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 may hold them at this level for a few more weeks, 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.