's Dalian futures market has become a hotbed of speculation over the past 2 years, since the government doubled bank lending to $1.4trn during 2009, equal to 1/3rd of GDP. Traders have particularly focused on the assumed linkage between LLDPE (linear low density polyethylene) and crude oil, with price movements mirroring each other most months.

But now there are signs the authorities are getting worried. Their concerns are focused on the agricultural sector, as speculative buying has helped cause food prices to rocket, in turn driving inflation to a worrying 4.4% in October. Thus the regulators have been told to "beef up supervision over the futures market to curb excessive speculation".

Hopefully, this will also dampen speculation in polymer markets, which have become a major factor in setting physical prices in China, as well as in Asia and globally. As the chart shows, LLDPE volumes (blue line) reached a record 93 million tonnes in November, nearly 4 times total annual global production.

Interestingly, however, Dalian's record volume did not lead to higher prices (red line), even though crude oil remained above $80/bbl. This may be the first sign that shrewder traders have decided it might be time to take profits and exit the market. Friday's decision to tighten monetary policy also suggests betting against the government is probably not going to be a winning trade.

Benzene is the blog's favourite leading indicator for chemical demand, due to its widespread use in the industry. Its recent price movements versus its naphtha feedstock, may therefore be telling us something quite important about changing supply/demand balances.

As the chart above shows, based on ICIS pricing, its spread versus naphtha has become very volatile in recent years. This is because, as discussed at our Conference last month, there are now no major sources of on-purpose supply to balance changes in demand. Thus although the spread used to be $80 - $200/t, it has usually either been above, or below, these levels since 2004.

Now in recent weeks it has suddenly halved, from $334/t in H1 to $169/t in Q4, to date. There appear to be two possible explanations for the change:

• Refineries have dramatically increased operating rates in Asia and Europe, due to diesel demand. In turn, this will be increasing benzene production.
• Crude oil prices have leapt to $90/bbl under the influence of the US Fed's QE2 Lifeboat policy. History shows this is a level when major demand destruction starts to occur, as consumers cut back on discretionary spending.

Of course, it could also be that we are seeing both these effects in combination. The blog will keep a close eye on future developments.

What happens if you suddenly double bank lending in a country, and make it equal to 1/3rd of total GDP? And, as part of the experiment, add a further 13% of GDP via a $580bn stimulus programme?

We don't know yet, because it has never been done before. But we are about to find out. Because this is what China has done over the past two years, since the Crisis hit, in order to keep its population employed.

The first part of the answer is easy to guess. A massive boom takes place in consumer spending, house prices leap, and demand generally goes through the roof. After all, we've been here before, with the US Federal Reserve's low interest policy following the collapse of the dot-com bubble.

But China's boom has been an altogether different level of magnitude. Even Alan Greenspan, when Fed Chairman, would never have dared to follow China's recent path. So all we do know, so far, is that China has become the main source of global demand growth for the chemical industry. Equally, as the chart shows, housing prices have soared.

According to an official survey by China's top Think Tank, the "actual value of commercial housing in Fuzhou is only 3,998 yuan ($600) per square metre, while the market price is 13,457 yuan". Its analysis suggests this is a 70.3% bubble, with other major cities such as Beijing not far behind.

Plus, today's figures show inflation is now rising very fast. It was 5.1% in November, up from 4.4% in October. Food prices were up an astonishing 11.7%. As the World Bank note in a new report:

"After the massive monetary expansion since the end of 2008 there is a lot of liquidity sloshing around, potentially putting upward pressure on prices, especially asset prices. In this setting, there are reports that speculative activity has driven up prices of several food products."

So will China now follow the Bank's advice and reduce lending, whilst also increasing interest rates? If they do, what will happen to growth rates? If they don't, how far might the housing bubble go, before it finally bursts?

As the blog noted in its Budget Outlook, the world has become a much more uncertain place over the past 2 years since the Crisis began.

Throwing money at the problem, as China is probably about to discover, is the easy part. The more difficult part, of dealing with the consequences of such rapid expansion, now lies ahead.

Oil price rises reduce chemical demand.

Initially, as we saw in 2007 - H1 2008, and in 1979 - 80, everything seems fine. Consumers continue to buy, and we all reassure ourselves that demand is still robust.

But, in fact, end-use demand starts to fall when prices rise, as individuals cut back on discretionary spending to pay higher gasoline and heating bills.

Europe's polyethylene market currently offers a clear example of this process in action. An excellent ICIS news report by Linda Naylor highlights how:

• "December monthly business is progressing normally".
• "But extra sales are reported at much higher price levels".

She also notes that buyers are "trying to obtain extra volumes in an effort to avoid higher prices in January", whilst "many sellers had taken the decision to hold on to inventories". As a result, LDPE prices for January are now talked €100/t ($130) higher than for December, with HDPE talked up to €160/t higher.

It is clearly impossible to stop this process, once it gets underway. Buyers are paid to buy below market, and sellers to sell above it, not the other way around. So if feedstock costs are moving higher, both sides have to react by building as much inventory as possible.

But demand for inventory is not the same as demand for consumption.

Crude oil prices have been rocketing lately. In turn, they have produced the seemingly 'strong' year-end for the chemical industry forecast by the blog in early November.

At this point, there is a clear divergence of view. The blog's bullish friends see this as a sign of a major recovery in demand, and confidently forecast prices over $100/bbl during H1. And, of course, Wall Street will no doubt remain very keen to continue booking its current profits from selling futures contracts to gullible pension funds.

But given the fundamentals of supply and demand, the blog is finding it more and more difficult to believe that prices can rise much further, with global inventories stuck at record levels.

Two arguments suggest we are getting close to the end of the rally:

• China is the major source of demand growth. But as Petromatrix note, its gasoline and diesel prices are at record highs, 41% above early 2008 (due to its 2009 move to better link prices to world levels). Whilst traffic congestion has now led Beijing to restrict new car sales to just 240k in 2011, one third of 2010 demand.
• Equally, the euro's weakness means that European prices are close to record levels. As the chart shows, they are at April 2008 levels of €70/bbl.

The blog is not yet quite ready, as in July 2008, to forecast that the bubble is about to burst, in the absence of geo-political factors.

But it is becoming more and more convinced that prices cannot stay at current levels without something extraordinary happening to either demand or supply.

The blog has gained important support for its view that oil prices are too high. and threaten the current economic recovery.

In an interview with the Financial Times, the chief economist of the International Energy Agency (IEA), Fatih Birol, has spelled out its view that "oil prices are entering a dangerous zone for the global economy."

The IEA estimates oil costs in the OECD richest countries have jumped $200bn to $790bn over the past year, reducing OECD GDP by 0.5%. The OECD accounts for 65% of all global oil imports, and Birol reminded OPEC that "oil exporters need clients with healthy economies. But these high prices will sooner or later make the economies sick, which would mean the need for importing oil will be less."

He also called for OPEC to increase production, in order to bring prices down to more sustainable levels, adding they need to "show their understanding that these high prices are not good for the global economy." Otherwise, he warned, current "price levels could bring us to the same financial crisis times that we saw in 2008."

US crude oil and product stocks have started the year where they finished in 2010. As the black dot on the above chart from Petromatrix shows, they are at yet another seasonal record. In terms of numbers, they are 101 million barrels above 2008 levels, and even 8 million barrels above last year.

It is clearly a nonsense that prices are still rising, when inventories have been so high, for so long. It is also bound to cause serious problems for the chemical industry when these stocks begin to be unwound, and prices fall.

In the short-term however, it is also leading to political instability in emerging economies, as food prices rocket. As the Financial Times has noted, "intensive agriculture is effectively the extraction of food from petroleum":

• India's government is facing serious problems over the rising cost of onions, an essential cooking ingredient
• China is now allowing vegetable trucks to travel toll-free on motorways, to try and keep costs down
• S Korea has released emergency supplies of cabbage, pork and other staples

The blog can't help feeling that this state of affairs can't continue for too much longer.

Last March, the blog highlighted the major changes taking place in ethylene, propylene and butadiene prices versus naphtha. It also analysed them in ICIS Chemical Business in September. The above chart now summarises the 2010 outcome, using European prices to enable comparison over the last 30 years.

It was a most remarkable year.

The chart shows the US$ 'spreads' of the 3 olefins versus naphtha, in real (inflation-adjusted) terms. It highlights how these remained within a $200 - $500/t range between 1992 - 2004. Before this period, ethylene had been the main price driver, with propylene and butadiene often seen as by-products.

The 2004-8 SuperCycle led to dramatic increases in these spreads, which then fell back to historical levels in 2009. But 2010 saw volatility rise again:

• Ethylene spreads (blue line) climbed to $551/t, due to feedstock shortages in the Middle East and ex-refineries in Europe.
• Propylene spreads (red) averaged $527/t, as US crackers turned to gas feedstocks, and operating rates for US/European refineries reduced.
• Butadiene spreads soared to a record $951/t, as output fell due to lower liquids-based operation on steam crackers.

In addition, of course, prices were supported by the rise in crude oil prices, as naphtha remains the main feedstock for olefin production.

This was remarkable enough, given that demand remained relatively weak in key sectors of the global economy, outside of China. But the combination of feedstock changes, and lower operating rates, led to both butadiene and propylene trading above ethylene for much of 2010. This has never been seen before on such a sustained basis.

The blog would feel more comfortable about forecasting a continuation of such trends, if they had been due to solid demand. But they were in fact mainly supply-driven, with OPEC quotas reducing ME feedstock availability, and lower gasoline demand reducing US/European refinery output. Equally, China's remarkable growth was due to massive government stimulus.

It will therefore be critical to see whether these trends can be sustained in 2011? Can polypropylene maintain its volumes at parity pricing to polyethylene? And what will happen to consumers' discretionary spending, which drives petchem demand, with oil prices at such high levels? The blog will continue to keep a very close eye on developments.

European operating rates (OR%) for ethylene averaged just 82% in 2010, according to APPE data this week. This meant there was no improvement over H1 OR%, suggesting the recovery from 2009's 76% OR% has stalled.

Of course, in terms of profitability, 2010 will have been a great year. The industry did its usual excellent job of passing through higher crude prices, whilst the low OR% led to tight propylene and butadiene markets, and strong co-product margins.

And so far, 2011 seems to have continued on a similar basis. But there are clear signs that it is becoming more difficult to pass through higher upstream costs:

• Prices for PVC, for example, a major ethylene user, are pegged by ICIS pricing at $1000/t, similar to January 2010, when Brent crude oil was $75/bbl.
• By contrast, PET prices, another major user, have moved up sharply over the past year due to tight supply conditions. But now, the Wall Street Journal is reporting that giants such as Coca-Cola are finding it very difficult to pass these on to end-consumers.

In the short-term, unrest in the Middle East is helping to support current crude oil pricing, just as Israel's threat to bomb Iran led them to peak at $147/bbl in June 2008. But in terms of the fundamentals of supply/demand along the value chains, today's oil prices are looking more and more out of line with reality.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

"Those in charge will continue to take small steps, but fail to step hard enough on the brakes. In turn, the current 'boom' in China's demand will continue to support the global chemical industry for the next few months. But clearly the risk is rising that we may then discover, too late, we have simply been in the middle of yet another China 'boom and bust' scenario."

The ICIS weekly margin reports continue to provide essential reading for anyone in the petrochemical value chain.

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

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

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

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

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

The IEA (International Energy Agency) is now very worried about the impact of today's high oil prices on the global economy.

Their chart above highlights the problem for the USA and EU. If oil prices average $100/bbl in 2011, then the EU (green column) will be paying more for its oil imports than in 2008, and the USA (yellow) nearly as much:

• The cost to the USA will be $385bn, 2.6% of GDP
• The EU will pay $375bn, 2.2% of GDP

As the IEA chief economist, Fatih Birol notes, this will cause a "serious problem for business and consumer confidence, which the U.S. economy desperately needs for sentiment to improve." Whilst the EU is also at risk, because "Europe is the weakest link in the chain of the global economic recovery."

Similarly, the Financial Times notes that "in the past - in 1974, 1979 and 2008 - sharp oil price rises have come shortly before recessions in leading advanced economies."

Update: The head of the IEA, Nobuo Tanaka, has told the Wall Street Journal that "financial speculation was partly to blame for sharp oil-price movements". And he went on to add that "the market is tightening because of economic recovery, but certainly speculation has a role and amplifies volatility."

Tanaka's comments support the blog's own view. Increased Chinese and Western demand are not the only reason why prices are at $100/bbl. There are still near-record levels of inventory around the world. And, as Tanaka also noted, "OPEC and Saudi Arabia have enough spare capacity and are ready to produce more".

February's data on US auto sales contained good news, and not such good news, for the chemical industry.

• The good news was that sales were relatively strong, as the chart shows (red line), although still below levels seen in the 2005-8 period (black line).
• And higher oil prices are supporting sales of more efficient autos. This should increase polymer sales, as steel and glass is replaced.

• The not such good news was that companies are still using heavy discounts to boost sales:
o GM continued to offer major incentives, plus cheap financing.
o Toyota was also offering large incentives, which will no doubt continue into March, as it seeks to counter news of a further 2.2 million vehicle recall.

This suggests the US auto industry is still suffering from a lack of pricing power, in spite of all the $bns spent in restructuring. This will not make it easy for chemical companies to push through further feedstock-related increases for its raw materials.

The blog's recent visit to Singapore included several discussions about the slow start to the New Year in China. And these concerns were confirmed last week in the downturn reported by the OECD's leading indicators for China (Organisation for Economic Co-Operation and Development).

Separately, as the chart shows, the Baltic Dry Index of ocean freight costs is signalling a similar trend. It is an excellent proxy for world trade and activity in China, as it covers the heavy bulk products (iron ore, grains, coal).

It was strong through 2007/8, before collapsing. And it then rallied again until last June. But since then it has fallen quite sharply, and is now very close to its earlier lows in Q4 2009.

Of course, part of its weakness relates to the terrible floods in Australia earlier this year. These clearly reduced coal and other volumes. But it has since shown little evidence of recovering, which is not a good sign. The blog will continue to monitor developments closely.

Japan's prime minister has described the current situation as "the country's worst tragedy since World War 2", whilst the emperor has said he is "deeply worried".

Certainly, never in our working lives have we faced the combination of an earthquake, a tsunami and a potential nuclear meltdown - all taking place in the world's 3rd largest economy.

We cannot, therefore, expect to know what will happen next, or how things will resolve themselves over time. Equally, we cannot yet be clear on the potential second-order effects that will occur, even though these could also have enormous impact on the chemical industry.

Today, the blog therefore simply wants to try and record, as objectively as possible, some key facts as we know them. It will also suggest some possible Scenarios that companies might use to help navigate through these difficult times.

The map above, from the Wall Street Journal, is also a good summary of key areas.

Equally, ICIS news and the Insight team are doing a superb job of trying to keep up with developments. Whilst my blogging colleague John Richardson is also highlighting key developments as they happen.

Energy markets
• We are already seeing major impact in this crucial area. 5 refineries (capacity 1.2mbd), and 11 nuclear plants, are currently offline in Japan. We have no idea when they may return. And, of course, the Fukushima Daiichi Nuclear Power Station remains in a state of emergency.
• This loss of power will not be restored quickly. Already the Tokyo electric company has begun "rolling blackouts" to conserve energy, and it expects these to continue until at least the end of April. This will impact all forms of manufacturing, as well as individuals.
• Japan's loss of capacity means its imports of LNG (liquefied natural gas) and distillate are already beginning to increase. This pushed up European LNG prices by 7% on Monday. Equally, it means refineries elsewhere will focus on distillate production. For petrochemicals, this could mean naphtha will become cheaper, as global gasoline demand will likely remain weak.

End-user markets
Autos: All Japan's auto factories are currently shutdown. This is the first time this has ever happened. Some, such as Toyota's, are now expecting to restart. But nobody can know whether vital components will be available, given the complexity of the various supply chains.
There may well be second-order impact in other regions, because of the supply chain issues. Toyota, for example, has already slowed production in the USA. In Europe, BMW is worried about supplies of electronic displays and navigation systems.
Housing/construction: There could well be a boom in construction, once the current crisis is over. Large numbers of houses and other buildings have been destroyed. But this will also depend on the wider state of the economy. If this weakens further, then major cities might see lower demand for office space, stores and hotel rooms.

Petrochemical/polymer markets Japan is a key supplier of products such as paraxylene and styrene, as discussed on Monday. It may not be easy to immediately replace these exports.
Equally, China relies on Japan for 13% of its imports, whilst Japan is a key supplier of advanced components to Asian nations that specialize in the final assembly phase of manufacturing.
Again, therefore, the key issue is potential supply chain disruption, where the lack of one, perhaps small, component, might stop production on a temporary basis till replacement sources can be found.

Financial markets.
Investors have grown used to central banks 'rescuing' us from crises in the past. But events such as the Asian and Russian Crises in the late 1990's, or the current Western financial crisis, are not the same as the widespread loss of life and the destruction of property and factories. The Bank of Japan can provide liquidity to help companies pay their bills. But it cannot wave a magic wand and rebuild what has been lost.
Equally, the cost of reconstruction, perhaps $200bn, will impact Japan's historical role as a supplier of capital to other Regions. It is one of the largest holders of US Treasury bonds, but probably it will need to sell some of these to finance reconstruction. Equally, it had promised to fund 20% of the proposed European bailout fund - but can it still afford to do this?

Plus, of course, we should not forget that this is not the only crisis that we currently face. Major problems continue in the Middle East and N Africa. Saudi troops had to go into Bahrain earlier this week to try and restore order. Whilst it also seems that the blog's fears of potential civil war in Libya may be coming true. Inevitably, however, the crisis in Japan means the world has less attention span and capacity to deal with these.

How should companies respond?Somehow, we have to find a middle way between panic and complacency. One way of perhaps achieving this might be to think in terms of different timescales:

• Short-term recovery. Let us hope that the nuclear issues will be resolved quickly, and that Japan might be on a path towards recovery and reconstruction within a few weeks. Equally, that other second-order impacts are relatively minor.
• Medium-term rebuilding. Perhaps this will not all happen within a few weeks, but may take some months to set in motion. Clearly, the risks of disruption will therefore be higher, plus the potential impact on markets elsewhere.
• Long-term damage. Suppose our worst fears are realised, and a nuclear meltdown does occur? Hopefully, this is a very minor probability. But if it were to occur, it would become such a major priority, that moves towards recovery and reconstruction could be significantly delayed.

Every company will have its own version of these potential Scenarios. Sharing these views internally, and externally with key partners in the value chain, might be very valuable, as something seemingly obvious to one business area or company might be a total surprise to another.

The above are the blog's own thoughts on some of the key issues, as they appear today. The facts reported come from sources known to be usually accurate, but of course nothing can really be guaranteed in today's circumstances. It hopes readers might find them helpful, and will try to update them as the situation develops.

EU auto sales remained weak in February, and dependent on just 4 countries. As the chart shows (red line), they followed January in being at the bottom of historical monthly sales. Overall, January and February were down 0.3% versus 2010, with 2 million autos sold:

• German sales were up 16% at 435K; France was up 11% at 390k, The Netherlands was up 24% at 124K, and Belgium up 10% at 106K.
• These 4 countries were 52% of total EU sales, up from 46% in 2010.
• The other 3 of the 'Big 5' markets continued to see major downturns - Italy down 21% at 325K; UK 10% at 192K; Spain 26% at 120K.

Equally worrying for chemical and polymer companies are the signs that the Japanese disaster is likely to lead to weeks, if not months, of supply chain disruption. Many auto and component factories there remain shutdown, and power outages look set to continue into April.

This will have some bright spots eg Toyota Prius prices are rising in the USA, as supplies ex-Japan run low. But GM has announced a complete ban on "non-essential spending" - the usual first sign of a major problem. It had already announced shift-cuts at 3 factories in the EU/USA, whilst Renault has cut production in S Korea, and Volvo has warned of potential major disruption.

The issue is that today's auto supply chains often depend on high-value electronic components, manufactured in Japan. Without these, the cars themselves cannot be assembled, even if all the other parts are still available.

Something very strange has been happening to US energy prices over the past 2 years. The chart above shows the ratio between WTI crude oil pricing and natural gas:

• It was between 6.0 and 13.0 for 22 years between 1986-2008, with some minor exceptions, and averaged 9.9.
• Yet since January 2009, it has been between 9.0 - 25.0, and averaged 18.3.

WTI has ~6 times the energy content of natural gas. So its floor at 6.0 makes good sense. Equally, there were periods of supply disruption between 1986-2008, such as Gulf War 1 in 1990.

But there is no logic behind the dramatic increase in the ratio since 2009. Crude oil inventories have never been higher, in either the USA or globally. And there is plenty of spare capacity, if supplies were to go tight.

The real reason is the easy money policies of the central banks, particularly the US Federal Reserve. These have combined with the development of super-fast computers, which now dominate much financial market trading.

As Bloomberg note in an excellent article, "as shares have been traded more furiously, the stock market has become more volatile, more disruptive and less useful". The blog's friends in energy markets see the same trend of increased volatility - last Friday, naphtha prices traded in a $25/t range!

In the short-term, Libyan oil seems likely to be removed from world markets by the current UN action. But Saudi is already pumping 8.9mbd, according to latest reports. And OPEC quotas have effectively been abandoned.

But as long as the US Fed provides the cash, the super-computers will party on:

• Today's high prices are causing demand destruction down the value chain.
• Yet chemical companies have to buy forward, as long as feedstock prices are rising.

The risk, of course, is that one day, the Fed may turn off the liquidity tap and stop the super-computers' party. Then we could easily suffer another period of major destocking, similar to that of H2 2008.

The blog has worried for some time about the growing dominance of super-computers in financial markets. Their activities are based on arbitrage between markets, not on fundamental analysis. And their power means that no financial market now knows what it is actually pricing.

The headlines above, from today's Bloomberg Energy page, highlight the issue. Even Bloomberg's experienced editors and reporters are now totally confused by what the markets are doing. Thus they report that:

• Oil prices retreated 0.6% on worries of lower Japanese consumption
• Oil prices increased 1.6% on hopes of higher Japanese consumption

All that has really happened is that the super-computers had spotted a brief opportunity to make money by forcing prices down for a nano-second or two, after forcing them up previously.

This is a very dangerous situation for anyone, like the chemical industry, who depends on markets for price discovery.

UPDATE: This afternoon, a leading US Fed Governor, Richard Fisher, said he thought the Fed's actions had produced "extraordinary speculative activity", and added that "there is an enormous amount of liquidity sloshing around the US economy." Its just a pity he only recognises this now, after the damage has been done.

The blog has built great loyalty amongst its readers. 24% visit it twice a week.

Recently, as during the 2008 financial Crisis, it has gained many new readers. They also want to better understand developments in the Middle East/N Africa (MENA), Japan, China, and oil markets, and what these might mean for future chemical demand.

The blog continues to believe that the key feature of today's world is "uncertainty". New readers might therefore like to read the blog's New Year Outlook, Planning for Uncertainty, and its recent White Paper 'Budgeting for Uncertainty' (click here for free download).

Recent key postings also include:

• The Potential Impact of the Japan Disaster, plus key exports
• Oil prices - the Libya factor, plus analysis of key exports
• Young populations lead social unrest in MENA
• Housing markets remain uncertain (plus US, UK, China markets)
• US auto companies lack pricing power, plus EU auto sales
• Super-computers party in financial markets, and speculation
• China's "60% risk of a banking crisis by 2013"
• ExxonMobil sees Integration as key strength

The blog's New Normal concept highlights the major demographic changes underway. It believes these will create new global demand patterns, and new growth opportunities, for those who recognise them:

• New Normal Seminar conclusions, plus P&G's and Dow Corning's successes with Shared Value
• Prof Michael Porter's Shared Value concept, as a driver for the next wave of global growth

The blog's recent Asian visit revealed considerable anxiety about the state of demand in China. As its blogging colleague, John Richardson, has also described, the country's lending cutbacks may finally be taking effect.

New official figures for lending and electricity consumption support this view. These are two of the only 3 figures trusted by likely future premier Li Keqiang. He described GDP numbers as being for "guidance" only.

And as the chart shows, both lending (red column) and electricity consumption (blue line) were down in February. Of course, part of this was due to Lunar New Year. But even so, total lending in Jan/Feb was down 24% versus 2010, a quite remarkable fall. Electricity growth also seemed to slow, up 'only' 11% compared to 2010's 28% rise.

Last week, further signs appeared that a 'pause' may now be underway:

• ICIS's Linda Naylor, one of the most trusted observers on the polymers scene, reported offers of Chinese polyethylene (PE) into Europe at €100/t ($143/t) below current prices.
• Earlier, ICIS's Fanny Zhang in Shanghai had reported ethylene sales underway from the Fujian JV, due to "high inventories".

Polyethylene is THE leading indicator for chemical demand in China. Not only is it the world's major polymer. But it has also been the focus of the massive speculation on China's Dalian futures exchange.

Equally, China's supply/demand balances mean that in normal times, it should always be an importer of both ethylene and polyethylene. In 2010, it was the world's largest PE importer at 4.9 million tonnes, according to Global Trade Information Services data.

It is probably still too early to be sure that today's 'pause' will continue. But if the blog was still running a major business, it would certainly be updating its ideas on how to mitigate a Downside Scenario, just in case.

Sadly, the blog needs to update its March 16 post, which analysed the potential impact of the Japan disaster.

Earlier hopes of a quick end to the problems have proved false:

• 250000 people are now in refugee accommodation
• The death toll is still rising, and is likely to reach at least 18000
• The head of the International Atomic Energy Agency says we are "still far from the end of the accident" at the Fukushima Daiichi nuclear plant.

Some in financial markets seem to regard current events as a 'buying opportunity'. But the blog disagrees:

• Japan is the world's 3rd largest economy, and its electronics industry powers much of the equipment we now take for granted in our personal and working lives
• Container shipping companies including Hapag-Lloyd and OOCL have stopped calling at Tokyo and Yokohama
• Radiation was found on a Mitsui OSK ship that had been 80 miles (128km) from the problem area
• Europe's auto suppliers association fears "the return to normal production levels may take months, and cost €bns of lost revenue"
• Bosch, the world's largest component company, says "it can't predict whether it will be able to secure component supplies beyond the end of this week".

As the Wall Street Journal map above shows, the US has now set a much wider evacuation zone (red dots) than the Japanese government (black dots). The US Navy was told Friday to stay 100 nautical miles away from the Fukushima plant, and yesterday the US embassy began handing out potassium iodide tablets in Tokyo.

And, of course, the problem of rolling electricity cutbacks across Japan continues. People have cut down heating, and train services have been cancelled, to try and conserve power. But damaged refineries and wrecked power stations cannot be replaced quickly. Whilst European and Asian diesel fuel prices have jumped 20% as a result of the crisis.

In terms of the Scenarios outlined on March 16, it now seems unlikely that we are going to see a Short-term Recovery Scenario. This has potentially very serious implications for industry:

• Many companies operate within extended global supply chains. It is therefore not easy to determine what components might be impacted. China, for example, is often the final assembler of goods for the West, but Japan is the key supplier in terms of the critical components.
• Some companies, such as Hewlett Packard and GM, have been well aware of the risks since the disaster began. But many may have been lulled into complacency by official statements.
• Japan pioneered the Just-In-Time approach to manufacturing. No shortages of critical components have yet been reported, but they may well now start to occur, as current inventories are exhausted.

Companies therefore need to quickly establish high-level Action Teams, reporting to senior management. Their remit should be to understand the implications of a move into either the Medium-term Rebuilding or (hopefully never to be needed) the Long-term Damage Scenarios.

We can, of course, all hope that a quick solution to current problems may be found. But in today's increasingly uncertain world, Boards will know that hope is not a strategy, or a sensible contingency plan.

Last November, the Chairman of the US Federal Reserve justified his $600bn QE2 programme to boost financial markets by claiming "higher stock prices will boost consumer wealth and help increase confidence", whilst also leading to "lower mortgage rates".

And stock prices have indeed risen. As the above chart from PetroMatrix shows, there has been an 86% correlation between the QE2 $600bn POMO purchases (Permanent Open Markets Operations, green column), and the S&P 500 stock index (blue line). Investors have also increased Margin Debt which, at $350bn, is now back to pre-financial Crisis levels.

But whilst the Fed's money has boosted financial markets, consumers are losing confidence. The key Univ of Michigan index fell a near-record 10% last month. Consumers are not stupid, and know they will have to pay the bill for the Fed's actions via higher taxes and spending cuts:

• In addition, of course, they are being hit hard by the rise in oil and gasoline prices. These have risen via the 'correlation trade', as traders use the Fed's low-cost money to speculate in commodity markets.
• Plus, by openly encouraging this move into risky assets, the Fed has actually caused interest and mortgage rates to rise.

Now we have to wait to see what happens next. Most investors are hoping for a 3rd round of liquidity to be unleashed, once QE2 ends in Q2. But some Fed Governors are now publically questioning its rationale.

The problem is that the damage has already been done. QE3 would lead to higher oil prices, and further depress consumer confidence.

But doing nothing would be equally painful. If oil prices returned to more realistic levels, for example, demand would suffer in the short-term as the Value Chain destocked, plus companies would face major losses on working capital.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

As Bloomberg note:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Please click here if you would like to see it.

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

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

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

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

Sadly, therefore, the blog sees no reason change its December view that China is between a rock and a hard place in terms of policy options. It feared then that:

"Those in charge will continue to take small steps, but fail to step hard enough on the brakes. In turn, the current 'boom' in China's demand will continue to support the global chemical industry for the next few months. But clearly the risk is rising that we may then discover, too late, we have simply been in the middle of yet another China 'boom and bust' scenario."

The first signs of this bust may now be emerging. An excellent ICIS Insight analysis by my blogging colleague, John Richardson, suggests "sharp corrections are on their way" in many key petchem markets. Its title says it all - "Events in China could signify dark days ahead".

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

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

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

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

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

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

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

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

A month ago, the blog suggested that chemical companies would "report excellent results for Q1". Its regular quarterly round-up, below, shows this expectation has been confirmed.

The blog was also pleased to see Huntsman CEO, Peter Huntsman, warn about the growing risks from high oil prices, unemployment, and economic fragility. As it noted last month, the history of the past 40 years shows high oil prices have always led to:

• An initial boom in volumes/margin as buyers rush to secure supplies
• Then a period of severe destocking, once oil prices stabilise

Sadly, many analysts only focused on the immediate short-term benefits. Some even upgraded their forecasts, on the assumption that good times are here to stay. The blog hopes they may prove correct, and that 'this time is different', but would not invest its own money on this basis.

Akzo Nobel. "Pricing and cost reduction actions are ongoing to mitigate the impact of higher prices".
Arkema. "Acceleration in the group's growth and its ability to pass on raw material cost increases through sales prices".
Ashland. "Our pricing actions enabled us to maintain overall margins sequentially despite a significant increase in raw material costs".
BASF. "What we have now on our books gives us some visibility for the next two months".
Bayer. "Expects to be able to pass on the raw material cost increases to its customers by raising selling prices."
Celanese. "Strong demand, combined with excellent execution of our strategies, more than offset rising material costs".
ConocoPhillips. "High olefins and polyolefins margins".
Dow Chemical. "Significant sales increases across all geographies and all operating segments through rigorous price and volume discipline".
Dow Corning. "Q1 profits were softened by sharply rising materials and energy costs".
DSM. "Improvement down to the company's focus on innovation and its global customer base".
DuPont. "Our science-powered innovation, keen focus on customers and disciplined execution contributed to delivering outstanding results".
ENI. "Improvement in product margins, mainly in the olefins business".
ExxonMobil. "Record chemical performance though volumes fell 3%".
Huntsman. "Express caution regarding the macro-economic conditions of high oil prices, stubbornly high unemployment rates, and the fragility of the US and European economic recovery,"
INEOS. "Monthly olefin pricing ensured the recent increases in raw material costs were passed on fully in the quarter".
LyondellBasell. "Margins increased in nearly all businesses despite significant raw material pricing pressures".
Methanex. "Demand continues to be strong and industry conditions remain relatively balanced".
Occidental. "Profits surged due to strong export sales, high margins and lower energy costs".
Olin. "Expected Q2 to be better than Q1, reflecting continual uptrend in pricing and sales volumes".
Orlen. "Macroeconomic factors connected with the increase in petrochemical margins".
PetroChina. "Offset any losses from the impact of high and volatile crude oil prices by leveraging fully into its refining and chemicals operations".
PPG. "Construction activity in developed regions remains low with no signs of imminent improvement".
Reliance. "Earnings and sales increased by 18%".
Rhodia. "Global economic growth should remain strong throughout the year, driven by sustained demand especially in fast growing countries".
SABIC. "Q1 profit jumped 42%, due to increased production and sales volumes, and an improvement in sales prices".
Shell. "Realised higher margins and sold more volume".
Sherwin Williams. "US domestic demand remains soft".
Sinopec. "Oil rose continuously, and domestic demand for natural gas, refined oil and chemical products grew steadily."
TOTAL. "Improvement was driven mainly by the improvement in the petrochemicals environment".
Westlake. "Abundant supply of shale gas production makes US ethylene derivatives globally competitive".
Yara. "Improved fertilizer prices linked to tight agricultural markets have more than compensated for increased energy costs from last year".

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

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

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

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

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

* Thanks to Barbara Ortner and Harriet Bourne for the research

They don't ring bells at market turning points. Otherwise, we could all retire to the Bahamas.

But there is growing anecdotal evidence, from chemical buyers and the main retailers, that we may have reached at least a temporary market peak. And Brent crude oil has been stable for 4 weeks at $125/bbl.

Equally, since 1970, sustained periods of oil prices above $50/bbl in real terms ($2011) have always led to economic downturns. Some may hope that 'this time it may be different', but the blog prefers Einstein's famous phrase that "the definition of insanity is doing the same thing over and over again and expecting different results".

Therefore the blog is launching its Downturn Alert. This shows the percentage change in prices recorded by ICIS pricing since the start of the year in 4 main markets: Brent crude oil; benzene in North West Europe (NWE); high density polyethylene blow moulding grade exports in the US Gulf (HDPE USG); terephthalic acid imports to China (PTA).

As one would expect, the first report shows a mixed picture:

• Brent prices (red dotted line) are up 32% from $95/bbl
• HDPE USG (purple) is up 31% at 74.5c/bl ($1642/t)
• Benzene NWE (orange) has rallied, but is only up 13% at $1310/t
• PTA China (blue) has fallen since March, and is up just 4% at $1330/t

HDPE seems the most optimistic market, as its jump last week means it has matched the rise in Brent. But ICIS pricing report that "spot exports are becoming decreasingly viable" versus supplies from the Middle East, China and South East Asia. The price move therefore seems more supply-related than consumer-driven.

Equally, the failure of both benzene and PTA to pass through the latest rise may turn out to be particularly significant:

• Benzene prices have jumped 375% since January 2009, versus Brent's 175% rise. But benzene is now down $85/t versus its February peak.
• PTA China prices have been falling steadily since March, and are now $200/t lower at $1330/t.

Markets, of course, have a habit of surprising. But as we saw most recently in 2008/9, the combination of destocking with a downturn in final demand, can have a devastating impact on the chemicals industry. Thus the blog will keep a close eye on developments in coming weeks.

Financial markets have been fired up over the past 2 years via the arrival of high volume computerised trading. This now dominates market action. And until recently, the US Federal Reserve was happy to finance this activity, via its $600bn QE2 programme.

The Fed's aim was to generate inflation, and so avoid the risk of following Japan's deflationary path since 1990. 'Making sure it doesn't happen here' was, after all, the title of the speech that catapulted current Fed Chairman, Ben Bernanke, into the limelight in 2002.

But, of course, the Fed also has a specific mandate to control inflation. And politicians know that voters become upset when energy and food prices get out of control. Thus it seems unlikely that the Fed will be allowed to proceed with QE3, when QE2 ends next month.

Significantly, therefore, we are now seeing the first divergence in 2 years between stock market performance and that of crude oil. As the chart shows, the main US stock index, the S&P 500 (red line), has failed to follow Brent crude oil (black line) higher since March.

The divergence is now quite striking. Brent is up 50% since January 2010, whilst the S&P 500 is 'only' up 23%. This suggests that equity investors have already begun to recognise that something very important may have changed in financial markets.

If it has, and liquidity is really going to be withdrawn, then crude oil prices could end up very much lower, as traders exit the market. As the blog warned back in October - once the QE2 Lifeboat party has ended,

"and the computers have been shut down for the night, it will be the real world of the chemical industry that will have to pick up the pieces.

There seems little doubt that China is increasingly worried by rising inflation.

The latest sign is Unilever, the giant consumer products company, being fined $300k (RMB 2 million), for discussing plans to increase prices due to higher raw material costs.

Those who can remember the US WIN (Whip Inflation Now) programme, or the UK's Prices and Incomes Board, will know what happens next.

Shortages will develop as companies refuse to sell at a loss. And China's position may be worse than the USA/UK's, as its army of small stallholders may instead start selling on the black market.

The incident also highlights worrying aspects of consumers' buying behaviour:

• Many supermarkets saw shelves cleared of soap, detergent and shampoos, as shoppers rushed to stock up before prices rose.
• This is the same pattern seen recently amongst chemical buyers, who have panic-bought in order to secure supplies as oil prices rose.

It therefore appears that inventories are well above normal, all along the value chain, even in China. This makes the blog question yet again, the widely held belief that the recent combination of higher prices and strong demand indicates a robust global economy.

Update: China reported today that inflation slipped slightly to 5.3% in April, whilst food price inflation stayed worryingly high at 11.5%.

The blog launched its Downturn Alert last week, since when we have seen dramatic moves in oil markets.

These may well lead to a slowdown in chemical orders, as buyers now have no need to secure supplies ahead of price increases, and may instead start reducing inventories to more 'normal' levels.

• Brent (dotted red line) is now up 24% since 1 January, versus 32% a week ago
• Benzene NWE (yellow) is up 14% versus 13%
• HDPE USG (purple) is up 25% versus 31%
• PTA China is back at 1 January levels, versus up 4%

The PTA move since the end of March is highlighted on the chart, as it may turn out to be a leading indicator for other products.

ICIS news also reported the following comments from a European PE trader on the new mood in the market:

"Suddenly there is much more availability in the market. Although producers might not be under so much pressure to sell, resellers are pushing volumes and cutting their losses. Buyers sense it, and so they wait. We offer reductions of €30-50/tonne to consumers, and they still want to wait for another few days before they buy".

The blog was very interested to see a recent ICIS interview with Torsten Penkuhn, BASF's petchem head in Asia, by Will Beacham. Penkuhn noted:

"We are more and more concerned at BASF about an increasing risk of overbuilding once again. We currently see a risk that people are becoming too ambitious, enthusiastic and optimistic. And that could lead us to where we have already been in this industry.

"Industry has a responsibility to look at cycles as man-made: we create them, they are not thunderstorms. I feel optimistic that people are able to learn from the past."Penkuhn was much more cautious than Dow about the short-term outlook in China, noting that:

"Underlying GDP growth in China is around 9%, with chemical industry growth perhaps into double digits. But if you look at Q1 results, you see 15-20% sales growth. So there is an underlying speculative element which comes from an anticipation of shorter availability of credit. There has been some pre-production by people worried about their credit lines being withdrawn."

Penkuhn also seems to share the blog's view that government efforts to control inflation will have a negative impact on China's manufacturing growth. "They cannot have inflation above 5% and they need to cool their economy".

A thousand years ago, the Viking King Canute had himself carried into the sea by his courtiers. He was the most powerful king of his time. But by showing that he could not turn back the incoming waves, he hoped they would understand that he was not all-powerful.

This is a lesson still to be learnt by European policymakers, including those at the European Central Bank (ECB). They continue to try to turn back the tide of debt restructuring in Greece, Ireland and Portugal.

Thus the EU Commission has told the European Parliament that Greece must not restructure its debts, because this would have "devastating implications" for Greece and the euro area. Whilst the ECB has said it would be "political suicide which would lead to poverty".

But if Greece clearly cannot repay this debt, pretending it cannot happen, helps nobody. Have policymakers not learnt the lesson from US Fed Chairman Ben Bernanke's experience, when he said in July 2007 the sub-prime crisis would only cost $100bn?

The problem, as the blog discussed back in December, is that the EU cannot have monetary union without fiscal union. Hopefully, the current talk from policymakers is just a smokescreen, whilst they develop a proper action plan. But if it isn't, and they really believe they can turn back the tide, then markets might have an very unpleasant shock ahead.

The blog is delighted to announce the title of its new eBook, jointly authored with fellow blogger, John Richardson.

It explains how Western BabyBoomers are changing chemical demand patterns, again. We believe it will become vital reading for all those working in the global chemical industry.

The first chapter of the book will be published online by ICIS next week. John and I look forward to bringing you more details then.

Q1 results were very good. But do they mean we are in a SuperCycle, as some analysts have suggested?

In a major 3 page article for this week's ICIS Chemical Business, the blog looks in detail at the risk from developments in China, Japan, the debt crisis and high oil prices.

It concludes that the outlook is most uncertain, and recommends that chemical companies develop robust contingency plans, in case H2 disappoints.

Please click here if you would like to download a free copy of the article.

Two years ago, the blog began to survey global stock markets on what turned out to be the day they began their major rally.

Its end-April launch of Downturn Alert may prove similarly fortuitous. Since then (shaded area), Brent crude oil is down 8%. Similarly naphtha is down 11%, benzene down 2%, HDPE 6% and PTA down 9%.

The chart shows prices since 1 January:

• Chinese PTA prices (blue line) are now 5% below January levels, after what ICIS pricing described as "panic selling" on Thursday.
• Brent (red dotted line) and HDPE USG (purple) are falling together, having risen together.
• In Europe, ICIS pricing reports on benzene that with "cheaper feedstock available, reformers are being run harder, which means that there is more material available".

Clearly buyers will no longer be rushing to secure supplies, with these price movements taking place.

It is still too early to be quite certain, but the blog's feared downturn is probably now getting underway. If it was still running a major chemical business, it would be asking the management team to check that the contingency plan is as robust as possible.

Today, the blog is proud to publish the first Chapter of its new eBook:

'Boom, Gloom and the New Normal: how Western BabyBoomers are changing global chemical demand patterns, again'

It is co-authored with ICIS' John Richardson of Asian Chemical Connections.

A new chapter will be published each month. Please click here for Chapter 1. We hope this will help to build discussion about its key messages.

These are as follows:

• It is most unlikely that we will quickly return to the Golden Age of chemical consumption between 1990-2008
• This was driven by the enormous purchasing power of the Western BabyBoomers (those born between 1946-70)
• They were the richest, and largest generation that the world has ever seen. But they are now moving into the 55+ age group, when people typically save more and spend less
• This is already impacting key sources of chemical demand, including housing and autos. These will not recover to previous peaks
• Equally, the age of outsourcing production to the emerging economies is also coming to an end
• Western demand is reducing, not growing, so there are no longer any capacity constraints to be overcome
• Instead, Western and emerging economies need to adapt to the New Normal, and its very different demand patterns

The eBook argues that the next wave of global growth will not be a simple replica of the past 25 years. Instead, it will require major innovation in business models and technology.

The industry will need to develop a sustained focus on key megatrends such as increasing food supplies, water availability and life expectancy, whilst reducing carbon footprint.

These represent major challenges. But the industry faced similar challenges in the 1970's, and overcame them to launch the Golden Age.

We hope the new eBook will prove valuable for everyone currently working in the global chemical industry. Please click here to download a free copy of Chapter 1. John and I look forward to your comments.

US housing used to be one of the largest chemical markets in the world. In 2006 it was worth $35bn, with 2.2 million new homes each using $16k of chemicals, according to American Chemistry Council (ACC) estimates.

Yet as the chart above shows, it has completely failed to recover since the financial crisis began:

• Last month, housing starts (purple) were just 523k
• Building permits (red) were only 575k

Yet April should be one of the strongest months in the year, as the weather improves and people think about moving home.

These figures prompted an interesting question to the blog from a major investor this week. He asked, 'how can we see a proper recovery in the US economy, if housing doesn't recover?' Its a good question, and one that has so far not been widely discussed.

Instead, most continue to believe a recovery is just around the corner. The excellent ACC weekly report, for example, reports today that the consensus view amongst leading US economists is:

• Housing starts will total 620k this year, and rise 39% to 860k in 2012.
• 6 months ago, however, the same economists forecast 780k starts this year, and 1.44 million in 2012.

This suggests, to the blog at least, that the forecasters are in denial about what is really happening in the housing market. In turn, of course, this raises question marks about likely future levels of US chemical demand.

John Richardson and I set out to tackle this key issue in our new eBook, 'Boom, Gloom and the New Normal', to be published on Monday.

Q1 saw near record margins for European petchem producers. And there was also a scramble for product, as buyers rushed to secure product ahead of feedstock price-related increases.

But this remained a supply-led market. As the chart above shows, based on APPE data, Q1 production (red triangle) was just 5.1 million tonnes. It was slightly above 2010 levels (dark red line), and the dreadful Q1 2009 figure (blue). But it was 7% below the average Q1 volume of 5.5MT between 2003-7.

The reason, of course, continued to be the lack of demand for refinery output. This meant feedstock supply was lower and cracker operating rates (OR%) remained low at 82%. And so the surge of demand did not lead to any increase in production.

But is this situation stable? The blog thinks not. It is the difference between real and perceived demand:

• Real demand is when the consumer feels confident, and has discretionary income to spend on products that contain chemicals
• Perceived demand is when buyers rush to beat price rises, whilst consumers suffer a loss of discretionary income as oil prices rise

The blog was speaking at the World Refining Association's global petrochemical conference last week, and raised this issue during the Q&A. Worryingly, it still does not seem to be widely understood. And yet it means we risk a repeat of the Q4 2008 downturn.

Real demand seems unlikely to increase in the next few months, as austerity programmes start to bite, and the summer holiday season approaches. Thus considerable destocking may well lie ahead, all down the value chain, before current inventories rebalance with real demand.

It is now 4 weeks since the blog launched its IeC Downturn Alert. Since then, as the chart shows (based on ICIS pricing reports):

• Brent (blue dotted line) is down 11%
• Naphtha (red) is down 13% in Europe
• Benzene (green) is down 9% in Europe
• HDPE export (purple) is down 7% in the USG
• PTA import (red) is down 9% in China

These are serious price declines. They support the blog's fears that buyers have now retreated to the sidelines.

Downturn Alert was introduced to provide chemical companies of an early warning of a slowdown, after the euphoria of Q1's excellent results.

Of course, prices may still rally. But for the moment, the Alert is suggesting we may now be at the start of the downturn that has always followed previous periods of high oil prices.

The blog is excited about its first New Normal seminar in Frankfurt, Germany next month.

It follows February's successful launch in Singapore, and is being held in association with ICIS, on 16-17 June.

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

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

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

But now, they are entering the 55+ age group, when people normally save more and spend less. This is already having profound effects on demand patterns in autos and housing in the West. Whilst emerging countries now need to replace their export-driven economies with domestic consumption.

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

Volume is a key driver for chemical company profits. High volume means operating rates increase, reducing unit costs. Companies also gain more pricing power.

But when volume is low, the reverse happens.

Thus the above chart from leading analyst Paul Satchell of Collins Stewart is telling an important story. It shows:

• Volumes were very strong from December, as buyers bought forward ahead of price increases
• But since mid-May, he is seeing "a sharp downturn" as buyers start to destock again down the value chain

Satchell says this trend is common across all 3 major consuming regions, and all 3 major petchem groupings:

• Asia is the weakest region, followed by Europe and the USA
• Aromatics are weakest, followed by olefins and polymers

Satchell concludes that "material weakness is volume has begun", with the most likely cause being destocking. He adds that "there are real risks to actual volumes traded in the short-term".

Satchell's analysis supports the blog's own belief that we are following the path of 1973/4, 1979/80, 1990/1 and 2007/8. As oil prices plateau, we first see buyers destock to a supposedly more 'normal' level of inventory. This will probably last over the summer period.

Then, from September, we may well find, much to our surprise of course, that higher oil prices have actually reduced demand - just as they have always done in the past.

Week 5 of the IeC Downturn Alert saw more stability in the markets. This was largely due to the efforts of the major investment banks. JP Morgan, Goldman Sachs and Morgan Stanley all issued 'buy' notes on crude oil, suggesting prices would soon return to $130/bbl, whilst Barclays said its current $102/bbl forecast was "conservative".

These banks have been active in persuading investors that commodities are a safe investment asset. Their profits would take a hit if this confidence was ever shaken. But as the chart shows, they achieved relatively little 'bounce' in the markets, despite 'wall-to-wall' coverage of their views in financial media:

• Brent (red dotted line) rose only $3/bbl in a quiet market
• Benzene Europe (yellow) fell $7/t and is down 10%
• HDPE USG (purple) was stable, down 7%
• PTA China (blue) fell $9/t and is down 10%

Petchem buyers clearly did not seem to share the bankers' viewpoint.

ICIS news noted in Asia that naphtha "demand is decreasing and the outlook is bearish", adding "its very difficult to find buyers these days". Whilst in polymers, they reported "a loss of buyer confidence and subsequent slowdown in demand (which) appears to have occurred on a global scale, freeing up the availability of certain grades dramatically".

China's stimulus programmes have been a major support for the global chemical industry over the past 2 years. In polyethylene (PE), for example, its total demand grew an astonishing 53% between 2008-10, from 11.7MT to 17.9MT.

But now, China's rapid demand growth seems to have slowed. According to Thomson Reuters, China's PE consumption actually fell 1.5% in Q1 versus 2010. This has potentially major implications for global H2 chemical demand.

Also, as the chart shows, PE imports (purple column) were down 14% in January-April versus 2010 (green), based on Global Trade Information Services (GTIS) data. Even more surprisingly, China's PE exports doubled to 168KT. And Sinopec, China's largest producer, is reportedly cutting production for the first time in its history.

The detail of the import data shows the pain has not been evenly spread:

• NAFTA was worst impacted: sales were 198KT versus 522KT in 2010
• NEA was down to 550KT from 662KT
• SEA managed a small increase to 468KT from 424KT
• But the Middle East saw its volumes jump from 871KT to 1MT

The ME-China 'strategic corridor', whereby the ME seeks markets and China seeks energy supplies, is clearly continuing to grow in importance.

Sinopec's cutbacks may be the most significant in terms of their implication for China's economic outlook:

• Its operating rate on ethylene has averaged 101.7% since 2000
• It has never cut back because of low margins

This is because Sinopec is 76% government-owned. It does not focus on profit, and its average EBIT (Earnings Before Interest and Taxes) in chemicals has been just 3.7% since 2000. Instead, it operates as a utility, providing reliable supplies of raw materials to China's factories, and helping to maintain high levels of employment.

Its reported cutbacks, are therefore unusual. They may well be due to lack of demand, combined with the need to produce more diesel to power local generators, as electricity shortages increase - (see earlier post). The fall in imports, and the rise in exports, seems to support this conclusion.

PE markets may therefore be telling us something very important indeed about the current state of China's economy.

The major US investment banks saw their revenues from commodity trading jump 55% in Q1, as oil and other prices rose. According to the Wall Street Journal, JP Morgan (which employs 1800 people in its commodities unit), made $750m in Q1, well ahead of its $1.2bn target for the whole of 2011.

The driving force behind these bumper profits was the widespread belief that crude oil and other commodities were going tight. Yet as the above slide from Thomson Reuters shows, oil demand is actually falling in both N America (dark blue line) and Europe (yellow). Whilst Asian growth (light blue) is plateauing.

Thus the latest International Energy Agency forecast suggests average 2011 oil demand will only be 89.2mbd, lower than the Q4 2010 rate of 89.4mbd. Equally they report global stocks at comfortable levels of 58.8 days in March, even though this was peak refinery maintenance season.

Similarly in the USA, the valuable Petromatrix report shows inventories remain near record highs. These have grown by 20mb in the past 4 weeks. At the same time, US demand is continuing to fall. It was down nearly 1mbd over the past 4 weeks versus 2010.

Financial investors now have $410bn in commodity-related assets, according to Barclays Capital. This is double the amount at the 2007 pre-crisis peak. But in the end, fundamentals will always prevail. Absent geopolitics or similar, we are probably at a tipping point.

OPEC, and Saudi Arabia in particular, have much to lose from current prices continuing. These support much greater use of renewables, as Saudi Oil Minister Naimi noted last November, and so pose a real threat to the long-term demand for oil on which Saudi's economy depends.

Chemical companies had to buy forward during Q1 in order to preserve margins. But the downside risk is now instensifying, as markets start to price in the demand destruction that these high prices have caused.

UPDATE: OPEC's meeting today failed to agree the Saudi proposal to lift output by 1.5mbd. Naimi described it as "one of the worst meetings we have ever had". Thomson Reuters reports that "Saudi will now raise output unilaterally".

It is now 5 weeks since the IeC Downturn Alert was launched. The chart above therefore updates the blog's regular review of financial markets, showing how these have moved over the same period.

Most are down around 4%-5%. Russia is the worst performer (down 8%) and Brazil the best (down 3%). But government bond prices (light green column) have risen in the major countries, causing yields to fall, as investors focus on 'return of capital', rather than 'return on capital'.

Petchem markets were relatively quiet over the week, with public holidays in the US/UK, and China's Dragon Boat holiday today. ICIS reporters noted, however, that sentiment continued to weaken.

• Europe. PE, "stocks in Asia and Europe are widely agreed to be at high levels". Olefins, "more risk of a downside than seen previously".
• China. PTA, "persistently weak export of polyester products";
• India. Polymers, "demand in the local PE and PP downstream sector is still looking bad".
• USA. PVC, "global demand has weakened". PE, "traders saying now is not the right time to be purchasing cargo from US suppliers, given the low cost of material from Asia and the Middle East".

The blog will look in more detail at developments in China tomorrow, and in oil markets on Wednesday.

The chairman of the US Federal Reserve, Ben Bernanke, has issued a sober update on the current state of the US economy.

Expressing his disappointment that growth this year "has been somewhat slower than expected", he then listed a number of key problem areas:

• "Supply chain disruptions" caused by the Japan disaster
• "The jobs market remains quite weak"
• "All segments of the construction industry remain troubled"
• "State and local governments continue to cut spending and employment"

And he added that:

"Households are facing some significant headwinds, including increases in food and energy prices, declining home values, continued tightness in some credit markets, and still-high unemployment, all of which have taken a toll on consumer confidence".

The key question for Wall Street was, of course, whether he would indicate that QE3 would now be unveiled. This would pour more liquidity into the markets to support the high speed traders, and their friends on the commodity desks, in pushing oil and other commodity prices higher.

Yet this was always unlikely. The Fed has spent $600bn of taxpayers' money on QE2 since Bernanke launched the concept last August. And even he accepts that the economy is still a long way from full recovery.

After all, as the famous scientist Albert Einstein noted: repeating the same action, and expecting a different result, is a good definition of lunacy.

Between 1854 and 1982, the US economy was in recession for 35% of the time, according to Deutsche Bank research.

But between November 1982 and December 2007, as the chart shows, it was only in recession for 5% of the time, just 16 months in 25 years.

Something very unusual clearly happened during this period. This will be the subject of Chapter 2 of the blog's new eBook, 'Boom, Gloom and the New Normal', to be published at the end of the month.

The blog's view is that this Golden Age was due to the arrival of the Western BabyBoomers (those born between 1946-70). They are the richest and wealthiest generation that the world has ever seen:

• Between 1980 - 2005, 78 million Boomers entered the 25 - 54 age group
• This was a 25% rise from 311m to 389m

25 - 54 is the age when people typically marry, settle down and have children. It is therefore the period of peak demand for housing, autos and electronics. In turn, these drive chemical demand. Each new US home, for example, is worth $16k of chemical sales, and each new auto $2984, according to American Chemistry Council research.

Thus between 1980 - 2005, we got used to the idea of 'pent-up demand'. Recessions almost became opportunities, not problems. Higher interest rates only cooled demand temporarily, and it would bounce back at higher levels when rates were reduced. Companies learnt to set 'stretch targets', to ensure their managers' expectations weren't set too low.

But now the Golden Age has ended. The number of 25-54 year olds peaked at 392m in 2010. Instead, the 55+ age group is becoming the key growth area. Older people typically save more and spend less. And the Boomers have to save more, as they have an extra 10 years life expectancy compared to their parents:

• The oldest Boomer became 55 in 2001
• Since then, their numbers have grown 22%, from 223m to 272m
• By 2020, these will have grown 45%, to 324m

So there will be no more 'pent-up demand'. In fact, as we have seen since the crisis began, even 0% interest rates and $trns of stimulus packages have failed to revive housing and auto markets. Instead, we will probably return to the much shorter business cycles seen before 1982.

Deutsche Bank's work suggests that we should expect to see 3 recessions over the next 10 years, and certainly not a new supercycle or Golden Age. Their 'best case scenario' suggests start-dates in August 2012, April 2017 and December 2021. Their 'worst case scenario' is that recessions start in July 2011, March 2015 and November 2018.

This need not be a disaster for companies, if they recognise what is happening and prepare for it. As my fellow-blogger and co-author, John Richardson, noted this week:

"A few bad quarters should not mean the end of the world for those used to handling downturns. But a valid question to ask, after such an extended upswing, is: "Who in your company has been around long enough to have the experience to deal with a downturn?"

When the blog launched its IeC Downturn Alert in early May, it noted that "they don't ring bells at market turning points". However, it hoped that the Alert would provide a replacement.

It seems to be doing its job. As the chart above shows, prices for all the products highlighted are now down between 9% - 15%. Financial markets seem also to have peaked, and so the blog is adding data for the US S&P 500 (red dots), as this is the main global index.

The blog fears this downturn may have a long way yet to go.

Policymakers, still very bullish when the Alert was introduced, are now talking of a "soft patch". This greatly minimises the problem, due to a fundamental misreading of future demand patterns. The blog will discuss this critical issue further on Wednesday. This is also, of course, the basis for its new eBook, jointly authored with John Richardson.

ICIS pricing reports highlight the position:

Naphtha Europe (brown dashed line), down 13%. "Market has become increasingly oversupplied this week due to a paucity of buying interest".
Benzene NWE (green), down 15%. Benzene is the blog's most reliable petchem market indicator, and first warned of the 2008 collapse.
PTA China (red), down 10%. "Peak season in China's textile industry has largely ended"; Indian inventories are reported at 2-3 months of demand.
HDPE USA (purple), down 9% . "Prices would need to come down by 10-12c/lb ($220-260/t) to compete with falling prices in Asia/Middle East".
S&P 500 (pink, dotted), down 7%.

These are major declines, especially over just 6 weeks. We are also unlikely to see much improvement over the summer months, so it may be September before we get a chance to properly assess the real state of end-user demand. Unlike most CEOs, the blog is also not optimistic about what we will then discover.

The main event last week was the failed OPEC meeting. The major investment banks, keen to protect their outsize profits on commodities trading, made great efforts to spin this as positive for prices.

But Friday's market action, when prices fell $2.50/bbl, tells us much more about likely future market directions. This is because there is one simple rule for successful oil trading, which is "never bet against Saudi Arabia".

And since the OPEC meeting, the world's largest oil producer has indicated it will increase production by over 10% from recent levels, to 10mbd. This is unlikely to prove a bullish sign for prices.

In turn, destocking is therefore likely to continue down the value chain.

There is worrying evidence that the US may be close to recession.

This may seem unlikely to those who have only known the world of the past 25 years. Between 1982-2007, US recessions were very rare. They took place just 5% of the time, as the wealthy Western BabyBoomers led to a SuperCycle of 'pent-up demand' during any slowdown.

But before 1982, the economy was in recession for 35% of the time.

Now, the US's best forecaster fears it may be close to a new downturn.

Readers may remember that in May 2008, the blog championed Martin Feldstein's view that recently released US GDP data was "grossly misleading". It felt he was in a good position to know, as chairman of the official panel that dates US recessions.

In July 2009, the US Commerce Dept finally admitted Feldstein had been right. The recession had indeed begun in December 2007, as he had said. The Commerce Dept noted that "the first 12 months of the US recession saw the economy shrink more than twice as much as previously estimated". Grossly misleading, indeed.

Now, Feldstein has been analysing the details of the US Q1 GDP report. His conclusions are alarming:

• Q1 GDP growth dropped to 1.8%, from 3.1% in Q4
• "Two-thirds of that 1.8% went into business inventories"
• "Final sales growth was at an annual rate of just 0.6%"
• "The actual quarterly increase was just 0.15%"

Feldstein then goes on to note that "after a temporary rise in March, the economy began sliding again in April". He adds that so far, May's data "are even worse than April's". Equally, the blog's own Downturn Alert suggests companies have been destocking for the past 6 weeks, since oil prices peaked.

It is still too early to be sure that we are entering a recession. But the evidence of the past 40 years would suggest Feldstein is right to worry. The above chart shows US recessions (shaded areas) and the oil price in $2011 terms (red line). A recession followed every time the oil price rose above $50/bbl. This happened in 1973/4, 1979/80, 1990/1 and 2007/8.

Today, as in May 2008, the consensus is ignoring Feldstein's argument. Most companies still have a strongly bullish outlook, and some even believe a new SuperCycle may be underway. But Feldstein was right before, and his new warning deserves to be taken very seriously.

The blog continues to worry about signs of a slowdown in China.

Major commodity trader, Glencore, said this week "we see a pullback in China and it will continue". This challenges the views of Dow CEO Andrew Liveris last month, and Rhodia CEO Jean-Pierre Clamadieu - who said last week he saw "no material signs of a slowdown".

Clearly it is still an area where reasonable people can disagree. But this week's evidence on inflation and bank lending seems to support the downside view:

• China's inflation (see chart) hit a new 3 year high of 5.5% in May
• Even more seriously, food inflation was at 11.7%

• Bank lending is finally slowing
• January-May lending was 12% lower than 2010

Food prices matter in a poor country like China. Guangdong is a wealthy province but average wages for a garment worker are just $300/month. Farmers in poorer provinces like Sichuan earn less than half this. Unsurprisingly, social unrest is therefore spreading, with riot police reportedly used in Zengcheng, a Guangdong city of 800,000 people.

China's Academy of Social Sciences forecasts 6% inflation in June, after the energy price rises. And so calls are intensifying to further slow the economy. The central bank raised reserve ratios to a record 21.5% following the inflation news, and clearly more tightening is on the way.

As my fellow blogger, John Richardson has reported, lack of credit is already restricting chemical trade. Opening a letter of credit used to be as easy as calling the bank, in the boom lending days of 2009/10. But today, foreign currency credits are being restricted, meaning that maybe 3/4 banks have to be involved just to buy one cargo.

The length and depth of the downturn will depend on the property market:

• Prices have skyrocketed with easy lending, and Beijing is now the 28th most expensive city in the world, alongside Vienna and Copenhagen
• Speculation has led to 64.5 million empty homes, according to the Academy of Social Sciences. Whilst the Beijing Real Estate Association has warned there is "a rather big bubble in the city's real estate market".

The government thus remains between a rock and a hard place, as the blog has warned for the past 6 months.

If it makes lending too easy, food inflation will continue to soar. If it cuts back too hard, property markets could implode. Its task in now managing this delicate balance is not going to be easy.

The IeC Downturn Alert launched on 2 May. Later that day, the US S&P 500 - the world's most important stock index - hit a post-Crisis high of 1370. Last Friday, it closed down 7% at 1268 (purple dotted line above).

Many expect this to be just a minor correction, and still believe a new chemicals SuperCycle is underway. The blog, however, fears that we have simply seen a liquidity-fuelled rally over the past 2 years, funded by US, European and China's central banks.

Its arguments are set out in ICIS Chemical Business this week. Please click here to download a free copy. This summarises Chapter 2 of its new eBook (co-authored with John Richardson), Boom, Gloom and the New Normal - more details tomorrow.

ICIS news confirms the current weakness. A European producer told Stephanie Wilson on Friday that "ethylene is falling like a stone in the spot market and you can find any price in the PE spot market. Traders and producers are offering huge discounts just to get rid of their stocks."

The chart, based on ICIS pricing, updates since the Alert launched:

Naphtha Europe (brown dashed line), down 20%. "Sources spoke of crackers running at reduced rates of around 80-85%, further diminishing petchem demand".
Benzene NWE (green), down 16%. Traders are unsure of how the market would unfold in terms of pricing... Demand is said to be softening in the European styrene market".
PTA China (red), down 12%. "Sellers rushed to offload their cargoes to lock in profits in view of the current tight credit crunch".
Brent crude oil (blue, dotted), down 12%. The banks produced new arguments to support crude prices, and their year-end bonuses. But even Goldman Sachs now only forecast $105-107/bbl by the end of July.
HDPE USA export (purple), down 11% "A buyer said Asian and Middle Eastern imports (into Latin America) were 15-20 c/lb ($330-440/t) lower than N. American prices".

Speculators, assisted by the US Federal Reserve, have driven crude oil prices to unsustainable levels over the past year. Now, the Fed is withdrawing the liquidity that has financed this rise.

The above chart from Petromatrix shows the surge in crude oil speculation on the Chicago futures market since August. The light blue line shows it taking off from net length of 50k contracts, to reach 200k by the end of the year.

The dark green line then shows it going even higher this year, to an all-time peak of nearly 300k.

It is no surprise at all that this 6-fold increase in futures demand powered crude oil prices higher. They jumped from $75/bbl in August to $125/bbl at their peak. Every chemical purchasing manager in the world had to buy forward as far as possible, to try and preserve margins.

But now the Fed's liquidity programme, QE2, has come to an end. Markets anticipated its arrival from August (it officially started in November). Now, since April, they have begun to anticipate a world in which supply/demand balances, not liquidity, determine prices.

How far has this move to go? One clue can be found from the fact that net length is still around 175k, compared to 50k in August. And, of course, there is nothing to stop it going negative, as it did in 2008 (light green line) and 2009 (red).

The Fed's aim with QE2 was to boost risk assets, and drive down the value of the US$. It thought this would kick-start consumer confidence. How wrong can you be?

European ethylene contract prices (CP) can be excellent indicators of profitability trends in the industry.

Buyers were caught short during December, as inventories had been run down for year-end reasons. So when crude prices started rising, they had to rush to cover their positions. The panic was particularly strong as most companies had set sales prices for the next 90 - 180 days.

As December progressed, buyers therefore scrambled to capture 'low-priced' product before it disappeared. Thus at the end of December:

• The January CP rose 10% from €1005/t to €1110/t ($1480/t)
• Brent crude oil, meanwhile, had risen $10/bbl to $95/bbl

Now, the trend is reversing. Buyers are trying to reduce inventories as they expect lower prices and slow demand during the summer months.

• The July CP has just been settled down 8% at €1090 ($1450/t)
• Brent, however, has only fallen (so far) to $110/bbl

As the chart shows, a US recession (shaded area) has followed every time oil prices were above $50/bbl in real terms ($2011, red line).

Now, companies have begun to issue profit warnings. AkzoNobel, the global paint and chemical company, was the first. It told investors this week that it had been unable to pass through higher prices to its customers, and added that demand remained weak.

Chemical company CEOs will now be planning their half-year reports. In Q2, only Peter Huntsman took the opportunity to remind investors of the threat from "high oil prices, unemployment and economic fragility". Others may now want to follow his lead.

The last week of a half-year period often sees greater volatility in financial markets, as players rush to position themselves for client reporting.

This was most obvious in stock markets, with the US S&P 500 Index (pink dotted line) staging a 5% rally during the week. Brent crude oil (blue dash) eventually ended unchanged versus last week's average.

Other constituents of the IeC Downturn Alert were quieter, however, as players avoided taking new positions ahead of the US 4 July holiday. European naphtha inventories were reportedly at a 2011 high.

China has been the weakest link since March. Europe, and then the USA, have followed its lead. As ICIS' Nel Weddle, a long-time observer of European olefin markets, noted Friday, "opportunistic buyers have had their pick of cargoes and are relishing the availability and weakening prices after months of increases".

The chart, based on ICIS pricing, updates developments since January:

PTA China (red), down 10%. "The market continued on its bearish trend this week because of persistently weak buying sentiment amid soft PTA futures and a generally downbeat outlook."
Benzene NWE (green), down 5%. "Values were relatively range-bound throughout the week."
Naphtha Europe (brown dash), up 6%. Petchem demand was limited, and the widening price spread with propane led to switching.
HDPE USA export (purple), up 12%. "Prices for Asian and Middle Eastern material continued to fall, and remained at least 15-16 c/lb ($331-353/t) below US prices".
Brent crude oil, up 16%. Consultants Petromatrix suggest the 30.2mmb sale from the US strategic petroleum reserve will put pressure on prices.

The start of a new half-year usually provides an excuse for the investment banks to publish bullish notes on oil markets. We discuss their role in Chapter 3 of Boom, Gloom and the New Normal, to be published later this month.

Thus Goldman Sachs last week suggested oil markets will become "critically tight" in 2012, adding "in our view, it is only a matter of time before inventories and OPEC spare capacity become effectively exhausted, requiring higher oil prices to restrain demand, keeping it in line with available supply".

The problem for the banks is that oil prices are already at levels which have always led to recessions in the past (new readers click here for details). The chart above shows just how far prices have risen since the market rally began in January 2009, with the period since the IeC Downturn Alert began highlighted in yellow.

Equally, it is hard to see how China's out-of-control inflation, or last week's disappointing US jobs figures, or the continuing Eurozone debt crisis, can really be bullish for demand.

The detailed moves since January 2009, with ICIS pricing commentary on market sentiment last week, are below:

PTA China (red), up 81% since January 2009. "Most market players would rather take a wait-and-see stance".
Benzene NWE (green), up 308%. "Upward movement was primarily caused by a $7/bbl hike in crude futures."
Naphtha Europe (brown dash), up 214%. "Demand from the petchem industry remains limited" with propane a more attractive feedstock
HDPE USA export (purple), up 88%. "Prices would need to fall into the lower 50 c/lb range before demand for US exports would improve".
Brent crude oil (blue dash, right hand scale), up 154%.
US S&P 500 Index (pink dot), up 51%.

Greece is about to become the first developed country to default on its debts since 1964.

On Thursday night, Eurozone leaders finally agreed to reduce Greece's €350bn debts, if only by 21%. They also agreed to take the first steps towards the creation of a European Monetary Fund.

After more than a year of defying the inevitable, this marks some progress towards recognising reality.

But will it prove 'too little, too late'? The blog hopes not. But the signs are not promising:

• The European Central Bank resisted the default until the very end
• It took a 7 hour French-German summit to finally broker the agreement

The leaders did talk about a Marshall Aid Plan for Europe to promote growth. But equally, the final agreement called for deficits to be reduced outside Greece, Ireland and Portugal by 2013.

Yet as Pimco's Bill Gross warned on Thursday, "debt is the disease, growth is the cure". Pimco, the world's largest bond fund managers, originally developed the New Normal concept back in 2009. And in their view, Europe and the USA now share the same problem:

• The burden of debt is still far too high
• Commodity prices have been allowed to spiral out of control
• Growth has become dependent on China

As a result, Pimco continue to warn that Western growth rates will reduce to 2%, or 'stall speed'. This creates a vicious circle. Companies don't invest, because growth is so low. Unemployment therefore remains too high. Central banks then create liquidity in place of the missing capital.

The ancient Greeks, of course, had a myth that describes the position. It is of Sisyphus (pictured) endlessly trying to push a massive rock uphill.

If policymakers recognised we are entering the New Normal, new forms of growth could be encouraged. The Shared Value concept is one powerful example. But if they stick with current thinking, the outlook for the next few years is not promising.

The blog's quarterly review of company results shows a considerable shift in mood since May.

Then, many analysts were completely fooled by the short-term support provided to margins by higher oil prices. And only Peter Huntsman warned about the risks of high oil prices, unemployment and economic fragility.

Q2 results show many more companies adopting his more defensive position.

The largest of them all, BASF, suffered a 5% fall in its share price as a result. The analysts who follow it had clearly believed their own propaganda. Oil prices at today's levels have always led to a global recession, and the risk of believing that 'this time is different' is rising all the time.

Most worrying was the change in tone from AkzoNobel. 3 months ago, they were still optimistic about the outlook. This time, CEO Hans Wijers warned about the risk of some "scenarios which are of course very scary". Wijers is a former economics minister in the Dutch government, and does not exaggerate.

Air Products. "See strong volume growth across a number of our businesses".
Akzo. "A very volatile world, with very little visibility, and there are scenarios which are of course very scary."
Arkema. "Repositioning in buoyant markets and the contribution of growth projects".
Ashland. "Significantly affected by steep raw-material cost increases".
BP. "Volumes were lower by about 8%, driven primarily by shutdowns".
BASF. "The economic risks remain".
Bayer. "Increase in raw material and energy costs was more than offset by higher selling prices".
Celanese. "We aggressively mitigated the impact of higher raw material and energy costs".
Clariant. "A more difficult but nevertheless solid business environment, characterised by softening demand".
ConocoPhillips. "Higher margins in olefins and polyolefins, and higher volumes".
Cytec. "Uncertain pace of global economic recovery, persistent high unemployment, fiscal constraints in the developed economies and inflationary concerns in the emerging markets".
Dow. "Our transformed portfolio, underpinned by our cost-advantaged and flexible operations, is now performing at a new level."
Dow Corning. "Uncertainty in the current business environment".
DSM. "Very solid results in materials sciences due to pricing strength and volume growth".
DuPont. "Compelling growth opportunities stemming from science-powered innovations and collaboration".
Eastman. "Higher raw material and energy costs, as well as strengthened demand".
ExxonMobil. "Improved margins...offset by lower volume sales".
Huntsman. "Given the sluggish global economic recovery, very pleased with the improving results".
INEOS. "Cracker margins have been at top of cycle levels", with chemicals EBITDA at a record €1923m for the past 12 months.
LyondellBasell. "Margins increased over already strong first-quarter levels".
Marubeni. "Rising prices of petrochemical products and increased volume".
Methanex. "Outlook is excellent."
Olin. "Bracing for softer demand in the third quarter because of anticipated chlorine customer outages and weakened vinyls exports".
Orlen. "Lower sales on the Czech market were partially offset by the increase in the Polish market".
Oxychem. "Strong export demand and higher margins."
Polimeri Europa. "High feedstock costs and lower demand".
PPG. "Anticipate the global economic recovery will continue, although at its uneven pace".
Praxair. "Strong growth in Asia and South America and moderate growth in North America."
Reliance. "Sales increase driven by higher volumes and higher prices".
Rhodia. "Solid levels of demand as well as excellent pricing power."
SABIC. "What keeps me awake at night is keeping the successes we have. This is about the 8.1 billion riyals ... How long can we sustain this? It is challenging."
Sherwin-Williams. "Domestic demand remains soft".
Shin-Etsu. "Domestic PVC sales suffered becuase of the temporary shutdown in quake-hit Kashima, while profits in the US improved".
Siam Cement. "HDPE-naphtha margin declined $60/t QonQ to its lowest since 2002".
Solvay. "Margins in plastics are currently above pre-crisis levels".
Syngenta. "Sales showed sustained volume momentum in all regions".
TOTAL "A generally favourable environment".

Petchem markets have moved into an interesting phase.

Optimists will point to the recovery in crude oil and financial markets, plus higher prices for naphtha and benzene. They will see these as signs that we are just in the middle of a typical correction. And they will hope for further price increases over the summer.

Pessimists will point to the higher prices being focused on products where financial players dominate, such as the S&P 500 Index and Brent. Equally they will note that benzene's higher price is due to lower US production, not stronger demand.

Neutrals will note that some markets have improved and some, like HDPE and PTA, have stabilised. But they will be worried by developments in European propylene, where ICIS' Nel Weddle reports:

• "Customers were saying that they could not deal with inventory levels"
• "One propylene producer said, 'Being honest, I am desperate'."
• A consumer "described the current situation as a catastrophe".

The blog will continue to watch developments very carefully.

Detailed moves since the IeC Downturn Alert launched at end-April, with ICIS pricing commentary on market sentiment last week, are below:

HDPE USA export, purple line, down 17%. "More interest in US exports, particularly in South America".
PTA China, red, down 11%. "End-users were resistant towards higher prices because their inventories remain abundant".
Naphtha Europe, brown, down 9%. "Little interest in naphtha from the petrochemical industry, but healthy demand from gasoline".
Brent crude oil, blue, down 6%.
Benzene NWE, green, down 5%. The US again led markets higher due to "lower production rates and firming energy futures."
US S&P 500 Index, pink, down 1%.

The world's major central banks, particularly the USA and China, have been the main driver of financial markets since the start of the Great Recession, due to the liquidity they have provided:

• China's credit bubble has funded astonishing growth in futures markets
• Monthly volume in LLDPE* (above) has averaged 44MT since Q4 2008
• This is more than total global production in a full year

• The US Fed's 'quantitative easing' has had even greater impact
• It has enabled high frequency trading (HFT) to dominate the markets
• HFT now accounts for 60% of all US share trading

The context of this trading game were defined 20 years ago by the legendary trader, Victor Sperandeo, who noted that:

• An investor's concern is with the fundamentals
• A speculator's concern is with price movement

He advised that when markets are being driven by credit expansion, as now, it is prudent to speculate, not invest.

Yesterday's report from oil analysts Petromatrix provides an excellent insight into today's speculative mentality. They cynically forecast:

"If the US debt extension passes, then it will be spun as something extremely positive for oil demand. If not, then it will be spun as negative for the dollar and so positive for commodities."

The blog will look in more detail tomorrow at the speculative impact on oil markets.

* LLDPE = Linear Low Density Polyethylene

As promised yesterday, the blog looks today at the impact of high frequency trading (HFT) on oil markets.

This now takes place in micro-seconds. It is algorithm-driven via 'black boxes', and so fast that as Andy Haldane of the Bank of England notes:

"Around 40,000 back-to-back trades can take place in the blink of an eye. If supermarkets ran HFT programmes, the average household could complete its shopping for a lifetime in under a second. Imagine."

It also creates 'bunching', where all the black boxes try to out-trade each other. As we discuss in the upcoming Chapter 3 of our eBook, Boom, Gloom and the New Normal, the finest mathematicians and physicists in the world are now employed to develop Wall Street's version of computer games:

• First, they aim to block the competition
• Then they execute their trade. In micro-seconds.

However, the recent end of the Fed's QE2 programme has reduced the liquidity on which these computers relied.

As the chart above shows, oil markets are now tracing out a triangle pattern, just as they did in Q4. Only this time, the triangle's top line (red) goes back to July 2008, whilst its bottom line starts in December 2008.

This makes it an even more significant pattern than the short-term one seen in Q4 last year.

The key question is whether oil's recent run-up to $125/bbl constitutes what traders would describe as a failed 'test' of the previous high set in July 2008. If it does, then Sperandeo's trading rules would suggest a major trend change could be underway.

Either way, the triangle pattern suggests we could well be getting close to another major price move - upwards or downwards.

China's surging demand led the chemical world out of recession and into boom territory. Its 53% increase in polyethylene (PE) demand between 2008 - 2010 (up 6.2 MT), was typical of the support it provided.

But H1 2011 has not maintained this momentum, as the chart shows. Its PE demand was actually down 2.5% versus 2010:

• Domestic production rose 8% to 5.1MT
• Imports fell 11% to 3.5MT
• Exports doubled to 307KT

Equally, it is becoming more selective about its import partners, as trade data from Global Trade Information Services shows:

• Middle East imports were up 16% at 1.5MT
• SEA were up 10% at 679KT
• NEA were down 20% at 752KT
• NAFTA were down 53% at 293KT
• EU were down 44% at 130KT

Middle East imports would probably have gained extra market share, if Iran had been able to supply. Its volumes were down 18% at 368KT.

Of course, H2 may show some recovery, if the government decides to increase lending again. And in the short-term, there appears to be some tightness building up due to supply issues, particularly LLDPE.

But overall, China's main strategy is to increase its own production, where Sinopec aims to be global No 1 in ethylene by 2014.

It will also maintain the strategic corridor with the Middle East, to ensure energy supplies. But its interest in absorbing surplus production from NEA, NAFTA and the EU is likely to be low.

Crude oil and commodities markets have lost touch with the fundamental realities. This didn't just happen yesterday, but began a decade ago.

That's the argument put forward by my co-author, John Richardson, in the latest chapter of our new free eBook, 'Boom, Gloom and the New Normal - how the Western BabyBoomers are changing chemical demand patterns, again'.

John highlights how the supposedly 'informed commentary' that gets widely reported in the media is often focused on boosting income for the trading houses, not market understanding.

I describe some of the issues this raises for chemicals in the above 3 minute interview with ICIS' Will Beacham.

We are delighted with the support we are receiving for the free eBook. Please click here if you would like to download Chapter 3.

Last month, the blog suggested that CEOs might want to warn investors of the threat to earnings from high oil prices, unemployment and economic fragility.

BASF, the world's largest chemical company, have done exactly this today. New Chairman, Dr Kurt Bock warned:

"The economic risks remain: We continue to be concerned about the development of the euro as well as the debt situation in some European countries and the United States. Added to this is the persistently high oil price, which is having a negative impact on margins across our value chains and is leading to some customers being more cautious in their orders."

Investors were clearly unprepared for BASF's note of caution, and marked the share price down 5% in early trading. They clearly still believe in the SuperCycle theory, and want to believe that earnings will rise steadily over the next few years.

Dr Bock and BASF are to be congratulated for injecting a note of realism into this wishful thinking.

Chrysler CEO, Sergio Marchionne, has issued a wake-up call to Western auto companies about the growth of China's exports. He warns that they "can't count on dramatic growth in Asia to drive prosperity", and suggests that China's plans to increase auto exports pose an "enormous" risk.

Meanwhile, US auto sales disappointed again in July. As the chart shows (red square), they have been back below the 1.1 million/month level since May. And optimism over a seasonal pick-up in August is fading.

Annualised sales this year are only 12.2 million. This is 27% down versus 2000-7's average of 16.8m. And thus the industry is getting ready to cut prices from current record levels in an effort to stimulate sales.

One problem is that Americans' love affair with autos has faded. High prices led to a 1.9% reduction in July's gasoline sales versus 2010. And vehicle miles travelled January-May were the lowest level since 2004.

The move towards the New Normal is also having a major impact. Americans are already spending less, and saving more, as the BabyBoomers (those born between 1946-70) enter the 55+ age group.

The US savings rate was 5.4% in July, versus ~0% by the end of the 1982-2007 supercycle. Sales are therefore likely to remain lower. especially as lending criteria become stricter and fears over job security rise.

We have another strong speaker line-up for our 10th European Aromatics & Derivatives conference on 22-23 November in Amsterdam, co-organised as usual with ICIS.

Patrick Thomas, CEO of Bayer Material Science, will talk about the outlook from the viewpoint of a major global aromatics consumer.

Alexander Farina, GM strategy for Shell Chemicals, will give his views on the prospects for the C6 chain.

Other leading speakers including Bob Young from refining analysts Wood Mackenzie, Pierre-Yves Francois from Rhodia, and Matthew George from Indian Oil will give their views on the major issues along the value chain.

In addition, the blog will discuss the likely impact of the New Normal, whilst its blogging colleague and co-author, John Richardson, will question whether China's growth story is coming to an end.

For more details, and to enjoy the Early Bird Discount, please click here.

The blog's IeC Downturn Alert is now 3 months old. The aim was to provide enough time for readers to develop robust contingency plans, as a new global downturn became more and more likely.

A key issue is that dysfunctional political systems in the eurozone, USA and China seem unable to deliver sensible solutions to today's problems:

• In the 1980s, leaders such as Reagan, Thatcher and Deng succesfully adapted their economies to the rise of the Western BabyBoomers (those born between 1946-70).
:
• Today their heirs, such as Obama, Merkel and Wen seem unable to recognise the importance of the ageing of the Boomers for future global demand

S&P's downgrade of US debt from its AAA rating is just one example of how their inability to lead is destroying confidence around the world.

Reuters poses the issue very well in relation to financial markets. They comment that:

"If one thinks:
• "We really are going to enter a double-dip recession, then stocks are not remotely attractive at these levels
• "Wise and proactive economic policy in the US and Europe can help prevent such a thing, then likewise it's a good idea to stay on the sidelines right now: there's no chance of that happening any time soon.
• "Less government is better government and that the private sector, left to its own devices, will create jobs and economic growth, then maybe what you're seeing right now is a buying opportunity."

Most investors, like most chemical company executives, would like to believe that governments could implement "wise and proactive economic policy". They are not at all used to the idea that the private sector might be on its own, left to 'sink or swim' by governments.

Equally, it is hard to see what the private sector can achieve on its own.

The Financial Times' Gillian Tett, one of the few to forecast the 2008 downturn, suggests that the parallels with that terrible time are growing. But instead of Bear Stearns and Lehman, its Greece and Spain who are going bust.

Oil markets are also looking weak. A major fall in prices looks increasingly likely, and would certainly panic those Chinese traders and others, who have been busy buying in recent days, in anticipation of a strong September.

The detailed moves since the IeC Downturn Alert launched at end-April, with ICIS pricing commentary on market sentiment last week, are below:

Naphtha Europe (brown dash), down 17%. "Buyers are in no hurry to purchase material while sellers are under pressure "
HDPE USA export (purple), down 15%. "Producers increased the price to traders and brokers, based on increasing global prices and improved demand ".
US S&P 500 Index (pink dot), down 12%
Brent crude oil (blue dash, right hand scale), down 9%.
PTA China (red), down 6%. "Prices rose on the back of PX prices after a fire hit Taiwan Formosa group's refinery complex ".
Benzene NWE (green), down 2%. "Mounting macroeconomic concerns saw lower offers that were not met with any firm corresponding bids."

The blog was almost alone at the end of April, when it launched the IeC Downturn Alert. Today, its fear that we are close to a global downturn has become mainstream.

As the American Chemistry Council report, "fears of another global recession are rising with several noted forecasters raising the chances of another recession to one‐in‐two".

The disfunctionality of financial markets is clearly a major factor in boosting chances of a downturn:

• 75% of US equity trading in August was High Frequency Trading
• This is traders playing computer games, in micro-seconds.
• It has no value whatsoever, and clearly destabilises markets
• But Wall Street-friendly regulators continue to excuse it

In terms of chemical markets, most players have sensibly retreated to the sidelines, as ICIS pricing comments note. The chart shows how prices have moved since April, when IeC Downturn Alert launched:

Naphtha Europe (brown dash), down 16%. "Factors dampening activity include the ongoing summer holiday season, and crude oil price volatility".
Brent crude oil, down 15%.
S&P 500 Index (pink dot), down 14%.
HDPE USA export (purple), down 13%. "Prices were assessed notionally higher based on price ideas from traders".
PTA China (red), down 7%. " Most buyers were pessimistic about the market outlook."
Benzene NWE (green), down 3%. "Benzene has been incredibly resilient to the volatility seen for crude."

A year ago, the blog feared we were "still towards the beginning of the crisis", not at its end. Sadly, its judgement seems to have been correct.

2 weeks after that post, the US Federal Reserve launched its now infamous $600bn QE2 programme. The aim was to provide further massive stimulus to the global economy. Previous efforts had clearly not worked, and it feared the economy was already weakening.

Unfortunately, QE2 not only failed to stimulate a recovery, but actually made it more difficult to achieve. This was because it provided the high frequency traders with the liquidity they needed to push up food and energy prices on commodity markets:

• Recovery was already difficult with oil at $60/bbl
• It became almost impossible when it moved above $100/bbl

Clearly also, the Eurozone debt crisis has since got worse, not better. A year ago, Greece was the main problem. Now it is Italy, a G7 country.

The key issue is that policy makers are still in the Denial phase of the crisis, as the chart shows. This uses Elizabeth Kübler-Ross' famous 'Paradigm of Loss' model as a guide on how the crisis is developing.

Investors, and some company managements, also remain in Denial. The hype surrounding QE2 led to a false sense of euphoria about the outlook. Even today, there is a clear lack of realism, and a focus instead on 'onwards and upwards' to peak earnings in 2015.

Q2 showed growth has stalled in both the USA and Europe. Yet many investors still believe the central banks will somehow be able to ride to the rescue and enable the world to avoid a seemingly inevitable recession.

Worryingly, though, we can see that the wider population is now moving into the Anger phase. Social unrest is building in many countries. Also, political systems have become more dysfunctional in the USA, Eurozone, Japan and even China.

Today's 419 point fall on the Dow Jones Average, and $6/bbl fall in WTI crude oil prices, may not be just another example of the wild volatility that has come to seem normal in financial markets.

It may also mark the end of an era.

Since 1994, the US Federal Reserve has used all its resources to support the stock market in times of strain. This took it well beyond its official mandate of fighting inflation and supporting employment.

Instead, it meant interest rates were lowered, and liquidity provided, any time the market experienced a major sell-off. It created the dot-com bubble in 1999-2000; the subprime housing disaster; and more recently the bubble in energy and commodity markets.

Today, for the very first time in 15 years, 2 senior US Federal Reserve Governors have spoken out against this policy:

• Philadelphia Fed chief Charles Plosser said taking action after stocks tumbled "signalled that we are in the business of supporting the stock market."
• Richard Fisher, the Dallas Fed chief, said the Fed "should never enact such asymmetric policies to protect stock market traders and investors."

It remains to be seen whether this change of policy becomes permanent. There are very powerful forces, not only on Wall Street, ranged against it. Will the Fed really do nothing, if today's falls continue next week?

But if it does, then financial markets will be quite different in 5 years time:

• Markets will not be protected from their own follies
• Investors who cannot evaluate credit risk will lose money
• Commodity prices will be driven by fundamentals of supply and demand
• Computerised high frequency trading will disappear

Unfortunately, it is almost certain that the path back to reality will be extremely painful. 15 years of Fed 'bubble-blowing' will take a long time to put right. But if Plosser and Fisher really mean what they say, then Fed policy is indeed headed Back to the Future.

The blog was in a minority of one when it launched its IeC Downturn Alert at the end of April.

But today, only a very few diehard optimists are still arguing the issue. GDP reports in Europe and the USA have shown virtually no growth in Q2, whilst China is clearly also slowing fast.

It is also hard to believe that until very recently, many analysts were arguing that a new Supercycle was already underway.

The blog remains convinced that we are in transition to a New Normal, not a new Supercycle. Next week sees the publication of chapter 4 of its new eBook, 'Boom, Gloom and the New Normal', co-authored with John Richardson.

This Chapter is titled 'Where we are Headed'. It offers 10 predictions about how the world will look in 2021. We believe it will become essential reading for anybody who is concerned about where we are headed in the next few years.

ICIS pricing is a very valuable resource, particularly at market turning points. It highlighted the start of the current downturn in April, when reporting that buyers had moved to operating on a 'hand to mouth' basis.

Now, its market editors are highlighting the fragility of demand due to 'economic uncertainty'.

This is the moment when buyers ought to need to order, as they return from the holidays:

• US retailers should be demanding rush orders for Thanksgiving/Xmas
• Auto companies should be seeing a flood of consumer enquiries
• Construction should be surging before the winter arrives

So far, the opposite is happening. US consumer confidence hit a 30 year low this month. Europe's debt crisis is getting worse, and has spread to Italy. China and India are seeing more social unrest, with inflation far too high for comfort in both countries.

Of course, we still have 2 weeks to go, before September will reveal buyers' true position. But ICIS' Linda Naylor remains an excellent barometer of market conditions. And she reported a large PE buyer saying last week that "customers have been cancelling orders and everybody wants to sell."

The chart shows the major surge in prices since January 2009, and highlights in yellow the downturn seen since April when IeC Downturn Alert began, with ICIS pricing comments below:

US S&P 500 Index (pink dot), up 26% overall since January 2009; but down 18% since April.
PTA China (red), up 96% since 2009; down 6% since April. Major plant and feedstock issues have led to only minor price rises recently as "the fragile macro-economic environment is weighing down sentiment".
HDPE USA export (purple), up 97%; down 13%. "Buyers were waiting to make purchases amid the economic volatility".
Brent crude oil (blue dash, right hand scale), up 141%; down 13%.
Naphtha Europe (brown dash), up 203%; down 15%. " Demand remains poor from the gasoline sector and petrochemicals. The propane market is bearish with plenty of material available".
Benzene NWE (green), up 335%; down 9%. "Widespread uncertainty surrounding the global economy, and the potential impact of this on the market, once players returned en masse from their summer holidays".

The investment banks have maintained a consistent focus on oil market supply disruptions and demand surges in recent years, alongside forecasts of sharply increasing prices. We discussed their role in more detail in the recently published Chapter 3 of our new free eBook, 'Boom, Gloom and the New Normal'.

As the above chart from the Wall Street Journal shows, based on leaked confidential information from the US CFTC (Commodities Futures Trading Commission), the investment banks are also major players in the futures markets. It shows positions on the day studied by CFTC, 30 June 2008, when crude was at $140:

• The banks appeared to hold most contracts. more than energy companies, airlines, hedge funds or Others.
• The WSJ also reports that Goldman Sachs, one of the most prominent bulls on oil prices, held 451k long WTI contracts and 419k short contracts (a net length of 32k contracts).
• Analysts Petromatrix calculate that if the WSJ is correct, "Goldman Sachs, for its own and its clients positions, was holding 35.2% of the WTI Open Interest on June 30th 2008".

Looking forward, many of the major supports highlighted in recent months for today's high oil prices by the banks are disappearing:

• Libya's 1.6mbd output should start to return to markets during H2
• China's demand January-July was only up 300kbpd vs 2010
• Saudi pumped 9.8mbd in June, up 918kbpd versus May
• Crude oil stocks in the US Gulf are close to record levels

Plus, of course, economic slowdown reduces likely future demand growth.

Yet as Petromatrix note, large traders known as the "Large Speculators (remain) very exposed to the long side of WTI" in US futures markets.

Thus the potential for further oil price declines back to the blog's expected $60/bbl is clearly quite high, even though the banks will no doubt remain highly bullish.

All of us would love to be able to see into the future.

Chapter 4 of our new free eBook, 'Boom, Gloom and the New Normal', does just this.

It offers 10 predictions about how the world will look in 2021:

1. Young and old will be focused on 'needs' rather than 'wants'.
2. A major shake-out will have occurred in Western consumer markets.
3. Housing will no longer be seen as an investment.
4. In emerging economies, companies will have recognised that the phrase 'middle-class' doesn't define people with Western income levels.
5. Chemical markets will have become more regional.
6. Western countries will have increased the retirement age beyond 65 to reduce unsustainable pension liabilities.
7. Taxation will have been increased to tackle the public debt issue.
8. Social unrest will have become a more regular part of the landscape.
9. Consumers will look for value-for-money and sustainable solutions.
10. Investors will focus more on 'return of capital' than 'return on capital'.

The New Normal offers the potential to restore a greater balance to society if companies refocus their creativity and resources on real needs.

There is also an urgent need for companies to focus on basic research to tackle these needs, rather than simply taking government grants to deploy old technologies.

The transition to the New Normal will be a difficult time. The world will be less comfortable and less assured for many millions of Westerners.

The wider population will find itself following the model of the ageing boomers, consuming less and saving more. Rather than expecting their assets to grow magically in value every year, they may find themselves struggling to pay-down debt left over from the credit binge.

More engineers and more scientists are going to be required to create the new products that will serve needs arising from the megatrends.

We will also need to find politicians with sufficient vision to sell the need for hardship and long-term struggle. This will be difficult, given that voters have become used to having all their wants met via quick 'fixes' of increased debt.

We could instead decide to ignore all of this potential unpleasantness.

But doing nothing is not a solution. It will mean we miss the opportunity to create a new wave of global growth from the megatrends. And we will instead end up with even more uncomfortable outcomes.

FREE DOWNLOAD OPTIONS FOR CHAPTER 4
Click here to download a 2 page summary of the Chapter .
Click here to download the full Chapter
Click here to view the 4 minute video with Paul Hodges

German Chancellor Merkel's recent comment that "I don't see anything which signals a recession in Germany" is just one sign of the current complacency about the global economy within the Western political elite.

Long-standing readers will remember Profs Eichengreen and O'Rourke 2009-10 work comparing today's Great Recession with the Depression of the 1930s. Worryingly, the parallels seem to be increasing again, as the chart above shows from new research by Prof Nouriel Roubini:

"World trade (dark grey line) has stalled since the onset of the year and is falling in line with lower growth in the developed world. While global industrial production increased slightly in June, it is still down on the quarter. July data, coupled with leading indicators such as PMIs (Purchase Manager Indices), points to Q3 weakness. Chinese commodity demand began to weaken in Q2 and continued to fall in July."

JACKSON HOLE MEETING OF ECONOMIC POLICYMAKERS
There was less complacency amongst economic policymakers at the US Federal Reserve's annual Jackson Hole meeting last week. There was no mention of a new QE3 programme to try and boost stock and commodity prices. Instead, as the OECD's head noted, policymakers are now realising that "this consolidation effort is going to take a generation."

Fed Chairman Ben Bernanke warned that "The quality of economic policy-making in the United States will heavily influence the nation's long-term prospects". Whilst Christine Lagarde, new IMF head, said economic risks "have been aggravated further by a deterioration in confidence and a growing sense that policymakers do not have the conviction, or simply are not willing, to take the decisions that are needed."

Policymakers, if not yet the politicans, may therefore be finallly realising that we face a solvency crisis, not one of liquidity:

• Solvency is whether one is able to pay one's total debts
• Liquidity is simply whether one can pay today's bills

The risk is, of course, that 2 years of implementing the wrong policies have left them dangerously short of time, and money. With actual US GDP growth just 0.33% ($40bn) in H1, there is surely a strong risk that the US is now entering a new recession. Europe cannot be in much better shape, despite the politicians' denials, given Q2 data.

IeC DOWNTURN ALERT UPDATE
Hopefully the blog's April launch of its IeC Downturn Alert launch has enabled chemical companies to prepare robust contingency plans for what may lie ahead. Price movements since April, and ICIS pricing comments this week are below:

S&P 500 Index (pink dot), down 14%.
Naphtha Europe (brown dash), down 13%. "Most sources still believe an oversupply threatens in September ".
Brent crude oil, down 12%.
HDPE USA export (purple), down 13%. "Latin America has now turned its attention to Asian offers".
Benzene NWE (green), down 11%. "Shutdowns downstream are expected to soften demand next month."
PTA China (red), down 5%. "Expected to be underpinned by rising PX prices caused by limited supply".

The above chart, from the invaluable American Chemistry Council (ACC) weekly report, highlights the scale of Q1's inventory build in N American polymer markets (polyethylene, polypropylene, PVC).

This build took place as consumers down the value chain rushed to buy forward, as WTI oil prices surged 41% between November - April.

Their buying was not based on actual demand, but on their need to protect margins. Most companies set sales prices for 90 or 180 days ahead, so anyone who had not bought forward could have seen planned profits turn into losses:

• The orange line shows the 22% rise in thermoplastic inventories from 4.25bn lbs (1.93Mt) to 5.2bn lbs (2.35Mt). Q2 saw this start to be worked through downstream, as consumers reduced new orders.
• Worryingly, however, we seem now to be entering the second stage of the downturn. The blue line shows that consumers are now seeing lower demand, and the ACC note the 3 month moving average dropped to 4.56bn lbs in July.

This two-stage process is exactly in line with the experience of previous oil-price induced recessions, as the blog highlighted in mid-April.

September will therefore be a crucial month.

History suggests end-user demand will remain weak, as individuals worry about the state of their finances and rising job insecurity. But, of course, we can still hope that 'this time will be different'.

Many readers have been taking a well-earned break over the past few weeks. The blog also continues to gain large numbers of new readers, as the financial crisis intensifies. As usual, therefore, it is highlighting key posts during August, to help you catch up as you return to the office.

Boom/Gloom Index suggests markets on the edge presciently forecast the recent volatility. Markets fall as politicians argue, US Fed policy may be going Back to the Future, Investors rush to save with the JUUGS, and US GDP still below 2007 levels explore the key issues

European cracker margins at 'top of cycle levels', China's PE market down 2.5% in H1 and Q2 chemical results raise concerns about the outlook look at the current state of chemical markets

China's power consumption hits new record looks at the strains now impacting China as it struggles to cope with an overheating economy. China's auto market goes ex-growth covers the same theme, as does China's bank lending nears its Minsky Moment

Policymakers remain in the Denial phase suggests the crisis is a long way from its end, as does Recession may now be very close and Towards a New Normal, not a new Supercycle whilst Goldman halves global ethylene growth estimate shows the analysts are slowly starting to recognise reality

Plus, of course, Chapter 4 of Boom, Gloom and the New Normal was published this week, and focuses on how the world may look in 2021

Readers will no doubt be pleased to see that Bloomberg have today published a major article on the likely changes in demand patterns due to the ageing of the Western babyboomers.

Its title, 'Aging Baby Boomers Shrinking Labor Force May Curb U.S. Growth for 20 Years', emphasises the parallels it makes with our analysis in Boom, Gloom and the New Normal.

Equally, it concludes that:

"This is not your mother's recovery.

"Women and baby boomers entering the American workforce after 1950 helped to supercharge expansions in 1975 and 1983 by filling an increasing number of jobs and purchasing more goods and services. Now as the share of women with jobs falls and older Americans age into retirement, the shrinking -- or, at best, slowly growing -- workforce will weaken economic activity for the next two decades." Clearly, mainstream investors and media organisations are now becoming aware of the critical link between future economic growth and the ageing of the Western babyboomers.

Our work looks in detail at how this will impact the chemical industry. You can obtain all four published chapters via free download by clicking here

You can also sign up for the next in our series of New Normal Workshops, and obtain further details, by clicking here

Chemical markets are traditionally 6 months ahead of the wider economy, as they are so focused on consumer demand. September may therefore provide a 'moment of truth' for the IeC Downturn Alert, launched in April:

• The petchems downturn since April may now become apparent in the wider economy
• Alternatively, demand may recover strongly, signalling recovery remains on course

It would be unwise to jump to conclusions this early in the month. But the failure of the US economy to add a single job in August, for the first time since 1945, is not a good omen.

Equally, only one downstream market, PTA in China, is currently showing any pricing strength. And even this seems somewhat precarious, according to the latest ICIS pricing report below. Other 'bellweather' markets such as benzene and polyethylene seem potentially weak.

Bulls, however, will take heart from the fact that Brent crude oil prices and naphtha both managed a small increase, even though inventories remained high. Any resumption of demand could enable derivative prices to recover quite sharply from the falls shown in the above chart.

Price movements since April, and ICIS pricing comments this week are below:

S&P 500 Index (pink dot), down 14%.
HDPE USA export (purple), down 14%. "Lower Asian export prices are continuing to reduce interest in US material".
Benzene NWE (green), down 13%. " Wider economic jitters could potentially affect demand and pricing."
Naphtha Europe (brown dash), down 12%. " Market is again bearish, and has lengthened from the previous week due to poor demand".
Brent crude oil, down 9%.
PTA China (red), down 3%. "Some players expect a downward correction, while others see prices continuing to rise amid firm PX costs".

UPDATE. Worryingly, Swisss firm Clariant became the first chemical company to issue a profit warning today, due to "order sizes coming down and more insecurity in the supply chain" in Brazil, US and Europe.

Bloomberg quotes the blog adding "There appears to be no 'seasonal surge' in demand from Western retailers in advance of Thanksgiving and Christmas. This is further confirmation perhaps that consumer demand is taking a real hit."

Companies are now starting the Budget process for 2012-14.

As always, the blog will present its own view next month. It will also review last year's Budget Outlook, presciently titled 'Budgeting for Uncertainty'.

In the meantime, companies might like to use its recent 'The world in 2021' as a way of challenging their own thinking about the likely future.

Conventional wisdom is still convinced that any day soon, the world will somehow return to 'normal'. Demand will then resume its steady upward growth, and today's economic and political uncertainties will magically disappear.

Of course, conventional wisdom may be right.

But its record at major turning points is shockingly bad. It may not, therefore, be very useful in current circumstances.

Boards and business teams may therefore find it valuable to debate the blog's alternative view, to help develop their own shared view of the outlook.

You can download a copy of the 2 page summary, 'The world in 2021' by clicking here. The full chapter can be downloaded by clicking here.

The blog hopes you will find its analysis helpful in these uncertain times.

The IeC Downturn Alert has hopefully done the job for which it was intended.

It was launched at the end of April, when the blog became convinced that the global economy was highly likely to enter a new downturn. It also realised from its experience in 2007-8, when it later became known as 'The Crystal Blog', that this view was probably not widely shared.

It therefore wanted to monitor the situation on a regular basis. It decided to select benchmark chemical products from the key regions, as a way of linking its wider concerns with the evidence on the ground.

The role of ICIS pricing, and its network of editors, has therefore been crucial. This has enabled the blog to follow individual product markets, and provide an objective analysis of their weekly fluctuations.

The chart above is, of course, a key reason why the blog was convinced a new downturn was near. As it noted in June, history shows that recession (shaded area) has occurred every time oil prices (red line) have remained above $50/bbl in real (eg inflation adjusted) terms.

Sadly, it appears that this time is not going to be different.

The evidence for a renewed downturn is now all around us:

• The OECD says "economic recovery appears to have come close to a halt in the major industrialised economies" with likely H2 growth at <1%.
• China's economy is slowing fast. Ethylene demand growth tracks GDP, and was just 1.9% in H1, compared to ~10% in 2009-10.
• The American Chemistry Council (ACC) reported Friday that "we see an economy still near stalling speed".

The blog hopes that the IeC Downturn Alert, coupled with its IeC Boom, Gloom Index, has helped to catalyse debate about the potential for a renewed downturn. We cannot avoid the severe problems that this will cause. But hopefully the Alert has provided companies with clear advance warning that problems lay ahead.

Equally concerning is the fact that Western central bankers and policymakers have so completely misread the underlying economic situation over the past 3 years. The blog will look at the likely reason for this terrible mistake over the next two days.

Price movements since the Alert launched, and ICIS pricing comments this week are below:

Benzene NWE, down 16%. "Values softened over the course of the week due to wider economic bearishness."
S&P 500 Index, down 15%.
HDPE USA export, down 14%. "Prices are still too high to compete with Asian prices".
Naphtha Europe, down 13%. "Demand from petchems remains weak".
Brent crude oil, down 9%.
PTA China, stable. "Underpinned by firmer feedstock PX prices and pre-holiday restocking activity by end-users".

Europe is at the eye of the storm when it comes to energy pricing. This is the last thing required by its struggling economy.

As the chart shows, Brent in euros (green line, RHS) is now back at the same level as June 2008, whereas WTI is 35% cheaper (black line, LHS).

Such a divergence has never happened before, and is due to two factors:

• Brent is now at $25/bbl premium to WTI, vs its usual $1/bbl discount
• The euro has fallen 12% from $1.60 to $1.40

Brent's unprecedented premium is clearly not due to strong levels of European demand. But an excellent article by Javier Blas in the Financial Times highlights one potential cause - the growing lack of liquidity in the Brent market:

• The Brent contract includes 4 fields (Brent, Forties, Oseberg, Ekofisk)
• But their output is declining and is forecast to be <1mbd by next year

The result, as the Oxford Institute for Energy Studies notes in a major new study is that:

"While the volume of production is not a sufficient condition for the emergence of a benchmark, it is a necessary condition for a benchmark‟s success. As markets become thinner and thinner, the price discovery process becomes more difficult. Oil price reporting agencies cannot observe enough genuine arms-length deals.

Furthermore, in thin markets, the danger of squeezes and distortions increases and as a result prices could then become less informative and more volatile thereby distorting consumption and production decisions.Brent's current $25/bbl premium to WTI seems to provide prima facie evidence that such "squeezes and distortions" may now be taking place.

Brent's premium also creates a further problem for Europe's economy. Unlike the USA, its prices for natural gas are closely linked to oil prices. So today's high premium for Brent creates a double whammy for consumers, and intensive energy users such as the chemical industry.

Financial bubbles are like balloons. Only instead of air, they need to be constantly pumped up with new lending. Otherwise they begin to deflate, and the Minsky Moment occurs.

The above chart of China's bank lending shows, as discussed last month, that the Minsky Moment is getting close. August's lending (red square) was exactly the same as in 2010 at RMB548bn ($86bn). And so far this year, it is down 8% (RMB60bn) versus 2010.

Last year, lower official lending was supplemented by the 'shadow banking' system, as described by the blog's co-author of the Boom, Gloom eBook, John Richardson in a 2-part July post. But that was when the authorities still believed they could contain inflation below 4%.

Today with inflation above 6% and food price inflation over 13%, they have tightened up considerably. 2 major plastics converters, who were also acting as traders, reportedly went bust in Guangdong recently with debts of Rmb100m each.

This leaves the problem of all the inventory, bought on borrowed money over the past 2 years, which is now filling warehouses down the value chain. Some of this is disappearing into exports, where it is depressing Asian and global prices.

For example, data from GTIS, the global trade data experts, shows polyethylene exports were:

• 350kt in January-July, double 2010 levels
• They were also more than 3 times 2009 levels

Of course, the government may panic, if growth really starts to slow sharply, and allow lending and inflation to rise again.

But if it doesn't, then the owners of the inventory will eventually begin a rush for the exits. At this point, when distressed selling starts, the Minsky Moment will have arrived.

An abrupt change of direction is never a pleasant experience in global financial markets. Yet unfortunately, the blog's regular 6 monthly review suggests this has started to occur since March.

Investors are beginning to fear we may not be be entering a new Supercycle after all. Some are also worrying that high oil prices may be leading to demand destruction.

The blog's view remains that the ageing of the Western Babyboomers (those born between 1946-70) means we are entering a New Normal era. And there are certainly signs that bond market investors are now starting to accept the argument of Chapter 2 in its Boom, Gloom and the New Normal eBook, that we are following Japan's model.

This is quite a change. Investors mostly took no notice of the blog's article in the Financial Times a year ago, which suggested the consensus might be wrong. But as the above chart shows, the US 30 year bond (light green) is up 16% since March, due to the fall in US interest rates.

• Germany's stock market (green) is the biggest loser since March, down 22%. A China slowdown will impact it badly, and investors fear it will have to pay for the costs of Greece's looming default
• Investors also worry that other emerging economies are slowing. Brazil (pink) is down 14%, Russia (lilac) down 19%, India (orange) down 8% and China (blue-green) down 16%
• Japan (purple) is down 15% after the earthquakes and tsunami
• The US (dark blue) and UK (brown) are down 7% and 8%, as recent economic data has disappointed

Even the major investment banks are suddenly becoming cautious. Goldman Sachs has now cut its year-end forecast for the S&P 500 from 1400 to 1250, citing "heightened uncertainty in global equity markets".

However, its commodities team is still on the bullish tack, forecasting that Brent will rise to $130/bbl over the next 12 months. They believe "emerging-markets demand for key commodities, including oil, is holding up well".

Oil supply is critical to today's global economy.

Now a new book by oil expert Daniel Yergin, author of 'The Prize', suggests that the outlook may be more promising than most believe.

Pessimists such as Marion King Hubbert have argued that the world is running out of oil. Hubbert, for example, gave his name to 'Hubbert's Peak', the original version of 'peak oil'. It suggested that US oil production would hit a peak between 1965-70.

Hubbert was proved right, as production did indeed peak in 1970. But Hubbert's other predictions were less successful. He forecast that US output would have declined to just 1.5mbd by last year. But in fact, new technology meant output was 7.5mbd.

Plus, of course, production would have been even higher if the US had opened up some of the most promising land/offshore areas for exploration. They are closed for environmental reasons, not because the oil doesn't exist.

Yergin's argument is that the truth is more complex than can be captured by a headline, or snappy sound-bite such as "peak oil". As his chart above shows, world oil production hit a plateau in the 1970s, and again over the past few years.

But higher prices are already leading to new supplies coming on stream. Equally, technologists are still getting better at extracting more oil from existing fields. Today, for example, only 35%-45% of the available oil is ever recovered from a field.

Yergin also notes that cumulatively, the world has produced ~1trn barrels of oil since the industry was founded 200 years ago. He adds that:

"Currently, it is thought that there are at least five trillion barrels of petroleum resources in the ground, of which 1.4 trillion are deemed technically and economically accessible enough to count as reserves (proved and probable)."

The chemical industry has a turnover of $3.4trn, and is the world's 3rd largest industry. It matters to the global economy.

Many of its leaders are about to meet next weekend in Berlin for the annual European Petrochemical Association (EPCA) meeting.

The blog strongly believes that this should not be seen as a 'business as usual' meeting. We cannot simply assume that the global economy is in fundamentally good shape:

• IMF head, Christine Lagarde, has warned the global economic situation is entering a "dangerous place"
• World Bank president Robert Zoellick has described world finances as being in a "danger zone"

These are not sound-bites being made for effect.

The danger signs have been building for months. The blog, after all, introduced its IeC Downturn Alert nearly 5 months ago, on 2 May.

Coincidentally, this matched the peak of the US S&P 500 Index, since when financial markets and crude oil prices have fallen dramatically, as shown in the chart above.

Every week since then, with the help of ICIS news and ICIS pricing, the blog has chronicled the approach to today's Downturn:

• First we saw customers around the world buying 'hand to mouth'. They tried to run down inventories built up during the 50% rise in crude oil prices between December-April
• Then everything went quiet during the summer. The retailers destocked after seeing end-user consumption fall due to the impact of higher oil prices
• Then it became clear that China's economy, the previous motor of the global economy, was slowing fast, as the government reduced credit to combat high inflation
• Now, in September, it is clear that demand has not returned after the holidays. And the wider economic outlook is getting worse, not better.

The blog made similar efforts to alert the industry to the issue of demand destruction before the 2008 downturn, and was later awarded the title of 'The Crystal Blog'. But sadly, its warnings were not taken seriously at the time when they could have had an impact.

The industry's leaders need to ensure that 'this time is different' in Berlin. It is no exaggeration to say that the very future of some companies, and of important sectors of our industry, may be at stake.

Price movements since April, and ICIS pricing comments this week are below:

Benzene NWE (green), down 26%. "A swathe of imports coming into the ARA region were also keeping supply ample as demand struggled amid weak end user confidence."
Naphtha Europe (brown dash), down 19%. "The impact of refinery run cuts is starting to show, and it is thought that the naphtha oversupply would have been more severe if not for these".
HDPE USA export (purple), down 18%. "The Asian market has slowed down, in part because of a national holiday, and in part because of concerns about the global economy. Asian prices were expected to fall in China because of tightening credit rules."
S&P 500 Index (pink dot), down 17%.
Brent crude oil, down 14%.
PTA China (red), down 4%. "Most buyers were adopting a wait-and-see stance because of the unclear market trend. Only a few end-users purchased cargoes on a need-to basis."

Today's economic situation is getting worse, not better. The blog believes this is because most policymakers still refuse to accept the wisdom contained in the Beatles' 'When I'm Sixty-Four' song on their iconic Sgt Pepper album.

The Western BabyBoomers (those born between 1946-70) are the largest and richest generation that the world has ever seen.

But last year, the oldest Boomer reached the age of sixty-four. And ageing Boomers simply don't need more housing or new cars, as they no longer have to provide for growing families.

So demand patterns are changing, radically, just as they changed in the 1970's. This was when the arrival of the Boomers set off the economic SuperCycle, as they entered their peak consumption years between the ages of 25 - 54.

Chemical companies are therefore not only facing an imminent economic slowdown, as the blog has chronicled over the past 5 months with its IeC Downturn Alert. They also need to change their business models, to adapt to this New Normal.

This month's Chapter 5 of the blog's free 'Boom, Gloom and the New Normal' eBook, co-authored with John Richardson, aims to help with this process. The first step is for CEOs to establish a high-powered team, operating with the support of their Board and line managers, to quickly put in place the necessary Action Plan.

The team needs to answer the 4 key questions required for any successful plan:

• Why. The Board needs a clear view of the likely impact of an economic downturn, combined with the demand changes caused by the ageing of the Boomers.
• What. The team needs to highlight the key issues which its plan aims to tackle. Speed is essential, and only the really super-critical issues can be addressed short-term.
• How. Implementation plans are critical. Resources need to be available, and key managers must 'buy-in' to the process, otherwise it will fail.
• When. Timing is also critical. Short-term priorities (credit control, working capital) have to be balanced with the business model changes needed to adapt to the New Normal.

The outlook is very uncertain. Tomorrow's post will discuss the relevant Scenarios that need to be addressed. And on Thursday, it will highlight the Critical Success Factors against which plans need to be measured.

The blog will be happy to provide any support or advice that may be helpful to readers as they develop their Action Plans.

International eChem/ICIS are also running three training courses in Houston, Singapore and London in Q4, to help with detailed implementation issues. Please click here for further details.

The transition to the new Normal is likely to be painful and long-lasting.

Future demand growth will be slower as the ageing Boomers spend less and save more.

More regular and deeper recessions are likely to become a feature of the global economy once more, in contrast to the relatively smooth growth seen during the Boomer-led Super Cycle.

Successful companies will also have to venture into the unknown, as until recently the 55+ generation had no real existence as a separate economic unit.

Previous generations usually found their needs at this age were focused on health-related issues - the Zimmer frame of popular mythology.

So as we venture into the unknown, Action Plans can't be too prescriptive about what we might expect to see over the next 20 years. Chapter 5 of the blog's free 'Boom, Gloom and the New Normal' eBook, co-authored with John Richardson, aims to help with this process.

As discussed yesterday, the Chapter outlines some potential Scenarios to highlight the key variables that need to be considered:

'All's Well that Ends Well'. In this scenario, the key dynamic is that there is a rapid adaptation to the New Normal. This may be driven by the observation of the major pain being suffered in countries already at the sharp end of some most unwelcome restructuring - Greece, Portugal, Ireland and Spain, for example. This gives Western politicians the courage to talk seriously about the issues that society now faces, whilst the wider population becomes prepared to listen to their messages and to accept that major changes need to be made.

'Muddle Through'. In this scenario, there is no rapid adaptation to the New Normal, and although a higher quality of dialogue takes place between policymakers and the electorate than in the past, no firm agreements are reached on key policies and objectives. However, and importantly, social cohesion is retained, and so society does not fragment into warring groups.

'If You Don't Know Where You're Going, Any Road Will Do'. A third scenario is based on the potential for politicians to remain more focused on sound-bites than on formulating policies that will drive long-term success for their populations. In this Scenario, the current dysfunctional state of many Western political systems, and their alienation from the wider electorate, is not a temporary phenomenon but a sign of the future.

'Don't Worry, Everything will be Just Fine'. This is the scenario under which the West had been effectively operating for the past few years, ignoring the demographic changes which are taking us in a new direction. It is characterised by an increasingly desperate belief that everything is just about to 'return to normal' (i.e. the former SuperCycle), via the magic elixir of either tax cuts or yet more stimulus.

Tomorrow's post will provide its view of the Critical Success Factors against which Action Plans need to be measured.

The blog will be happy to provide any support or advice that may be helpful to readers as they develop their Action Plans.

International eChem/ICIS are also running three training courses in Houston, Singapore and London during Q4, to help with detailed implementation issues. Please click here for further details.

Yesterday's Scenarios hopefully provided valuable insight into the challenges ahead for companies and individuals. They also suggest some Critical Success Factors for achieving a successful transition to the New Normal, as set out in the chart above:

1. Flexibility. This involves adapting to new circumstances and being willing to compromise rather than battling for an impossible nirvana.
2. Change management. The next 20 years will likely see rapid and unpredictable change in the business environment in contrast to the remarkable stability of recent decades.
3. Scenario Planning. Companies need to adapt their planning processes to cope with the greater uncertainty that will come from operating in a more 'events-driven' world.
4. Real needs. Over the past 20 years, Westerners have often confused 'wants' with 'needs'. In the New Normal, mere 'wants' are unlikely to be reliable market drivers for the future.
5. Action orientation. Uncertainty can breed a loss of energy, and so companies will need to encourage their employees to experiment creatively if they are to move forward.

The positive news is that most Boomers are likely to lead active and healthy lives well into their 60s and 70s. So the opportunities to capture their interest and their business are very large indeed. We will highlight some valuable case studies to help with this process in Chapter 7.

Companies focusing on the emerging economies face similar challenges, as we will discuss in Chapter 6 next month. Their core market will also consist of a currently underserved demographic, those just moving out of poverty and able to afford a bar of soap, or a bra and pair of panties, for the first time.

But the Beatles provide a reliable guide, if we are prepared to listen to their message from 'When I'm Sixty-Four'. The megatrends such as an ageing population and the need for improved food production provide the key to future success.

The blog will be happy to provide any support or advice that may be helpful to readers as they develop their Action Plans.

International eChem/ICIS are also running three training courses in Houston, Singapore and London during Q4, to help with detailed implementation issues. Please click here for further details.

Petchem markets are continuing to act as leading indicators for the global economy. The IeC Downturn Alert shows there was no September rebound in orders after the holiday period.

October will have to bring a sudden, and powerful reversal of the downward trend. Otherwise Q4 could be very difficult indeed. Benzene, the blog's favourite market indicator, is now down 27% since the Alert began 5 months ago.

Equally, crude oil prices are looking very weak, and seem to be heading towards the blog's $60/bbl target. The damage they have already created to demand means prices could end up much lower.

Meanwhile, financial markets have become dysfunctional under the influence of the super-computers. These now control 60% or more of trading in most markets. They are programmed to:

• Read and interpret financial market headlines in real time
• Issue thousands of buy or sell orders in response to these
• Then close their positions after micro-seconds, and start again

The computers are fine when it comes to reading numbers. But they completely fail when interpretation is required:

• Thus markets soared on Thursday, after German Chancellor Merkel won her parliamentary vote to support the European Financial Stability Facility
• But they then reversed direction on Friday, when new headlines suggested the vote had not resolved any of the Eurozone's problems.

This demonstrates how financial markets have lost touch with their real purposes - of raising funds to allow companies to expand, and of allowing producers to hedge commodity price risks. High-frequency trading instead simply creates unhelpful market volatility for the profit of those owning the most powerful computers.

Price movements since the Alert's launch, and ICIS pricing comments this week are below:

Benzene NWE (green), down 27%. "Market values have eroded throughout the past month on continued macroeconomic bearishness as well as slower downstream demand."
Naphtha Europe (brown dash), down 20%. "Refinery run cuts are reducing supplies...demand remains weak".
HDPE USA export (purple), down 18%. "Traders said US inventories were building....but very little export activity was yet taking place."
S&P 500 Index (pink dot), down 17%.
Brent crude oil, down 17%.
PTA China (red), down 10%. "Sellers were forced to offload their cargoes to take in cash ahead of the National Day holiday in China."