Chemicals & The Economy

The US Senate thinks the Amaranth hedge fund increased the costs of natural gas futures contracts last year. Any pension funds invested in Bear Stearns' hedge funds might want to check on the current value of their holdings.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Some of these quotes just seemed too good to ignore…

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Black holes are an apparently empty region of space, with the power to destroy anything that comes too close. The US subprime crisis seems to be turning into their financial equivalent. It never seems to get resolved. It just gets worse. The last few days have demonstrated this key learning once again.

One might have thought that the departure of CEOs at Citigroup and Merrill Lynch, plus multi-billion dollar write-offs, might have marked the end of the story. But it seems that the more we learn about subprime lending, the more uncertain it all becomes.

The underlying issue is that there is no transparency about what has been happening. Most of the lending activity has been taking place ‘off-balance sheet’. And where this lending has been reported, it is only in obscure footnotes to regulatory filings. Even then, it has been subject to massive revision.

Consider the following table, which has been put together by the Financial Times in an excellent piece of analysis. This apparently represents Citigroup’s ‘off-balance sheet liabilities’. And just look at the numbers:

At the end of last year, Citi apparently told the US Securities & Exchange Commission in its 10Q filing that it had $228bn of such liabilities. Then it revised the number to $294bn, by deciding to include its Asset Backed Commercial Paper liabilities (ABCP). By September this year, the total figure had risen to $343bn, with increases in all categories apart from ‘Others’.

Even the FT gives up, however, when it comes to telling us what this might mean for Citi’s published balance sheet in due course. But it does comment that ‘There are questions to be raised about whether maximum loss exposure figures are set to keep rising for some banks.’

Notes:
SIVs are ‘Structured Investment Vehicles’ that make loans that don’t tie up a banks regulatory capital. ABCP conduits do the same for ‘Asset Backed Commercial Paper’. The * indicates the restated numbers for December 2006.

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.

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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

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

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

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

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

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

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

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I am indebted to Paul Krugman for passing on this piece of black humour, now going the rounds in financial markets.

Unfortunately, these problems are getting closer to home. Carlyle, who have a number of private equity investments in chemical companies, defaulted on a $16.6bn bond fund today.

We have now seen 3 financial disasters in a matter of days:

• Northern Rock, the UK’s 5th largest mortgage lender, was nationalised last month, after failing to secure sufficient funds to continue lending.
• Carlyle, one of the world’s largest private equity firms, saw their $16.6bn mortgage fund default on Thursday, due to its excess leverage.
• Bear Stearns, the 5th largest US investment bank, had to be rescued by the US Fed/JP Morgan over the weekend, as it too hit a liquidity crisis.

Bear were the subject of one of my first postings in the blog, last July, when I commented that its hedge fund troubles sent ‘a chill down my spine’. My fears have been amply justified by subsequent events. As the BBC’s business editor, Robert Peston, said on Friday, "the rescue of Bear Stearns demonstrates that the worst of the global credit crunch is not yet behind us." He added ‘that if Bear Stearns had been allowed to collapse, it could have put the whole financial system at risk’.

And although stocks rallied globally on Thursday, after S&P were reported as saying the end of subprime writedowns was ‘now in sight’, it is clear from reading the full S&P statement that their real views are quite different:

‘We believe that any near-term positive impact of reducing subprime risk in the financial system via increased disclosure and write-downs will be offset by worsening problems in the broader U.S. real estate market and in other segments of the credit markets. A major repricing of credit risk is taking place across the debt markets, with credit spreads having further widened in most segments since the beginning of 2008’

As I have noted since September, the whole zeitgeist is changing in financial markets, with lenders now focused on ‘return of capital’, rather than ‘return on capital’. Clearly, they don’t like the prospects they see ahead, and who can blame them? But with housing markets so important to the chemical industry, it is hard to believe that we will avoid major impact from the financial disasters now taking place.

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’?

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

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

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

Paul Tucker of the Bank of England has consistently warned about the dangers posed by the credit crunch to the global economy. Back in December, he identified the key issue as being that central bankers ‘must try to avoid a vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other’. He also highlighted ‘monetary policy, liquidity policy, and regulatory capital policy as being amongst the instruments the authorities would need to use’.

In a new speech, he now highlights the fact that major stresses remain in the global financial system. He also warns that ‘in the US at least, evidence of a feedback loop is apparent’. Many senior chemical industry executives accept that the US is in recession, but expect it to be fairly short-lived. Unfortunately, this hope may prove too optimistic, if Tucker’s analysis is correct.

Last week the IMF warned there was a 25% chance of a global recession in 2008. Today, it said that the ‘crisis (was) creating serious macroeconomic feedback effects’ and could have ‘profound financial system and macroeconomic implications’.

We normally expect central bankers to weigh their words carefully. But now the IMF has decided to throw caution to the winds in an effort to get its core message across as clearly as possible. Challenging those who believe the crisis is already history, it emphasised that:

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

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

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

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

UK readers, and others invested in the outlook for the UK housing market, may be particularly interested in the FT this weekend. It devotes 2 prime pages to a detailed analysis by Fitch, the ratings agency, of sub-prime and buy-to-let lending. As we know from the US, these are the most risky types of lending, as borrowers have little ‘skin in the game’ and can most easily walk away from their losses.

In an early blog last July, I marvelled at the contrast between the then upbeat nature of financial markets, and the gloom apparent elsewhere. I suggested that these two views of life couldn’t ‘continue to exist alongside each other for ever’, and suggested that whatever scenario came out on top would ‘have major implications for the chemical industry’. I added that I personally thought the Access deal for Lyondell (announced that week), would mark a market top, and forecast ‘storms ahead’.

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

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

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

ICIS has just announced its annual Innovation Awards for the chemical industry. Perhaps ICIS might now consider establishing a separate award for central bankers? A rush of new lending facilities seems to be on the way, as they try to find new ways to unblock the pipes that allow money to flow between banks.

Ineos’ 200,000bpd Grangemouth refinery in Scotland is on strike today and tomorrow, over a pension dispute. This will presumably cost the workers 2 days pay. The costs for INEOS and the UK are enormous in comparison. BP, for example, has had to shut down a pipeline that carries 40% of the UK’s oil production, because it is powered from Grangemouth. Bloomberg suggests that N Sea producers alone might lose £50m/day whilst the refinery is shut.

INEOS, of course, will also lose. The refinery and associated petchem plants had to be shut down last week, before the strike started. And the company estimates that it may take up to 3 weeks for full supplies to be restored. Some financial analysts have suggested the overall cost could amount to $60m. In addition, of course, there is all the disruption caused to INEOS customers, and other parts of the industry.

The strike also creates political risk for INEOS, given the potential for it to disrupt gasoline and fuel supplies across Scotland, where it is the only refinery. This is an uncomfortable position for any company, and one that will not be helped by the coincidental publication today of the UK’s annual Rich List in the Sunday Times. This ‘sharply’ cuts INEOS’ value to £2.5bn as a result of its ‘hefty borrowings, an economic slowdown and more competition from the Middle East’. Even so, according to the Sunday Times, Jim Ratcliffe, INEOS’ owner is still in 25th place and worth £2.3bn, more than double the Times’ estimate of his worth in 2006.

Even after the plants are back online, there is no guarantee that further strikes will not occur, as the pension issue looks unlikely to disappear quickly. Whilst an interesting new note from Goldman Sachs, published before the strike was called, suggests that INEOS’ value may continue to ‘underperform over the next 12 months’. Goldman base their view on the fact that ‘Ineos has not reduced leverage ahead of the coming cyclical trough, during which we think it will be among the most highly levered commodity chemical companies.’

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

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

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

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

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

Back in August, as the credit crisis began, I tried to capture the heart of the issues it raised in a few quotes. Many people now believe that it is coming to an end. I am not so sure, and fear it may, in fact, be simply moving from Wall Street to Main Street. If it does, the following quotes may provide a guide as to where we are now, what may happen next, and why we are in this mess:

'As real estate prices plunge, so does the ability of homeowners to borrow against the value of their homes, crimping a major artery of spending. As banks grow tighter with their dollars in a period of uncertainty, families are running up against credit limits, forcing many to live within their incomes. And as companies lay off employees and cut working hours, paychecks are effectively shrinking.' New York Times

'Government efforts should focus on helping the housing market reach equilibrium without overshooting. This can be done only through widespread restructuring of unaffordable mortgages into affordable ones. However, it is questionable whether government programmes can, or should, help borrowers who view home ownership as a leveraged investment. Solutions should focus on those with a long-term commitment to remaining in their homes and paying their mortgages if they had an affordable payment. Sheila Bair, Chairman, US Federal Deposit Insurance Corporation

`Investment banks leapt into commercial banking without the deposit base, while commercial banks went into investment banking without knowing risk management, and this is where we end up.' Brad Hintz, Sanford C. Bernstein & Co

'Wall Street's money-making machine is broken, and efforts to repair it after the biggest losses in history are likely to undermine profits for years to come'. Bloomberg

'A friend, who is a teacher, lamented to me recently: "For years we have been told that bankers were paid so much because you were cleverer than the rest of us. Now it turns out you were not clever at all and we are all suffering for your stupidity."'Abigail Hofman, former investment banker

After a while, large numbers lose their power to shock. So Bloomberg and the FT have performed a service this week by reminding us of the scale of losses in the financial sector. They calculate that so far, US and European banks have had to raise $216.9bn of new capital. And, of course, whilst this phase of the current credit crunch is now coming to an end, the IMF estimates the total bill will be close to $1000bn.

As Warren Buffett told his Annual Meeting this weekend, ‘the worst of the crisis in Wall Street is over. In terms of people with individual mortgages, there’s a lot of pain left to come’. This warning adds to my caution over the outlook for the chemical industry.

The chemical industry moves a lot of product by ship. Recent rises in freight rates have therefore had a major impact on costs for producers and consumers. But there was always the thought that rates would soon decline, once shipbuilders began delivering all the new ships on order.

But now Bloomberg is suggesting that 10% of these orders have already been cancelled due to the credit crunch. 'A year ago, banks would finance as much as 80% of an order, with 12- to -15- year loans,' according to Fortis Bank. 'Now, financing usually doesn't exceed 65%, and terms are 10 years or less'.

And the squeeze is not just affecting ship-buyers, but also those planning to build new shipyards. 20% of current orders are scheduled to be built by Chinese shipyards that are themselves not yet in operation. Equally, there are major delays on critical parts - the waiting time for main engines is now 4 years, and even for diesel generator is 2 years.

Supply chain managers must be starting to wonder whether globalisation and outsourcing will remain viable tools for cost-reduction.

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

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

Every 3 months, the Bank of England publishes its Inflation Report. This is packed with useful charts and commentary on just about every aspect of the world economy. It also normally includes the Bank's own indicator of where UK house prices are headed. This is based on surveys by the Royal Institute of Chartered Surveyors, and figures from the main lenders. But this quarter, the chart did not appear.

Oil markets could become more volatile again, on news today that Saudi is to pump an extra 3000kbd of oil in June. Other Gulf States including Kuwait and UAE may follow its lead.

For years, former US Fed Chairman Alan Greenspan said that it was impossible to recognise an 'asset bubble' until after it had burst. Thus the dot-com bubble, and the US housing bubble, were able to grow without central bank interference.

Now however, Fed Governor Frederic Mishkin has broken ranks and provided this detailed description of how a 'bubble' develops:

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 ....

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

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

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

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

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

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

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

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

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

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

Three major themes (ICIS Jun08.pdf) emerged from our Asian Conference last week, co-organised with ICIS:

• Change. The world is clearly changing very rapidly. Feedstock prices are rising. At the same time, major new capacity is starting to come on-stream in the Middle East, and in Asia.
• Complexity. There are many more issues to understand. Feedstock costs are being affected by geo-politics, gasoline and biofuels. Whilst economic growth is also looking much weaker.
• Challenge. Over the past decade, companies have focused on optimisation within their own chosen 'silos'. This has been a very successful strategy, but it may not be sufficient for the future.

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:

Last September, I wrote to the Financial Times on the subject of the US sub-prime disaster. At a time when many banking commentators were trying to minimise the problems, I suggested that 'a "buyer of last resort", such as the Federal government, would probably need to emerge if this situation is to be stabilised'.

Yesterday, 10 months later, the government took a major step in this direction with its emergency measures to support Fannie Mae and Freddie Mac. Between them, these two lenders guarantee 47% of all US mortgages, worth over $5 trillion. That sum is equivalent to 10% of global GDP, or about the combined size of the French and UK economies.

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

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.

The current downturn is different from anything that has occurred in the last 15 years. Policy makers are clearly worried. The UK's Finance Minister, Alistair Darling, told Bloomberg today that 'the effect of what has happened is going to be far more profound than people predicted at the start of the year'. He added that 'conditions have become much worse across the world'.

Noting that banks have already had to raise $324bn in new capital, Darling warned that `I don't think anyone would be wise to start speculating on how long the present difficulties will last. We are dealing with them here (in the UK), and other countries are dealing them as well. If you look at the problems the banks have had, they have moved into a different phase and governments have to take account of that.'

I noted back in February that US banks were tightening lending standards into the housing sector. Now they are doing the same with business loans. The New York Times reports today that businesses around the country are finding it more difficult to borrow. As a result, companies that depend on bank financing are having to delay or cancel expansion plans.

The NYT reports one thriving company who called their bank for a routine loan to be told 'We're saying 'no' to almost everyone'. And their experience is not unique. In June, bank credit declined by an annualised pace of 6%, according to a Goldman Sachs analysis. This is a sharp turnaround from 2007, when credit was still growing at double-digit rates.

Back in February, one hoped that it would take 'months' rather than 'years' for domestic US chemical sales into housing and autos to recover. Now, with business loans being cut back as well as mortgages, one fears that it could indeed be years before a genuine recovery is underway.

When a leading banker says things look 'terrible', one know they must be really bad. Jamie Dimon is CEO of JP Morgan Chase, the only major US bank not to take write-downs on its housing loans to date. He described the US housing market as follows: 'We saw subprime go first, then you see home equity go and then you see prime go.' He then added, 'the prime looks terrible. We're sorry, but it looks terrible.'

'Prime' is comprised of loans made to high quality borrowers, who would normally have negligible default levels. These are people who have steady jobs at executive levels. But the latest Case-Shiller US house price index shows why Dimon was so downbeat. Compared to last year, US house prices are now:

• Down 16% on a national basis, and falling in every major US city
• Down nearly 30% in Miami, Los Angeles and Las Vegas

And it is likely that there is worse to come. Inventories of new and existing homes are still very high, even though the spring is usually the peak time for home sales. Last month, existing home inventory actually rose to 11.1 months.

A year ago, it was fashionable to claim that the Asian economies had 'decoupled' from the West. Any slowdown would simply pass them by. Last December, I noted a rare dissenting voice, Stephen Roach of Morgan Stanley, who commented that 'decoupling is a good story, but its not going to work going forward'. In March, I noted that 'away from the headlines, the Shanghai stock exchange has been collapsing', and was already down 44% from its peak.

Chemical company CFOs need to step up their monitoring of customers' creditworthiness. That's the clear message today from ratings agency Moody's, who report that corporate defaults are rising sharply.

According to Moody's Director, Kenneth Emery, 'the pace of corporate defaults increased considerably in July as economic conditions weakened and more companies experienced financial distress. Under our baseline model forecast scenario, the global default rate is expected to climb sharply over the next twelve months to 6.3%, while it could reach 10% in a downside scenario of a protracted U.S. recession.'

The credit crunch began a year ago. At that time, the blog was very much in a minority when worrying that it might turn into something big enough to impact 'the real economy'. A year later, it is fascinating to review the crunch's impact so far, and how people's attitudes have changed:

Tighter lending standards, and higher spreads for borrowers, are continuing to create headwinds for the US economy. As far back as January, senior loan officers at major US banks were reporting that they were tightening mortgage lending standards. Yesterday, the latest quarterly US Federal Reserve survey showed that 60% of banks have now tightened their standards 'in all major loan categories'. And, the Fed reports, most expected to keep tightening into 2009, whilst 80% of banks said they had increased the spread they charged to corporate borrowers.

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

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

When you're the richest man in the world, you can generally say what you think. Thus Warren Buffett reflected reality back in March, when he commented that 'by any commonsense definition, the US is in recession'. Yesterday, he probably ruffled a few more feathers when he told CNBC that he thought the US economy was still in recession, and 'could be worse' at the end of the year.

He also remarked that a 'financial crisis reveals which players have been swimming naked, because the tide goes out'. And, he added, 'we (have) found out that Wall Street has been kind of a nudist beach'. As a result, he expects both the US mortgage giants, Fannie Mae and Freddie Mac, to require 'federal government help' to survive. He also expects more US banks to collapse as a result of 'failures where the bankers were dumb in what they did'.

US house prices, according to today's S&P/Case-Shiller Index, are still falling quite sharply. As shown in the chart, they are now down 17% versus last year. The key influence, according to S&P, is that 'the markets that were the high-flyers during the recent real estate boom continue to be the ones that are leading the current decline'. Thus prices in Miami, San Francisco, Las Vegas, Los Angeles, Phoenix and San Diego are all down around 25%, whilst cities such as Atlanta, Chicago, Detroit, Minneapolis and Washington are 'only' down around 10%.

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

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

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

A trend seems to be developing amongst the world's policy makers. Last month saw China and the UK's finance ministries warning of bad times to come. Yesterday, France's finance minister joined the chorus, saying that she had 'underestimated the spillover from the US financial and housing market turmoil'. Even more significantly, her boss, French prime minister Francois Fillon, announced a cut in the government's 2008 growth forecast to just 1%, and warned that the world was facing 'A very, very serious global economic slowdown'.

'Deleveraging' is an ugly word, and it has ugly implications. Bill Gross of Pimco, who manages the world's largest bond fund, has done us all a favour by trying to explain its impact, and why it is likely to continue for some time to come.

He notes that all financial institutions are now reducing the leverage that they use, and as a result:

1. The costs of borrowing are rising, as more equity capital has to be used
2. These costs will continue to rise, until enough new equity capital has been raised
3. Whilst this happens, 'the price of all assets will go down'

Pimco had long forecast that housing markets were most vulnerable to deleveraging. And once house prices began to fall, equity markets soon began to weaken. More recently, commodity markets have also been hit. Oil markets have fallen sharply, as the blog forecast back in mid-July, when suggesting that prices 'could easily fall $50/bbl to $100/bbl'.

But deleveraging has other implications for chemical companies. Banks now need to cut back on corporate lending, to preserve their equity capital. Small companies have already seen overdraft limits cut back. Next, it will be the turn of larger companies.

This could be very painful. As recently as a year ago, you could still find companies who had convinced themselves that cyclicality was no longer a problem. As a result, debt levels were often much higher than considered prudent when I joined the industry.

This high leverage boosted earnings during the boom period. But as the blog warned back in August 2007, 'when we go into the 'down' cycle, leverage will exert its same impact on the downside'.

CFOs will be very busy people in the next few months, as they seek to identify and manage their credit risk.

The US government has finally decided to nationalise the two home loan giants, Fannie Mae and Freddie Mac. Readers will remember I forecast this would be necessary a year ago, in a letter to the Financial Times. I argued then that 'a buyer of last resort, such as the Federal government, would probably now need to emerge, if the situation is to be stabilised'.

Fannie and Freddie guarantee 47% of all US mortgages, worth over $5 trillion - equal to the combined GDP of the UK and France. According to the excellent Gretchen Morgensen in today's New York Times, today's move 'grew out of deep concern among foreign investors that the companies' debt might not be repaid', with China owed at least $340bn.

As the blog noted in July, this vast debt was supported by just $70bn of capital. And Morgensen reveals today that even this number is probably overstated. As I discuss below, high leverage makes earnings (and management) look wonderful whilst things are going well. But it also, as we now see with Fannie/Freddie, makes bankruptcy much more likely in the down cycle.

A year ago, Tesco, the UK supermarket giant, were early to see problems ahead in consumer markets. Now, they see problems developing for corporate lending. Last week, Tesco paid €100m more than expected when borrowing €3bn. But Nick Mourtant, group Treasurer, still thought it a good deal.

He said 'the company wanted to raise as much as possible while it could, and paid a premium to secure the money quickly'. He added that 'relying on short-term funding does not feel comfortable in the current market conditions'. Shrewd chemical company CFOs will no doubt be following Tesco's lead as fast as possible.

The blog has never liked disaster movies, but it was quite a weekend for those who do. First, there was the hurricane hitting Houston and Texas. I used to live in Houston, and watching the pictures of the damage, could recognise familiar places washed away, or burnt down. The blog's sympathy goes to all those affected.

Then, the financial hurricane arrived in New York. By Sunday night, Lehman, the 4th largest investment bank in the US was preparing for bankruptcy. And the world's largest brokerage firm, Merrill Lynch, had been rescued by Bank of America. Ken Lewis, head of BofA, was quoted last October as saying that 'I've had all the fun I can stand in investment banking'. Many more people will be echoing that thought this morning.

The scale of the US banking crisis is now starting to become clear to the world. The US government last week had to nationalise the two largest mortgage lenders, Fannie and Freddie. Both Bear Stearns and Merrill Lynch have had to be rescued by other banks. And now Lehman has been let go, whilst 10 of the world's largest banks have had to establish a $70bn fund to try and mitigate the fallout from its collapse.

Slowly but surely, what began a year ago as a sub-prime collapse, is becoming a financial disaster of epic proportions. As the Wall Street Journal, the house magazine of Wall Street, writes this morning, 'The American financial system was shaken to its core on Sunday'. These are strong words from a publication not given to exaggeration. And more problems are round the corner, with insurance giant AIG now seeking a $40bn lifeline from the Federal Reserve.

Chemical company CEO's need to start preparing contingency plans for surviving a major economic downturn. After the events of the last 48 hours, the chances of this occurring are becoming uncomfortably high.

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

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

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

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

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

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

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

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

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

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

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

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

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

The Wall Street Journal draws an apt comparison between the strict regulation of chemical companies, and the lack of effective regulation on financial firms. It comments:

'Chemical companies are under strict government regulations about what kinds of toxic waste they can produce, where they can store it, and how they can handle it and dispose of it. But during the past five or even 10 years, financial companies have been allowed to create a vast amount of financial toxic waste without much, if any, oversight at all.

'There were few rules on transporting, handling, or storing it. The labeling was inadequate at best. No one had any idea of how to dispose of it, either. It was the other guy's problem. This is how all this stuff ended up in your local bank, money market manager, or pension fund.'

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.'

20 years of investment banking as an independent activity came to an end on Wall Street last night. Bear Stearns was the first to go in March, rescued by JPMorgan. Last week Lehman failed, and Merrill Lynch sold itself to Bank of America. Now the two remaining survivors, Morgan Stanley and Goldman Sachs, have thrown in the towel and successfully applied to become traditional deposit-taking banks.

A further stage in the brutal process of deleveraging is now underway in financial markets. According to the New York Times, Goldman operated with average leverage of $22:$1, and MS with $30:$1, more than double Bank of America at $11:$1. This led to massive bonuses in the good times, with Goldman's CEO and 2 co-presidents each being paid more than $67m last year. But it meant they couldn't survive a downturn.

The chemical industry will surely be affected as Wall Street's risk appetite continues to decline. Traditional debt-to-equity ratios of c35% will now become the norm once more, as investors suddenly remember that high leverage means high risk, in whichever industry you operate. (Those who are interested in better understanding the maths behind the risks, may like to revisit the posting from August last year.)

Industrial production is the key indicator for chemical sales. And it appears a significant decline is now underway in manufacturing. The chart shows August's purchasing manager indices (PMIs) for most of the major countries/regions. India, Switzerland, Greece and Brazil were the only ones showing expansion.

Reporting on the eurozone figures this morning, the Financial Times says they indicate that it 'has fallen into recession, with industry particularly badly hit by the fallout from global economic turmoil'. It adds that new orders in the eurozone are falling at the 'fastest pace in 5 years'.

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'.

Peer Steinbrück, the German finance minister, has joined the growing list of politicians with a view on the current economic crisis.

His analysis differs markedly from that expressed by President Bush on Wednesday. 'The financial market crisis is above all an American problem', Steinbrück told the Bundestag (German Parliament) yesterday.

He added that 'the current turmoil was allowed to develop because of a reckless pursuit of short-term profit and huge bonuses'. Policy makers had lacked the 'political backbone' to stand up to 'bankers' greed'. And Steinbrück expects the results of the current crisis to be far-reaching. 'The U.S. will lose its status as the superpower of the world financial system, and the world's financial system will become multi-polar'.

As a result, he sees a bigger role for European banks and sovereign wealth funds from the Middle East and Asia. He also expects greater regulation of the financial system, as proposed earlier this week by Nicolas Sarkozy, French President. Separately, Sarkozy again warned that 'the crisis isn't over, and the consequences will be serious'.

Another day, another bank failure. That almost seems to be the pattern in US financial markets at the moment. Yesterday the nation's 6th largest bank, Washington Mutual, was taken over by government regulators and sold to JP Morgan. The 119 year old bank, headquartered on the US West Coast in Seattle, had $307bn in assets and was brought down by its risky loans in the housing sector. Its rescue also showcased a further example of the Wall Street greed that helped to cause current problems. WaMu's new CEO, Alan Fishman, has only been in the job for 3 weeks. But apparently he will now receive $11.6m, and keep his $7.5m signing bonus.

More banks disappeared in Europe and the USA over the weekend:

• Bradford and Bingley, one of the UK's largest mortgage lenders was nationalised. The government will now pay $18bn to Spanish bank Santander to enable a transfer of retail deposits to take place
• Fortis, Belgian's biggest bank, has been partly nationalised by the Belgian, Dutch and Luxembourg governments at a cost of $11bn
• Wachovia, the leading US bank, will be rescued by Citigroup with the assistance of the Federal Deposit Insurance Corporation.

As the blog noted earlier this month, the deleveraging process is now unstoppable, and we have reached the 'Minsky moment'. Investors have recognised they overpaid for assets over the past few years, and a 'rush for the exits' is underway, causing 'distress sales' to take place due to an absence of new buyers.

Currently, this process is focused on the financial sector. The blog's fear is that investors' attention may soon turn to other areas, including chemicals and key customer industries.

As if a global financial crisis wasn't enough, we now have a political crisis in the USA. Leaving aside the question of whether the 'bailout' would have worked, last night's rejection of the proposal means that we are in uncharted territory on how to move forward. The blog cannot remember a time when a sitting US President was voted down by his own party on a critical issue by a 2 - 1 majority. 133 Republicans voted against, with only 65 in favour.

An analysis in the Wall Street Journal suggests that the main opposition to the bailout came from lawmakers facing a tough re-election fight in November. It notes that '18 of the 21 most vulnerable Republicans up for re-election, and 10 of the 15 Democrats in the closest races voted against the $700 billion financial rescue'. And it adds that this illustrated 'the political hazards of bailing out Wall Street, without offering an equally generous hand to taxpayers'.

Ken Rogoff was Chief Economist at the IMF, and is now a Harvard professor. His view on Wall Street's current problems is refreshingly different. Writing in The Guardian, he notes that 'efficient financial systems are supposed to promote growth in the real economy, not impose a huge tax burden'. But, he adds, 'the US financial sector, in greasing the wheels of the real economy, has been soaking up an astounding 30% of corporate profits and 10% of wages'.

Rogoff therefore wonders whether 'significant shrinkage of the financial sector, particularly if facilitated by an improved regulatory structure, might actually enhance efficiency and growth?'

Warren Buffett, the world's leading investor, was quite candid yesterday in his views on the US economy. `In my adult lifetime, I don't think I've ever seen people as fearful, economically, as they are right now,' Buffett, 78, told PBS. 'They are not wrong to be worried'. He added that a lack of short-term credit is `sucking the blood out of the economic body of the United States.'

Buffett is a long-term investor, who says his favoured holding period for stocks is 'forever'. But even he added that, whilst he assumes a bailout bill will soon pass Congress, he doesn't expect much improvement in the economy over the next 6 months.

Last March, the blog noted an excellent article on Iceland by Gillian Tett of the Financial Times. She argued that Iceland was 'the first country run like a hedge fund'. And she worried that its banks might prove not 'too big to fail', but 'too big to rescue'? Now, it looks as though we are close to finding out the answer.

In 2007, according to Bloomberg, the assets belonging to Iceland's 3 biggest banks were 9 times the country's GDP. But on Monday, the government had to bail out the 3rd largest bank, Glitnir, to save it from bankruptcy. And now the Wall Street Journal reports growing doubt about the government's ability to rescue any other large banks.

After months of denial, Iceland's government has finally begun to face facts. On Thursday, the Prime Minister, Geir Haarde, warned that 'Government, companies, households and people have seldom faced such great difficulties'. But it may already be too late, as there are suggestions that the country will soon require a rescue package from the International Monetary Fund.

'Buy on the rumour, sell on the news' is the classic definition of a weak market. So the US stock market's reaction to the passing of the US bailout is a worrying indication that further problems may lie ahead. On 19 September, the Dow rocketed to 11388 as the bailout was confirmed. Last night, as the bailout passed into law, it closed 9% lower at 10325.

Nor do we yet know all the answers to the 5 key questions that worried the blog when the proposal was first announced last month:

What is the likely total cost? We know the cost has risen by $150bn plus from the original $700bn requested, in order to gain support from the House of Representatives. But as the New York Times points out, the bailout still has to 'put a dollar value on mortgage related assets that nobody wants'. And previous bailouts in the 1930s and 1990s ended up costing at least twice the number originally proposed.
Is it a done deal? The blog was clearly right to suggest that the bill might well not pass in its original form. And even now it has passed into law, there are serious questions over how it will operate. Will Congress allow tens of $bns to be siphoned off by Wall Street in fees, as apparently proposed by Treasury Secretary Paulson? And will he really be allowed to recruit former colleagues from Goldman Sachs 'to advise him'?
How will the money be spent? It is being suggested that it will take at least 6 weeks to put the necessary systems in place. But already people such as Alan Blinder, former vice chairman of the Federal Reserve, are warning that 'you need to worry about conflicts of interest' when it comes to 'determining the bailout's winners and losers'.
Who will pay the bill? As expected, there are no tax increases planned. So the Treasury will have to borrow from domestic and overseas markets instead. With credit already tight, this may well 'crowd out' borrowing by companies and individuals, as happened in the 1970s.
Will it solve the crisis? The final package is clearly an effort to re-start interbank borrowing. But as the blog noted originally, nothing is being done about the underlying cause of today's crisis, namely 'the excess supply of homes and the large number of mortgage borrowers in dire straights'. Until this is addressed, it is hard to see how markets, and the 'real economy' in which the chemical industry operates, can truly recover.

Against this background, 'buy on the rumour, sell on the news' seems an entirely logical reaction.

A year ago, the blog was in a minority of one, with its forecast for 2008. Its heading was 'Budgeting for a Downturn'. By contrast, the consensus post-EPCA was for $70bbl oil, debt market problems to be contained, and for chemical margins to remain at 2007 levels.

This year's EPCA mood was different. There was an acceptance that a downturn was now underway. The only question was whether this would be short, or lengthy. The blog believes it will be multi-year, on the basis that not only are we entering a global economic downturn, but we are doing this at a time when the oil price is high, and when over-capacity is developing in almost every major product area.

As discussed in my ICIS radio interview, it is also clear that a financial crisis is already well-advanced, even before the economic downturn has really taken hold. What will happen if/when major industrial companies crash over the next few years? Experience from the multi-year recessions of the early 1980's and 1990's suggests that this is probably inevitable. We do not know how this will play out, but it is unlikely to be pleasant.

However, experience from previous recessions also shows that 'self-help' is a better policy than simply waiting for 'something to turn up'. The former allows companies to become 'players', and to retain some control over their own fate. The latter leads to the development of a 'victim' mentality, in which apathy develops and critical issues are left undecided.

It is also important to remember that economic cycles have always been a part of life in the chemical industry. The last 4 years have been amongst the best in our history, and we have enjoyed blue skies. So whilst there are now storm clouds ahead, a 3 - 4 year downturn does not mean that the industry will never recover.

Photo courtesy of www.freefoto.com

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

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

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

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

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

The 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. As Nigel Davis notes in an excellent ICIS insight article, we are not there yet. But the warning signs are building.

As he observes, 'the slowdown in demand growth has until now been masked by supply chain inventories, but those clouds are drawing back to reveal the true situation. Producer stocks are building as the situation deteriorates. Polymer prices have fallen sharply over the past two weeks.'

The causes are the same as in 1980:

• End user demand for polymers is focused on housing/construction and autos. As the blog has chronicled over the past year, this demand has collapsed by 20 - 60%, depending on country.
• The petchem industry, however, has been living in a 'parallel universe'. All down the value chain, buyers were instead focused on buying ahead of likely oil price rises.

As I noted in my radio interview last week, the 1980 experience tells us what to expect. First, buyers have to reduce their stocks to more 'normal' levels. This probably took place in Q3. Now, they have to adjust stocks to today's actual level of demand, which is a lot lower than 'normal'. This process will probably take most of Q4.

I remember 1980 as the scariest moment of my 30 year chemical career. We simply had no idea what was happening to us. 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.

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

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

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

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

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

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

The blog welcomes the co-ordinated action by central banks, including the US Federal Reserve, European Central Bank, and the Banks of England and China, in cutting interest rates. Anything that suggests policymakers are starting to get their act together is good news.

But as the blog has argued since February, cutting interest rates in today's financial climate is like pushing on a string. Today's cut similarly seems to be more gesture politics than a strategy to tackle the real causes of today's problems - overleveraged banks, and collapsing housing markets.

Prospective lenders have clearly found current rates of interest unattractive, and so have exited the market. The blog therefore finds it hard to believe that cutting their potential reward will now encourage them to return

Readers may remember the satirical John Bird/John Fortune video on the causes of the housing crisis. Now the Financial Times Diary has provided a satirical view of the causes of the banking crisis:

A new bank model
1) Take money from members of the public in savings accounts on pretext of keeping it safe
2) Use that money to lend to people who are unlikely to repay it.
3) When loan defaults rise and wholesale markets dry up, start refusing loans and credit to those who are able to repay.
4) Resist paying more for insurance scheme to guarantee savings accounts. You can always take money from the public, through nationalisation, as the price of keeping their money safe.
5) As investors notice structural weakness, start hoarding cash.
6) When this leads to system crisis, take money from the public by offloading bad loans by swapping for Treasury bills at Bank of England.
7) As turbulence continues, stop lending money to businesses.
8) Take more money from the public through government recapitalisation, in return for promise to keep lending people their own money.
9) Slash dividend. Create new executive remuneration scheme.

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

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

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

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

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

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

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

You're looking at the man who, according to today's New York Times, is now responsible for 'choosing which US financial institutions live, and which die'. He's 35, and the assistant Treasury secretary for financial stability, Neel T Kashkari. His qualifications? He used to be a banker at Goldman Sachs, and is 6 years out of business school.

The blog feels distinctly underwhelmed. At this critical moment, was there really nobody in Washington capable of providing sound advice based on actual experience of managing financial crises?

The UK's Sunday Telegraph newspaper reports that 'Ineos, the chemicals group which is one of Britain's biggest private companies, is considering selling assets in an effort to reduce its debt burden'. It adds that 'the company, which has expanded rapidly through debt-fuelled acquisitions, is understood to be looking at disposing of a number of businesses in the US, according to people familiar with its plans'.

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.

In August, the blog welcomed the statement by UK Finance Minister, Alistair Darling, that the 'global economy was at a 60-year low'. It noted that he was 'the first western politician to abandon reassurance and instead to focus on the reality of current problems'. But it still took until last weekend before all the relevant policymakers had taken this message on board.

Financial markets are now busy celebrating their 'escape' from the prospect of a major Depression. And so is the blog, as an economy without functioning banks would have been difficult indeed. It is just a pity that this situation was ever allowed to occur. I spelt out the potential problems in a series of 3 letters to the Financial Times in 2006-7, but policymakers were too busy cheerleading the boom years to listen:

• On 3 November 2006, I argued we should 'beware lending institutions bearing gifts'
• On 27 March 2007, I called for 'action, not words, to end the liquidity party'
• On 4 September 2007, I summed up the problem in 'Every mania is based on an illusion'

As is the way of large organisations, Darling's boss, UK Prime Minister Gordon Brown, will now probably get most of the credit for the rescue that is now underway. But the blog tips its hat to him.

And before we all get too carried away, it is worth remembering that the housing crisis is still unsolved. This is the origin of current problems, and the events of recent weeks have nothing to help stabilise them. The continuing decline in house prices also remains the single most important problem facing the chemical industry, as it weakens demand in core customer sectors.

As the aptly named Mr Darling said in his famous August interview, the coming downturn 'will be more profound and long-lasting' than most people expect. He was right about the risk of Depression and, unfortunately, he is right about this too. The blog will analyse the issues this poses for the chemical industry next weekend, in its annual Budget outlook.

On Monday, governments announced c$3.5 trillion of recapitalisation and capital injection into the global banking system. One would have then expected the major investment institutions to rally round in support.

But on Wednesday, they conspicuously failed to do this. Instead they argued that the taxpayer should provide yet more money, in the form of dividends from the bankrupt banks. Unsurprisingly, stock markets then swooned again.

It is these same shareholders, by their focus on quarterly earnings, who have completely undermined the long-term role of company Boards. They were the ones who pushed for ever higher gearing, and who tried to unseat managements at banks, such as LloydsTSB, who expressed any sense of caution about the likely consequences of such lending.

The blog increasingly suspects that today's convulsion marks the end of the 25-year bull market from 1982 to last year's final highs. It also suspects that the next 25 years will see a return to more sobriety and careful analysis amongst major investors. The bonus culture, and its focus on maximising short-term 'shareholder value' would then disappear.

In turn, this would enable Boards to return to their proper role, as defined prior to 1982, of taking stewardship of the business for the next generation.

Today sees a supportive follow-up in the Financial Times to yesterday's posting about LloydsTSB, and its willingness to rebuff those who parroted the 'shareholder value' mantra. The man who led the bank's director development programme reveals that its former Chairman, Sir Brian Pitman, 'drummed into us that the board's main focus was to ensure continuing economic value added by balancing three seemingly incompatible issues:

- the reasonable demands of the shareholders
- the cost of capital
- ensuring the long-term health of the business.

In addition we had to have the professionalism and moral courage to say "No" to any unreasonable demand of the owners and to be ready to resign if necessary.'

The blog prefers to be optimistic. But 30 years in the chemical industry has taught it to be extremely realistic. So its motto for 2009 Budgets is 'batten down the hatches'. Chemical companies are likely to be sailing in some very rough seas, with treacherous currents and plenty of dangerous rocks. Survival, not growth, is therefore the prudent objective.

The key question is whether your business is robust enough to survive an extended period of low volumes and margins, against a background of tight credit markets, and continuing volatility in oil and currency markets?

Companies therefrore need to change their 2009 budget process in response to this challenge. Normally, they would develop a 'base case', and then investigate 'upside' and 'downside' scenarios. This year, companies should instead focus on the key variables around their survival Budget, so that they are prepared for most possible outcomes.

As the blog noted earlier this month, everyone looks to the majors for guidance during difficult times. It therefore welcomes today's comments from SABICs CEO, Mohamed Al-Mady, when announcing their Q3 results. SABIC are probably the strongest petchem producer in the world, with experienced management and access to advantaged cost feedstocks.

Al-Mady confirmed that SABIC has completed the financing of its new projects. But he then added that " the expected global recession may lead to a decline in demand for products in most of the international markets". This is clearly a carefully worded comment, which anticipates an actual decline in demand, and not just a decline in growth rates. Al-Mady's downbeat view seems similar to the blog's, which yesterday published its own 2009 Outlook, 'Budgeting for survival'.

We now have an possible indication of how far house prices may have to fall in some parts of the USA, in order to attract buyers. Last month, Southern California saw a 65% rise in property sales versus September 2007. The reason, a major increase in foreclosed properties for sale. The impact on prices was severe - median prices dropped 33% versus last year, and are now down 39% from their peak.

One of the oldest rules in investment is that 'When a good management finds itself running a bad business, its the reputation of the business that survives'. Legendary US investor Kirk Kerkorian has just proved he is no exception. Back in April, he spent $1bn on buying a 6.3% stake in Ford Motor Co, and publicly supported its turnaround plan. Today, his stake is worth around 1/3rd of its initial value, and he has begun to sell. If Kerkorian is giving up, then this suggests that Ford may not have long to survive in its present form.

When Manchester United play Newcastle on 4 March next year, the US government will also be playing the UK government. United's main sponsor is AIG, now owned by the USA, whilst Newcastle's sponsor, Northern Rock, is also nationalised. West Ham, of course, were sponsored by an Icelandic bank, now bust.

The President of the UK's Football Association warned recently that the $5bn debts of the main Premier League clubs were 'high risk'. The clubs, just like many banks in recent months, immediately denied this. But the fact remains that the blog's team, Manchester United, have debts of $1.2bn; Chelsea owe $1bn: Arsenal owe $700m and Liverpool owe $600m. And only Arsenal made a profit last season ($60m), whilst MUFC lost $100m, Chelsea $125m, and Liverpool $35m.

These losses were in spite of the clubs' receipts from the current $4.6bn Sky TV deal. And the blog does wonder whether the clubs will be able to renew this on similar terms next season? Equally, will UK football fans continue to pay $100/match for the cheapest seats as the UK recession bites? Is this the real reason for Cristiano Ronaldo's unusually thoughtful face, as he turns out at Old Trafford each match?

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.

Many Asian companies have been cutting back petchem production in recent weeks. Now TOTAL have become the first to follow suit in Europe, with the announcement that they will shutdown the Carling No 2 cracker for a month from mid-November. These decisions are never easy. But as the blog has noted before, when times are bad, the industry looks to the majors to take a lead. The blog therefore applauds TOTAL's management for biting the bullet, painful as it will be.

It also applauds Dow CEO, Andrew Liveris, for his continued honesty about the outlook. Liveris is now warning that "we will likely see a global recession through most of 2009". BP's Steven Welch was equally candid when noting that BP are currently seeing "reduced real demand (not just destocking)". However, the blog is puzzled, to say the least, by yesterday's claim from Nova's Jeffrey Lipton that N American "customers will have to order heavily to maintain production" during Q4.

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

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

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

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

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

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

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

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

Last week, the blog didn't know whether to laugh or cry when Alan Greenspan told Congress that he was "in a state of shocked disbelief" to find that that his self-regulation policy for banks had failed. Gretchen Morgenson of the New York Times was similarly surprised to discover the former Chairman of the US Federal Reserve had really thought lenders "would rein themselves in, when there were billions to be made?"

Echoing the famous line from the 'Casablanca' movie, she adds ironically that, last week, "Mr Greenspan was shocked, shocked to find there was gambling going on in the casino".

There are welcome reports this morning that the US government is finally putting in place measure to help homeowners in danger of foreclosure. The FDIC (Federal Deposit Insurance Corp) has developed guidelines that will "lower a loan's interest rate, extend the life of the loan or defer payment on a portion of the principal". The aim is to reduce monthly mortgage payments to a max 38% of the borrower's pre-tax income.

The blog welcomes this move, as it should help to keep people in homes, and avoid more neighbourhoods being devastated by foreclosures. Unfortunately, though it is a "fix" and not a solution to the housing crisis. It is unlikely to kick-start demand for new homes once more, and the revised borrowing terms will put more pressure on lenders. So it will do little to stimulate chemical/polymer demand in this important sector.

Last week, the Financial Times tried to lighten the current mood of doom and gloom. It began a letters page discussion about the merits of humour as an antidote to panic.

Many blog readers clearly enjoyed the recent posting 'A new bank model'. They will therefore understand why the FT today carries the blog's suggestion that Robert Shrimsley's weekly Notebook deserves to be widely read.

US house prices continued their downward path in August, and "every region reported negative annual returns", according to today's new Case-Shiller index. Nationally, average prices were down 17%, with Phoenix and Las Vegas down over 30% since last August. The recent Panic in financial markets makes a quick recovery even more unlikely. US chemical companies would be wise to budget for relatively low levels of demand from this important sector during 2009.

The US Federal Reserve is now bypassing the banking system, and dealing directly with major corporate borrowers. These have been cut off from many sources of credit, as banks hoarded their cash.

The impact has been immediate, with 1500 transactions already done for a record $67bn - 10 times last week's daily level. This should provide major help for companies, as it frees up their ability to undertake normal day-to-day operations. Equally encouraging is the fact that it also caused a 20% fall in 90 day borrowing rates, to an average 2.55%.

The blog warmly welcomes this latest move to unblock credit channels. If followed by other central banks, it should mark the end of the Panic that has frozen most all financial markets since Lehman's failure last month.

Prof Nouriel Roubini of New York University was one of those to correctly forecast a global recession. He is now warning in a detailed new article that "sharp deflationary pressures" are likely to hit in 2009.

As evidence, he notes:

• the supply glut that has emerged in "housing, consumer durables, motor vehicles"
• "the unemployment rate is sharply up" and "commodity prices are sharply down"
• "the Baltic Freight index - the best measure of international shipping trade - is down 90% from its May peak"

These conditions have already led to a major loss of pricing power for many chemical products in recent weeks. Whilst the blog hopes that the New Year may see some improvement, Roubini's analysis suggests that today's problems might instead continue for some time. Prudent CEOs and CFOs will need to develop contingency plans for this depressing prospect.

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.

BMW, the world's largest luxury car manufacturer and owner of Rolls Royce motors, today abandoned its August forecast of record auto sales and a 4% operating margin for 2008.

CEO, Norbert Reithofer, was in downbeat mood, saying that "the financial crisis is by no means behind us yet, particularly its impact on the real economy in 2009''. BMW is cutting production, and increasing its provisions from €695m to €1.04bn, as bad debts are rising and resale values for leased vehicles are falling.

Rolls Royce prices are usually very robust in the used car market, only falling during severe recessions. Their slide suggests Reithofer's concern about the outlook for 2009 is well-founded.

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".

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

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

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

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

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

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

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

Last month, the blog titled its 2009 Outlook, Budgeting for Survival. This week, the Financial Times has begun a series on developing recession survival strategy. Its key tips are:

• Manage your cash. Don't spend money unnecessarily.
• Keep a strong balance sheet. Have as little debt as possible.
• Price your products/services keenly. Be imaginative.
• Keep faith in the future. Eventually, downturns lead to an upturn.

"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.

2 months ago the blog raised 5 key questions about the $700bn US bailout. Yesterday's news about additional government funding for insurance giant AIG confirms its concerns.

Originally, the US Treasury had insisted it would only support "healthy" firms. Now, this fiction has been abandoned. After AIG announced its 4th straight quarterly loss ($24.5bn), its original loan has had to be increased from $85bn to $112.5bn, whilst the Treasury invested another $40bn in preference shares.

Treasury said the increased support "was necessary to maintain the stability of our financial system". But as Bloomberg reports, it means that loss-making AIG has effectively become a "zombie" company, along the lines of those created in Japan during its financial market collapse of the 1990's. "The living dead keep on walking", as one commentator described it.

The blog fears that this will just be the start of a trend, with one or more of the US auto companies likely to be given a similar "lifeline" before too long. Chemical company CFOs have yet one more thing to worry about.

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

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

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

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

The UK's Finance Minister said today that interest rates might need to be cut "to an unprecedented zero". And the Bank of England warned there is a real "risk of persistent and damaging falls in prices". Deflation would be a major challenge for chemical companies, for two main reasons:

• Demand is deferred, because prices are falling. This is the opposite effect to inflation, which encourages demand to be brought forward to avoid the impact of rising prices.
• Inventory becomes very expensive, as it is always falling in value.

The chemical industry is suffering badly at the moment. The blog fears that if deflation arrives, as it did in Japan during the 1990's, life could become even more difficult.

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.

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

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

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

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

The International Energy Agency (IEA) is the global energy watchdog. Its new annual report, just published, says "the world's energy system is at a crossroads", and adds that "current global trends in energy supply and consumption are patently unsustainable". As examples, it highlights:

• The world will need 45 mb/d of new capacity (4 times current Saudi capacity) by 2030, just to offset the effect of oilfield decline.

• Conventional oil production will only rise by 5mb/d between 2007-2030, "as almost all the additional capacity from new oilfields is offset by declines in output at existing fields".

• 51% of world oil supplies will come from OPEC by 2030, as non-OPEC output falls. Saudi Arabia will have to increase production to 15.6mb/d.

• NGLs, and new output from Canadian oil sands, will have to provide most of the supply increase that the world will require by 2030.

Yet in the short-term, oil prices remain under pressure. The value of the "OPEC basket" has now dipped below $50/bbl, causing OPEC to warn of further production cutbacks. And as the blog noted earlier this month, today's low refining margins, and year-end cash pressures, may well put further short-term pressure on crude oil demand.

So there is at least a chance that we may end the year with prices, temporarily, in the $20-$30/bbl range, just when the IEA is calling for major investment to fund new sources of production.

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

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

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

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".

6 weeks ago, I warned that "the scariest moment of my 30 year chemical career" was about to be repeated. This had been in 1980, when "for some weeks it seemed that demand for many petchem products had simply stopped".

Three weeks later, the blog confirmed that "the moment it had long feared has now begun to happen. 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."

The first company to report this "moment" was Celanese, whose chairman told analysts "basically, orders just stopped". And as the blog then forecast, this "moment" has since been "repeated in other product areas and in other regions", with the effect being magnified as "customers aim to keep working capital low for year-end reasons".

The blog went on to advise that "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."

Today BASF have experienced the "moment". Chairman Dr Jurgen Hambrecht announced that "customer demand in key markets has declined significantly" since the end of October, whilst "sales volumes are being impacted by increased reduction of inventory by customers".

In response, BASF are following exactly the policy advised by the blog, and are "temporarily shutting down around 80 plants worldwide...and reducing production at approximately 100 plants".

The blog salutes BASF for their courage in taking this painful but necessary step. Clearly, there will now be a final period of inventory reduction down the chain, as CFOs insist that companies end the year with maximum cash on the balance sheet.

But the blog would counsel against keeping inventory too low. In January, the auto companies and other key industries will start operating again, after their extended shutdowns, and demand will return again.

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.

My colleague Bob Townsend is well known to many in the chemical industry as an olefins expert. He has pointed out today's most unusual situation in olefins.

Normally, an unplanned outage by one or more crackers would cause major disruption. Yet today, 10 European crackers are down, for technical or other reasons, and many others are operating close to technical minimums.

Those offline include the Wilton and Moerdijk crackers (both technical), with planned maintenance ongoing at Repsol's Tarragona and FAO's NC1 cracker in Antwerp (and speculation another NC Antwerp cracker may also be offline). Munchmunster, Litvinov, Notre Dame de Gravenchon and Pitesti are also all reportedly offline. Priolo is due back after maintenance, whilst the Carling No 2 closure has been announced.

Other regions, notably Asia and N America are also seeing similar shutdowns. Yet Bob notes that butadiene is the only product where even minor shortages have been seen. This tells its own story about the massive clearance of inventory now underway down the value chain.

Last week's BASF announcement marked the end of Phase One of the downturn. This began over a year ago, with the first signs of financial crisis. Now, we will move into Phase Two - a long, multi-year recession, which will probably include several bear-market rallies.

The end of this "beginning" Phase is seeing a disastrous fall in demand, and fire-sale pricing, caused by three main factors:

Destocking. Customers are having to unwind the "extra" volumes bought ahead of price increases during 2007 - H1 2008. Plus, they are also having to unwind any panic purchases made in June/July, when oil was widely expected to be on its way to $200/bbl.

Demand destruction. Whilst all this extra inventory was being built, end-user demand into the key housing / construction and auto sectors was actually declining. So companies are also now having to adjust their stocks to this new lower level of demand.

Year-end factors. Companies are understandably anxious to exit 2008 with maximum cash on the balance sheet. This is reducing demand still further, albeit on a temporary basis.

The first factor meant many companies were holding 20% extra stock by the end of July. Now, they not only have to work-off this volume. But they are also having to adjust to ongoing demand levels that are 20% below 2003-7 levels. Effectively, therefore, the industry has suddenly hit an "air pocket", where physical demand has temporarily appeared to vanish.

The key question, of course, is what happens next? Demand is unlikely to resume previous growth levels for some years to come. But every now and then, there will be sudden rallies, when stocks have become too low.

Such a rally could well take place in Q1, with demand "surprising" on the upside. But it would be very risky to assume this rally also marked the end of the downturn, particularly if credit markets remain difficult.

The UK's Finance Minister, Alistair Darling, was the first western leader to warn that the current recession was the worst in 60 years. He was also the first to effectively nationalise major banks, to stave off their collapse. Now he has become the first to try to tackle the real threat of deflation, by cutting sales tax (VAT) by 2.5% to 15%.

The real problem with deflation is that it rewards buyers for postponing their purchases. Why buy today, when it will be cheaper tomorrow? We are already seeing the impact of deflation at work on chemical sales, and the results are not pleasant.

Darling's £12.5bn (€14.6bn, £18.8bn) VAT initiative is an attempt to tackle this specific problem, by offering a temporary tax cut that will expire at the end of 2009. As such, the blog welcomes the move. But unfortunately, £12.5bn may well prove too small an amount to counter the deflationary danger that Darling has correctly identified.

The World Bank has cut its growth forecast for China's GDP to just 7.5% next year. Only 3 months ago, it was expecting 9.2%. And the Bank warns that the economy is dependent on "higher public spending" for more than half its forecast growth next year.

Chemical companies will also be alarmed by the Bank's suggestion that China's "export growth is likely to slow sharply", as "financial market turmoil hit the economies in other emerging markets". The blog's own forecast last month, in 'Budgeting for Survival, that China's growth could bottom as low as 5%, is no longer looking quite so unlikely.

US housing continues to weaken as the financial crisis of the past 2 months takes its toll of prospective homebuyers. Yesterday's Case-Shiller index of house prices showed a "broad-based decline" in September, posting record annual declines of 17%.

Similarly, the above chart from the ACC's weekly report shows new housing starts (red line) at a record low since they were first recorded in 1959. Building permits (blue line) are a leading indicator of future activity. These also remain weak, and are 40% down on 2007.

In response, the US Federal Reserve has committed $800bn to support mortgage finance. But as the blog has now argued for over a year, such measures do not address the real issue, which is that long-term interest rates are too high. This is because banks are scared to lend to each other, and so the LIBOR rate doesn't respond to changes in short-term rates.

Nouriel Roubini has some useful suggestions this morning as to what could be done to improve the situation, including the direct purchase of long-term credit instruments by the Fed. The blog hopes that the Obama team is already working on how to put such ideas into practice.

The Queen of England recently asked "Why did nobody see the financial crisis coming?"

The Financial Times took the view that "Some did, Ma'am. Some did." It then initiated a search for these people.

Today's Financial Times now recognises some of those who correctly warned that financial crisis was close. I am sure readers will be pleased to know that it chose to highlight my analysis, and the blog itself.

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.

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

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

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

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

The end of a major trend is usually marked by a significant increase in volatility. This seems to be what is happening to the equity bull market that began back in 1982. It has weathered a number of storms over the years, as traders kept faith with the underlying trend. But this week's Barrons, the US investment magazine, notes that the recent collapse has been marked by unprecedented volatility.

It points out that that there have been nearly 15000 trading days on Wall Street since 1950. And in all this time, there have only been 68 days when the Dow Jones has gained or lost more than 4% in a day (33 down, 35 up). Apparently, 28 of those days have occurred in the last 3 months. It seems that the Wall Street bull market may be joining the baby-boom generation, which sponsored it, in retirement.

Yesterday, Dow announced its new structure post the K-Dow JV and the planned acquisition of Rohm & Haas. This covered two main elements:

• Implementation of November's cost reduction announcement
• Dow's new organisation (the chart above)

The cost reductions were severe, with a headline 11% of staff facing redundancy. 20 plants in "high-cost areas" will close. 2000 of the 5000 jobs lost are in businesses targeted for divestment, and this process will now be "accelerated". Another 6000 contractor jobs will also go. Research spending is being reduced by $600m, and working capital by $2bn.

"New Dow" contains "feedstock-driven" and "market-driven" businesses:
Feedstock-driven includes those areas where Dow has been pursuing its "asset-light" strategy for some years. It consists of the various JV's, including Dow's share of K-Dow, plus the remaining associated petchem and basic chemical businesses. The focus will be to maximise upstream integration and become/remain lowest cost producers.
Market-driven will be solution-orientated, aiming to anticipate and meet market needs in forecast future growth areas.

The new organisation pursues the concepts first announced back in July, at the time of the R&H deal. At that time, Dow had indicated it was expecting the industry trough to last until 2011/12, with the next peak not till 2015. This led many analysts to fear a dividend cut, for the first time since 1912. In response, Dow's CEO Andrew Liveris has had to put his job on the line, saying it would not happen "on my watch".

"New Dow" is being born at a difficult time. Global markets are in recession, causing profits to weaken. But "new Dow" cannot just cut costs, as "old Dow" would have done, pay the dividend and wait for the recession to pass. It will now have to also find a way of continuing to invest in new product development within its market-focused businesses, in order to sustain their current revenue streams.

A long-standing industry friend sent me an email overnight about ethylene derivative margins. Only after sending it, did he realise that spell-check had decided to change the word "derivative" to "debilitative". But as he noted in a follow-up email, "amazing the insights of a spellchecker - I meant 'derivative' but maybe 'debilitative' is more of a commentary on the current situation..."

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.

INEOS has now confirmed that it has obtained the required covenant waivers from its banks. They had little choice, as pushing INEOS into bankruptcy would have destroyed value on a massive scale for everyone concerned. But as the blog expected, lenders successfully demanded an increased interest charge in exchange for their consent.

Investors' attention will now turn to the new business plan that the company has promised to present in Q2. Petchem and polymer markets will hopefully improve in Q1, after Q4's fire-sales. But INEOS knows its real challenge will be to demonstrate its robustness in "normal" industry bottom-of-the-cycle conditions, such as the extended downturns of the early 1980's and 1990's. The waiver request has clearly dealt a serious blow to investors' confidence. INEOS will have to work hard to regain it.

The world's major retailers, particularly Wal-Mart and Tesco, keep a very close finger on the global economic pulse.

They spotted looming recession 18 months ago - long before it became more widely apparent this year.

Yesterday, Wal-Mart's UK head went further, referring to "the dawning of the age of austerity". He added that "this won't be a recession where it is a blip, and then we are back to where things were". Instead, he forecast that "the era of conspicuous consumption is over. Saving money by cutting out waste of all kinds will be the priority".

Wal-Mart's view is echoed by Tesco CEO, Sir Terry Leahy, who noted that "the main thing is that we have to reshape the business". Customers have "less money to spend" and "you can't just buck a downturn".

Wal-Mart President, Lee Scott, also told analysts last week that there was "very little visibility as to what the economy's going to do". Scott's view is that it is now critical to "position yourself as a company that saves people money so they can live better".

Chemical companies largely ignored last year's early warning from the retailers. They have paid for this oversight in Q4, as they have had to dump inventory at firesale prices. It is vital for the future health of the industry that companies now respond quickly to the emerging new trends being highlighted by Wal-Mart and Tesco.

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".

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

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

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

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

Yesterday the US Fed cut interest rates to an all-time low of 0% - 0.25%. Once again, Wall Street celebrated with a major rally, even though the move had more symbolic than practical purpose. It made it appear that the authorities were "doing something", even though the evidence of previous rate cuts indicates they have had absolutely zero effect. The reason is two-fold:

• Back in January, the blog quoted Merrill Lynch's Richard Bernstein, who argued that "the Fed can lower interest rates quite a lot, but they will likely have minimal impact on the economy unless credit creation grows".
• Even earlier, in September last year, the blog quoted Rodrigo Rato, then head of the IMF, who argued presciently there was a real risk that "systemically important banks may face constraints in extending credit". This is exactly what has happened, as banks continue to deleverage.

The only encouraging element in the Fed's statement yesterday was the implicit recognition that its policy of focusing on massive interest rate reductions has been equivalent to pushing on a piece of string. There is no other way to interpret its conclusion that, after 5.25% of cuts, "financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further."

In admitting it had been wrong, the Fed did leave the door open for a more useful policy to emerge, when adding that it "will continue to consider ways of using its balance sheet to further support credit markets and economic activity". But "to consider" is not the same as "to act". There is still no sign that the authorities have yet developed a clear and workable plan for resolving today's crisis.

The recession will have a major impact on M&A activity next year, according to a new analysis by Pilko & Co. Their key conclusions are:

• Increasingly,deals will be the result of financial restructurings, workouts or bankruptcies.
• Buyers with cash and debt capacity will be able to dictate terms.
• Asian/Middle East buyers will dominate, as they can still obtain funding, and have a longer-term approach.

In the boom years, too many deals were based on a view that any purchase price was acceptable, as long as sufficient debt could be found to leverage the earnings of the acquired company. 2009 will see the painful process of unwinding this fallacy get underway.

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

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

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

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

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

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

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

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

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

2008 has not been a good year for M&A in the chemical sector. First, there was the collapse of Hexion's Huntsman acquisition. Today, the Kuwait government has signalled its intention to "scrap" its $17.4bn deal with Dow to form K-Dow.

This is a quite extraordinary decision by a major Middle East government, especially as it comes just 2 days before the JV was due to begin operations. Citing "major changes in the world economy, the serious impact of the global financial crisis on the assets of companies and the sharp slide in oil prices", the government says it has decided that "going ahead with this deal involved big risks".

But none of these risks are new. And none of them have suddenly appeared in the last few weeks, since the K-Dow JV was finalised earlier in December. The real reason, as the Kuwait Times notes, is undoubtedly that pressure on the deal has since been mounting in the National Assembly, with opposition MPs threatening to "grill the prime minister (in the Assembly) if the government did not cancel the deal".

The cancellation of the deal at this late stage is clearly a lose-lose for both parties. It is clearly very damaging to Kuwait's reputation in world markets. Kuwait also loses its chance to further develop a leading global position in petchems, whilst Dow loses the support it would have found from allying its petchems business with a strong upstream partner.

But Dow is still the world's No 2 chemical company. And it will no doubt have developed a contingency plan, in case the K-Dow venture did fall through. It could, for example, step-up the current relationship with Saudi Aramco, its partner in the $20bn Ras Tanura project. And nobody would be very surprised if it also now sought to renegotiate the proposed Rohm & Haas acquisition.

2008 has not ended well for the chemical industry. First there was the collapse in demand, as the various value chains destocked in response to slowing consumer demand and lower oil prices. Then INEOS, the world's 3rd largest chemical company, had to seek covenant waivers from its lenders. Now, according to the Wall Street Journal, LyondellBasell, the 4th largest chemical company, may be about to file for bankruptcy.

The underlying issue is that petrochemicals has always been a highly cyclical industry. A typical 7 year cycle involves 2 years of stunning profitability as demand recovers after a downturn, 3 years of average returns as supply and demand rebalance, and then 2 years of horrendous losses as new supply comes online just as demand slows.

We are now 5 years into the current cycle, which started in 2003. So a downturn should not therefore come as a surprise. And, of course, it follows a lengthy period when central bankers had completely failed to do their job, and had allowed personal and corporate debt to reach record levels. As I noted in a letter to the Financial Times back in March 2007, they had proved totally:

"unwilling to implement the famous dictum of William McChesney, the long-serving Fed chairman in the 1960s, that "the job of the Federal Reserve is to take away the punch bowl just when the party starts getting interesting". Instead, they seem to confuse being market-friendly with being friendly to markets."

Thus they allowed demand to continue accelerating between 2005-7, by actively promoting ever-higher levels of leverage. This benefited housing and auto demand - prime markets for petchems - whilst also encouraging companies to increase their own levels of debt. But as the blog has warned many times:

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

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.

Q4 was never going to be good for US housing markets. The financial crash of September/October not only terrified potential buyers, but also meant they found it increasingly difficult to secure loans.

As the chart shows, this lethal combination hit house prices hard. The latest S&P/Case-Shiller figures show prices down 24% in October from the mid-2006 peak. 14 of the 20 metro areas saw record levels of decline, whilst S&P comment that the Pacific Northwest and Mid-Atlantic South regions joined the Sunbelt in experiencing a "severe contraction".

The East Coast is still seeing "only" single digit declines, but San Francisco saw a 31% decline versus 2007, whilst Miami was down 29%. And 6 cities, including Atlanta and Detroit, posted a record monthly decline. As S&P comment, "the bear market continues", with average prices now back to March 2004 levels.

Manufacturing output is contracting around the world. JP Morgan's global index sank 15% in December, and they expect "an intense contraction phase" to continue "for some months to come". The G7 and BRIC countries are all seeing a decline, as Nouriel Roubini notes:

• The US ISM manufacturing index hit a record low of 32.2 in December
• Eurozone manufacturing hit a record low of 33.9
• Japan suffered its worst-ever fall in November, plunging 8.1%
• Brazil's index is at 41.6, well below the neutral 50 level
• Russia's index fell to 33.8 in December, lower than in the 1998 crisis.
• India's production fell in October for the first time in 15 years
• China's December index remained close to November's record low

Meanwhile, Nobel laureate Paul Krugman points out that despite recent government moves to provide banks with more liquidity, "credit remains scarce, and the economy is still in freefall".

He warns that "this looks an awful lot like the beginning of a second Great Depression". And he worries that the fiscal stimulus planned by President-elect Obama may take months to pass Congress, and end up being too little, too late.

The past few weeks have not been good for the chemical industry, with 4 major companies suffering significant problems:

BASF warned that "customer demand in key markets has declined significantly" since October, and have temporarily shutdown 80 plants worldwide, whilst reducing production at another 100 plants.
Dow suffered a major reverse with the last minute collapse of the K-Dow venture, and had previously announced a restructuring programme.
Ineos had to seek covenant waivers from their banks.
LyondellBasell entered discussions to avert a bankruptcy filing.

This week's ICIS Chemical Business carries my forecast for 2009, which focuses on what CEO's can do, immediately, to ensure the survival of their business. Please click here if you would like to read it.

December was another bad month for US auto sales, with volumes down 36% versus 2007. Total 2008 sales of 13.2 million were the lowest since 1992, when the economy bottomed in the 1990-4 recession.

As the chart shows, sales volumes dropped continuously during 2008. They were down 10% in Q1, and then Chrysler and Ford's weakness dragged Q2 volumes lower. Q3 saw no recovery. GM then suffered a terrible October, with sales down 45%. Chrysler won the 'wooden spoon' award, however, with sales down 53% in December.

Overall, Chrysler's total volumes were down 30% in 2008 versus 2007; GM were down 23%; Ford down 21% and Toyota down 16%. And for the moment, there appears no sign of recovery. In fact, weakness continues to spread around the world, with Japanese sales down 22% in December, and both Toyota and Nissan today announcing Q1 output cuts.

LyondellBasell has become the largest-ever chemical company bankruptcy, just 12 months after its formation. Its US operations (Lyondell Chemical Co), and Basell Germany Holdings GmbH, filed for Chapter 11 protection in New York tonight. The company expects its other non-US operating entities to continue to function independently of the Chapter 11 process.

The blog is saddened by the news, particularly by the effect it will have on employees and business partners. But it will come as no surprise to blog readers. On 20 July 2007, just after the deal was announced, the blog commented as follows:

Those who liked the blog's earlier satirical postings on the banking crisis and subprime disaster, may enjoy this video from the Canadian show "This hour has 22 minutes", kindly sent to me by a US reader.

The sketch's punchline - "The money you give won't just save a life, it'll save a lifestyle" - says it all.

The fallout from the Lyondell bankruptcy continues to grow. One analyst has suggested Swiss bank UBS has exposure of $500m - $1.5bn. Other banks, including Citi and the UK's RBS, also have large exposures. Writing-off these debts will in turn reduce the banks' own capital. And so it will further reduce overall credit availability.

Meanwhile yesterday's bankruptcy court hearings in New York ran until after midnight, as creditors, lenders and the company negotiated on funding needs. Eventually an interim $2bn interim loan was approved, plus a $100m "super emergency loan" which will be used to fund Lyondell for the next 2 days.

Lyondell's next objective is to finalise an $8bn 'debtor in possession' loan, which would enable it to keep operating in the medium term. But for the moment, it is very hand-to-mouth. Thus it also had to obtain the court's approval to pay $8.1m of overdue wages to employees - Lyondell Chemical has 17000 employees worldwide, of whom 8000 are in the USA.

The US suffered 2.589 million job losses in 2008, making it the worst year since 1945. December's 524k losses caused the jobless rate to rise to 7.2%, the highest since 1993. Equally, the average work week fell to a record low of 33.3 hours.

Stock markets are still forecasting a V-shaped recession, but as the blog discussed last month, an extended U-shape is the most likely outcome, given the scale of the downturn. The current rally is based on the expected $750bn Obama stimulus programme, which is the latest in a long line of government initiatives since the recession started ($168bn of tax rebates, the $700bn TARP etc). This is said to be a Keynesian policy, akin to the New Deal.

But as Prof Peter Clarke of Cambridge University has pointed out, Keynes was never in favour of artificially boosting "demand by stimulating consumption". He regarded this as doomed to failure. Instead, his 'General Theory' was based on the idea of government-led investment during recessions, as "it was common sense to put idle resources to work. Savings otherwise not invested and workers otherwise left unemployed, could create valuable public assets if government took the initiative".

The new ACC weekly report rightly notes that "any economic recovery will likely begin with a turnaround in the residential housing situation". This is also the critical issue for the chemical industry, still reeling from last week's Lyondell bankruptcy filing. Yet as the ACC's chart shows above, no improvement is yet in sight. New home inventory is now 11.5 months, compared to just over 9 months in the early 1990's recession.

Stock markets have been hopeful that the new 'American Recovery and Reinvestment Plan', being proposed by President-elect Obama, will mark a turning point. But a new analysis by the incoming Administration of its own Plan does not build confidence.

One can certainly praise the authors for their honesty, but it is disturbing to find them emphasising that "all of the estimates presented are subject to significant margins of error". In fact, the blog counted 9 uses of the word "uncertainty". And the conclusion of the Executive Summary is that "uncertainty is surely higher than normal now".

The blog will judge the Plan, when it is finally published, on the same basis as it judged the earlier $700bn TARP plan. Will it "do anything about the excess supply of homes and the large number of mortgage borrowers in dire straits"? For the moment, the signs are not hopeful.

Dominique Strauss-Kahn, MD of the International Monetary Fund (IMF), has a surprisingly hard-hitting interview today in Bloomberg.

Casting aside normal central bank reticence he warns:

• Their current $1.4 trillion forecast of global financial losses will soon be increased by a "significant" amount.
• They will have to further reduce their November GDP forecast, which was already at a recession-level 2.2%.
• US tax cuts might have "very little impact on growth" unless targeted only at "the most vulnerable," who are likely to spend the extra cash.
• W European governments are "behind the curve" in implementing stimulus packages and are "still underestimating the needs."
• "Rates in Europe will probably go down in coming months. A decrease in interest rates is welcome but the impact will not be very important."
• "If in six months from now the crisis has worsened and many other of our members need our help, the demand may be above what we have."

As a former French Finance Minister, his final warning on the European outlook has psrticular resonance. He worries that "a rate of growth between -1% and -2% may have some really strong social consequences".

Over the last few weeks, INEOS had to scramble to get a covenant waiver from its lenders, and Lyondell went into Chapter 11. Now Dow's debt is facing a potential cut to junk status from the main ratings agencies.

Dow's rating has already been cut, following the collapse of the K-Dow deal with Kuwait. And the agencies are worried by the lack of a convincing contingency plan to cover the lost cash. The blog suggested this would be required last month. The need is now urgent, due to the perceived lack of long-term financing for the proposed Rohm & Haas acquisition.

Moody's for example, have said they "would not assign an investment grade rating to this company if it had short-term debt of $11 billion to $12 billion". Similarly, S&P have said they want "proof of $15bn in financing to maintain the investment-grade rating". A junk rating would mean tens of millions in dollars in extra financing costs - not something that could be easily absorbed in today's difficult markets.

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.

Moody's, the global ratings agency, is today forecasting a 70% chance of a U-shaped recession, and a 15% chance of either a V or L-shaped downturn. This broadly agrees with the blog's own view, set out a month ago. Moody's also singles out the chemical industry as being one of those most at risk from a lengthy downturn. It highlights 2 key risks as being higher crude oil prices, and a major downturn in commodity margins.

It also worries about the impact of the "weak credit environment" on "financially stressed companies". It points out this will make it difficult for them to "sell assets and generate liquidity", and could force them "to sell their best businesses". Moody's worries that this "would greatly impair their ability to recover in a weak operating market". CFOs will also be be worried when they read the report (Moody's credit risks Jan09.pdf).

In the soccer world, the UAE has been making headlines this week. It is proposing to fund the first-ever £100m ($150m) transfer - of the Brazilian player, Kaka, to Manchester City. But behind the scenes, the collapse of the oil price has been playing havoc with the economies of the Gulf countries (GCC).

HSBC, for example, is warning that the region faces its most severe downturn in 20 years. It expects only the UAE and Kuwait to balance their budgets this year. Other countries will have to use their reserves to finance spending plans. And even the UAE is exposed to the major downturn now underway in Dubai.

Patrick Townsend of Instrata Capital tells the blog that "the mood in the GCC has become more despondent and redundancies are a fact of life - but not much reported. There are not many banks in the Middle East that have any lending appetite, and there is a large overhang of projects (especially power projects) waiting to get financed."

Current petchem projects in the Region are already financed, but as Patrick notes, future projects will only go ahead once the lending backlog has cleared. He also adds that clients now expect "to achieve meaningful cost savings" from their engineering contractors, and "are delaying orders" until these have been achieved.

Bond markets are a good place to look if you want to understand the outlook for major companies in the chemical industry. A key market is in 'credit default swaps' (CDS), which offer insurance against the possibility that a company might default.

The way they work is that the owner of a bond, or a speculator, can buy a CDS to insure against the possibility that a company might default over the next 5 years. Today, Bloomberg is suggesting that "trading in their bonds shows" that "Ineos Group Holdings, Georgia Gulf Corp. and Chemtura Corp. are crashing on a mountain of takeover debt and may follow Lyondell Chemical Co. into bankruptcy".

Bloomberg reports that "credit-default swap traders are demanding €8.2m upfront plus €500k a year to protect against default on €10m of Ineos bonds for five years". It adds that "the upfront cost soared from €4.8m two months ago. A year ago, it was €716,000 a year with no upfront payment". Bloomberg's conclusion is that this latest trading in INEOS "credit derivatives priced in almost certain odds the company will default".

Bloomberg also notes that Georgia Gulf's 9.5% bonds due in 2014 were trading at 28c on the dollar, to yield 45.8%. It says CDS buyers for Chemtura are having to pay $5m upfront and $500k a year to protect $10m of debt for 5 years. Whilst online news service 'Capital Structures' (CS) says INEOS reported an operating loss of €301.6m for November, and an operating profit year to date of €361.5m versus a budget of €1.35bn.

CS also says INEOS is seeking "new equity from 3rd party investors", and that an "asset sale process is ongoing". They add that "senior management has visited the Middle East as part of this process and has plans to return there". CS claims trade sales had earlier been discussed for two businesses at prices of c$1.5bn and c$1bn, but that "deteriorating conditions in the chemical sector made achieving fair value even harder".

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."

A month ago, after the collapse of the K-Dow deal, the blog suggested that Dow would need to move quickly to a Plan B. It added that "nobody would be very surprised if it now sought to renegotiate the proposed Rohm & Haas acquisition". This now seems to be underway, judging by two pieces of evidence:

• An interview with Dow's CEO, Andrew Liveris, in the Wall Street Journal (WSJ) where he says that Dow are "unable to complete the deal without stable financing".
• An analysis by the New York Times' (NYT) legal expert that suggests "Dow is worried about compliance with its $13bn bridge facility (and)...is using this worry to attempt to force Rohm to the table".

The issue is one of leverage. The Bridge facility has a covenant that requires Dow to maintain its Total Leverage Ratio below 4.25: 1.00, if Dow's debt ratings reduce to a certain level (BBB- from S&P, for example). At the moment, S&P rates Dow just one notch above this at BBB, but the NYT notes that "more downgrades" are possible.

At this point, the NYT suggests Dow "conceivably gains a solvency argument" to use in any negotiations with R&H. Was Liveris preparing the ground for this, when he told the WSJ, "Why would you put two more American companies at risk in this most horrible of markets?"

A year ago, the International Monetary Fund rightly warned that the world was facing a "serious economic slowdown". This week, it has updated its forecasts, and now "expects the global economy to come to a virtual standstill in 2009". This will be "the lowest rate of global GDP growth since World War II". As the chart shows, the IMF expects all countries and regions to suffer:

• USA growth will be -1.5%, Eurozone -2%, UK -2.8%
• Japan growth will be -2.6%, China just +6.7%, Middle East +3.9%

The IMF has reduced its global growth figure by 1.75% since November, because of the global financial crisis. It says this "has weakened consumer and business confidence, raised uncertainty and destroyed wealth, leading to much lower consumption and much lower investment". Emerging economies have been hit by 3 extra factors:

• A collapse in exports
• An inability to borrow overseas
• A decline in commodity prices

The IMF is, however, still forecasting a V-shaped recovery at the end of 2009. It argues that this could occur if a "comprehensive framework for restoring financial health" is put in place, including liquidity provision, capital injections, and the disposal of bad assets". It also advocates large fiscal stimulus by governments to promote spending.

Clearly the IMF has to remain optimistic, as it attempts to persuade governments to adopt its policies. And the blog hopes the IMF is right. But it would be unrealistic for chemical companies to plan on this basis. Today's demand slump, plus the growing risk of deflation, means that a U-shaped recession, lasting till 2011/12, is a more sensible Base Case.

The blog hopes that its recently published "CEO's Survival Guide" will be useful, as companies start to update their 2009 forecasts.

The credibility of some chemical industry CEO's seems to be under increasing attack, due to their apparent failure to develop proper contingency plans in advance of the current recession.

One example this week comes from the USA, where Jim Cramer is one of the most well-known business TV commentators. He suggests that Dow's CEO, Andrew Liveris, "may be the single worst CEO ever to run a major company". You can see the full version by clicking on the picture, and then scrolling down to start the video (it begins with an advert).

Prof David Blanchflower, of the Bank of England, is not optimistic that the current recession will end soon. He notes that "few macro-economists actually spotted the greatest financial crisis in a hundred years". And in the chart above, showing OECD forecasts for the UK economy during the last recession, he demonstrates that forecasters kept predicting a "V-shaped recovery" for the whole 3 years of the downturn.

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

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

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

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

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

The scale of the crisis in Asian economies becomes clearer, month by month.

Exports account for nearly half of S Korea's GDP. In January, these dropped 33%. Of course, January is always a slow month, due to the Lunar New Year, but these figures followed earlier falls of 19% in November and 18% in December.

S Korea's chemical industry is heavily dependent on exports to China, from where they are manufactured into finished goods for the West. With China slowing fast, and domestic GDP dropping 5.6% in Q4, survival is definitely the key priority for the industry in 2009.

The financial fallout from the Lyondell (LBI) bankruptcy continues, as the banks slowly begin to acknowledge their losses.

According to Bloomberg, RBS has taken a $1.47bn hit, Citigroup $1.4bn, and Goldman Sachs $850m. UBS are also believed to have lost at least $500m. But like Bank of America (new owners of Merrill Lynch), they have yet to reveal any details. Nor have hedge fund Apollo, who are believed to have bought $1.9bn of senior debt from Citi last April.

The final losses could be much larger. LBI's net debt at the time of the deal was reportedly around $22bn. And whilst investors comfort themselves with the hope that LBI's senior debt (first lien) will eventually be worth over 70c on the $, the current market value is reportedly just 22.6c. In addition, $8bn of more junior debt could well end up worthless.

Update 10 February. UBS disclosed a loss close to $1.2bn.

European auto sales fell 25% in January, according to JD Power. This equals an annualised rate of just 11m cars, the lowest since the early 1990's. 13.6m were sold in 2008. And although the forecaster hopes for some improvement later in the year, it suggests that "a late 2010 recovery is the most likely timing". It notes that major markets, such as Spain, Italy and the UK, continue to struggle. France also weakened, in spite of the sales incentives on offer.

The blog found some optimism on a recent German visit about the impact of the government's "new for old" deal. The aim is to boost consumption by encouraging older, more polluting cars, to be scrapped. But JD Power say that its introduction "was less than convincing", with German sales down 15% in January.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

TOTAL's CEO, Christophe de Margerie, has become even more pessimistic on the future of oil supplies. In 2007, when prices were rising, he suggested it would be very difficult for production to reach even 100mbd, versus the 130 mbd or more assumed by the IEA and the US government.

Now, he is warning that the limit may be 89mbd, only 4mbd above recent production levels, due to 3 main factors:

• Project delays/cancellations as oil prices weaken
• Faster output decline in older fields, such as the N Sea
• Political constraints in Iran and Iraq

This forecast highlights a key dilemma for the oil-dependent chemical industry. Oil prices are currently too low to encourage necessary investment for the future, even if there were no political obstacles. But as and when oil supply and demand do begin to rebalance, it will be too late to bring on new supply quickly. At that point, oil prices of $100/bbl might not be just the temporary phenomenon that we saw last year.

Vita Group has chemical sales of €1.5bn, 5000 employees, and manufactures in 20 countries. In December it announced that it was in talks over restructuring, to avoid breaching covenants on the €663m of debt taken on in 2005, when it was bought by private equity group, Texas Pacific (TPG).

It now looks set to emerge with a new structure. This provides an important first example of what may happen to other over-leveraged chemical companies, as the recession intensifies.

The basic principle in restructuring is that debt gets exchanged for equity. The 'class' of debt is critical, and in Vita's case it seems that the debt-equity swap may end up as follows:

• 'Junior' debt of €200m will be exchanged for 2% of the equity
• 'Senior' debt of €300m will be exchanged for 32.5% equity

In addition, a further €95m of working capital is being provided by senior and junior debt holders, in exchange for further equity.

Vita's restructuring was relatively simple from a legal point of view, as it just involved European rules. But Lyondell Chemical's bankruptcy filing last month under the US Chapter 11 process seems to have thrown up some very complex legal issues. This is because it involves two different sets of bond-holders - those who bought the European debt issued to fund the original Basell purchase from Shell/BASF in 2005, and those who bought LyondellBasell debt in 2007 to fund the Lyondell purchase.

The Lyondell Chemical Chapter 11 filing had also included 1 German subsidiary. According to today's Financial Times, this was to enable the new 'Debtor in Possession' funding (raised as part of the US process) to be used to "service the European debt while the restructuring took place". However, the rules governing European and US restructurings are quite different, and the FT quotes one lawyer who argues that some European creditors do not want companies to "stretch the reach of Chapter 11 to European companies".

The FT says the issue could lead to a battle over jurisdiction between US and European courts. At the moment, Lyondell has "secured a temporary injunction against a group of European creditors to prevent them from enforcing their claims, as it feared this could push the European business into insolvency". But the creditors are contesting the injunction, on the grounds that "the Chapter 11 filing is an event of default under the terms of the bonds in question".

Now the US courts will have to decide on Monday whether to make the injunction more long-lasting. The legal wrangling is potentially very serious, as Lyondell has also told the court that "the potential loss of control to a foreign liquidator would be disastrous to the debtors' reorganisation efforts".

Update 27 February. Al Greenwood reported last night for ICIS news that the temporary injunction has been extended by the bankruptcy court to give 60 days protection to LBI.

The current recession is the blog's fourth, after those of the mid-1970s, and early 1980's and 1990's. It is, however, already different from these, as it is the only one which has led to comparisons being made with the 1930's Great Depression. As Harvard's Prof Shiller has noted, "Depression fear did not take off" in these earlier recessions.

The leading retailers are also flagging up major change in consumer values. Last year, they suggested we are now in an "Age of Austerity". Further evidence of this is becoming clear. Wal-Mart's US CEO, Eduardo Castro-Wright, noted on Tuesday that a "major consumer pullback on discretionary spending was now underway". Wal-Mart also said their "every day low cost model (now) works around the world".

Equally, as shown by the above chart of US auto sales, something quite different is happening in durable goods markets. The current fall in sales is far worse than anything seen since records began in 1967, in terms of absolute volumes and the 6 monthly average. Clearly, if this continues, it will be very bad news for chemical demand into this important sector.

The blog worries that this trend might become permanent. We might see an L-shaped recession, whereby an aging Western/Japanese population leads to an aging global economy. The New York Times reports today, that even after Japan's 'Lost Decade' ended, consumers have continued to hold back on spending, with car sales now 50% below 1990 levels.

The key issue may be one of "needs" versus "wants". Savings are being badly hit during this recession, with stock markets down c50% in many countries, and many corporate pension schemes in trouble. In this environment, consumers will focus on absolute "needs", such as food, housing and transport. And with most durable goods now lasting longer, they can make their money go further by cutting out the "wants", such as new cars and new kitchens.

As the blog argued in December, CEO's should encourage their Boards to seriously consider the potential impact of an L-shaped recession on their business. A U-shape is still the sensible Base Case. And we all hope the Upside Case of a quick V-shaped recovery may occur. But it would certainly be prudent to consider what might happen if the world now follows the example of Japan post-1990.

Nova's CEO, Jeffrey Lipton, has always been the great optimist of the petrochemical industry. As recently as December, he was arguing at the GPCA meeting that "demand forecasts will prove to be too low", and forecasting a shortage of ethylene and polyethylene in 2012.

However, optimism isn't a business strategy, particularly when it leads to over-leveraging the business. As the chart shows, Nova's shares had fallen 95% since September. According to Bloomberg, Nova needed "to secure $100 million in additional financing by Feb. 28 and $100 million more by June 1". So yesterday, Nova was instead forced to accept a $2bn offer from Abu Dhabi's IPIC. Lipton himself acknowledged that "it was pretty clear that this was the best alternative, you have to deal with today".

Nova's strategic mis-step is Abu Dhabi's gain. Nova benefits from advantaged feedstocks in the shape of Albertan ethane, has several excellent facilities and a highly professional workforce. With a sensible debt structure, it should now survive the present downturn. It should also be complementary to IPIC's existing investments in Borealis and OMV. The blog wishes Nova well under its new owner.

At a time of uncertainty, its sometimes helpful just to frame the questions that need to be answered about the future. Pimco, the world's largest bond fund managers, have done just this in two separate analyses. Their answers mirror those advanced by former Treasury Secretary Nicholas Brady, and make good sense to the blog:

Q1. How bad could this get?
Answer: "No one knows for sure, but common sense would provide a good guess. If the government cannot substitute credit to the same extent that it is disappearing from the private system, then the U.S. and global economies will retreat. If the economy is viewed as a bathtub filled with water (credit), then draining it back down might reduce economic activity proportionately. Liquidate credit to 2003 totals and you just might reduce economic activity (GDP) to 2003 numbers as well. Whoops! That would mean a 10%+ contraction in the US economy with unemployment approaching the teens."

Q2. What can be done?
Answer: "Keeping the tub sufficiently full means advancing policies in content and magnitude never contemplated since the days of FDR. The U.S. and global financial systems require credit creation and foreclosure prevention, not bank nationalization as currently contemplated by some. Trillions will be required in the U.S. alone and it is critical that there be a high degree of policy coordination among all nations, which avoids protectionist measures reflective of failed policies in the 1930s."

Q3. What is the new credit paradigm?
Answer: "Expect to see lower levels of liquidity (making price discovery harder), more corporate defaults (and restructurings), and lower recovery values. You can no longer assume a 40% recovery rate as a bond investor. Government bailouts will likely be based on political parameters, rather than commercial reasoning."

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

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

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

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

Past performance, as we all know, is no guarantee of future performance. But there seems to be sufficient evidence for Comstock's analysis to make the blog concerned that they may just be right.

Kevin Swift at the American Chemistry Council issued a new 2009 Outlook this week. His analysis suggests that we will see a V-shaped recession, as the "massive stimulus being injected into the US and other world economies will foster demand and a virtuous cycle of recovery will engage". His optimism is very welcome, given the dire news this week from US housing markets, which are so critical to chemical sales.

The chart above, from the excellent weekly ACC report, shows that new home sales in January were down 48% versus 2008. New home inventories also rose to 13.3 months, which will no doubt lead to further cutbacks in housing starts. Meanwhile the S&P Case-Shiller house price index fell for the 29th successive month, with "all 20 metro areas reporting annual declines".

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

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

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

Q. How do you know your bank is in trouble? A. When its share price is less than the cost of taking money out of one of its ATMs.
The blog is indebted to Thomas Friedman for this gem.

Thanks also to a blog reader for these 2 jokes from the Jay Leno show:

'The US has made a new weapon that destroys people but keeps the building standing. It's called the stock market.'

'I want to warn people from Nigeria who might be watching our show. If you get any emails from Washington asking for money, it's a scam. Don't fall for it.'

Newer readers of the blog may also like to refer back to an earlier joke page, linked to the Financial Times' collection of sub-prime jokes,

The decline in auto sales is now threatening many industry suppliers around the world:

• Today, the main Japanese car parts group has warned that "Toyota's production cuts will cause bankruptcies among suppliers if the government restricts aid to large manufacturers".
• Last month, the main US associations requested $18.5bn in support from the Obama administration, and met Treasury officials this week to press their case.
• Similarly, Bosch's CEO, Franz Fehrenbach, has warned that in Europe, "A slew of suppliers will no longer be able to finance themselves and stay solvent in the first quarter."

The chart above represents a sad story, with all major stock markets now down at least 48% since their peaks in 2007/8. When the blog last reviewed performance in September, Shanghai had been the worst performer, down 69% from its October 2007 peak. Since then, it seems to have stabilised, with the market down 64% yesterday.

The other BRIC markets (Brazil, Russia, India) have continued their decline, and are now down 49%, 77% and 60% respectively, as exports collapse. Industrialised country markets have also seen further major declines, with the US S&P 500 now down 56%, similar to the loss on Germany's DAX. Japan is down 61%, whilst the UK emerges as the 'best' performer, down 'only' 48%.

This confirms the blog's fear, back in September, that we would see a second round of declines as the financial crisis evolved into a severe economic downturn. We will, no doubt, continue to see major bear market rallies as, for example, followed the Obama victory. But a sustained recovery will probably have to wait until earnings show signs of stabilising,

The world's major financial institutions become more pessimistic each time they report on the economic outlook. 6 weeks ago, the blog noted that the IMF expected "the global economy to come to a virtual standstill in 2009".

Today, the World Bank is forecasting that "the global economy is likely to shrink this year for the first time since World War 2". Equally worrying is its forecast that "world trade is on track in 2009 to record its largest decline in 80 years, with the sharpest losses in East Asia".

Yet many policy-makers still seem to underestimate the problems. As Nobel Prize-winning economist Paul Krugman wrote last week, "the reality is that when it comes to dealing with the banks, the Obama administration is dithering. Policy is stuck in a holding pattern."

Several European policymakers also seem stuck in denial mode. In January, for example, the IMF warned of "deflation risk" if the current policy approach failed. Yet Sunday's central bank meeting didn't even discuss the issue. European Central Bank President, Claude Trichet, said "It's not something we consider a high probability at all at a global level."

As economic risks rise, the blog hopes policymakers will quickly turn their attention to contingency planning, in case their expectations for a V-shaped recovery prove illusory.

The blog has always had enormous respect for Dow. This was due to their ability to manage unconventional risks, in a way that other chemical companies (such as the blog's former employer, ICI), found impossible. Even when things went wrong, they always had a Plan B, which allowed them to exit on a sensible basis.

This time, however, there was clearly no Plan B with regard to the K-Dow JV and R&H purchase. This seems very strange, given that it was increasingly obvious through H2 that the value of chemical assets was declining very fast. Equally, there was always the awful warning of ICI's attempted transition from petchems into downstream businesses in the 1990's. This became a classic example of how to "buy high, sell low".

Now Dow is faced with making the best of a very bad job. As ICIS news notes, it is paying $78.97/share versus the original $78/share. Plus, there is always the worry that, like ICI, an 'efficiency-driven' Dow may not really understand that R&H's innovation-driven businesses rely on R&D for their long-term profits. Dow's announcement of the "additional consolidation of 6 R&D facilities" is a very worrying sign.

The blog wishes 'new Dow' well, but its confidence has been badly shaken by the events of the last few months. Restoring it will take time.

The G20 represents over 85% of the world's economy. And there is certainly no shortage of major issues for government leaders to discuss when the G20 meets next month in London.

But the blog is not over-hopeful about their ability to make things happen. In November, the G20 promised "concrete policy outcomes" from its meetings. But the rather bland weekend communiqué from the preparatory meeting of finance ministers suggests there is still little of substance behind the words.

Human beings go through a number of stages when confronted by major change. As first described by Elisabeth Kübler Ross, the process starts with:

• Denial that any change is taking place
• Then anger at the implications of the change
• Bargaining to reduce its magnitude
• Depression as reality begins to be confronted
• Finally acceptance of what has happened.

John Authers notes perceptively in today's Financial Times that Kübler Ross' model is likely to be a good guide to the evolution of the financial crisis. He suggests that the world is now moving on from Denial, into the Anger stage. Some still deny we are facing a major downturn. But public anger over the bonus payments issue is now on the rise around the world.

Authers suggests that Bargaining will be the next stage, as players try to develop a solution to the crisis. Then we will go through a stage of Depression, at what has been lost, before reaching the Acceptance stage, and moving on. Moving through the Denial stage has taken almost 2 years. So the blog fears we may still have a long journey ahead.

ICIS Chemical Business has just published my article, 'Low-cost operation key to survival', which discusses business strategies for surviving the downturn. Please click here if you would like a copy.

You can also hear a radio interview with ICB Deputy Editor, Will Beacham, by clicking here, or read Will's summary of the interview in ICIS news.

Last month, the blog supported former US Treasury Secretary Brady's argument that 'mark to market' accounting rules were helping to worsen the current financial crisis. It therefore welcomes the decision by the US Financial Accounting Standards Board to revise its rules with effect from April 2. It applauds Paul Kanjorski, chair of the relevant House sub-committee, for forcing this change through so quickly.

It is less optimistic that current Treasury Secretary Geithner's new plans for dealing with 'toxic assets' will work. These seem to be based on the belief that people want to buy these 'toxic assets', but can't find the cash. The blog fears they are 'toxic', simply because they will never be repaid.

US new home sales began falling in 2005, when they peaked at 1.4 million a month. Last month, as the above chart from the ACC weekly report shows, they were down to just 337,000. Similarly, new home inventory has risen to 12 months. Each new home uses over $16k of chemicals, so this decline has had a major impact on industry sales.

But, at last, there are signs that the decline may be slowing:
• Existing home sales have been stable at c4.6 million since November
• Foreclosures have accounted for c40% of this volume
• Foreclosure prices are c20% below market, encouraging buyers
• The US Fed aims to cap interest rates via its 'quantitative easing' policy

Equally, spring is normally the peak time for sales. And after 4 years of constant decline, any relief, even temporary, would certainly be welcome.

There had been speculation that President Obama's mid-West background might tempt him to take a soft line on the troubled automotive industry. But his comments on Thursday that there has been "a lot of mismanagement of the auto industry over the past several years", suggested this was unlikely. Today's news confirms it:

• GM's CEO has been fired, along with some other Board members
• GM has to provide another business plan within 60 days as a pre-condition for further funding
• Chrysler have been told to finalise the merger with Fiat within 30 days, if they wish to receive further funding
• The threat of bankruptcy still hangs over both companies

The core issue is summarised in the above chart from TheChartStore. US auto sales are currently at an annualised rate of just 9 million units. During the 2003-7 boom period, they averaged almost double this amount. Even in the 1991 recession, they only dropped to 12m units.

The new President's tough line suggests that he, like the blog, does not expect a quick, V-shaped, recovery back to 2007 levels.

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.

The blog still finds it hard to adjust to Dow Chemical's current financial status, following the K-Dow/Rohm & Haas episode. But facts speak for themselves. Earlier this week, S&P lowered Dow's debt rating to just above junk grade, on completion of the R&H deal.

However, news that Dow has sold R&H's Morton Salt to Germany's K&S, for a cash payment of $1.675bn, shows that the company hasn't forgotten all its negotiation skills. K&S are paying 6.2 times 2008 EBITDA of $270m, a reasonable multiple. And whilst salt is less cyclical business than polymers, Morton's 2006 EBITDA was only $138m.

The blog has been reading the G-20 communiqué, and various news reports, to understand whether the London summit answered the 5 key questions it raised in advance of the meeting.

Reuters provides a good summary of the outcome in terms of 3 blog questions:

• Global trade. "The Summit 'reaffirmed' commitment from previous summit last year to refrain from raising new barriers to investment and trade. In practice, however, many of the G20 countries have adopted protectionist measures since the Washington summit in November to defend domestic companies." On the positive side, the Summit also provided $250bn to support new credit lines for international trade.
Blog conclusion: more talk than action.

• Fiscal stimulus. "The United States, Britain and Japan had been strong proponents of concerted action around the world to pump more government funds into stimulus packages; France and Germany led calls to hold off, preferring to wait for results from funds already committed. The Summit set no obligation for further fiscal measures."
Blog conclusion: talk, but no new action.

• Regulation. "Clear Summit commitment to extend regulation and oversight to all systemically important financial institutions, instruments and markets. Credit rating agencies will also be covered."
Blog conclusion: clear action plan.

The summit communiqué covers another question:
• Role of Governments: Leaders have "committed ourselves to work together with urgency and determination to translate these words into action. We agreed to meet again before the end of this year to review progress on our commitments."
Blog conclusion: much talk, no clear action plan.

• Plan B: The final question, of a contingency plan in case the global economy does not begin to recover, seems not to have been addressed.
Blog conclusion: No sign of a 'Plan B' being developed.

The blog is delighted that the Financial Times' Gillian Tett has been named Journalist of the Year, in the annual UK awards. She was the first journalist to call attention to the dangers developing in financial markets, and has been an invaluable source of information.

Two postings, from March 2008 and December 2007, illustrate her ability to spot potential problems long before they became major issues: 

Too big to rescue

Posted by Paul Hodges on March 28, 2008 1:39 PM

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'?

2008 economic outlook

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

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

What worries me about the consensus view, as with the consensus on oil prices that I discussed in October 2007 in 'Budgeting for a Downturn', is that it is not a true base case. It is easily the most optimistic scenario. The other outcomes are both downside cases in terms of the 2008 outlook for the 'real world' in which the chemical industry operates.

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

Tom Hicks was a major player in private equity, but then moved on to sports investment via his Hicks Sports Group (HSG). He owns the US Texas Rangers baseball and Dallas Stars ice hockey franchises, as well as a 50% stake in the UK Premier League's Liverpool FC.

Now The Guardian reports that HSG has missed $525m of payments on 3 separate loans, and soon needs to refinance a £350.5m Liverpool loan. Hicks has also confirmed he is searching for "partners that share my long-term vision".

The blog noted in October that many major Premier League teams were loss-making due to excess leverage. Even Manchester United may be impacted. Its US owners seem set on selling Cristiano Ronaldo to Spain's Real Madrid next month for £75m, to help pay their debts.

Benzene is the blog's favourite leading indicator of chemical industry demand. It is one of the most widely used products and, as a liquid, it is also widely traded.

Its recent successes as an indicator include calling a peak on industry profitability, when its prices peaked a year ago. And then it provided early confirmation in October of the downturn, since when it has been at a sustained, and unprecedented, discount to naphtha.

But very recently, prices have begun to recover, with European benzene now trading around $575/t according to ICIS pricing, versus naphtha at $450/t. US benzene prices are at similar levels, around $1.85/gal. Asian levels are over $630/t. Thus benzene is once again trading at a healthy 'spread' to naphtha around the world.

This suggests that, finally, destocking down the value chains may be coming to an end. But the blog remains very cautious about whether this will then lead to a full-scale V-shaped recovery by the end of the year. The prudent policy is still to hope for recovery, but to plan for an extended downturn.

To misquote the famous HL Mencken phrase, "nobody ever went broke under-estimating the losses caused by the credit crisis".

Initially, Fed chairman Ben Bernanke estimated the losses at just $100bn.

Then, a year ago, the IMF said its estimate was $1 trillion. Now, the IMF is raising its estimate even higher, this time to $4 trillion.

According to The Times, the Fund expects $3.1trn of these losses from US-originated assets, and $900bn from EU lending. Even more worryingly, as Nouriel Roubini points out, these estimates do not include prospective losses from corporate loans to highly-indebted companies. According to respected analyst Mike Mayo, the banks are still carrying these loans at close to face value.

CLICK HERE FOR PDF VERSION

Recently the blog has identified a number of signs that US housing and auto markets are stabilising, at least temporarily. This should feed through into chemical demand during Q2, and enable production volumes to show some improvement.

What happens next? In order to answer this critical question, we have to understand where we are today, and where we have been:

Downturns are difficult times. There is always the hope that markets might improve, and this can delay the implementation of tough decisions on plant closures. Nobody wants to shut down, and then see a competitor benefit from an improving market.

But if markets do stay depressed, then precious cash is being wasted whilst plants operate at a loss. This can put other businesses at risk. So it is important to get the balance right. There are no easy options.

The position of LyondellBasell is particularly difficult. It became the largest-ever chemical company bankruptcy in January (with $26bn of debt), and Lyondell Chemical is now operating under Chapter 11 rules. This has already given rise to major legal issues, as different sets of creditors fight for their position.

This led to a worry that financial and legal issues might over-shadow the equally essential need for major business restructuring. Therefore it was very positive when the company announced it was appointing a COO to consolidate management of the worldwide businesses, including its manufacturing divisions.

Ed Dineen was also an excellent choice for the role, given his extensive industry experience and understanding of the LBI businesses. Since October, when the blog published its 2009 Outlook, 'Budgeting for Survival', it has been clear that we were facing one of the worst crises in the industry's history. It is important in these conditions for management to lead from the front, and be open and honest about the problems.

It is also critical that implementation is effective. Since Dineen's appointment was announced, the company has confirmed a target of 4800 job losses amongst employees and contractors, plus the closure of 14 plants, with around half of these already underway. The aim is to achieve $700m fixed cost savings by year-end 2010, with a further $600m of savings targeted by other business improvement measures.

The blog knows and respects many LBI employees, and is saddened by these job losses. But as Dineen noted yesterday, "March and April have not given indications of any significant change in market conditions." In these circumstances, delaying the inevitable would be an abdication of responsibility.

The last 6 months have been traumatic for many parts of the chemical industry. The next 2 or 3 years may well continue to be very difficult.

How should your company best position itself to survive?

That is the key question I will discuss on Thursday 14 May in my Webinar, 'A Checklist for Survival'. Please click here for details, and to register.

The above chart is a real 'labour of love' by the American Chemistry Council. It represents their best statistical effort to model:
• Change in inventories for the major thermoplastics
• Change in underlying demand for them, down the value chain

This is critically important for the chemical industry, as it shows what is really happening in the US economy in terms of demand for the major volume products - polyethylene, polypropylene, polystyrene and PVC.

The conclusions are sobering. Inventories fell 31% from 2008 to trough. Actual demand fell 17% from the same 2008 peak, and is not showing any signs of being about to recover in a major way.

The blog was never convinced by US Treasury Secretary Paulson's efforts to manage the financial crisis. Its view was that Paulson avoided the real issues, and focused instead on trying to boost market sentiment. Worryingly his successor, Tim Geithner, seems to have inherited the same mindset.

2 months ago, Geithner announced that 19 major US banks would be subjected to a 'stress test'. The idea was to check whether their balance sheets were strong enough to withstand more losses on their loans, if the economy continued in recession.

Soon afterwards, global stock markets took off on a major rally. Clearly some people believed that the tests would encourage investors to turn positive on financial companies again. This theory was confirmed when news 'leaked' that all 19 banks would, indeed, pass the test.

However, party-pooper Prof Nouriel Roubini now points out the test is "meaningless". He says this is because actual data for the 3 variables being tested (GDP, unemployment and house prices), "are already running worse than the (so-called) 'worst case scenario'".

You can read the full details on Roubini's blog. But it poses an interesting question. Will the Administration still have the nerve to suggest that all 19 banks are in the clear? Or will it, as the Financial Times suggests, now have to revise the tests to make them more credible?

Either way, the banks will still be in trouble. Their problems now include not just dodgy sub-prime housing mortgages, but also credit card debt and corporate loans. Rising unemployment means consumers will increasingly default on their credit cards, whilst continuing recession will force more companies into bankruptcy.

Parts of Europe are now following the US lead and seeing deflation.

Spain saw prices fell 0.1% last month, for the first time since records began in 1961.

In the UK, the retail prices index fell 0.4%, to register the first decline since 1959. Prices have also fallen in Portugal, Ireland and Luxembourg

Economists have been queuing up to explain that this is only temporary. But the blog is not an economist, just a practical business-person. And it remembers many of the same economists telling us last year that a financial crisis was impossible.

The blog's concern is simple. It believes that inflation and deflation depend on the balance of supply and demand. If demand is greater than supply, then prices and inflation will rise. But if supply is greater than demand, then deflation is a serious possibility.

This seems to be the situation today. Major over-capacity exists in many parts of the global economy, with petrochemicals being just one example. At the same time, demand is low, as consumers prefer to save instead of spend. So prices are falling.

The risk is that this downward spiral might become self-reinforcing. Consumers might come to believe it is better to delay purchases, because they will then be cheaper. This has not happened in the West for a sustained period since the depression. But it did happen in Japan during the 1990's, and may well now be returning there as well.

The prospect of bankruptcy is finally sharpening the knife at GM. As the blog noted last month, inventories are at astronomical levels.

781000 vehicles were in stock at the end of February, and this figure had only dropped by 15000 vehicles during March to 765000 vehicles. This equates to around 6 months supply.

Now the inevitable is finally under discussion.

According to the Wall Street Journal, GM will shut most of its plants for 2 months over the summer, instead of its normal 2 week break. Chemical companies will also take a big hit, with lost sales of c$2500 per auto.

The blog's chemical career began with selling raw materials to the paint industry during the recession of the early 1980's.

Since then, it has always regarded the decorative paint sector as an excellent real-time indicator of underlying economic conditions.

Today's results from Akzo, one of the global leaders, confirms the sector's reputation. Akzo said decorative paint volume was down 16% during Q1. EBITDA was down 41% in constant currencies.

Stock markets may have rallied over the past month. But the International Monetary Fund (IMF) sees no cause for optimism. In March, it thought the economy would contract by 0.5% - 1.0%. Now, it is forecasting a contraction of -1.3% in 2009.

The chart, from the Wall Street Journal, compares the current downturn to the average of the 1975, 1982 and 1992 recessions. It is worse, by every measure.

Yet many investors are still more worried about missing the recovery - hence the bear market rallies continue. We have seen such disconnects before, and the fall-out can be very painful when reality dawns.

The blog is particularly worried about the impact of this speculation on crude oil prices. Not only do these remain in contango, with prices for future delivery being higher than today's. But all the while, oil product demand is slowing, with US demand down 4.3% in 2009 versus 2008. The result is that oil stocks are building:

• Total US inventories are at their highest level since 1990
• PetroMatrix estimate US Gulf stocks are only 3mb off all-time highs
• Commerzbank suggest oil in floating storage now totals 100mb

There is therefore a growing risk that the speculative bubble will eventually burst. This could take prices back towards January's $32/bbl low. In turn, this would destabilise chemical prices and margins, and lead to another wave of destocking down the value chain.

It seems highly likely that GM, the largest US car manufacturer, will enter Chapter 11 bankruptcy proceedings in the next few weeks. Chrysler, the 4th largest US company, may well follow them.

Even if it avoids bankruptcy, GM's own restructuring plan has the potential to be equally traumatic. It is based on a forecast US market of just 10 million vehicles/year - compared to the 15-17 million/year sales seen between 1995-2007.

This raises a number of serious issues for chemical companies supplying into the auto industry value chain:

• Bankruptcies are nearly always messy affairs. It is therefore very hard to forecast just how they will develop. A judge will most likely be in charge of the process, and whilst they will be aware of commercial issues, their first priority is to follow the law.
• A bankruptcy of this scale will be unprecedented. It is also important to remember that a key aim of the process, as the Wall Street Journal notes today, would be to help GM "outmanoeuvre uncompetitive supply contracts with parts makers".
• So far, auto suppliers have received a $5bn support package from the government in March. But we don't know whether any more money will follow this, or on what conditions.
• Chapter 11 will probably only apply formally to GM's US-based companies. But there is clearly a strong risk that some lenders will also seek to involve GM's overseas affiliates (as we have seen with LyondellBasell), adding to the complexity.
• Emotional issues will also come to the fore. Not only will many people be losing their jobs, and their businesses, but brands such as Pontiac have iconic status. Nobody can therefore predict just how the media and wider population may react.

As the Journal warns, the Chapter 11 process "could lead to a unintended collapse of the whole network of companies dependent on the two companies". An up-front investment of time now, in finalising a contingency plan, could be a very wise move.

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.

Chrysler. Yesterday, Chrysler entered bankruptcy. It will idle most of its US plants during the court proceedings. The government hopes the bankruptcy can be finalised in a "quick visit" of just 30-60 days. But even if this can be achieved, there is little doubt that Chrysler's suppliers will suffer major write-offs.

Bank 'stress tests'. Widespread criticism of these as being "meaningless" has led to a tightening. Apparently at least 6 of the 19 banks, including Citi and Bank of America, will now need new capital.

Deflation. The Bank of Japan is now forecasting that prices will fall for the next 2 years, even though it still expects the economy to begin a recovery next year.

The International eChem team are very experienced in turnarounds and restructurings. We have undertaken these both as employees within our former companies, and then as advisers. This has taught us to be alert for the 'tipping point', when a situation begins to change, for better or worse.

The blog believes the Chrysler bankruptcy is one such 'tipping point'. Before it happened, one could still hope that pre-2008 US demand levels might return one day. Now, it is clear we are on a different path. Two factors lead to this conclusion:

Auto plant closures. Chrysler will shut most of its plants for the duration of the bankruptcy. GM have also announced major closures. Both companies have massive inventory (Chrysler 86 days, GM 122 days). Closing so many plants, so abruptly, risks bankrupting many suppliers. But the Obama administration seems to have now decided that there is little alternative. Average auto sales incentives in April increased by 29%, or $680 per vehicle, as companies fought for survival.

Future market size. US autos/housing are core to chemical demand:
• Each new auto consumes $2.7k of chemicals, according to the American Chemistry Council. US auto sales averaged 15m - 17m from 1995 - 2007, worth $41-46bn of chemical sales. Today they are running at a 9m rate, worth only $24bn. And GM's new business plan forecasts the future US market will be just 10m vehicles a year.
• Each new home consumes $16k of chemicals, according to the ACC. In 2006, starts were running at a peak rate of 2.2m, worth $35bn of chemical sales. Today they are running at a 500k rate, worth just $8bn. Even in 1975, 1981 and 1991, starts only fell to 800k.

Why, then, is this a 'tipping point'? The blog has long argued, here and in the Financial Times, that recent housing market growth (in the US and elsewhere) was based on the "illusion that house prices would always rise". And rising prices also allowed home owners to extract mortgage equity - supporting a whole range of consumer markets, particularly autos. Now this illusion is well and truly shattered. Banks are no longer able to make the loans that made the dream appear possible.

Chrysler's bankruptcy therefore marks the 'tipping point', when the first major company is finally forced to adjust to a permanently lower level of demand. A similarly brutal restructuring is probable in US housing markets, where new home inventories are 11 months of demand.

Chemical company CEOs will need to carefully consider the implications of the Chrysler bankruptcy for future levels of global demand.

The European Commission has again reduced its growth forecast for the EU. It now sees a 4% decline in GDP this year, and for the first time is suggesting that recovery will be delayed until mid-2010. As a result, it expects unemployment to reach 11%, which will further slow consumer spending.

'Across the pond', banks are busy increasing interest rates at a furious pace to both commerical and individual borrowers. The US Federal Reserve says 80% of banks have increased the rates they charge on commercial loans, whilst many banks have apparently doubled, or even tripled, credit card rates.

The only good news is that the Fed says bank lending criteria are finally starting to stabilise after 2 years of tightening. It reports that 'only' 40% of banks tightened their criteria in Q1, down from 55% in Q4.

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.

More details are now emerging of the US government's plans for Chrysler. Initially President Obama said he hoped the bankruptcy process would only last 60 days. But according to Bloomberg, the administration now accepts that this period will just cover the "sale of Chrysler's best assets" to Fiat.

Suppliers, including those in the chemical industry, now face a potential double hit. First, they may not be chosen as a supplier to 'new Chrysler', given that this will be a much smaller entity. Second, if they are not chosen, their claims for previous supplies may take many years to be resolved. And cleani-up costs, for those factories that cannot be sold, will probably account for most of any money remaining for creditors.

Suppliers preparing their contingency plans for a possible GM bankruptcy will no doubt take note.

Only 8 countries saw house prices rise, adjusted for inflation, in 2008, out of 32 major property markets. And according to Global Property Guide, "downward price momentum significantly accelerated" in Q4, with 9 countries seeing 5% price falls. As the chart shows, Latvia, Ukraine and Hong Kong saw prices fall over 10% during the quarter.

Employment levels are a key driver for house prices, and so rising jobless figures suggest that any recovery in prices will be some years away. Realistically, therefore, this important source of chemical and polymer demand is unlikely to stage a quick V-shaped recovery back to the boom period of 2003-7.

Back in April, the blog noted that stock markets had embarked on "their 7th bear market rally since October 2007". So far, it has been the most impressive of them all, with the S&P 500 rising 40% between 6 March - 8 May, before falling 5% last week. And as the chart shows, crude oil has also rallied, with WTI rising 35% over the same period.

The result has been that the S&P's price/earnings ratio, the most fundamental measure of stock market value, has risen to an astonishing 122 (based on reported earnings). Whilst oil inventories are probably at record levels, if floating storage and other tankage are included.

Financial investors are responsible for both of these rallies. They are convinced that economic recovery is just around the corner. And as MF Global brokerage told Bloomberg on Friday, "if we are seeing a recovery, things could tighten up very quickly on the energy front".

The blog traded oil products early in its career, and certainly respects the power of sentiment to move market prices in the opposite direction to fundamentals. As Petromatrix note, investors are paying even higher prices for future delivery, with May 2010 priced 14% above today's level.

But the longer the rally continues, the higher the risk that it will all end in tears, if recovery turns out to have been delayed. The blog is not alone in worrying about this, with OPEC noting in its latest monthly report that "oil market fundamentals have continued to weaken".

Last July, when WTI was close to $150/bbl, the blog suggested chemical companies might be wise to hedge for a swift downside to $100/bbl, as well as for higher prices. Similar risks are on the horizon today.

A move towards $80/bbl is certainly possible by the summer, if investors remain confident. But if sentiment begins to change, $40/bbl could happen very quickly.

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.

It is now generally accepted that reckless lending has helped cause the greatest collapse in the global economy since the Depression years of the 1930's. Yet many bankers still maintain it is vital they continue to pursue "innovation" of the type that has brought about this collapse.

Martin Wolf, a former EPCA speaker, makes a good riposte to this argument in today's Financial Times. He notes that "maximising innovation is a crazy objective. As in pharmaceuticals, a trade-off exists between innovation and safety".

The full extent of the recent damage to chemical industry output can be seen in the above chart, based on new figures from the American Chemistry Council. The story is stark:

• Global chemical output was down 14% in March, after falling off a cliff in Q4. The 1979-80 pattern repeated itself again, as the blog forewarned.
• All regions, with the exception of the Middle East (ME), were down at least 13% in March. And even the ME saw growth slip to just 3%.

The only positive is that the figures do indicate that we have reached at least a temporary bottom. The key markets of housing, autos and electronics ought now to be close to the end of the destocking process.

But the blog would be very cautious about assuming that this end to destocking will now be followed by an immediate and sustained V-shaped recovery in consumer demand.

Sadly, as noted by Nouriel Roubini in his latest analysis, today's widely publicised "green shoots" are instead more likely to be revealed as "yellow weeds".

Dow and Ineos are two of the world's largest chemical companies. Both found themselves in tight financial situations at the start of the year. Dow's debt rating was cut to just above junk, whilst Ineos had to ask for covenant waivers.

Since then, Dow has moved to tackle its debt issues very energetically. First it sold Morton Salt for $1.7bn. Then it sold $2.25bn of new equity, whilst successfully refinancing $4.65bn of long-term debt. Now it has announced further sales of its calcium chloride and TRN refining businesses for $925m.

Ineos has not yet announced asset sales. And the company has had to ask lenders for an extension to July for its covenant waivers, whilst discussions continued on its proposed new business plan. However, CFO John Reece told Reuters last week that 'there was "a lot of activity" in the company's plans to sell assets, with proceeds to be used to pay off debt'.

US house prices are still seeing "record declines" according to today's Case-Shiller home price index. The national price was down 19.1% from March 2008, and 32% from the Q2 2006 peak. As before, the over-built Sunbelt led the way, with Phoenix, Arizona down 36% from last year. But now, the index is picking up major weakness in Detroit (down 5% in just one month) and New York (down 3%), as unemployment rises.

Equally, the figures for building permits show no sign of any green shoots. These are a key indicator for future chemical demand, with each new house using $16k of product. As the above chart from Ron Griess of theChartStore.com shows, permits to build new homes are now at their lowest level since records began 1960, and down 50% on last year.

At their peak, housing starts were 2.2m/year, worth c$35bn of chemical sales. In April, only 458k homes were started, worth just $7bn, and only 494k permits were issued. Yet Q2 is normally the peak season for construction. The blog fears Q4 may have worse surprises in store, if unemployment rises and loans remain hard to obtain.

The Financial Times today highlights the overwhelming importance of falling US house prices to the outlook for the global economy. It notes that prices are now falling by 2.2%/month, causing a $380bn wealth loss in March alone. It adds that if prices continue to fall at this rate, "the total loss in 2009 would be about equal to the economic output of China".

Back in December, the blog analysed statements by King Abdullah, and concluded that Saudi Arabia had a 'target range' for oil prices of $75 - 100/bbl. Yesterday, this analysis was confirmed by Saudi Oil Minister, Ali Naimi, who said the world economy could now "weather oil prices at $75 - 80/bbl".

The blog fears that Naimi is being too optimistic. High oil prices effectively act as a tax on consumers, reducing their discretionary spend. This impact can be disguised for a period, as happened in 2007 - 8, whilst the value chain builds inventory in advance of anticipated price increases. But in the end, underlying demand is revealed to have collapsed, as the chemical industry has recently discovered to its cost.

There is, however, another side to the Saudi's argument about prices. And here the blog is in agreement with their analysis. This is that $75/bbl is probably the minimum level required to attract the investment required to maintain current supply levels. And this is a critical consideration, with oil field depletion rates currently running at 9.1%/year on existing fields.

So the chemical industry is caught in a vice. If oil prices stay low now, this will help sustain demand in the short-term, but then likely lead to much higher prices (>$100/bbl?) in the future. If they rise now, this will help to assure supplies for the future, but at the cost of a sustained period of lower (perhaps even negative) growth rates.

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.

Picture: www.amazon.com

"Sometimes, I've believed as many as six impossible things before breakfast" said the Queen in Lewis Carroll's famous book, 'Alice in Wonderland'.

Today would have been a good day for her to practise this ability, as she read her newspaper:

GM, once the world's largest auto manufacturer, went into bankruptcy. US stock markets celebrated, rising 2.6%.

Europe's jobless rate hit a 10 year high of 9.2%. Several regional stock markets, including Germany's, also rose 2% or more.

S Korea's exports (responsible for nearly 50% of GDP) fell back in May, and were down 28% versus 2008. The stock market rose 1.4%.

Oil prices rose over $2/bbl to a 2009 high of $69/bbl. The International Energy Agency reported that "financial and economic meltdown have slashed demand".

UK Finance Minister, Alastair Darling, has been a key figure in restoring confidence in financial markets. The Financial Times suggests he will shortly lose his job due to a £668 error in an expense claim.

Judge Robert Gerber of the New York circuit will be responsible for making all major decisions in the GM bankruptcy. His existing responsibilities for Lyondell's Chapter 11 process (and others), was apparently leaving him plenty of spare time.

By the end of May last year, 6.2m autos had been sold in the US market, each containing $2700 of chemicals (according to the ACC). The total sales value to the chemical industry was $16.8bn. So far this year, just 3.9m autos have been sold, with a value of $10.7bn.

Recent downturns have always seen a temporary dip in US auto sales. But annual volume between 1995-2007 still stayed within a 15m - 17m range. This time has been different. Annualised volume is currently just 9.9m.

The chart provides some comfort, as it is clear that sales have bottomed recently, as expected. Inventories are also being reduced, with both GM and Chrysler shutting their plants during the Chapter 11 process, although this is very painful for chemical sales in the short-term.

Chemical company boards therefore have some difficult decisions ahead:

• Short-term, they must plan for major capacity cuts, in line with expected auto industry demand. Volume is most unlikely to rebound to the previous 15m-17m range. GM's new business plan assumes a US market of just 10m/year. And the Obama industry taskforce is clearly keen to encourage the industry to focus on profits in the future, rather than volume.

• But they need to target such cuts very carefully. In the medium-term, the move to increase auto fuel economy by 42% could well compensate for at least some of this lost volume. Lighter-weight, more fuel-efficient, autos will require more chemicals and polymers, not less.

Getting this balance right will be complicated, to say the least. CEOs might like to dust out their copy of the blog's 'CEO survival guide' for its advice on how to move forward.

During the growth years, it became fashionable for politicians to claim that central banks were "independent". But as the current crisis has grown, this has been increasingly exposed as a myth.

As the blog noted back in September 2007, Alan Greenspan (former US Federal Reserve Chairman), revealed that 'the presumption that we were fully independent and have full discretion was false'.

Now Germany's Chancellor, Angela Merkel, has gone one step further. Speaking in Berlin, she made a remarkable attack on current central bank policies. "What other central banks have been doing must be reversed. I am very sceptical about the extent of the Fed's actions and the way the Bank of England has carved its own little line in Europe. Even the European Central Bank (ECB) has somewhat bowed to international pressure with its purchase of covered bonds."

In other words, the ECB should do what the politicians tell it to do, not what it thinks is the right policy. The blog will watch to see if it now begins to retreat on recent initiatives, even at the cost of breaking central bank unity as the current crisis deepens.

Picture: www.businessoffashion.com

A senior figure in the investment community told the blog recently that companies' views on the outlook for the economy seemed to vary according to their own financial position: "the stronger the balance sheet, the more realistic (and worse) the view on the economy".

This analysis was confirmed at an interesting M&A Round Table organised last week by Pilko & Associates. Some key insights from the event were:

• Risk analysis. Many CFOs are organising up-front strategic reviews to better understand not only their own corporate risk profile, but also those of their major counter-parties (eg suppliers, customers etc)
• Scenario analysis is becoming much more common. Few people believe in a quick V-shaped recovery, and the risk of an L-shaped 'lost decade' is perceived to have increased (as seen by Japan in the 1990's). The base case is increasingly a 3 - 5 year U/W-shaped downturn.
• Refinancing. A large number of businesses will need refinancing over the next couple of years. Banks like this type of business, due to the high fees involved. But their credit committees are being much more cautious than during the 'boom years'. It now takes 12-18 months to achieve a refinancing, versus 6-9 months in 2006-7.
• Business analysis. Investors cannot now 'flip' businesses for a quick profit after 12-18 months, and instead need to be committed to running them for several years. They therefore need to understand the business's fundamental drivers, and to evaluate its operational skills.
• M&A timescale. It is much harder to auction businesses via the use of a generic Information Memorandum and a timetabled sale process. Instead M&A is often a 'one-on-one' process, where finding a qualified buyer can require months of patient effort. And the total 'package' has to be right, to fit the buyers' own strategic needs.
• The buyer's process now starts by understanding the key drivers and issues for the business, and how its acquisition might fit with their overall strategy. They then develop realistic scenarios for the future outlook, as a means of highlighting key issues for testing during due diligence.
• Leverage. Lack of liquidity in financial markets means deals often require much higher equity levels (>50%). Equally, banks are more concerned about the strength of warranties and parent company guarantees, and how enforceable these might be in a continued downturn.
• Restructuring will need to bring in new investors, who will be focused on cash-flow risks, because of refinancing problems. This will benefit acquirors with capital, and a long-term view.

M&A activity is therefore much lower than in the past, as players adapt to the new environment. At the moment, a lot of deals are stalled due to sellers adopting a V-shaped outlook, and expecting a quick profits recovery, whilst buyers are worried about the potential impact on profits of a prolonged L-shaped downturn.

Today's high levels of uncertainty also led participants to emphasise "the huge opportunity for high quality advice". Major value could be added by those who had correctly foreseen the downturn, and could now describe the likely key issues ahead.

The European soccer transfer market is a good example of a market where sentiment often outweighs fundamentals. Research by London's Cass Business School shows that transfer fees have only a 16% correlation with success on the pitch. They found that salaries were the key driver, accounting for 92% of variation in league position.

Spain's Real Madrid is a prime example of a club obsessed with transfers. Between 2003-6, they bought very expensive 'galacticos', but won no trophies. Now their President from those years, Florentino Perez, has returned. His first moves this week were to buy Ronaldo for £80m and Kaka for €65m. The blog sees this as further evidence that sentiment has become relatively bullish, and will maintain its support for Manchester United, with or without Ronaldo.

Sweden is an influential adviser on credit crunch issues. This is because of the lessons it learned during its own major banking collapse in the early 1990's, which has close parallels with today's global crisis.

Its central bank argues that the main risk now facing the world is deflation, not inflation. It points to the very worrying parallels between the progress of the current crisis, and that of the Great Depression.

The chart above, from Profs Eichengreen and O'Rourke, summarises the bank's argument. It maps the decline in global industrial output from the Depression's start in June 1929, versus the period since April 2008.

Of course, policy responses have been different in this crisis. But chemical production is closely tied to changes in industrial output. Any further decline from current levels would be very bad news indeed.

Footnote, 17 June. The Financial Times today follows up the blog's posting above on the work of Profs Eichengreen and O'Rourke. After detailed analysis, the FT concludes that "those sure we are at the beginning of a robust private sector-led recovery are almost certainly deluded. The race to full recovery is likely to be long, hard and uncertain."

The 'Falkirk Herald', based close to Ineos's Grangemouth facility in Scotland, is not normally the place that the blog would look for news of the potential sale of a major part of the world's 4th largest chemical company.

However, that is what happened today, when the 'Herald' reported that Grangemouth site manager Gordon Grant had confirmed Ineos was looking for "partners", and "had some interest from PetroChina". Being questioned by the local community council, Grant then reportedly added that "Ineos has stated very clearly we are committed to the Grangemouth site, but nothing is forever. We will see what comes out of these discussions with PetroChina".

Rumours of potential INEOS sales have been around for some months. And whilst a deal may not be quite as close as the Herald suggests, INEOS is certainly under intense pressure from its lenders, as it seeks to agree a new business plan by a revised deadline of 17 July. A sale of part or all of the Grangemouth refinery could bring in significant cash, given the $725m that Dow achieved recently for its TRN refining business.

The blog's close eye on Scotland's media has again been rewarded this morning, as 'The Scotsman' reveals that Ineos have appointed Morgan Stanley, the investment bank, to advise on the sale of Grangemouth.

It suggests that a company such as "PetroChina could buy the refinery, while Ineos would retain the polymer and petro-chemical processing plants located on the same site". But worryingly from Ineos' point of view, it quotes a PetroChina official as saying that "downstream business has a poor margin nowadays and talks can take a really long time".

The great wave of destocking is finally coming to an end. And it is clear that underlying global demand is well below previous "normal" levels.

The evidence for this can be seen in the above chart, based on American Chemistry Council data, which shows global chemical production down 12.8% in April versus 2008. And as Nigel Davis noted in ICIS Insight last week, BASF (the world's largest chemical company), has said that it is "operating worldwide at less than 75% of operating capacity".

The ACC's data covers 33 key countries, who probably have slightly better competitive positions that other producers. Thus a decline of 15 - 20% is probably a reasonable estimate, and would also correlate with the BASF data (as effective maximum operating rates are c95%).

This is not a good starting point as we enter H2. Not only will more capacity be starting up for many products in the Middle East and Asia (particularly China). But also Q3 is normally seasonally slow, whilst year-end cash management is likely to mean December demand will be weak.

The chemical industry is always a leading indicator of the global economy. One of the blog's oldest friends used to be a central banker, and he made no secret of the fact that our discussions about demand levels were often an important factor in his overall analysis.

So it is no great surprise that the World Bank has issued a rather gloomy new forecast for the world economy. It is now predicting a 2.9% decline in 2009, compared to a 1.7% fall in March. And it is only expecting a modest 2% rebound in 2010.

The Bank also warns that "developing countries are expected to grow by only 1.2% this year, after 8.1% growth in 2007 and 5.9% growth in 2008. When China and India are excluded, GDP in the remaining developing countries is projected to fall by 1.6%, causing continued job losses and throwing more people into poverty."

Economic recovery can't come soon enough for Ineos. After 7 months of negotiation, it has finally agreed new covenants for its €7.3bn of debt with its major lenders. These will now be put to all 230 lenders for approval by 17 July. But the price is high:

• Initially, Ineos was paying c2.5% over euro base rates (Euribor)
• Now this premium is to rise to 6.50% on €5bn of loans

The Financial Times estimates that this will cost Ineos €260m a year, as well as €82m in one-off fees.

And in spite of the agreement, bond markets remain nervous about the company's ability to eventually repay its debt. According to Bloomberg, it now costs €6.16m to insure €10m of Ineos debt against default, plus €0.5m a year. In January 2008, the upfront cost was just €716k, with no annual payment.

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.

The chemical industry has benefited from a benign paradigm over the past 25 years:

• Demographics in the west have encouraged consumption, as the baby-boom generation reached middle age
• Globalisation meant this could be achieved at lower cost, by outsourcing production to lower-wage countries in the east
• Workers in the east saved their money, which allowed banks to make good profits by lending it back to consumers in the west

Now, all three pillars of this paradigm are under threat:

• The baby-boom generation is starting to retire and a new, more frugal, type of consumption is emerging in the west.
• Asian countries are trying to rebalance their economies, to promote more domestic demand and replace lost exports.
• And many banks are amongst the ranks of the walking wounded, unable to resume lending at previous levels

What happens next, is therefore a key question. The Bank for International Settlements (BIS), the central bankers' bank, suggests that "A financial crisis bears striking similarities to medical illness. In both cases, finding a cure requires identifying and then treating the causes of the disease."

Its analysis, in its newly-released Annual Report, suggests that investors, consumers and policymakers have been "fooled into thinking that trend growth was higher than it really was". And the BIS's conclusion is that "countries have been left with bloated financial sectors, the ability to build more cars than their populations need and, in some cases, surplus housing stocks."

Housing and auto demand have, of course, been a key support for chemical demand in the past few years. If the BIS are right, then considerable downsizing awaits the industry over the next few years, as it adjusts to the new realities.

Source: Wall Street Journal

Everybody's favourite Christmas film is 'Its a Wonderful Life', in which the hero rescues a failing US bank during the Depression. But until today, the blog had never realised that a major role model for the plot-line came from Chicago in 1932.

Nouriel Roubini's blog notes that the city saw the largest and most important bank panic of the Depression, after Chicago ran out of money and had to start issuing IOUs to employees, creditors and others.

Fast forward 77 years, and the situation is now repeating itself in California. If independent, the State would be the 8th largest economy in the world. Yet it ran out of cash on 1 July, and has since had to start issuing IOU's to employees and creditors, just as in Chicago.

The State has a budget deficit of $26.3bn, on revenues of $113bn, according to the Financial Times. And it is constitutionally unable to raise taxes in many obvious areas, due to voters' reluctance to vote the necessary increases. Their ability to pay higher taxes is also questionable, with unemployment already at 11.5%, and house prices down c20%.

Nobody currently expects California to default on its $59bn debt load. The Federal Government would probably feel forced to intervene before that happened. But with Hollywood within the State's border, no doubt President Obama is already nervously wondering if he will end up starring in 'Its a Wonderful Life - 2', this time in real-life.

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.

In 2007, Sweden was the largest private equity market in Europe, as a percentage of the country's GDP. And the local banks lent freely, as elsewhere, to fund investments. Now they, and other Nordic banks, are struggling to minimise their losses.

According to Bloomberg, Sweden's second-biggest bank, Handelsbanken, "seized parts of Plastal Group and Plastal Holding AB on July 2, after a cash infusion from Stockholm-based private equity firm Nordic Capital failed to save the plastic-parts maker from bankruptcy".

75-year old Plastal had sales of €1.3bn in 2007, and 6000 employees in 10 countries. But since then, it has been badly hit by the downturn in its core automotive market. Now "Handelsbanken, which loaned the company 2.1 billion kronor, plans to merge Plastal's Belgian, Norwegian and Swedish units into a new company".

Sadly, Plastal is unlikely to be the only company whose ownership moves from private equity to their bankers, as the downturn continues.

As expected, Ineos have today confirmed that their proposed new covenants have now been accepted by their lenders.

For those unfamiliar with the mechanisms used in the world of high-yield debt, this does not involve any new money, or a refinancing. Instead, it means that the lenders have agreed to provide Ineos with more head-room in terms of its day to day operations. Thus the company have confirmed that there will be a "reset of the Leverage, Interest Cover and Debt Service Cover covenant levels, effective from September 2009".

This sounds like financial small print. But it means Ineos and their lenders have agreed to make an adjustment to the conditions of existing loans, rather than to change the whole capital structure of the business. So Ineos employees, as well as their customers and suppliers, will no doubt be very reassured that everything has now been finalised.

There are two main views on the financial crisis that began last September. The mainstream view, as expressed by the US Federal Reserve, is that it was a problem of liquidity. Banks became frightened to lend, and so the Fed stepped in as "lender of last resort". So given time, everything will soon be back to "normal".

The other view, as expressed by Pimco, the world's largest bond fund managers, is that the crisis was, and is, about solvency. As they describe it, US consumers have suffered a wealth loss of $15 trn, and global consumers a loss of "multiples of that figure". As a result, Pimco forecast a "new normal", for at least a generation, of "higher savings, lower consumption ...and growth closer to 2% rather than (the historical) 3.5%".

The blog continues to side with the Pimco analysis, for one simple reason. This is that it has long argued that the heart of the financial crisis was the reckless lending to the housing sector. Yet these loans are still on the books of the lenders at close to their original value, at a time when US house prices have fallen by more than 30% from their peak, and the number of foreclosures is still increasing.

Now, a very detailed article in the Wall Street Journal by 2 Stanford University professors analyses the real value of these loans. And they are "clear that the problem was not liquidity, but rather the insolvency risks of counterparties with large holdings of toxic assets on their books".

It may suit the lenders, and the Federal Reserve, to maintain that the issue is just liquidity. But after reading this article, and the lack of transparency that it describes about the real value of these loans, the blog feels it is only prudent to follow Pimco's analysis, rather than the Fed's.

The excellent weekly report from the American Chemistry Council (ACC) has a number of interesting insights:

• As the chart shows, global chemical production seems to have bottomed. All regions are, however, now showing a decline versus 2008.
• Separately, the ACC has updated its valuable survey of the state of inventories down the US polymer chain. This suggests that these were finally being rebuilt in May and June, for the first time in a year.
• Equally, they note that total inventory of existing US homes reduced to 9.4 months, with sales stable at similar levels to June 2008.

The latter is a critical leading indicator for chemical sales. But according to the US Realtors Association, the housing market is now seeing 2 quite different sets of drivers:

• Homes priced under $250k are selling fast, often via foreclosure, and inventories are down to 6 months
• But homes priced over $1m are seeing very little activity, with inventories now at 20 months.

The question, of course, is what happens next? The risk is that rising unemployment starts to force owners of more expensive homes to sell on a distressed basis. This would clear inventories, but would also cause further problems for the financial system, as lenders would then have to go through another round of debt write-offs.

Hopefully, these owners will be able to hang on. But even then, the chances of a V-shaped recovery remain low. As the ACC note, it is likely that "headwinds from massive deleveraging and lingering fallout from housing will offset the typical inventory bounce".

Source: Chartoftheday.com
There are "lies, damn lies, and statistics" according to Mark Twain, the famous American humorist. His argument was that statistics are often (a) untrue* and (b) used without the necessary context.

Last week provided a perfect example of the latter. As the blog's own Boom/Gloom Index© shows, sentiment is currently very positive in global financial markets. And so US markets rallied 4%, on the basis that reported company earnings were "above estimates".

Yet in context, this "outperformance" disappears. The above chart from ChartOfTheDay.com (COTD) shows 12-month, 'as reported' S&P 500 earnings, adjusted for inflation. And COTD highlight that these are now down over 98% since peaking in Q3 2007. Equally, they say this is "by far the largest decline on record (the data goes back to 1936)".

Also ignored last week was S&P's own report on Friday that forecasted total S&P 500 earnings for the 12 months to September "to be negative ($-1.01 EPS), for the first time in index history". Howard Silverblatt, S&P's senior equity analyst noted that any recovery in earnings will depend on a recovery in sales, as "you can only cut so much, and for so long".

*The blog carefully checks all those it uses with reputable sources

Its not only the blog (and fellow blogger John Richardson), who worry about the speculative frenzy underway in China, and its impact on global polymer and chemical markets.

Wu Xiaoling, former deputy governor of the central bank, has called the growth in new lending "excessive", and warned it is creating "bubbles in the property and stock markets".

Wu says China's bank lending in 2009 will be "a staggering increase of 40% of the entire stock of outstanding loans". The blog had to read this statement several times to fully grasp its importance.

It does not mean that bank lending will increase by 40% in 2009 versus 2008 - which would still be a very large increase. It means that the total value of all bank lending at the end of 2008 will have been increased by 40% during 2009.

Equally, Stephen Roach, chairman of Morgan Stanley Asia, and a long-time China bull, says he "is starting to worry" about the direction of current policy. The blog likes Roach, particularly for his accurate analysis in December 2007 that "decoupling (of China's economy from the West) is a good story, but it's not going to work going forward". He notes:

• In 2007, premier Wen Jiabao warned the economy was becoming "unstable, unbalanced, uncoordinated and ultimately unsustainable"
• Roach claims that current policies "compound the very problems the premier warned of: aiming a massive liquidity-driven stimulus at its most unbalanced sector"
• He adds that they "leave little doubt as to how bad it was in China in late 2008 and early 2009", to cause the government to react in this way

But Roach warns the loan growth is "ultimately a recipe for failure".

This week, the government began to respond to its critics, with regulators starting to insist that its Rmb 7400bn ($1080bn) of loans so far this year, be "used to bolster the real economy and not to speculate". But as we know from recent experience, bubbles on this scale don't usually subside gently. And when they burst, a lot of innocent people can get hurt.

The blog's favourite financial journalist, Gillian Tett, has written an excellent article summarising the similarities between today's problems in the western banking system, and those of Japan's during the 'lost decade' of the 1990's.

Her point is that although central banks are pouring money into the system via 'quantitative easing', it is clearly not reaching the wider economy. In particular, small and medium sized enterprises (SMEs), find bank loans very difficult to obtain.

Tett says she observed exactly the same issue in Japan, when working there 10 years ago. As now, politicians were jumping and down, urging the banks to lend. The government even set quotas for SME lending. But Tett describes the results as "almost comical". Her research uncovered, for example, that some banks were meeting their SME quota via loans to Toyota subsidiaries; hardly the result that was required.

Fast forward 10 years, and it seems the same process is being repeated. Large corporates, seen as low-risk, can tap markets - Dow raised $2.75bn to repay borrowings this week. But as Tett notes, "numerous small or risky corporate ventures in the West complain they cannot get loans". Consumers also struggle. And she concludes that "the pipes (of the banking system) are badly clogged, if not broken".

As a result, Tett says we are seeing a "backflow" of the liquidity created by the central bank money. It is ending up back with the government, via purchases of government bonds. In Japan, this process caused long-term interest rates to fall to 1%. The blog suspects that the same outcome could occur in some western countries too, if the plumbing of the banking system remains blocked.

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".

Cerberus' timing was clearly not very good with its Chrysler acquisition in Q3 2007.

And Steve Feinberg, Cerberus co-founder, admitted this when he told the New York Times "we were too optimistic on timing. Maybe what we should have done was not bought it."

So far, they have lost $6bn of their original $7.4bn investment. But the interview makes clear that their mistakes were not just due to timing, or over-optimism at the top of the 2003-7 credit bubble. They are also a warning sign of how new influences are starting to shape the investment landscape in the 'new reality'.

Steve Lewandowski of Total Chemicals wisely pointed out to the blog recently that Political, Environmental, Societal and Technology (PEST) issues are moving up the agenda around the world. The blog shares his view that careful study of these should be high on the list, when companies look at producing SWOT (Strengths, Weaknesses, Opportunities, Threats) analyses.

The blog is very interested to see the different outlooks being proposed by central bank heads. US Fed Chairman Ben Bernanke claimed Friday that the financial crisis was due to "panic", rather than fundamental problems such as reckless lending. As a result, with the "panic" over, he now saw the potential for securing "a sustained economic recovery".

But at the same meeting, European central bankers were more cautious, believing that the world economy still faced major problems:

• Germany's Bundesbank President Axel Weber said it was "too early to say it won't be a bumpy road ahead."
• Whilst European Central Bank President Jean-Claude Trichet was "uneasy when I see that because we have some green shoots here and there, we are already saying, 'Well after all we are close back to normal".

The underlying issue is shown in the chart from thechartstore.com, which shows "official" recessions in grey. And these are much shorter than the "real" recessions faced by industries such as chemicals. This is because the end of the destocking process produces a statistical recovery, as GDP rises in response to a renewal of underlying demand.

Thus the "official" 1980's recession ended in 1982, and that of the 1990's lasted just 6 months. Yet in reality, the chemical industry had to wait 3-4 years before a real recovery took place. And even the minor downturn of the early 2000's was far shorter officially, than in reality.

The US housing crisis is still getting worse, causing the weekend collapse of Guaranty Bank, the 11th largest US bank failure. As the Wall Street Journal notes, this marks a "new stage" in the banking crisis. Guaranty Financial had bought low quality, "toxic" mortgage loans, and its woes illustrate the "boomerang effect" that is now hitting thousands of small to medium sized US banks.

The problem, as the Independent Community Bankers of America note, is that most low quality mortgage loans "have declined in value, and it is not clear when they are going to come back in value, if at all." Whilst the Mortgage Bankers Association warn that "more than one in eight homeowners (are now) delinquent or in the foreclosure process". And Deutsche Bank calculate that 27% of US homeowners (14m) now owe more on their mortgages that their homes are worth.

Thus it is not really good news that US sales of existing homes rose in July, as shown in the above chart (blue column). For new data shows that "two-thirds of (existing) home sales are either foreclosures or banks taking a loss on the mortgage". And the 13% rise in inventory (red line) since January suggests more forced sales are in the pipeline.

Financial markets continue to believe in a quick V-shaped recovery. But wishful thinking of this kind would be dangerous for chemical company Boards. Today sees the end of an important source of recent demand, as the US "cash for clunkers" auto stimulus programme finishes. And with US banks now failing at the fastest rate since 1992, the blog fears that the outlook for demand is unlikely to see much medium-term improvement.

Last April's G-20 Summit brought together the leaders of the major world economies. Yet in terms of their announced goals for the Summit, financial regulation seemed to be the only one that gained traction.

That impression is confirmed by the weekend's meeting of Finance Ministers, in preparation for the next Summit in Pittsburgh later this month. The key deliverable now under discussion is that of requiring banks to reduce their leverage. There may also be some minor curbs on pay mechanisms within the finance sector.

As the blog has continuously warned of the dangers of excess leverage, it has to applaud the G-20's efforts, even if they are an example of shutting the stable door after the horse has bolted. But it will save its full approval for the moment when the G-20 endorses the new Trade and Development Report, published today.

Issued by UNCTAD (UN Conference on Trade & Development), this notes that "in the United States, the share of the financial industry in GDP grew from 5% to 8% between 1983 and 2007, while its share in total corporate profits rose from 7.5% to 40%". As chief economist Heiner Flassbeck suggests, the real need now is "to focus banking on supporting investment in productive businesses".

Coincidentally, both the US Federal Reserve and the Bank of England yesterday signalled the probable end of the 'the recession' yesterday. But as the blog noted last month, statistics don't tell the whole story.

The issue is that economists usually define recession as simply being 2 or more quarters of negative growth. Automatically, therefore, any improvement - however small - marks the end of 'the recession'. This is what both Ben Bernanke and Mervyn King are now signalling. Both, however, added important caveats to their comments:

• Bernanke noted that "even though from a technical perspective the recession is very likely over at this point, it's still going to feel like a very weak economy for some time as many people will still find that their job security and their employment status is not what they wish it was."
• Whilst King went further, noting "It is very important not to lose sight of the fact that growth rates don't tell the story. It is the levels that really matter. The depth of the recession is great and it will continue even if we get a small positive growth rate over the next few quarters."

Some readers may remember the 2007 and 2008 reports from the Bank of International Settlements (the central bankers' bank). In July 2007 the blog titled its summary '4 risks to the world economy', and July 2008's was titled 'The difficult task of damage control'.

Not all of the BIS's forecasts proved correct, but it was the only major financial institution that came remotely close to forecasting the current downturn. Thus the blog paid particular attention today to an article by the author of those reports, William White, who has now retired from the BIS, and is therefore free to speak his own mind. White's key points are as follows:

• Trying to avoid recessions "at all costs" is a dangerous policy. White believes today's problems could have been avoided if central banks had not cut interest rates in previous downturns eg the 1997 Asian crisis, 1998 Long Term Capital Management collapse, and the 2001 dot-com debacle.
• He says the result was equivalent to allowing "undergrowth to accumulate in a forest". It made "subsequent downturns more dangerous", and "available policy instruments less reliable in response".
• White argues that efforts to stimulate demand ignore the fact that we "also have an undergrowth problem on the supply side". He cites autos, banking, construction, transport and distribution as examples of industries which have been allowed to become "too big and must be wound down".

The core of White's argument is that "many countries that relied heavily on exports as a growth strategy are now geared up to provide goods and services to heavily indebted countries that no longer have the will or the means to buy them". In this, White allies himself with those, like the blog, who believe we face a "new normal" now recession is ended, where demand will be much slower than in the 2003-7 boom period, as people choose to save more, and spend less.

White argues that his former central bank colleagues don't seem to understand that "good crisis management also contributes to crisis prevention". He believes that cash-for-clunkers and other demand stimulation "policies are equivalent to trying to resuscitate a patient long since dead". And he worries that by encouraging the current boom in asset prices they risk creating "yet another boom-bust cycle", far worse than anything we have yet experienced.

The blog believes that the landscape has changed during the current downturn. We came into it on the back of a major boom in consumption, supported by reckless lending and borrowing. This mind-set seems unlikely to return quickly.

Instead, as the period of destocking/restocking comes to an end, we may face a "new reality". This probably involves a paradigm of higher savings, lower consumption, and global GDP growth of perhaps 2.5% rather than the historical 3.5%.

This scenario is more challenging than the consensus view of a quick V-shaped recovery. But if correct, it will also present a number of major opportunities for those companies who recognise that the basis of industry competition has now changed.

I outline some of the key issues in a new article for this week's ICIS Chemical Business. Please click here if you would like to read it. As always, I would welcome your insights on the points discussed.

When the G-20 met last April, it issued a Communiqué containing just 688 words. Its Pittsburgh meeting over the weekend produced a Leader's Statement containing 9292 words.

"More" does generally not mean "better" when it comes to writing action plans. Instead, the document simply seems to be a catch-all of comments from the 20 leaders. It still ducks most of the key issues, although finance ministers will press on with their work to strengthen financial regulation.

The blog is also concerned by the G-20's assumption that the current stimulus/inventory "bounce" will now lead straight to a full recovery for the global economy. Using the phrase "It worked" in the Statement, to describe the impact of recent measures, seems far too optimistic.

Coincidentally, another view is provided by Mohamed El-Erian, CEO of Pimco, the world's largest bond fund. He suggests that its "the absolute levels of income, debt, wealth and unemployment, not just the rates of change, are what matters today". Or, in the blunt view of the Governor of the Bank of England, "It's the level, stupid - its not the growth rates".

The good news is that the IMF thinks that the economy may have stopped getting worse. The bad news is that it thinks it may be a long time before we get back to earlier levels of demand.

The main problem is the ongoing weakness of the banking system. The IMF has maintained its April forecast of a total $2.8trn of losses. But as the chart shows, we are less than half-way towards all of these being recognised. Banks are still sitting on loans that will never be repaid - some of them, no doubt, in the chemical sector.

This means the world faces a further $1.5trn of write-offs over the next 18 months (the red bars). US banks have faced up to 60% of their expected losses, but EU banks are still hiding 60% of theirs. Overall, the IMF estimates banks will have to raise a further $310bn of capital. In turn, this overhang will reduce their ability, and willingness, to lend new money.

This makes the coming recovery very different from those of the early 1980's and 1990's, when banks were still able to lend freely. Thus the IMF forecasts that the current recovery will be "weak by historical standards". And it warns that additional government stimulus programmes may be needed "if downside risks to growth materialise".

Coal miners used to take a canary with them, to help detect poisonous fumes. If the canary stopped singing, then they knew there was a problem. This led to the concept of "the canary in the coalmine acting as a warning of danger".

Small countries can play the same role in the global economy. Last year, Iceland, "the first country to be run as a hedge fund", provided early warning of global financial meltdown.

Now it may be Latvia's turn. Its homeowners took on massive loans, 80% of them at a low rate in euros, at the height of the boom. Since then house prices are down 70%. And the economy is in such bad shape, that there are fears the government may have to devalue the currency against the euro. This would further increase homeowners' losses.

Homeowners, not banks, vote in elections. So the government may now allow homeowners to write off their losses. According to the Financial Times, its "proposals would allow banks to collect only the current value of the property, rather than the original value of the mortgage".

Swedish banks would lose billions under this proposal. German and Austrian banks are also worried, as they made vast loans in Central Europe on a similar basis. For the moment, the Latvian canary is still singing, as the proposal has not yet become law. But the blog will listen carefully, as the Latvian proposal is debated.

The blog has argued for some time that the chemical industry is facing a "new normal" as growth returns to the economy. Now US Federal Reserve Governor Dan Tarullo has helpfully spelt out some important changes that he expects to occur. He notes that:

• "Just about everyone understands we will never return to the credit markets of the middle part of this decade"
• "The habit of building personal savings predominantly through appreciation of one's home is one that Americans will have to change.
• "The growth models of emerging market countries dependent on unshakeable American consumption and ever-increasing borrowing will not be sustainable even as recovery becomes more established."

Tarullo also highlights the fact that "very few people believe they understand what the "new normal" will look like once the crisis has fully passed and the economy is on a sustained recovery path." He adds that "I suspect that this uncertainty is itself an impediment to stronger growth, since it makes financial planning more difficult."

The blog will aim to answer some of these key questions, as they relate to the chemical industry, when it presents its annual Budget Outlook next weekend.

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.

"Never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform."
Bank of England Governor, Mervyn King,
proposing that banks should be split up.

He argues that high-risk trading activities should be split off from low-risk utility banking (eg payment systems). Then, next time the investment bankers go bust, only their shareholders will suffer. The blog imagines most people in the chemical industry would support the Governor's argument.

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.

Over the past year, much of the Western financial system has been on life support. Now the European Central Bank (ECB), like its peers, is grappling with the question of 'What happens next?'

ECB Board member Lorenzo Smaghi set out the key issues yesterday:

• "Our role (as a central bank) is limited to the provision of liquidity to solvent banks.
• "This role does not include the recapitalisation and restructuring of the banking system.
• "We expect banks to take a more active role in the process of recapitalisation.
• "The banking system cannot be supported indefinitely by the extraordinary measures taken by central banks. An exit strategy will inevitably need to be implemented in due course.

He highlights the issue with the above chart, which shows the collapse of all forms of financial activity in the eurozone over the past 2 years. And he argues that nothing will change unless "individual incentives, those of bank managers and shareholders, are aligned with the collective incentives to support the economy."

Currently, of course, most banks are instead pursuing their own agendas to maximise short-term bonuses and profits. The blog therefore shares Smaghi's concern that unless politicians and regulators act quickly, the eurozone may well repeat "the experience of Japan over the past decade, where delays in restructuring and recapitalising the banking system undermined the recovery after the crisis".

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.

The US accounts for 23% of global GDP. Its economy is 3 times larger than the No 2 country, Japan. And most critically for the chemical industry, 70% of US GDP is consumer-based.

Developments in US housing/construction, auto and electronics industries are therefore the biggest single influence on global chemical sales.

In turn, the level of unemployment is a critical influence on consumer spending. Sadly, especially for those who have lost their jobs, it rose to 10.2% in October. The broader measure, including those who have given up looking for work, or have taken part-time work, reached 17.5%, or 1 in 6 of the total workforce.

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?

The blog has recently noted a major change of mindset in the financial community. As the Financial Times commented this week:

"For the first time in a long time, banks seem to be in control of their lending policies. During the credit boom, the banks were held hostage by companies and private equity groups, as they chucked their balance sheet behind deals almost for free, in exchange for higher margin investment banking products such as advising on mergers and acquisitions. Today, the banks are controlling their lending decisions."

A rare interview today with INEOS CEO, Jim Ratcliffe, in The Times confirms this trend. It notes that INEOS's covenant waivers in the spring came at a high price in terms of interest charges. And Ratcliffe comments that "Under our agreement with the banks, we need to generate levels of cash which it is difficult to imagine the business doing. At some stage there has to be an asset sale".

The Times reports that "the total sum that must be raised is €700 million in two "bullet" repayments". And it says that Ratcliffe "thinks that a sum of €250 million due in January 2011 is manageable 'with a fair wind', but the second tranche in July of €450 million is 'quite a large slug'".

As Ratcliffe notes, Ineos could reasonably expect in the Boom period to make €2bn EBITDA. But this target will be hard to achieve in the future, if we are moving to a 'new normal' of slower growth and less debt, as the blog set out in its 2010 Budget Outlook. With INEOS debt at €7.3bn, the risk is that the banks will become increasingly hard taskmasters.

UK Finance Minister Alistair Darling is widely reported today as being about to announce a 'super-tax' on bonuses paid to bankers working in the UK.

The government's argument, notes the BBC's Robert Peston, is that "Investment banks are making exceptional profits, as a result of the intervention of government and the Bank of England to limit the economic damage from the mess caused by those very same banks. So it would be outrageous if they paid those profits to employees and bonuses. We are determined to prevent that."

Darling was the first western minister to warn of the likely end of the Boom period in August last year. He was widely derided at the time for suggesting that the downturn "will be more profound and long-lasting" that most people had expected. But he was, of course, proved right by events.

Similarly, it will be argued that bankers can easily retain their bonuses by moving abroad. But those who relocated last year to Dubai might now regret their decision. And given popular anger at the mess caused by the banking crisis, and the need to raise taxes, the blog suspects that other countries may well follow his move in coming months.

"The more things change, the more they stay the same". Or, as the blog's French-speaking readership might say, "plus ça change, plus c'est la même chose".

When the blog started work in the chemical industry, in 1978, it was possible to pay up to 114% of one's income as tax in the UK, if one was a very high earner. That regime was swept away by Margaret Thatcher after the 1979 election.

But now governments need to quickly increase their tax revenue. Thus the UK government has confirmed plans for a new 50% 'super-tax' on bank bonuses, in addition to the normal 40% top rate. Of course, it is described as a "one-off" tax. But then income tax itself was originally introduced as a "one off" tax in 1799 to pay for the UK's war with France.

Bankers are already muttering about leaving to go somewhere else. But where? The list of countries in severe financial trouble as a result of the financial crisis is rising all the time - last week it was Dubai, then Greece on Monday, and now Spain is having 'crisis' cabinet meetings.

Paul Volcker was the last US Federal Reserve chairman who believed that a key part of its role was "to take away the punchbowl just when the party starts getting interesting".

He successfully brought inflation back to single figures during the 1980's downturn, setting the scene for the major economic recovery that followed.

Now head of President Obama's Economic Recovery Advisory Board, he is warning that regulators '"have not come anywhere close to responding with necessary vigor" to the worst economic crisis in 70 years'.

Volcker bases his argument on the belief that "we need to produce more, finance less". He also highlights the fact that "some banks have "pervasive conflicts of interest". And his core argument is that "this isn't any time to go back to business as usual."

As Bloomberg notes, Congress took 4 years from the 1929 Crash to enact meaningful banking reform. So it is no surprise that nothing has yet been achieved. Yet since 2007, the 4 largest US banks have got bigger, rather than smaller. They now hold 35% of all US deposits versus 27%. Globally, the world's top 10 banks hold 26% of assets, versus 18% in 1999.

Similarly, as Barrons notes, the US housing crisis - the core of today's financial problems - is still unresolved. 1 in every 8 mortgages is now in either foreclosure or delinquent, and foreclosures themselves are forecast to reach 3.9 million in 2009, versus 3.2 million last year. Equally, debt problems continue to raise concern in the eurozone and elsewhere.

The problem is that regulators continue to confuse being market-friendly, with being friendly to markets. Thus they fail to take the difficult steps that would make the financial system safer for its users. The blog believes Volcker when he says "I think I'm probably going to win in the end." It just hopes that further debt crises aren't required to finally force regulators to act.

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

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

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

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

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

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

Thank you very much for your continued support.

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

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

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

US auto sales last year at 10.4 million were the worst since 1982. Even this figure was slightly artificial, due to the support provided by the $3bn 'cash for clunkers' programme in the summer.

This impact can be seen in the chart, with total volumes (black line) picking up again in December under the impact of major discounting as manufacturers cleared stocks of deleted model lines. Overall:

• Toyota (red dotted line) moved into the No 1 spot for the first time
• GM (blue line) continued to downsize, after its bankruptcy
• Ford (green line) remained the most successful American manufacturer
• Chrysler (purple line) made little progress under Fiat's ownership

Total sales of chemicals and polymers to the US industry were worth just $31bn in the year, based on the ACC's estimate of $2973/auto. Between 1995- 2007 they were worth $45-50bn at today's value, with auto sales steady at 15 - 17 million/year. And even the most optimistic analysts only expect 2010 sales to recover to 12.5m.

On a more positive note, China is now the world's largest auto market at 13.6m. Its sales grew 46% last year, under the impact of the government's stimulus programme, which including halving the sales tax on smaller cars. But analysts suggest growth will moderate to 5% in 2010.

The other bright spot for auto sales this year should be India, where sales rose 17% in 2009. But analysts expect Europe and Japan to remain difficult, as consumers continue to cut back on non-essential items. Even with incentives, Japan expects 2010 sales to be at 1978 levels.

The Financial Times reports today that Ineos has postponed plans for an initial public offering. It says this "was one of a range of options that had been considered by the company to strengthen its balance sheet, which was burdened with more than €7bn ($10bn) of debt". It adds that Ineos is still looking at "full or partial sales of operating businesses to help reduce its debt", as noted last month by the blog.

The FT says that the possible IPO was discussed with Barclays Capital, one of Ineos' main lenders. But it notes that in today's investment climate, "highly leveraged companies such as Ineos may find it difficult to float". It says Ineos' net debt "was €7.49bn at the end of 2008, roughly seven times last year's expected EBITDA" and compares this with "a survey of investors by RBS Hoare Govett in the summer (which) revealed investors' reluctance to support IPOs for companies whose net debt after flotation would be more than three times their EBITDA".

Blog readers have a wide range of interests.

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

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

In alphabetical order, it is as follows:

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

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

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

Iceland, "the first country to be run like a hedge fund", was the original warning sign of the current financial crisis. Today's chaos in the country, following its rejection of the €4bn bank compensation deal agreed with the UK and The Netherlands, may similarly prove to be the fore-runner of the next stage in the crisis.

Back in March, the blog suggested that public reaction to the financial crisis would probably follow the Phases first described by Elizabeth Kubler Ross:

• Denial that any change is taking place
• Then Anger at the implications of the change
• Bargaining to reduce its magnitude
• Depression as reality begins to be confronted
• Finally acceptance of what has happened

Today, some are still in Denial mode - particularly those in financial markets, who claim to believe in a rapid V-shaped recovery back to 2007 Boom levels. This Denial of reality is helping to fuel a rapid rise in Anger amongst the rest of the population - particularly as 2009 bonus payments seem likely to reach $65bn.

In the US, Nobel laureate Paul Krugman is now warning that "there's a populist rage building in this country, and President Obama's kid-gloves treatment of the bankers has put Democrats on the wrong side of this rage". If such Anger, however understandable, comes to dominate political debate, then it will become very difficult to move to a Bargaining phase that seeks to mitigate the major problems we now face.

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

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

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

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

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

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

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

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

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

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

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

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

One by one, Western political leaders are coming to the conclusion that taxes on the banks need to rise. Last month, the UK proposed a 50% 'super-tax' on bonuses, on the grounds that "investment banks are making exceptional profits as a result of the intervention of government".

At the time, the blog thought it spotted an emerging trend, even though the US administration was critical. And so it has proved. Today, President Obama has proposed a $90bn tax to recoup the costs of the bailout.

Even more interesting was his comment during the announcement that "What I say to (bank) executives is this: Instead of sending a phalanx of lobbyists to fight this proposal or employing an army of lawyers and accountants to help evade the fee, I suggest you might want to consider simply meeting your responsibilities."

It is a long time since the blog last heard a Western politician, let alone a US politician, suggesting that investment banks were part of the problem, not the solution. Clearly, the zeitgeist is indeed changing.

The downside of the credit bubble continues to impact the UK's Premier League, and the blog's own soccer club, Manchester United.

Today's Guardian notes that United were bought by the US Glazer family for £810m ($1.3bn) in 2005, using £540m of debt. Since then, it says this debt has "cost United £340m in cash" in interest/fees. "Over £200m" of interest is also secured on the Glazers' own shares, via PIK (payment in kind) loans at 14.25% interest.

Now the club intends to refinance again. The Guardian says this will allow the Glazers "to reduce the amounts they owe in PIK" loans, and to "take almost £130m cash out of the club next year".

This financial engineering is clearly a short-term win for the Glazers. But longer-term, the picture is not so rosy. The interest bill on the new £500m bond will be £45m alone. This cash might otherwise have enabled United's manager, Sir Alex Ferguson, to buy new players to support his title hopes. Equally, ticket prices have doubled, which will no doubt reduce the fan base for the future, as families can no longer afford to attend.

Will Beacham of ICIS interviewed me yesterday in London's Trafalgar Square. Please click above if you would like to see the discussion. Or click here if you would like to see Will's summary on ICIS news.

US housing is still limping along the bottom. December's housing starts were only 0.2% above 2008 levels. Overall, 2009 saw just 554k starts, the lowest level for 50 years, despite the support of the $8k tax credit.

During the Boom period, as the ACC's chart above shows, starts (blue line) peaked at a 2.2 million rate. This was worth $35bn in terms of total chemical sales, with each house using $16k of products (in 2009 money). The current figures imply a market of c$9bn.

On the positive side, building permits (red line) rose 16% in December versus 2008. This is hopefully a leading indicator that some confidence is returning to the market. But a full recovery to the 2006 peak would require a 400% increase from today's levels. The blog would not bet its own money on this happening any time soon.

The US government used to depend on China to fund its deficit. In 2006, China bought 47.4% of all US bonds issued. But last year, as the chart from the NY Times shows, China bought just 4.6%, leaving US investors to buy the rest.

This is a yet another indicator of the profound changes underway in global finance. China couldn't afford to lend as much to the US, as it was already lending $1.4trn to its domestic economy. Equally, the so-called 'virtuous circle', whereby China lent money to the US to fund purchases of China's goods, has come to an end.

China's departure has hardly been noticed in US government bond markets, even though interest rates are low, and US borrowing has risen from $300bn in 2007 to $1.4trn last year. Clearly, with stock and housing markets looking increasingly risky, US investors seem happy to prioritise 'return of capital' versus 'return on capital'.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

No wonder alarm bells were ringing in China's central bank last week. The above chart (from China Daily) shows how total lending rebounded to $204bn in January, only 14% below the 2009 level.

Total lending doubled during 2009 to $1.4bn, an astonishing amount for a country with total GDP of $4.3trn. Of course, this enabled China to easily reach its target of 8% GDP growth. But it also led to higher inflation, and a surge in house prices, which rose 11%.

The government now aims to cut lending by 22% versus 2009, to help keep inflation under control. January's lending figure was clearly too high for comfort, causing the central bank to order an unexpected rise in banks' reserve ratios on Friday, just before the Lunar New Year holiday.

Further tightening is probably inevitable. Chemical companies therefore need to carefully reassess likely levels of Chinese demand for their products, given that key elements of last year's major stimulus programmes may now start to be removed.

15% of Americans were either in foreclosure, or at least one payment overdue, according to the Q4 Mortgage Bankers Association survey. This is a record high, but the MBA sees some signs that the numbers may have peaked. It is concerned, however, over the rise in the number of long-term unemployed, now a record 40% of total unemployed.

US housing was a $35bn market for chemicals as recently as 2006, when housing starts ran at a 2.2 million rate. They are now 74% below that level. January's figures showed some sign of a bottoming, but were still just 591k. One sign of the current crisis is that, as shown in the above chart from thechartstore.com, they need to rise c35%, just to get back to the lowest level ever seen in the period 1959-2008.

Update: In later news today, the S&P Case-Shiller Index of house prices fell 3.1% versus December 2008. 11.3 million US households are now in negative equity (where the house is worth less than the mortgage). This equals 24% of all US properties with mortgages.

A year ago, the Dow Chemical stock price was below $6, giving the company a total market capitalisation of just c$7bn.

Since then, Dow has regained the initiative in a very focused way.

First, it sold Morton Salt for $1.7bn, then it sold $2.25bn of new equity and refinanced $4.65bn of long-term debt. Next, it sold the calcium chloride and refining businesses for $925m. And now Tuesday saw the disposal of the Styron business to Bain for $1.63bn. Plus Dow puts a $400m value on the long-term supply/purchase deals attached to the sale.

The stock price has, of course, responded to these successes. It is now trading at c$29, giving a market capitalisation of $33bn. The blog congratulates those responsible in Dow for this major turnaround, at a time when market conditions have remained difficult.

By coincidence, the blog's 6-monthly review of global stock markets takes place in March/September, so its review last March took place just as the market rally began. This week is therefore a good time to review developments since then.

Russia has been the the best performer (up 160%) and India up 100%. Brazil, another BRIC country, is in 3rd place (up 85%). But China, the fourth BRIC, is last, with a rise of 'just' 40%, behind Japan (up 45%). The US, Germany and UK are up c60%.

The blog maintains its view that this is a typical bear market rally, however, with a further decline to come. And the chart above provides some evidence for its belief. Even after these rallies, all the major markets are still down versus their 2007/8 peak. The best performer remains Brazil, down just 6%.

China and Japan are the worst performers, down 50% and 43% respectively since their peak. Russia is still 39% down, in spite of its recent rally. Then come Germany and the US, down 27%, with India and the UK in 2nd place, down c18%.

More evidence is emerging of the real estate bubble that China's easy money policy has created over the past year. Wen Jiabao, China's premier, has described property markets in some cities as now being like a "wild tiger". And new figures explain his concern, with the government reporting property sales rose an astonishing 80% last year, to a value of $560bn:

• Shanghai is the epicentre of the bubble, with prices 150% above their 2003 level
• The average apartment now costs $200k, although average wages are just $5k
• Luxury apartments cost 20% more than in New York's Manhattan district
• Outside Shanghai, Tianjin has built a $3bn "floating city" on a reservoir
• It is about to add the world's largest indoor ski resort

Property bubbles can be fun whilst they last. But after they burst, the hangover can be very painful for chemical companies, due to housing's importance as a key sector for demand. As we saw in the 2003-7 Boom period, a bubble leads to over-optimistic forecasts of future demand. And the new plants built to meet this perceived demand remain online, to depress prices and margins, long after the original bubble has collapsed.

Further evidence that the West is moving into a 'new normal' can be seen in the rising number of Napa Valley wineries facing foreclosures.

The concept, adopted by the blog for its recent 2010 Outlook White Paper, suggests that the 'conspicuous consumption' seen in the West during the 2003-7 Boom is being replaced by more budget-conscious consumers, and slower growth.

Napa Valley, long the most expensive of US wines, provides strong evidence in favour of the theory. According to Bloomberg, "2010 may be a vintage year for foreclosures in the Valley, as a result of falling land values and a consumer shift to cheaper brands".

Land values have already fallen 15% since the 2007 peak. Whilst last year saw a 15% fall in the sales of $30/bottle wine, and a 10% fall for $15/bottle product. Even some former high-rollers are cutting back from $750/bottle wine to $40/bottle.

The main problem causing foreclosure is excess leverage. As buyers pay less for wine, so a vineyard's land is worth less. And those who bought at the peak, when average prices jumped above $200k/acre for top properties, are now finding the banks are unwilling to refinance.

Experts suggest that winners from the shakeout will be those who "don't compromise quality, and manage their wines and land better" than competitors. Meanwhile, Napa's problems do mean that those of us in the chemical industry will find it cheaper to "drown our sorrows" with wine.

A week ago, the BBC carried a report that PetroChina had completed "preliminary work" on a possible bid to buy a stake in Ineos' Grangemouth refinery.

The BBC quoted Ineos as confirming it was in talks with "a number of parties" over the future of Grangemouth, whilst cautioning that "the discussions with interested parties are exploratory and it would be premature to speculate on whether any might lead to investment in the site. The Grangemouth petrochemical and refining facility remains a strategic part of the Ineos Group and the company is committed to its long-term development."

The BBC report came after a rare interview in The Times last December with Ineos chairman Jim Ratcliffe, who noted that "Under our agreement with the banks, we need to generate levels of cash which it is difficult to imagine the business doing. At some stage there has to be an asset sale".

This still seems a sensible strategy, even though the blog understands that Ineos doubled EBITDA to €1222m in 2009, versus €594m in 2008, and is currently trading ahead of its business plan. Its liquidity has also improved by c€100m via the Ineos ChlorVinlys divestment, whilst the $350m fluorochemicals sale should complete later this month.

Then 2 days ago, the Sunday Times newspaper reported "that Ineos has recently held exploratory talks with Sabic, and Kuwait's Petrochemical Industries Company." It added that Ineos CEO Tom Crotty had refused to disclose the identity of the potential suitors, but had said "we are in talks with several parties that may lead to us bringing someone in, either as an equity partner in the group or on certain assets".

Yesterday, the Daily Telegraph added that the "proposals discussed with the Middle Eastern players are thought to have included the possibility of the company hiving off its petrochemical commodities business." It quoted an Ineos spokesman as saying that the company had been open about its plans to "further strengthen its balance sheet", although it had "no pressing need to do any deals given our current performance".

Morgan Stanley, the investment bank have reportedly been advising Ineos on Grangemouth since last June, when 'The Scotsman' newspaper suggested that "PetroChina could buy the refinery, while Ineos would retain the polymer and petro-chemical processing plants located on the same site". Perceptively, however, the paper had also quoted PetroChina as saying that "talks can take a really long time".

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

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

There are probably three main causes for this decoupling:

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

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

Every now and then, a single quotation summarises a complex situation.

In August 2007, CitiGroup CEO, Chuck Prince, described their blindness to the financial crisis about to unfold. "We see a lot of people on the Street who are scared. We are not scared. We are not panicked. We are not rattled. Our team has been through this before.' We are 'still dancing'".

Similarly, a quote from Lloyd Blankfein, Goldman Sachs CEO, may well come to typify the aftermath of the crisis, as regulators begin to sift through the wreckage. Giving evidence to Congress in January, the New York Times (NYT) quoted him as saying "when Goldman sells a security that subsequently goes up (i.e., on which the other party makes money), "we wish we hadn't sold it"."

As the NYT commented, "so much for putting the customer first".

Today, the Wall Street Journal reports that the main US regulator, the Securities and Exchange Commission, has charged Goldman with fraud in respect of a sale of mortgage securities which the SEC says left investors with "losses of more than $1bn". The SEC says Goldman earned "about $15m for structuring the deal and pitching them to investors".

Last year, Blankfein also described himself to the London 'Sunday Times' as "doing God's work". The blog is not sure that investors would necessarily agree.

We are often told that investment bankers are much cleverer than the rest of us. But sometimes, they do seem to lack common sense.

Their behaviour since the Crisis, in paying out $bns in bonuses to the lucky few, seems no way to appease understandable public anger over the cost of the banks' bailout. The International Money Fund (IMF) today calculates this cost at a staggering $862bn, c1.5% of global GDP.

Thus they shouldn't be too surprised that the IMF is today proposing two new taxes. One is aimed at financing any future bailouts, whilst the other is a more general Financial Activities Tax, or FAT. And when the IMF bothers to think up an acronym like this, you know it means business.

Equally, chemical companies should also be concerned at the way bank profits routinely tower above theirs. As the above Financial Times chart shows, UK banks Return on Equity (the purest measure of profitability), has been consistently over 20% in recent years. Other Western banks have been similarly profitable. By comparison, BASF's ROE between 2000-9 averaged 16%.

The easiest way to start restoring the balance might be a more cautious response when taking investment bankers' calls re prospective M&A targets. This activity accounts for a high proportion of banks' profits, yet all the evidence suggests that most M&A destroys value for the acquirer.

Being smarter at M&A, and only doing higher quality deals, might therefore be an excellent way to boost companies' ROE whilst reducing that of the banks.

LyondellBasell (LBI) is to exit from Chapter 11 bankruptcy on 30 April, 15 months after entering it in January 2009.

The past 15 months have been an expensive lesson for those debt-holders who financed Basell's purchase of Lyondell in July 2007, at the peak of the market.

LBI entered Chapter 11 with $24bn of debt. It will now exit with just $5.2bn of net consolidated debt. Holders of senior secured debt will receive 93% of the new Class A shares in exchange for their claims. The value of these will depend on the outcome of LBI's proposed IPO in Q3. Most other original lenders are wiped out.