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: equity. Then in a good year, ROE would hit 30%, but be -18% in a bad one. Things could get tricky.
• 90% debt? In a good year, ROE would hit a fabulous 126%, but in a bad year would be -114%. The company would be bankrupt.

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

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

Some of these quotes just seemed too good to ignore…

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

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.

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