ICI and Akzo
ICI has experience of fighting off unwelcome acquisitions. And Akzo may find itself in a difficult position if ICI wins again. Unless this bid, like Hanson's in 1991, marks the 'top' in the currrent M&A cycle.
ICI has experience of fighting off unwelcome acquisitions. And Akzo may find itself in a difficult position if ICI wins again. Unless this bid, like Hanson's in 1991, marks the 'top' in the currrent M&A cycle.
The prices paid for Petkim and for Lustran reflect two very different perspectives on the current market:
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”.
If you read the financial pages of your newspaper, everything sounds rosy. But if you turn to the news section, its all gloom. Both views can’t continue to exist alongside each other for ever. Whichever scenario comes out on top, will have major implications for the chemical industry. My own view is that this week’s Access deal for Lyondell will be seen, in hindsight, as marking the top. There could be storms ahead.
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:
This could become ‘the worst banking crisis since 1931’. Jochen Sanio, head of Germany’s financial regulator.
‘We see a lot of people on the Street who are scared. We are not scared. We are not panicked. We are not rattled. Our team has been through this before.’ We are ’still dancing’. Chuck Prince, Citigroup CEO.
I have been at this for 22 years, and this is about as bad as I have seen it in the fixed-income market.’ Samuel L. Molinaro Jr., Bear Stearns’s CFO.
‘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).
It seems from the media comment that Akzo is likely to announce an agreed bid for ICI tomorrow (in order to meet Friday’s Takeover Panel deadline) of around £6.70 plus the dividend. Will this be the end of the story?
The share price suggests not, trading at c£6.30 as I write, some 7% below the likely bid price. As I wrote a month ago, Akzo remains as much prey itself as bidder, in this particular situation. Its €14bn cash pile from the sale of the pharma business has now attracted a large number of hedge funds onto the share register. They may well account for 30 – 40% of the shares, according to some reports I have seen.
They smell blood in the water, and don’t want a deal to be done. Instead, they want Akzo’s cash pile to be distributed to them. So will they vote it down? There have certainly been mutterings in the press from several of the funds about any move by Akzo to offer over their £6.50 estimate of top value for ICI.
One assumes that Azko is aware of the problem, and will make a gesture in their direction with a share buyback of at least €1bn. This should be enough, but who knows? And then, of course, if a bid is made, one or two commentators have also suggested that this could be the cue for another bidder to emerge. Allegedly both Dow and Reliance are said to be interested, particularly in the fast-growing Asian paint business, plus possibly others.
So although the odds must remain in favour of Akzo, the fat lady may not have sung yet, as they say in the movies.
9 August, 12:45 BST update. It has just been announced that the Takeover Panel has allowed an extension of the deadline to 13 August. The fat lady's performance is, indeed, being delayed.
14 August update. Yesterday saw the delayed announcement of a bid effectively valuing ICI at £6.79/share. In addition, Akzo announced a €1.6bn share buyback, and promised 'up to €3bn' of further buybacks, starting in 2008. By raising the immediate buyback amount from the expected €1bn, and offering an additional buyback next year, they clearly think they have done enough to win approval from their shareholders. Today's reaction in the financial press seems to support this judgement, as although a few shareholders seem to still oppose it, most seem to be in a mood of reluctant acquiescence. However, the share price has fallen significantly since the announcement, indicating that investors are not convinced that the deal will go ahead. The fat lady may be warming up for her performance, but has still not yet started to sing.
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?
All manias gain their strength from a widely believed ‘fact’ that turns out to have been an illusion. With subprime mortgage loans, the ‘fact’ was obvious. Everyone wanted to believe that US housing could only ever go up in value. The mortgage brokers believed this when they gave $500k loans to truckers earning $50k a year. They knew the borrower couldn’t afford it, but were sure that increasing property values made the loan bankable.
Similarly the banks also ‘knew’ that if there were any problems with repayment, then they could easily sell the house for a profit. And the ratings agencies were happy to give AAA ratings to part of these loans, when securitised, because their models showed that US house prices hadn’t declined nationally since the Great Depression.
And, of course, there were plenty of buyers for these loans outside the US. With global interest rates so low, the returns to be made from lending to the US housing market looked very attractive by comparison. And they came with all the right paperwork to assure investors and the compliance officer that everything was okay.
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.
‘Trust was shaken today (Wednesday). Credit depends on trust. If trust disappears, then credit disappears, and you have a systemic issue.’ Thomas Mayer, chief European economist, Deutsche Bank.
‘The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly, regardless of their quality or credit rating.’ BNP Paribas, explaining its decision to temporarily suspend redemptions on three funds that had invested in US mortgage securities.
‘I don’t think any of the regulators have a handle on where the net exposure of subprime is’. Christopher Whalen, managing director of Institutional Risk Analytics, which builds risk systems for regulators and auditors. He added that ‘the situation was worse in Europe, where even less public data was available’.
‘Our current system of levered finance and its related structures may be critically flawed. Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment.’ Bill Gross, PIMCO (the world’s largest bond fund).
‘You find surprising linkages that you never would have expected. What matters is who owns what, who is under pressure to sell, and what else do they own. People with mortgage securities found they could not sell them, and so they sold other things. If you can’t sell what you want to sell, you sell what you can sell.’ Richard Bookstaber, hedge fund author.
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.
Last Thursday, BNP Paribas suspended redemptions on 3 of its funds, forcing the ECB to inject €95bn of liquidity into the financial system. Yesterday, the largest US mortgage lender, Countrywide Financial, had to raise an emergency €11.5bn loan in order to continue trading, whilst the US$ fell over 3% against the Japanese yen from ¥116 to ¥112.
We now seem to be on the edge of a downward spiral, where all the elements that supported financial markets unwind at once:
• US house prices fall, causing lenders to restrict further loans
• Food and energy prices rise, leading inflation to reappear
• Currency markets readjust, ending the ‘carry-trade’
• Risk perceptions change, making M&A unattractive
• Volatility returns, as people sell indiscriminately
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’.
The report in today's 'Financial Times' that Barclays Bank has lost 'several hundred million dollars', means that the UK has now joined every other global financial centre in suffering from the US subprime mortgage crisis. The news followed Friday's 5% drop in the value of Bank of China's shares, after it revealed it held $9.7bn of securities backed by sub-prime loans.
The question now is whether this purely financial crisis will roll over into the real economy? So far, the signs are hopeful that it won't. The latest weekly Economic Report from Kevin Swift at the American Chemistry Council actually shows a slight improvement in its running tab of positive indicators to 16 out of 20.
And outside the USA, the ACC report shows that 'global chemical industry production expanded in July', offsetting a revised decline during June. It says that the 'improvement was broad-based and was strongest in Africa and the Middle East and in Central and Eastern Europe.'
However, Kevin does caution that key US indicators such as durable goods orders and leading economic indicators may not yet be fully reflecting recent financial turmoil. Whilst the US National Association of Realtors reported yesterday that the median US house price fell in July for a record twelfth consecutive month, and is now 0.6% lower than a year ago.
At the moment, liquidity seems to be improving again in financial markets, and some confidence has returned. But as I noted on 10 August, US house prices haven't declined nationally since the Great Depression. With median wages static, and falling house prices, will US consumers decide to cut back their spending? And will lenders be happy to continue lending to them, if they need to borrow more to maintain their spending?
The subprime crisis is too recent for anyone to know the answers to these questions. But people are already beginning to return from the beach, as the summer holiday season comes to an end in the northern hemisphere. As we move into September, we may therefore begin to discover whether the Barclays news marks the end of the current financial crisis, or is a prologue to its extension into the real economy.
I first wrote about the subprime crisis two months ago, as it began to be noticed in the press. Housing represents an important source of chemicals demand, and so it seemed to have potentially major implications for the chemical industry. Since then, it has become clear that the crisis could have far-reaching implications, if not properly handled. I therefore thought it might be useful to summarise the insights I have gained via a letter to the Financial Times, which they have kindly published this morning. I thought you might like to see it.
From Mr Paul Hodges.
Sir, There is another reason Washington should follow your excellent advice and "resist" the urge to intervene in the subprime crisis ("Subprime loans - subprime solutions", editorial September 1). This is that the scale of the problem is probably too large for any congressional action to be effective.
All investment manias have their illusion. They then gain in strength as the "fact" underpinning the illusion becomes more widely accepted. Thus large numbers of dotcom investors came to believe that "page-clicks" would lead to profits. So US house-buyers, and lenders, all began to believe that house prices would always rise.
When brokers pushed unaffordable loans to low-earning borrowers, they were sure that increasing property values made subprime loans bankable. The ratings agencies were happy to consider AAA ratings, because their models showed that US house prices hadn't declined nationally since the Great Depression. And central banks were keeping global interest rates low, thus encouraging investors to chase the higher yields on offer.
The problem is that the whole story turns out to have been an illusion. The S&P/Case-Shiller US home price index is firmly in negative territory, while the number of unsold houses is climbing. A "buyer of last resort", such as the Federal government, would probably now need to emerge if the situation is to be stabilised.
Even Congress would surely balk at the amount of money that this scale of intervention would require. Unfortunately, therefore, the myth behind the US housing mania is likely to become increasingly transparent, as the fallout from it widens.
Published: September 4 2007 03:00 | Last updated: September 4 2007 03:00
This week has seen more downbeat news on US auto and housing sales.
Ford said their total August vehicle sales were down 14% versus August 2006, and that their car sales were down by an amazing 34%. Toyota, who have been growing market share, said they were down 2.8% in total, and that their car sales were down 8%. GM bucked the trend with total vehicle sales up 5%, although they didn’t break out car sales, and did note there had been a ‘double digit decline in daily rental sales so far this year’. Chrysler, who mainly focus on trucks, said their sales were down 6%.
The accompanying comments to the sales figures were also concerning, with words such as ‘challenging’ and ‘competitive’ being used to describe current market conditions. Typical was Jim Lentz, EVP of Toyota, who said that ‘reduced credit tied to the subprime squeeze challenged consumer confidence this month’.
Housing is the other main driver for US chemical demand, and here the National Association of Realtors (NAR) posted a worrying 12% decline in their index of pending home sales for July, even before August’s turbulence. The NAR regard the index as a forward-looking indicator, and its fall prompted them to sound an unusually downbeat note about prospects, saying that ‘existing-home sales are likely to decline in coming months as mortgage disruptions work their way through the housing market’.
Early news on August sales from key retailers such as Wal-Mart also confirms that 'price leadership initiatives' are proving important in maintaining sales volumes. So July and August seem to be indicating that more difficult times may lie ahead. In the English countryside, the movements of migratory birds are often used as a sign of the changing seasons, although a rustic proverb reminds one that the mere sighting of ‘two swallows’ doesn’t necessarily indicate the arrival of summer.
Similarly, one does need to be cautious in predicting a downturn, based on the sighting of a slowing in retail markets over just two months. But unless there is a significant improvement in September, we will probably have to accept that the good times have already ended.
There’s an interesting indication today of the changes taking place in the Chinese economy. Bloomberg are reporting that Blackstone, the US private equity group, is to purchase around 18% of specialty chemical company China BlueStar for $500m. This will be Blackstone’s first Chinese investment, and follows the Chinese government’s $3bn investment into Blackstone in June.
The report is also interesting for the detail it provides about the way the deal has been structured. We already knew that China had decided to move some of its considerable US$ holdings into equity-type investments, via the establishment of a $200bn Sovereign Wealth Fund. The investment in Blackstone was clearly signalled as being part of a strategy to use selected Western companies to help them invest this money wisely.
And it is true, of course, that Blackstone do have a long-standing interest in chemicals. How can one forget their investment in Celanese in April 2004?
They spotted an anomaly between the ratings of chemical companies listed in Frankfurt and New York, and bought Celanese (which had 60% of its assets in the US) for $3bn. They then loaded up the company with $3.2bn of debt, before IPOing it 9 months later. According to Forbes, this meant that by June 2005, Blackstone had achieved a return of $3.1bn in exchange for its original $650m stake, whilst retaining a significant equity stake in the company.
But the structure of the deal with China is different. German investors complained bitterly after the pyrotechnics with Celanese. China seems to have played its hand much more carefully.
Blackstone may still do well, but is acting more as a ‘hired hand’ than as an individual entrepreneur. BlueStar had initially intended to raise $300m in an Hong Kong IPO, but under Blackstone this will be deferred to the end of next year (probably no bad thing given the current problems in financial markets). Blackstone will also be charged with integrating BlueStar’s French holdings (Drakker and the silicone business bought from Rhodia), before grouping the assets for a listing.
It therefore gets to do all the work, whilst paying $500m upfront for the privilege. But China National Chemical will remain the biggest shareholder in the company, and so will still reap its share of any rewards that Blackstone may generate. Whilst China’s holding in Blackstone means it will also profit from the latter’s success.
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.
BP and Reliance Industries are both powerhouses in their own fields. BP’s new CEO, Tony Hayward, has just given his first interview in the new job. Comparing, and contrasting, his comments with last week’s AGM statement by Reliance’s Chairman, Mukesh Ambani, is very revealing in terms of content as well as tone.
Hayward’s interview in the Financial Times showed him as making a decisive break with the Lord Browne era. He believes that the company had done a ‘fantastic job assembling a great set of assets, but a much poorer job in really making them run efficiently’. He also ‘admitted that morale at BP was poor, and that the company had been failing to recognise and reward excellence among its employees’.
Over the same period, of course, BP has divested much of their petchems business via the Innovene sale to INEOS. But according to Hayward, they have still managed to ‘increase the complexity of BP’s structure’, as a result of which ‘it is so tough to get things done’ within BP.
Ambani, of course, had no need to eat humble pie. He titled his talk ‘Towards a quantum leap’, and in it he set out the major changes now underway in Reliance’s portfolio. From small beginnings with a single polyester plant, Reliance is now the world leader. And Ambani announced a move from 1.9 MT to 4.5 MT of PX capacity, in association with the refinery expansion at Jamnagar.
The site will also feature 2 MT of new olefins capacity, with further expansion already planned. Ambani explained that the petchem business now aims to ‘follow the path to global leadership set by the polyester business’. Reliance has also become one of the top 20 private upstream companies in the world, and he revealed that they are now planning to invest a further $4bn to build on the success of the past 7 years.
But even Reliance now needs to make a number of major strategic shifts. Ambani accepts, for example, that although they have been able to focus on organic growth to date, ‘acquisition’ will have to become a more important part of their growth process. He also accepts this will require a shift in mind-set, towards ‘partnership’ and more JVs of the type carried out with Chevron in the Jamnagar refinery expansion.
What is interesting about both Hayward and Ambani’s viewpoints is the stress that they lay on operational expertise. Reliance’s success to date, like BP’s in the past, has been based upon their ability to deliver. To recapture excellence in this area must be Hayward’s objective for BP, if he is to achieve the turnaround he targets.
I mentioned PetroChina in the very first blog entry, when the stock was trading at $155 in New York. It seemed to me to typify the new mood of confidence that I was finding as I travelled in Asia on the 10th anniversary of the Asian financial crisis. Little did I think that just 3 months later, it would be trading at $260.
This meteoric rise in the Chinese stock market has left me feeling more than a little uneasy, as to whether confidence has now turned into pure speculation. And this concern has been amplified by news this week that legendary investor Warren Buffett has sold his entire 11% holding in PetroChina, for a $3.5bn profit. Agreeing that, as usual, he sold ‘a little too soon’, he told Fox Business News yesterday that the sale was due to his concern over valuation.
Buffett clearly feels that the best of the China stock market run is behind us, at least for the moment. It will be interesting to see how much longer the present surge can last, and what the impact will be if (when?) it tumbles back to reality.
And in the meantime, it was also interesting to see that in the same interview Buffett denied that he had ever been interested in buying troubled investment bank, Bear Stearns. He added that he was still steering clear of the housing market and US housing stocks, as ‘prices still didn’t seem low enough’. As Buffett tends to buy and sell early, this is a salutary warning that there may well be more trouble ahead for this critical area of chemicals demand.
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.
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.’
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.
Gazprom is becoming a player to watch in petchems.
For decades, observers have speculated that Russia might increase its petchem activity. A recent comment by Gazprom deputy CEO, Valery Golubev, seemed to bring this concept closer to reality. He said that Gazprom aimed to increase its ethylene production by 350% to 7.66 million tonnes (MT) by 2015. He also said Gazprom plastics production would rise from 400 KT to 1.7 MT in the same period.
Now Gazprom has announced a further initiative, this time with Dow. As Nigel Davis and Sergei Blagov reported on ICIS news, Gazprom and its petchem arm, Sibur, will study with Dow the potential for joint gas processing projects near the Valanzhinsk gas deposits in Russia's Yamalo-Nenets Autonomous Region, as well as a possible joint venture based on expanding Dow's petrochemical production units in Germany.
This agreement builds on an earlier MOU signed last year. And the concept seems well in line with Dow’s developing asset-light strategy for commodity businesses. Earlier this year, Dow’s CEO Andrew Liveris said that Dow could cooperate with Gazprom on the building of bulk chemical production facilities, in return for the sale of feedstock from it at a lower price. Liveris added that Dow is ‘a very advanced provider of technology. Gazprom would be able to achieve a great deal of synergy from it’.
BASF have also been talking about JV’s with Gazprom, and it is probably no coincidence that Gazprom chose the same day to announce the formation of a new JV with BASF, Gazprom YRGM Trading, which will trade gas from the jointly owned Yuzhno-Russkoye field. Earlier this year, of course, BASF’s own Solvin JV with Solvay announced a Sibur JV to build Russia’s first world-scale fully integrated vinyls plant in Kstovo in 2010.
Gazprom has been indicating since 2004 that it was interested in selling a 50.6% stake in Sibur. Dow and BASF were both said by Gazprom’s former deputy CEO, Alexander Ryazanov, to have made informal offers. Today’s announcements probably also bring this intriguing process one step nearer to realisation.
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.
Its always interesting to see the news stories that are slipped out just before major public holidays, when media attention is likely to be low.
Only ICIS news seemed to spot the announcement by Moody’s that they were placing SABIC Innovative Plastics (the former GE Plastics business) on watch for a potential ratings downgrade. Yet this is a story with potentially major implications for the chemical industry.
SABIC bought the GE business in July, when it was already well known to be suffering from high feedstock costs and increasingly difficult market conditions. But Moody’s felt no qualms then about issuing a provisional Ba2 rating for the debt. Yet on 21 December, Moody’s said that Q3 results might lead to a downgrade.
The key to the story is Moody’s sudden concern over the fact that SABIC used ‘a highly leveraged funding structure', which it now believes could ‘put more pressure’ on the business. In July, this structure was the norm for chemical M&A deals. But as I noted in October, the subsequent credit crisis has caused lenders to become more risk-averse.
Nobody, least of all Moody’s, is really questioning SABIC's support for its new Innovative Plastics business. But the ratings agencies, including Moody’s, were very slow to recognise the developing problems in the banking world as a result of the subprime disaster.
By rushing out news of a possible downgrade on this debt, Moody’s are making it easier for themselves to downgrade more debt issued by less well-placed companies during 2008. They can point to the SABIC example as ‘justification’ for a tougher line. Existing borrowers should therefore prepare for similar actions, as well as higher interest payments, during 2008.
For the chemical industry, much depends on whether the US economy goes into recession during 2008. The signs are not encouraging, with even former Fed Chairman Alan Greenspan believing it is a 50:50 chance.
So how would any recession impact the current credit crisis? Writing in the Financial Times their banking editor, Gillian Tett, provides one answer. She has an excellent track record, as I have noted before, and in her forecast for 2008 she points out that current $100bn losses in the banking system could easily grow by a further $200bn if the housing slowdown leads to credit card and commercial property defaults. She then adds:
‘The nightmare scenario, however, is one in which risky companies start to default on their loans. Thankfully, there is no sign of this occurring yet. But if the US economy goes into recession, the chance of corporate defaults will rise - which could produce more losses for banks, and thus a second chapter in the credit crunch story.’
Finance Directors will also have taken note of Chrysler CEO Nardelli's comments recently to employees that the company is 'operationally bankrupt' and likely to have to sell assets quickly to raise funds. A policy of close monitoring of customers' financial solvency would seem to be a sensible precaution, gicen the uncertainties around.
S&P have quickly followed Moody’s in putting SABIC Innovative Plastics’ debt on creditwatch for a downgrade. As I commented with the Moody’s downgrade, this is not really to do with a newly discovered decline in the polycarbonate market. S&P have very competent chemical analysts, and must have been aware in August (when the original grade was announced), that Q3 was turning out to be a tough quarter, and that future profits were likely to slow.
Again, ICIS news have done a good job uncovering this story during the quiet holiday period. Most revealing is the comment from S&P analyst, Tobias Mack that ‘We expect that SABIC will likely have to offer some parental support in 2008 to protect its subsidiary SABIC Innovative Plastics from a distress scenario’.
SABIC is one of the strongest chemical companies around. In making this demand, S&P are clearly preparing the ground to put major pressure on less well-supported companies with high leverage. They are also signalling that life will be quite difficult for those still trying to finance deals completed towards the end of 2007.
My conversations over the holiday period suggested that lenders’ lawyers are already busy examining the fine print of loan agreements, even those supposedly ‘cov-lite’ with few covenants to enforce performance. Finance directors don’t want to be caught unaware, if a major downgrade is likely. They need to ensure their sales and purchasing teams are monitoring credit conditions at their customers and suppliers very closely.
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.
Very few non-OPEC oil projects have been financed in recent years, although market prices have risen from $20/bbl to $100/bbl. This is because oil companies and banks assumed that current prices would fall back to $40/bbl, or even lower, within 3 – 5 years.
But a new reality has been dawning, summed up by Total’s CEO last year, when he commented that major production increases from today’s $85mbd ‘would be difficult’ to achieve. Now BP have also reacted. Under new CEO Tony Hayward, they will now test projects against an assumption of $60/bbl. This 50% increase reflects a growing sense that the oil price will stay higher, and for longer, than oil companies had previously expected.
Futures markets still regard this price as too low. WTI for 2009 delivery is trading today at $85/bbl, and for 2016 delivery at $88/bbl. Buyers at these prices are aware that history would suggest oil prices should tumble in a US/western recession. But they also know that most demand growth is now taking place in Asia, and this is less price-sensitive due to subsidies.
Will the change in BP’s assumptions lead to more oil appearing? BP will certainly now invest more money, but construction costs have more than doubled in recent years. So the net effect will not be large. But at least they are investing. This was something that never appealed to Hayward’s predecessor, Lord Browne. His priority was always share buy-backs rather than investment.
‘‘I despair at times at why the equity markets can’t see how serious the credit crunch is’, said one senior credit analyst at an investment bank. ‘They just trade off the day-to-day newsflow’.
This interview from yesterday’s Financial Times reminds me of last July, when I noted how financial markets seemed to have become divorced from reality.
My musing then was prompted by the fact that Access had offered $12bn for the Lyondell business. This struck me as an extraordinary amount of money. Net debt was forecast at $22bn and 5.5 times current ebitda. And although the deal has now closed, I understand that the underwriting banks have still not been able to offload the debt into the market. This is a clear sign of the problems in credit markets to which the FT is referring.
Equally worrying is the fact that Wal-Mart, probably the best managed company in the world, yesterday reported that US sales were ‘below expectations’ during January. If Wal-Mart are now being surprised on the downside, then it is clear that things are really bad in US retail markets.
The FT goes on to warn that debt markets are growing ‘increasingly pessimistic about companies’ ability to withstand the bursting credit bubble and a possible recession’. Equally, the Wal-Mart warning means that US domestic chemical sales in the first half of the year will probably be much weaker than normal seasonal trends would suggest.
The prudent course for CEOs and CFOs must be to ignore the rose-tinted glasses still being worn in equity markets. They need to review January’s performance for early signs of weakness. They also need to test current budgets against an assumption that credit markets will get worse. Unfortunately, this week’s Plastech bankruptcy is probably not an isolated event, but just the first of many.
The Bank of England’s quarterly survey of corporate credit conditions, published today, shows that companies are finding it harder to get credit, and that rates are rising. This is in spite of the massive liquidity injections made by the Bank over the past 6 months, and its 0.5% interest rate cut.
The Bank says that ‘lenders reported a tightening of credit supply in Q4 and expect to tighten supply further in coming months’. Equally, as shown in the chart, the Bank says that ‘the effective rate of borrowing has remained elevated, despite falls in Bank Rate'. The Bank also worries that ‘although the effective rate on new business has fallen since its peak in August, this decline may be misleading, as it is likely to reflect the fact that as banks cut back on riskier higher-rate loans, the average rate on new lending falls'.
I noted 2 months ago that CFO pessimism was increasing in the chemical sector. This week’s reports from the Fed and Bank of England will do nothing to lighten their mood.
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 $78/bbl. So its perhaps understandable that Hambrecht felt able to tell the Financial Times he is currently still ‘sleeping well at night.’
‘If it walks like a duck, and quacks like a duck, then its a duck’. This simple logic probably best sums up Warren Buffett’s position on the current state of the US economy. ‘By any commonsense definition’, said Buffett yesterday, ‘the US is in recession’.
Buffett is the world’s leading investor. And key evidence from a chemical industry perspective supports his conclusion. US vehicle sales fell 10% in January, after a terrible 2007. Housing starts are 50% down on earlier peaks, and US house prices are falling nationally for the first time since the Depression. As Buffett added, ‘most people (are) experiencing recession’, and ‘their net worth (is) heading south’.
Buffett’s warning about the US$ 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:
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.
Those who liked my earlier posting about Margin calling, might like to look at the new online Financial Times page devoted to subprime jokes. For example, 'What's the definition of an optimistic investment banker?' 'Someone who irons 5 business shirts on a Sunday night.'
It also mentions the prospect of a new breakfast cereal being launched, ‘Credit Crunch’. One hopes this won’t be served along the RiverWalk at San Antonio during next week’s NPRA meeting.
Readers will know that I am a great admirer of Gillian Tett’s analyses of banking issues in the Financial Times. Today, she has another thought-provoking article, this time on the emergence of Iceland as ‘the world’s first country run like a hedge fund’. The article is worth reading in itself, but also for the question that it raises in conclusion. This is whether the leverage used in recent years by some banks now means that they are ‘not just too big to fail, but also too big to rescue’?
China is well worth watching at the moment. Quietly, away from the headlines, the Shanghai stock exchange has been collapsing. It is now down 44% since its October peak, and fell over 5% on Wednesday.
This matters to the chemical industry for two reasons:
• The immediate cause of Wednesday’s fall was news that Sinopec and PetroChina lost money in January and February. Their shares fell over 8% as a result. This shows the level of ‘subsidy’ now being offered to Chinese consumers following the government’s decision to freeze oil product prices in January. It turn, this subsidy delays any rebalancing of demand (as I noted on Wednesday), putting more pressure on western consumers.
• The collapse itself indicates that the Chinese ‘growth story’ may be about to take a break. The government has been raising interest rates very steadily, because of worries about ‘over-heating’ in the economy, and rising inflation. The stock market is forecasting that these measures will work, and that we may well see a major slowdown after the Olympics. This would be extremely serious as China was the powerhouse behind the recent boom in global chemical demand.
Of course, stock market collapses do not always lead to economic downturns. But they are often linked. The establishment of contingency plans for dealing with a global slowdown is fast becoming an urgent priority for chemical industry managements.
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
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.’
Archie Norman is one of the most successful CEO’s of recent years. When he joined ASDA in 1991, it was a struggling, nearly bankrupt, UK food retailer. 9 years later, it was sold to Wal-Mart, after he had transformed it. Shareholders benefited from an 8-fold increase in the share price over the period, whilst Norman earned just £300k ($600k) a year.
Looking back on the experience, Norman does not think he was treated unfairly. In an interview today with the FT, he comments:
• ‘It has never occurred to me that money would have any bearing on my pace of work. I don’t work harder or less hard depending on the amount of money I earn. You are only as successful as your last challenge. I regard the things I have done in my career as a preparation for the next project’.
• His tip for successful management is also refreshing. ‘You have to be humble. You have to be prepared to listen to people whether they are cleaning the floor or in management’.
Spare a thought for the plight of the world’s investment bankers. According to the Financial Times, some minor cutbacks are finally taking place in the extravagant lifestyle to which they have come accustomed:
• UBS, having lost $11bn in Q1, has now told its analysts to fly economy on short-haul flights.
• Merrill Lynch bankers have to work an extra 30 minutes before they are entitled to a taxi ride home after work.
• Goldman Sachs employees no longer have access to free bottled water
Deutsche Bank has gone one further, according to Der Spiegel, and will no longer ‘approve any adult entertainment’ such as hotel porn channels.
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%.
Increases in Russian oil supply have played a major role in balancing world oil markets, at a time when other non-OPEC sources such as the N Sea have been declining. Production rose from 6.2mbd in 1999 to 9.6mbd by 2006. But as I noted last month, there are signs it may now have peaked.
The reason for this is perhaps to be found in a comment by Leonid Filimonov, former USSR Oil Minister, in this month's 'Petroleum Review' . He said that from 1998, Russian oil "companies were focusing on the 'easy fields', racking up tremendous production gains, leaving only the 'difficult fields' for the future".
More recently, under Putin, Russia has become much more professional in its marketing of crude. According to the Financial Times, he has re-established central control of Russian crude sales by supporting the growth of Gunvor, a Geneva based trading house now responsible for an estimated $70bn worth of Russian oil sales this year. This has helped to support oil prices, by comparison with the previous free-for-all, and is credited with helping to 'reduce the discount between Russian Urals and western Brent'.
European isomer players may recognise some of the names involved in Gunvor, as it owes its origins to the Kirishi refinery, a regular PX/OX producer for many years. Kirishi is, of course, close to St Petersburg, where Putin was formerly Mayor. And according to the FT, the relationship is still maintained via a common interest in judo, with Putin and Gunvor boss Gennady Timchenko both members of Moscow's Yavara Neva club.
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.
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:
Dow's potential interest in Rohm & Haas had been much rumoured since December, when it announced the petchem/polymer JV with Kuwait's PIC. That deal has yet to close, but further evidence of the growing link with Kuwait comes with the news that the Kuwait Investment Authority will invest $1bn as part of Dow's financing for yesterday's $18.8bn purchase of R&H.
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.
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 suppose when an industry has lost $400bn in a year, some sacrifices have to be made. In May, I documented how Deutsche Bank was no longer approving expense claims for 'adult entertainment'. Well, things have got worse since then, as the losses have continued to mount:
• Goldman staff have to contribute to repair costs for their Blackberries, if the damage is their fault
• UBS bankers in the US now fly economy if the flight is less than 5 hours
• Several banks are asking staff to use taxis rather than limousines
And the C-suite are also setting an example. After a record 4 consecutive quarters of losses, Merrill Lynch executives now have to 'seek clearance from the global head of investment banking' before using private jets.
There is little doubt that chemical growth is weakening. The above chart, taken from Kevin Swift's excellent weekly report for the American Chemistry Council, indicates that a serious downturn is underway.
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.
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.
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.
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'.
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.
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.
'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 proposal now before Congress to authorise the spending of $700bn to bail out Wall Street contains just 849 words. It avoids the need to go into further detail via its suggestion that the Treasury Secretary should simply have unlimited authority to act as he 'deems necessary'. But 5 key questions are bound to be asked over the next few days:
What is the likely total cost? The headline number is currently $700bn, plus the $50bn spent on Friday to insure money market funds. But, of course, there is also the estimated $200bn cost for bailing out mortgage giants Fannie and Freddie, in addition to the costs of the earlier Bear Stearns bailout and of the $100bn tax rebate in May/June. So already the sums involved are more than S Korea's total GDP ($939bn).
Is this a 'done deal'? No. The Wall Street Journal (WSJ) notes that House Speaker Nancy Pelosi has already said 'the Democrats will insist on adding measures to protect taxpayers and tighten regulation of the industry'. They also want more help for homeowners threatened with foreclosure. So the cost is bound to rise - the Savings and Loans bailout took 10 years (1989-99), and cost more than double the original $50bn estimate.
How will the money be spent? One suggestion is that the Treasury will purchase the assets via reverse auctions. This leads the WSJ to comment that 'the government may find itself in a quandary: Does it pay more than fair-market value for hard-to-assess distressed assets, putting taxpayers on the hook for any losses? Or does it drive a hard bargain, buying for pennies on the dollar? The latter approach would further hurt financial institutions, since they would have to write down the losses and take additional hits to their balance sheets.'
Who will pay the bill? The proposal calls for US national debt to rise by a further $700bn, to $11.3 trillion. There is no suggestion that taxes will rise - instead, the government will borrow more. Global interest rates will therefore end up being higher than would otherwise have been the case. And as the blog noted in September, financial institutions are already deleveraging thier balance sheets. So this new government borrowing will 'crowd out' borrowing by companies and consumers, forcing them to cut back, and further slowing the economy.
Will it solve the crisis? The WSJ notes that the proposal only deals with one-half of the current problem. 'A revival of the credit markets and a bottoming of the housing market are keys to a revival' it comments. 'The government's debt plan may reduce the level of fear in the market, enabling the credit markets to operate properly. But such a plan wouldn't do anything about the excess supply of homes and the large number of mortgage borrowers in dire straits.'
In early August, the blog noted that politicians were beginning to recognise the seriousness of the economic situation. First, China's finance minister Liu He warned that 'an economic restructuring was inevitable'. Then the UK's finance minister said the 'global economy was at a 60-year low', and France's Prime Minister added that the world was facing a 'very, very serious global economic slowdown'. Last night, US President Bush joined the chorus, warning that 'our entire economy is in danger'.
No doubt Congress will now try again to approve some form of bailout for the US banking system. And stock markets may well rally, at least briefly, in relief. But as the Wall Street Journal comments this morning, the underlying issue behind the crisis is that 'homes were grossly overpriced, fueled by binge borrowing. For that to correct, prices must return to more affordable levels'. And it adds that even with a bailout, 'it isn't clear home prices will rise. They could simply stagnate.'
This is a critical issue for chemical companies, given the importance of housing markets for chemical demand. And a new report today suggests they are getting worse, not better. Prices are now falling in 21 of the 33 countries monitored by Global Property Guide. A year ago, only 5 countries were in a downturn.
As the blog suggested 10 days ago, CEOs could be well advised 'to start preparing contingency plans to survive a major economic downturn'. The chances of this occurring remain 'uncomfortably high'.
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.
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'.
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:
US to follow UK in buying bank shares
'Incompetence and denial'
Iceland calls in IMF
Europe, N America, China cut interest rates
The zeitgeist continues to change
The time for piecemeal solutions is past
UK part-nationalises its major banks
The Swedish model
Bailout bill passes, Wall Street falls
Housing crisis and chemical demand
Credit crunch causes demand destruction
Auto markets face 'outright collapse' in 2009
'Demand and prices in free fall'Blue skies disappear
US car sales plummet, house prices fall again
Shell's priorities for the gathering economic storm
Akzo halts share buybacks
And finally, for those who would like a break from it all:
A satirical look at the banking crisis
It is nearly time for the blog's annual forecast of chemical industry prospects. Of course, past performance is not necessarily a guide to future outcomes. But it is one of the better guides that we have. So before publishing the forecast next weekend, it makes sense to assess the blog's credibility by looking back at last year's outlook.
This was titled 'Budgeting for a downturn'. It took issue with the then current consensus, suggesting that this was 'very optimistic' in its belief that 'oil would remain at $70/bbl' for the year, that 'debt market problems would be contained', and that 'margins will remain at 2007 levels'.
It argued instead that there was 'a real possibility' oil prices would reach $100/bbl, and noted the alarming parallels with 1979-80, when apparent petchem demand increased (due to stock-building ahead of likely prices increases), whilst actual end-user demand collapsed. It also worried that 'the underlying position in financial markets is clearly deteriorating', and that 'new housing starts and US house prices were already very weak'.
Its main concern was that 'the latest upward rush by the oil price will be the catalyst that that finally causes the US consumer to cut back on non-essential spending. Equally, the continuing problems in the banking sector may well turn off the tap of consumer, and maybe even corporate lending'. It concluded that 'if I was drawing up budgets for 2008, I would be putting in place contingency plans for just such an outcome'.
The whole aim of the blog is to 'share ideas about the influences that may shape the chemical industry over the next 12 - 18 months'. The blog hopes that its 2008 forecast achieved this aim, and enabled readers to better prepare for today's more difficult economy.
You're looking at the man who, according to today's New York Times, is now responsible for 'choosing which US financial institutions live, and which die'. He's 35, and the assistant Treasury secretary for financial stability, Neel T Kashkari. His qualifications? He used to be a banker at Goldman Sachs, and is 6 years out of business school.
The blog feels distinctly underwhelmed. At this critical moment, was there really nobody in Washington capable of providing sound advice based on actual experience of managing financial crises?
The UK's Sunday Telegraph newspaper reports that 'Ineos, the chemicals group which is one of Britain's biggest private companies, is considering selling assets in an effort to reduce its debt burden'. It adds that 'the company, which has expanded rapidly through debt-fuelled acquisitions, is understood to be looking at disposing of a number of businesses in the US, according to people familiar with its plans'.
Sir Fred Goodwin, CEO of RBS, was one of the poster boys of the new banking model. Along with his peer group, he preached the virtues of the 'efficient balance sheet'. Equity was for wimps. The blog warned over a year ago that the 'seeming genius' in recent years of people such as Sir Fred 'has been due to nothing more than the application of high leverage during the 'up' part of the business cycle. As and when we go into the 'down' cycle, leverage will exert its same impact on the downside.'
This morning, Sir Fred is gone. So is Sir Tom McKillop as Chairman - a very talented and friendly man, but out of his depth when he moved from running AstraZeneca to chairing the 'go-go' bankers at RBS. Instead, Gordon Brown is now effectively the blog's bank manager, as the UK government will end up owning 60% of RBS in exchange for a £20bn ($35bn) capital injection - twice its recent market capitalisation.
Financial markets currently seem to be discounting the end of the world. So it would be no great surprise if the recent panic was replaced by a more balanced outlook. But the unusual feature of this recession is that the banks have already gone bust, even before the 'real economy' has turned down. So unfortunately, as the blog warned early last month, this probably means that deleveraging still has a long way to run.
In August, the blog welcomed the statement by UK Finance Minister, Alistair Darling, that the 'global economy was at a 60-year low'. It noted that he was 'the first western politician to abandon reassurance and instead to focus on the reality of current problems'. But it still took until last weekend before all the relevant policymakers had taken this message on board.
Financial markets are now busy celebrating their 'escape' from the prospect of a major Depression. And so is the blog, as an economy without functioning banks would have been difficult indeed. It is just a pity that this situation was ever allowed to occur. I spelt out the potential problems in a series of 3 letters to the Financial Times in 2006-7, but policymakers were too busy cheerleading the boom years to listen:
• On 3 November 2006, I argued we should 'beware lending institutions bearing gifts'
• On 27 March 2007, I called for 'action, not words, to end the liquidity party'
• On 4 September 2007, I summed up the problem in 'Every mania is based on an illusion'
As is the way of large organisations, Darling's boss, UK Prime Minister Gordon Brown, will now probably get most of the credit for the rescue that is now underway. But the blog tips its hat to him.
And before we all get too carried away, it is worth remembering that the housing crisis is still unsolved. This is the origin of current problems, and the events of recent weeks have nothing to help stabilise them. The continuing decline in house prices also remains the single most important problem facing the chemical industry, as it weakens demand in core customer sectors.
As the aptly named Mr Darling said in his famous August interview, the coming downturn 'will be more profound and long-lasting' than most people expect. He was right about the risk of Depression and, unfortunately, he is right about this too. The blog will analyse the issues this poses for the chemical industry next weekend, in its annual Budget outlook.
On Monday, governments announced c$3.5 trillion of recapitalisation and capital injection into the global banking system. One would have then expected the major investment institutions to rally round in support.
But on Wednesday, they conspicuously failed to do this. Instead they argued that the taxpayer should provide yet more money, in the form of dividends from the bankrupt banks. Unsurprisingly, stock markets then swooned again.
It is these same shareholders, by their focus on quarterly earnings, who have completely undermined the long-term role of company Boards. They were the ones who pushed for ever higher gearing, and who tried to unseat managements at banks, such as LloydsTSB, who expressed any sense of caution about the likely consequences of such lending.
The blog increasingly suspects that today's convulsion marks the end of the 25-year bull market from 1982 to last year's final highs. It also suspects that the next 25 years will see a return to more sobriety and careful analysis amongst major investors. The bonus culture, and its focus on maximising short-term 'shareholder value' would then disappear.
In turn, this would enable Boards to return to their proper role, as defined prior to 1982, of taking stewardship of the business for the next generation.
Today sees a supportive follow-up in the Financial Times to yesterday's posting about LloydsTSB, and its willingness to rebuff those who parroted the 'shareholder value' mantra. The man who led the bank's director development programme reveals that its former Chairman, Sir Brian Pitman, 'drummed into us that the board's main focus was to ensure continuing economic value added by balancing three seemingly incompatible issues:
- the reasonable demands of the shareholders
- the cost of capital
- ensuring the long-term health of the business.
In addition we had to have the professionalism and moral courage to say "No" to any unreasonable demand of the owners and to be ready to resign if necessary.'
The blog prefers to be optimistic. But 30 years in the chemical industry has taught it to be extremely realistic. So its motto for 2009 Budgets is 'batten down the hatches'. Chemical companies are likely to be sailing in some very rough seas, with treacherous currents and plenty of dangerous rocks. Survival, not growth, is therefore the prudent objective.
The key question is whether your business is robust enough to survive an extended period of low volumes and margins, against a background of tight credit markets, and continuing volatility in oil and currency markets?
Companies therefrore need to change their 2009 budget process in response to this challenge. Normally, they would develop a 'base case', and then investigate 'upside' and 'downside' scenarios. This year, companies should instead focus on the key variables around their survival Budget, so that they are prepared for most possible outcomes.
One of the oldest rules in investment is that 'When a good management finds itself running a bad business, its the reputation of the business that survives'. Legendary US investor Kirk Kerkorian has just proved he is no exception. Back in April, he spent $1bn on buying a 6.3% stake in Ford Motor Co, and publicly supported its turnaround plan. Today, his stake is worth around 1/3rd of its initial value, and he has begun to sell. If Kerkorian is giving up, then this suggests that Ford may not have long to survive in its present form.
Many Asian companies have been cutting back petchem production in recent weeks. Now TOTAL have become the first to follow suit in Europe, with the announcement that they will shutdown the Carling No 2 cracker for a month from mid-November. These decisions are never easy. But as the blog has noted before, when times are bad, the industry looks to the majors to take a lead. The blog therefore applauds TOTAL's management for biting the bullet, painful as it will be.
It also applauds Dow CEO, Andrew Liveris, for his continued honesty about the outlook. Liveris is now warning that "we will likely see a global recession through most of 2009". BP's Steven Welch was equally candid when noting that BP are currently seeing "reduced real demand (not just destocking)". However, the blog is puzzled, to say the least, by yesterday's claim from Nova's Jeffrey Lipton that N American "customers will have to order heavily to maintain production" during Q4.
The blog first raised this issue last December, when noting that global chemical industry production growth had already "slowed significantly".
At that time, it questioned whether "central bankers will be able to wave the magic wand that restores us to a growth path". And it warned "it is hard to imagine that the chemical industry can avoid a serious downturn". The above chart, based on Kevin Swift's must-read weekly report for the ACC, shows how serious the situation has now become.
• Asia Pacific growth has fallen from 10% in June 2007 to 3% in August
• Central/Eastern Europe has crashed from 10% to -3%
• Latin America growth has fallen from 3% to zero
• Western Europe has fallen from 3% to -1%
• N America has gone from zero to -3% in September
The Middle East is the only robust region, where new capacity based on advantaged feedstocks has caused growth to increase from 5% to 13%.
World chemicals growth is usually close to GDP. So it is ominous that growth had fallen from 5% to 1%, even betore the current Crash. This must further impact demand and credit availability. The blog therefore believes that the industry needs to prepare for a serious and extended downturn.
Last week, the blog didn't know whether to laugh or cry when Alan Greenspan told Congress that he was "in a state of shocked disbelief" to find that that his self-regulation policy for banks had failed. Gretchen Morgenson of the New York Times was similarly surprised to discover the former Chairman of the US Federal Reserve had really thought lenders "would rein themselves in, when there were billions to be made?"
Echoing the famous line from the 'Casablanca' movie, she adds ironically that, last week, "Mr Greenspan was shocked, shocked to find there was gambling going on in the casino".
Last week, the Financial Times tried to lighten the current mood of doom and gloom. It began a letters page discussion about the merits of humour as an antidote to panic.
Many blog readers clearly enjoyed the recent posting 'A new bank model'. They will therefore understand why the FT today carries the blog's suggestion that Robert Shrimsley's weekly Notebook deserves to be widely read.
The blog has been thinking about last week's leaked report from the International Energy Agency (IEA). This said that the world needs "to invest $360bn each year until 2030 to replace falling oil production and increase supply". The IEA based this sum on a new analysis of 500 oilfields, which showed the current depletion rate was 9.1% every year, and 6.4% even if companies invested in more wells at each field.
This means that the world is currently losing nearly 8mbd each year of current oil supply due to depletion, more than double the previous 4% assumption. Even the 6.4% rate means 5.5mbd of new oil needs to be found each year, just to keep supply stable. And, of course, demand has been growing in recent years, due to industrialisation in emerging economies in Asia, the Middle East and Latin America. This demand growth means more oil has to be found.
And there is another aspect to the issue. This is that OPEC countries, who produce 44% of the world's oil, are facing major problems from the global recession. According to Bloomberg, Dubai's government-controlled companies owe "at least $47bn, more than Dubai's GDP". The money has been borrowed on the back of a huge property boom, and the expectation that tourist numbers will double to 15 million by 2015. Other oil producers, including the 2nd largest, Russia, are in similar difficulties.
This would suggest that oil prices need to rise, on a permanent basis, in order to encourage exploration and production. Equally, oil producers need higher prices if they are to balance their budgets, and avoid social unrest. But at the moment, with destocking underway around the world, prices are instead under downward pressure. OPEC has already had to announce cuts of 1.5mbd, and may be forced to announce more, just to try and stabilise prices at today's $60/bbl.
Oil prices will probably remain under pressure whilst the current period of destocking continues. But after that, they could easily spike quite sharply, even if underlying demand is actually quite slow, as OPEC is likely to be cautious about raising production once more. And longer-term, today's relatively tight supply/demand balances may well continue. Ongoing price volatility, and a global recession, will make it difficult to fund the large investments that the IEA says are needed.
• Manage your cash. Don't spend money unnecessarily.
• Keep a strong balance sheet. Have as little debt as possible.
• Price your products/services keenly. Be imaginative.
• Keep faith in the future. Eventually, downturns lead to an upturn.
"Our normal customers have no orders to place with us, and our credit department won't let us sell to others who might want to buy". The blog was given this plain-spoken assessment of current chemical market conditions by one of the majors yesterday.
Coincidentally, US Fed Governor Kevin Warsh was making one of his rare speeches, analysing today's "unprecedented levels of volatility and dramatic financial market and economic distress". He concluded that "we are witnessing a fundamental reassessment of the value of virtually every asset everywhere in the world".
Warsh is one of the few central bankers who tried to warn of coming problems. He pointed out in April that "liquidity should not be mistaken for capital". Now, he sees companies and investors being forced to reassess "seemingly benign risks - credit, liquidity, counterparty, and even sovereign risks". As a result, credit controllers are refusing to allow sales to be made unless they are sure the invoice can be paid.
The G-20 was created in 1999, after the financial crises that had hit emerging countries from 1997 onwards. It includes the G7 group of major industrial companies, plus the main emerging economies, including the BRIC countries (Brazil, Russia, India, China). Its ministerial meeting this weekend became a preparatory session for its first-ever Heads of State meeting in Washington on Saturday, with the aim of developing "concrete policy outcomes".
Encouragingly, China used the occasion to announce a $586bn stimulus package, to be spent by the end of 2010, focusing on rural development and infrastructure programmes. As Zhou Xiaochuan, governor of the People's Bank of China, noted "if China can maintain domestic demand, its helpful for global stability". The BRIC countries also announced measures to promote trade flows between themselves, in an effort to compensate for lost exports to the West.
The background to these efforts is a forecast from the International Monetary Fund that world growth in 2009 will be at a recession level of 2.2%, and less than half the 5% seen last year. The IMF also forecasts that "output in the advanced economies (US, Europe, Japan) will contract" next year. This would be the "first annual contraction since 1945", and be "broadly comparable" to the major recessions of 1975 and 1982.
The blog's forecasting record is reviewed in ICIS Chemical Business this week. Click here if you would like a copy. The blog's aim is to "highlight relevant information for the busy executive, and to provide relevant and actionable analysis of key issues". The article particularly notes the blog's willingness to challenge consensus forecasts.
The blog has warned for over a year that the chemical industry faced a global downturn. It has developed a good track record on forecasting movements in oil prices, and it also forecast the global financial crisis in early September under the heading 'the price of all assets will go down'.
The Financial Times series on surviving the downturn focuses this week on CFOs. It includes advice from Feike Sijbesma, CEO of DSM, who suggests that "you need to see how creditable your debtors are, very quickly", and advises that "maintaining a good relationship with your creditors and banks is also critical".
The Key Tips from the article are worth considering by any CFO:
• Cash is king. Monitor it daily.
• Be visible. Raise your profile in the company.
• Rethink bonuses. Make them focused on cash generation.
• Stress test. Will oil prices stay at $50/bbl? Will we see deflation?
• Strike a balance. Be tough, but don't overreact.
CFOs have a vital role in preserving the financial health of the business. They need all the help and support they can get, at this critical time.
• Regulatory reform, where finance ministers have been given until the end of March to work out new rules for the world's financial markets
• Fiscal stimulus, where the International Money Fund (IMF) proposed countries should co-ordinate a stimulus of up to 2% of GDP via tax-cuts and spending
The scale of the current crisis means that it is going to take many months to put together a sensible and deliverable strategy for recovery. This will also require co-operation amongst all the major economic powers. The G-20 is certainly the right body to take this type of initiative, rather than the G8. The blog hopes that it is up to the task.
Current market conditions are causing problems for everyone in the chemical industry. But as the blog has long feared, they are particularly testing those companies with higher debt levels. On Friday, Moody's announced a downgrading of the Corporate Family Rating of Lyondell Basell Industries to B3 to B1, and said the outlook "remains negative".
Yesterday, INEOS asked for "a waiver on its covenants". As the Financial Times reports: "The highly indebted chemicals group is struggling with a loss on its large inventory of oil following the decline in petrochemicals prices. It is also feeling the knock-on effects of a rapid deterioration in the housing and automotive sectors, two big users of its products."
The FT says that INEOS currently has €7.3bn in net debt. Q3 EBITDA was reportedly 20% down at €402m, causing INEOS to ask for the waiver for the next 6 months "whilst we wait for the mists to clear". The FT adds that INEOS will present a new 5 year business plan to its bankers by April, and could consider selling assets to reduce leverage.
6 weeks ago, I warned that "the scariest moment of my 30 year chemical career" was about to be repeated. This had been in 1980, when "for some weeks it seemed that demand for many petchem products had simply stopped".
Three weeks later, the blog confirmed that "the moment it had long feared has now begun to happen. Everyone in the chemicals value chain suddenly realises that they have been living in a parallel universe. Whilst they have been building inventory in advance of future oil price-related increases, demand in the real economy has been collapsing."
The first company to report this "moment" was Celanese, whose chairman told analysts "basically, orders just stopped". And as the blog then forecast, this "moment" has since been "repeated in other product areas and in other regions", with the effect being magnified as "customers aim to keep working capital low for year-end reasons".
The blog went on to advise that "now, the task is simple. Those of us who had the misfortune to be around in 1980, at least know what needs to happen next. Supply and demand need to be rebalanced to today's lower level of demand as quickly as possible."
Today BASF have experienced the "moment". Chairman Dr Jurgen Hambrecht announced that "customer demand in key markets has declined significantly" since the end of October, whilst "sales volumes are being impacted by increased reduction of inventory by customers".
In response, BASF are following exactly the policy advised by the blog, and are "temporarily shutting down around 80 plants worldwide...and reducing production at approximately 100 plants".
The blog salutes BASF for their courage in taking this painful but necessary step. Clearly, there will now be a final period of inventory reduction down the chain, as CFOs insist that companies end the year with maximum cash on the balance sheet.
But the blog would counsel against keeping inventory too low. In January, the auto companies and other key industries will start operating again, after their extended shutdowns, and demand will return again.
My colleague Bob Townsend is well known to many in the chemical industry as an olefins expert. He has pointed out today's most unusual situation in olefins.
Normally, an unplanned outage by one or more crackers would cause major disruption. Yet today, 10 European crackers are down, for technical or other reasons, and many others are operating close to technical minimums.
Those offline include the Wilton and Moerdijk crackers (both technical), with planned maintenance ongoing at Repsol's Tarragona and FAO's NC1 cracker in Antwerp (and speculation another NC Antwerp cracker may also be offline). Munchmunster, Litvinov, Notre Dame de Gravenchon and Pitesti are also all reportedly offline. Priolo is due back after maintenance, whilst the Carling No 2 closure has been announced.
Other regions, notably Asia and N America are also seeing similar shutdowns. Yet Bob notes that butadiene is the only product where even minor shortages have been seen. This tells its own story about the massive clearance of inventory now underway down the value chain.
The UK's Finance Minister, Alistair Darling, was the first western leader to warn that the current recession was the worst in 60 years. He was also the first to effectively nationalise major banks, to stave off their collapse. Now he has become the first to try to tackle the real threat of deflation, by cutting sales tax (VAT) by 2.5% to 15%.
The real problem with deflation is that it rewards buyers for postponing their purchases. Why buy today, when it will be cheaper tomorrow? We are already seeing the impact of deflation at work on chemical sales, and the results are not pleasant.
Darling's £12.5bn (€14.6bn, £18.8bn) VAT initiative is an attempt to tackle this specific problem, by offering a temporary tax cut that will expire at the end of 2009. As such, the blog welcomes the move. But unfortunately, £12.5bn may well prove too small an amount to counter the deflationary danger that Darling has correctly identified.
The World Bank has cut its growth forecast for China's GDP to just 7.5% next year. Only 3 months ago, it was expecting 9.2%. And the Bank warns that the economy is dependent on "higher public spending" for more than half its forecast growth next year.
Chemical companies will also be alarmed by the Bank's suggestion that China's "export growth is likely to slow sharply", as "financial market turmoil hit the economies in other emerging markets". The blog's own forecast last month, in 'Budgeting for Survival, that China's growth could bottom as low as 5%, is no longer looking quite so unlikely.
The Queen of England recently asked "Why did nobody see the financial crisis coming?"
The Financial Times took the view that "Some did, Ma'am. Some did." It then initiated a search for these people.
Today's Financial Times now recognises some of those who correctly warned that financial crisis was close. I am sure readers will be pleased to know that it chose to highlight my analysis, and the blog itself.
Surprisingly, our 7th European conference this week in Cologne (co-organised with ICIS), was one of our most successful. Delegate numbers were down, as companies cut travel budgets. But those attending said they had gained much more, than if they had stayed in the office.
For a start, there was the opportunity to share experiences, and put today's problems in context. My colleague, John Keeley, focused on the scary nature of today's demand slump when opening the conference. But he also reminded delegates that one must remain pro-active. His "yes, we can" approach became the key theme of the event:
• Pierre-Emmanuel Goffinet of GTIS showed how companies could use trade statistics to better understand what is happening in their markets
• Phil Allen of GEMS outlined new marketing tools to maximise profit by better understanding customer needs
• Wood Mackenzie suggested that the coming gasoline glut created an opportunity for producers to obtain cheaper feedstocks
Delegates also came away with a real insight into current problems in financial markets. Nigel Davis of ICIS insight analysed the factors behind the current collapse in demand. Whilst Paul Satchell of ING, who had correctly warned last year that the crisis had hardly begun, focused this year on the problems caused by lack of visibility down the value chain.
Summing up the 2 days, I said that I hoped the New Year would see a welcome recovery in demand. Factories will reopen downstream, and customers will need to rebuild inventories. But I warned that this would provide only temporary relief, with housing and autos in recession.
My advice was therefore to use the next few weeks to develop, and implement, robust plans to survive an extended downturn.
Last March, the blog supported Warren Buffett's statement that "by any commonsense definition, the US is in recession". I also wrote an article for ICB in April, "Building your defences", to suggest how companies could develop contingency plans to deal with the "real threat" of recession.
At the time, government figures did not support Buffett's claim. But today, the official US body responsible for dating recessions has formally declared that the US entered recession last December.
As the blog expected back in May, when quoting Mark Twain's famous line "Lies, damned lies and statistics", Buffett's call has turned out "to have been right, after all".
The chart presents a sobering view of recent stock market performance. It shows (courtesy of chartoftheday.com) the Dow's performance in the first year of all bear markets since 1900. Since its 2007 peak, the Dow has fallen more than in any other bear market, even more than in 1929.
Foresight, and long-term relationships, have paid off for Dow.
Yesterday, CEO Andrew Liveris announced that a binding agreement has now been signed with Kuwait's PIC to form K-Dow Petrochemicals. PIC will pay $2bn less for their stake than originally agreed a year ago. This represents an exceptionally good outcome for Dow, given what has happened in world financial and petchem markets since then. It is also a major success for PIC, who now become a leading industry player. As the blog forecast last year, MEGlobal and Equipolymers will become part of K-Dow, taking its sales to $15bn.
Liveris and the Dow Board showed great foresight in creating the deal whilst the industry was still enjoying reasonable times. Equally, they would never have been able to conclude it, during the current meltdown, without the high level of trust developed between PIC and Dow, since the latter inherited the original Equate JV in 2001.
The blog congratulates those concerned for their ability to remain focused on the bigger picture, through all that has gone on in recent months.
INEOS is the world's 3rd largest chemicals company. Its €7.29bn debt burden ($9.2bn) means that it is also Europe's largest issuer of high yield debt. This is an unfortunate combination, given today's chemical markets.
Last month, INEOS was forced to ask its lenders for a waiver on its debt covenants. It offered to pay a 0.5% upfront fee for the waiver, plus an ongoing fee of up to 1.25%. Its lead bankers, Barclays and Merrill Lynch, offered their support immediately, but other investors have been cautious.
Bloomberg reports that INEOS has a number of US lenders, and says these are used to receiving much higher fees in return for covenant waivers. S&P data shows US companies paid an average 2.40% so far this year. And according to Reuters, "the markets' reaction shows that investors remain unconvinced that the company will be able to solve its problems by the end of May and avoid a full balance sheet restructuring".
Reuters adds that investors' concerns are also shown by the fact that insurers have recently required payments of "€7m upfront to protect €10m of the company's debt against default". INEOS senior debt has been trading around 50% of face value, whilst its junior debt has traded below 20% of face value.
INEOS has warned of an expected €400m loss on inventory write-down, if oil is $60/bbl at year-end. It announced a management restructuring of its European Olefins and Polymers businesses, and is taking a number of measures to reduce costs and improve working capital. John Reece, INEOS CFO, has also reassured investors that "the Group as a whole can produce significant profits and cash flows even at the bottom of the cycle".
Decision-time for the 233 members of INEOS's banking syndicate is 9 December, when the waiver request is likely to receive majority approval. Reports suggest, however, that the company may well have to pay an extra 0.5% in fees.
In September, the blog wondered whether "China's interest in remaining the manufacturing capital of the world may be starting to wane". Yesterday, Lou Jiwei, the chairman of China's sovereign wealth fund (China Investment Corporation) confirmed the new focus on domestic growth. He suggested that "if China can do a good job domestically, that is the best thing it can do for the world".
Lou's statement echoed last week's comments from President Hu Jintao that "difficulties in the global economy threaten to undermine growth in China". Lou also added that major losses in their western financial investments (for example, Blackstone down 82% since they bought at $29.60/share), meant they "do not have the courage to invest in financial institutions because we do not know what problems they may have".
Asian chemical demand is tied to GDP/capita growth in the West, not to domestic needs. So China's new focus means much slower growth in local chemical demand. As the blog warned a year ago ,"decoupling (of the Asia economy from the West) is a good story, but its not going to work going forward".
Yesterday, Dow announced its new structure post the K-Dow JV and the planned acquisition of Rohm & Haas. This covered two main elements:
• Implementation of November's cost reduction announcement
• Dow's new organisation (the chart above)
The cost reductions were severe, with a headline 11% of staff facing redundancy. 20 plants in "high-cost areas" will close. 2000 of the 5000 jobs lost are in businesses targeted for divestment, and this process will now be "accelerated". Another 6000 contractor jobs will also go. Research spending is being reduced by $600m, and working capital by $2bn.
"New Dow" contains "feedstock-driven" and "market-driven" businesses:
Feedstock-driven includes those areas where Dow has been pursuing its "asset-light" strategy for some years. It consists of the various JV's, including Dow's share of K-Dow, plus the remaining associated petchem and basic chemical businesses. The focus will be to maximise upstream integration and become/remain lowest cost producers.
Market-driven will be solution-orientated, aiming to anticipate and meet market needs in forecast future growth areas.
The new organisation pursues the concepts first announced back in July, at the time of the R&H deal. At that time, Dow had indicated it was expecting the industry trough to last until 2011/12, with the next peak not till 2015. This led many analysts to fear a dividend cut, for the first time since 1912. In response, Dow's CEO Andrew Liveris has had to put his job on the line, saying it would not happen "on my watch".
"New Dow" is being born at a difficult time. Global markets are in recession, causing profits to weaken. But "new Dow" cannot just cut costs, as "old Dow" would have done, pay the dividend and wait for the recession to pass. It will now have to also find a way of continuing to invest in new product development within its market-focused businesses, in order to sustain their current revenue streams.
George Soros is one of the most successful investors in recent decades. The blog came across today a report of Soros' graphic description of the dangers of having too much debt in a business, or personally:
"Leverage was like driving along a straight, clear freeway with a sharp spike pointing from the centre of the steering wheel to an inch or two above your chest. All would be fine if the road and the traffic continued as they were, but any sudden application of the brakes would stab you through the heart."
The current credit crunch is, of course, equivalent to the "sudden application of the brakes" to which Soros referred.
There is now general agreement that we are in a global recession. The World Bank's new 'Global Economic Prospects' report expects global GDP growth of only 2.5% this year, and just 0.9% growth for 2009.
This is well below the 3% level that signals recession. And the Bank also forecasts that world trade will contract in 2009, for the first time since 1982.
The key question is therefore how long this recession will last? The blog's research has highlighted 4 main scenarios:
V-shaped. The optimistic view is that recovery is just round the corner. But this seems unlikely, given the headwinds of the credit crunch and looming over-capacity in many key chemical products.
U-shaped. This is the blog's base case. It implies the recession bottoms in 2010/11, and then begins to recover. Early decisions to close high-cost plants, and cancel unnecessary new capacities, would also be required.
W-shaped. This is often seen in serious recessions. Severe destocking leads to an apparent early recovery, as the value chain restocks. But demand then slips back again, before properly recovering.
L-shaped. This is the worst case scenario, as it implies demand could fail to recover by 2011, and might instead remain at a low level. This would mirror Japan's experience post-1990.
The blog's view is that it would be very optimistic for companies to plan on the basis that this recession will be V-shaped, as in 2002/3 and 1997/8.
Instead, it shares the view of a senior BASF executive, who has reportedly said he had "hoped it would be a U-shaped recovery (as in the early 1980's and 1990's), but now thinks it could become L-shaped".
Japan went through its "bubble years" in the 1980's, with the Nikkei index peaking at 39000 (versus 8664 today). The blog well remembers standing in front of Tokyo's Imperial Palace in Tokyo in 1988, when its land was said to be worth more than all of California.
Since then, housing and stock market bubbles have occured in many other countries. Whilst Japan was picking up the pieces, after its bubble burst in 1990.
In his first interview today, the new Bank of Japan Governor says they found no "magic formula" that could "spare economies the pain of dealing with the excesses that led to the bubble in the first place". He adds that "alarm bells should have gone off when the global economy was growing at an unsustainable 5% from 2003-7".
The result, he warns, is that "the economic cost is so huge", fiscal stimulus or low interest rates will make little difference. In Japan, for example, "the cumulative drop in property prices was 60-80%". The uncomfortable lesson from Japan, he says, is that "the economy will have to grind out the excesses - high house prices and unsustainable household debt - that inflated the bubble in the first place".
The recession will have a major impact on M&A activity next year, according to a new analysis by Pilko & Co. Their key conclusions are:
• Increasingly,deals will be the result of financial restructurings, workouts or bankruptcies.
• Buyers with cash and debt capacity will be able to dictate terms.
• Asian/Middle East buyers will dominate, as they can still obtain funding, and have a longer-term approach.
In the boom years, too many deals were based on a view that any purchase price was acceptable, as long as sufficient debt could be found to leverage the earnings of the acquired company. 2009 will see the painful process of unwinding this fallacy get underway.
The blog has been searching the websites of the major central banks, such as the IMF, World Bank, Federal Reserve and Bank of England, for research on the history of credit crises. Several readers, including Paul Noble of Parsons Brinckerhoff, have also kindly forwarded helpful studies.
The most comprehensive study that it has found analysed 33 banking crises between 1977-2002 and concluded:
• The average length of each crisis was 4.3 years
• The median loss of GDP was 7.1%
• Major crises (such as today's) caused GDP losses of at least 10%.
• GDP losses can double if the banking crisis leads to a currency crisis
The studies also suggest that lack of effective government action (eg depositor guarantees and liquidity support) causes even greater GDP losses. The US Depression led to 30% of GDP being lost.
Another key message from the research is that even "successful" government intervention comes at a high price. This is because it causes banks to lower their risk profile in two key ways:
• They prefer to hold government debt rather than make corporate loans
• They only lend to the very safest borrowers
This change in risk profile means that government intervention has the side-effect of breaking the process by which banks provide credit for the real economy. Inevitably, therefore, credit crunches are deflationary.
History's lessons on the likely course of today's crisis are thus not encouraging. Governments will initially find it easy to borrow, but face the risk of a currency crisis if foreign lenders begin to suspect they will never be able to repay the money borrowed. Companies however, will find it more difficult to borrow, as banks "de-risk" their balance sheets.
Consumers therefore face an increased risk of unemployment, and so will tend to save more, rather than spend money. In turn, this will reduce demand - further pressuring companies, and government's ability to provide fiscal stimulus.
2008 has not been a good year for M&A in the chemical sector. First, there was the collapse of Hexion's Huntsman acquisition. Today, the Kuwait government has signalled its intention to "scrap" its $17.4bn deal with Dow to form K-Dow.
This is a quite extraordinary decision by a major Middle East government, especially as it comes just 2 days before the JV was due to begin operations. Citing "major changes in the world economy, the serious impact of the global financial crisis on the assets of companies and the sharp slide in oil prices", the government says it has decided that "going ahead with this deal involved big risks".
But none of these risks are new. And none of them have suddenly appeared in the last few weeks, since the K-Dow JV was finalised earlier in December. The real reason, as the Kuwait Times notes, is undoubtedly that pressure on the deal has since been mounting in the National Assembly, with opposition MPs threatening to "grill the prime minister (in the Assembly) if the government did not cancel the deal".
The cancellation of the deal at this late stage is clearly a lose-lose for both parties. It is clearly very damaging to Kuwait's reputation in world markets. Kuwait also loses its chance to further develop a leading global position in petchems, whilst Dow loses the support it would have found from allying its petchems business with a strong upstream partner.
But Dow is still the world's No 2 chemical company. And it will no doubt have developed a contingency plan, in case the K-Dow venture did fall through. It could, for example, step-up the current relationship with Saudi Aramco, its partner in the $20bn Ras Tanura project. And nobody would be very surprised if it also now sought to renegotiate the proposed Rohm & Haas acquisition.
2008 has not ended well for the chemical industry. First there was the collapse in demand, as the various value chains destocked in response to slowing consumer demand and lower oil prices. Then INEOS, the world's 3rd largest chemical company, had to seek covenant waivers from its lenders. Now, according to the Wall Street Journal, LyondellBasell, the 4th largest chemical company, may be about to file for bankruptcy.
The underlying issue is that petrochemicals has always been a highly cyclical industry. A typical 7 year cycle involves 2 years of stunning profitability as demand recovers after a downturn, 3 years of average returns as supply and demand rebalance, and then 2 years of horrendous losses as new supply comes online just as demand slows.
We are now 5 years into the current cycle, which started in 2003. So a downturn should not therefore come as a surprise. And, of course, it follows a lengthy period when central bankers had completely failed to do their job, and had allowed personal and corporate debt to reach record levels. As I noted in a letter to the Financial Times back in March 2007, they had proved totally:
"unwilling to implement the famous dictum of William McChesney, the long-serving Fed chairman in the 1960s, that "the job of the Federal Reserve is to take away the punch bowl just when the party starts getting interesting". Instead, they seem to confuse being market-friendly with being friendly to markets."
Thus they allowed demand to continue accelerating between 2005-7, by actively promoting ever-higher levels of leverage. This benefited housing and auto demand - prime markets for petchems - whilst also encouraging companies to increase their own levels of debt. But as the blog has warned many times:
"The seeming genius of many private equity funds in recent years has been due to nothing more than the application of high leverage during the 'up' part of the business cycle. As and when we go into the 'down' cycle, leverage will exert its same impact on the downside."
The blog is now 18 months old. It has a truly global readership, and as shown in the above map, is now read in 1244 cities and 89 countries.
Its aim has always been to identify 'the influences that may shape the chemical industry over the next 12 - 18 months', and to 'develop useful insights into the key factors that will drive the industry's future performance'. So today is a suitable moment to review its development:
Economic events. The blog has been widely recognised for its success in forewarning readers of the global financial crisis. This was most obvious in its posting of 7 September, titled "The price of all assets will go down", which was written 2 weeks before the Dow Jones began its fall from 11,200 to a low of 7500. Its insight does not depend on economic models, but on its willingness to identify the key facts and let them speak for themselves.
Chemical industry growth and margins. The blog's prime interest is in understanding the trends that will drive chemical demand and profitability. Thus it follows developments in housing, autos, oil prices and the financial markets on a daily basis. Over time, this enables it to identify patterns of cause and effect. Thus its 2008 Outlook was titled 'Budgeting for a Downturn', and warned that "the consensus forecast for 2008 is very optimistic". Its more recent posting on 19 October, giving its 2009 Outlook, was titled 'Budgeting for Survival'.
Oil and feedstock prices. The blog's prime focus has been to stress the likely volatility of oil prices. This is due to tight supply/demand balances, which mean that small fluctuations around the core 85mbd level can lead to large changes in prices. This insight enabled the bog to forecast ever-high oil prices until July, when it was virtually alone is suggesting that oil prices "could easily fall $50/bbl to $100/bbl" in the absence of any military action on Iran. It then built on this success by forecasting that a further fall to $70/bbl was likely, followed by a warning on 4 November that "a $20-$30/bbl range for crude, albeit temporarily, would not be impossible". WTI's $33.87/bbl mid-December low justified this caution.
Summary. The aim of the blog is to identify key changes in the wider landscape, as early as possible. As a natural optimist, I would prefer these to be positive changes. Unfortunately, however, the last 18 months have instead proved to be full of warning signs. I hope that reading the blog has provided you with valuable insights into the underlying issues. And I will do my best to ensure that it continues to helps you prepare for the problems that we now face.
Manufacturing output is contracting around the world. JP Morgan's global index sank 15% in December, and they expect "an intense contraction phase" to continue "for some months to come". The G7 and BRIC countries are all seeing a decline, as Nouriel Roubini notes:
• The US ISM manufacturing index hit a record low of 32.2 in December
• Eurozone manufacturing hit a record low of 33.9
• Japan suffered its worst-ever fall in November, plunging 8.1%
• Brazil's index is at 41.6, well below the neutral 50 level
• Russia's index fell to 33.8 in December, lower than in the 1998 crisis.
• India's production fell in October for the first time in 15 years
• China's December index remained close to November's record low
Meanwhile, Nobel laureate Paul Krugman points out that despite recent government moves to provide banks with more liquidity, "credit remains scarce, and the economy is still in freefall".
He warns that "this looks an awful lot like the beginning of a second Great Depression". And he worries that the fiscal stimulus planned by President-elect Obama may take months to pass Congress, and end up being too little, too late.
The past few weeks have not been good for the chemical industry, with 4 major companies suffering significant problems:
BASF warned that "customer demand in key markets has declined significantly" since October, and have temporarily shutdown 80 plants worldwide, whilst reducing production at another 100 plants.
Dow suffered a major reverse with the last minute collapse of the K-Dow venture, and had previously announced a restructuring programme.
Ineos had to seek covenant waivers from their banks.
LyondellBasell entered discussions to avert a bankruptcy filing.
This week's ICIS Chemical Business carries my forecast for 2009, which focuses on what CEO's can do, immediately, to ensure the survival of their business. Please click here if you would like to read it.
LyondellBasell has become the largest-ever chemical company bankruptcy, just 12 months after its formation. Its US operations (Lyondell Chemical Co), and Basell Germany Holdings GmbH, filed for Chapter 11 protection in New York tonight. The company expects its other non-US operating entities to continue to function independently of the Chapter 11 process.
The blog is saddened by the news, particularly by the effect it will have on employees and business partners. But it will come as no surprise to blog readers. On 20 July 2007, just after the deal was announced, the blog commented as follows:
Those who liked the blog's earlier satirical postings on the banking crisis and subprime disaster, may enjoy this video from the Canadian show "This hour has 22 minutes", kindly sent to me by a US reader.
The sketch's punchline - "The money you give won't just save a life, it'll save a lifestyle" - says it all.
The fallout from the Lyondell bankruptcy continues to grow. One analyst has suggested Swiss bank UBS has exposure of $500m - $1.5bn. Other banks, including Citi and the UK's RBS, also have large exposures. Writing-off these debts will in turn reduce the banks' own capital. And so it will further reduce overall credit availability.
Meanwhile yesterday's bankruptcy court hearings in New York ran until after midnight, as creditors, lenders and the company negotiated on funding needs. Eventually an interim $2bn interim loan was approved, plus a $100m "super emergency loan" which will be used to fund Lyondell for the next 2 days.
Lyondell's next objective is to finalise an $8bn 'debtor in possession' loan, which would enable it to keep operating in the medium term. But for the moment, it is very hand-to-mouth. Thus it also had to obtain the court's approval to pay $8.1m of overdue wages to employees - Lyondell Chemical has 17000 employees worldwide, of whom 8000 are in the USA.
The US suffered 2.589 million job losses in 2008, making it the worst year since 1945. December's 524k losses caused the jobless rate to rise to 7.2%, the highest since 1993. Equally, the average work week fell to a record low of 33.3 hours.
Stock markets are still forecasting a V-shaped recession, but as the blog discussed last month, an extended U-shape is the most likely outcome, given the scale of the downturn. The current rally is based on the expected $750bn Obama stimulus programme, which is the latest in a long line of government initiatives since the recession started ($168bn of tax rebates, the $700bn TARP etc). This is said to be a Keynesian policy, akin to the New Deal.
But as Prof Peter Clarke of Cambridge University has pointed out, Keynes was never in favour of artificially boosting "demand by stimulating consumption". He regarded this as doomed to failure. Instead, his 'General Theory' was based on the idea of government-led investment during recessions, as "it was common sense to put idle resources to work. Savings otherwise not invested and workers otherwise left unemployed, could create valuable public assets if government took the initiative".
The new ACC weekly report rightly notes that "any economic recovery will likely begin with a turnaround in the residential housing situation". This is also the critical issue for the chemical industry, still reeling from last week's Lyondell bankruptcy filing. Yet as the ACC's chart shows above, no improvement is yet in sight. New home inventory is now 11.5 months, compared to just over 9 months in the early 1990's recession.
Stock markets have been hopeful that the new 'American Recovery and Reinvestment Plan', being proposed by President-elect Obama, will mark a turning point. But a new analysis by the incoming Administration of its own Plan does not build confidence.
One can certainly praise the authors for their honesty, but it is disturbing to find them emphasising that "all of the estimates presented are subject to significant margins of error". In fact, the blog counted 9 uses of the word "uncertainty". And the conclusion of the Executive Summary is that "uncertainty is surely higher than normal now".
The blog will judge the Plan, when it is finally published, on the same basis as it judged the earlier $700bn TARP plan. Will it "do anything about the excess supply of homes and the large number of mortgage borrowers in dire straits"? For the moment, the signs are not hopeful.
Dominique Strauss-Kahn, MD of the International Monetary Fund (IMF), has a surprisingly hard-hitting interview today in Bloomberg.
Casting aside normal central bank reticence he warns:
• Their current $1.4 trillion forecast of global financial losses will soon be increased by a "significant" amount.
• They will have to further reduce their November GDP forecast, which was already at a recession-level 2.2%.
• US tax cuts might have "very little impact on growth" unless targeted only at "the most vulnerable," who are likely to spend the extra cash.
• W European governments are "behind the curve" in implementing stimulus packages and are "still underestimating the needs."
• "Rates in Europe will probably go down in coming months. A decrease in interest rates is welcome but the impact will not be very important."
• "If in six months from now the crisis has worsened and many other of our members need our help, the demand may be above what we have."
As a former French Finance Minister, his final warning on the European outlook has psrticular resonance. He worries that "a rate of growth between -1% and -2% may have some really strong social consequences".
Over the last few weeks, INEOS had to scramble to get a covenant waiver from its lenders, and Lyondell went into Chapter 11. Now Dow's debt is facing a potential cut to junk status from the main ratings agencies.
Dow's rating has already been cut, following the collapse of the K-Dow deal with Kuwait. And the agencies are worried by the lack of a convincing contingency plan to cover the lost cash. The blog suggested this would be required last month. The need is now urgent, due to the perceived lack of long-term financing for the proposed Rohm & Haas acquisition.
Moody's for example, have said they "would not assign an investment grade rating to this company if it had short-term debt of $11 billion to $12 billion". Similarly, S&P have said they want "proof of $15bn in financing to maintain the investment-grade rating". A junk rating would mean tens of millions in dollars in extra financing costs - not something that could be easily absorbed in today's difficult markets.
Early last year, the blog flagged up a warning from Gillian Tett in the Financial Times that Iceland could go bankrupt, as its banks were "too big to rescue". Yet at the time, the United Nations had listed it as having "the highest standard of living of any country" in the world. Unfortunately, however, Iceland's 'wealth' was all based on leverage, and in October the banks failed, causing the Icelandic currency to become virtually worthless.
Readers will also, of course, remember that last autumn's financial crisis originally started with a few, seemingly isolated, banking problems over subprime. So they will understand why the blog is taking recent concerns over the future stability of the eurozone quite seriously. Nobody is suggesting that Germany, for example, is at risk. But two developments signal that the situation could become serious:
• Yesterday, S&P downgraded Greece's credit rating, due to its high debt levels, and may downgrade Portugal, Spain and Ireland
• Bonds issued by Greece, Spain, Portugal, Ireland and Italy are now yielding record amounts versus the German benchmark
The core of the issue is whether any of these countries may be forced either to devalue against the euro, or to leave the eurozone entirely. The implications for the chemical industry would, of course, be enormous if this happened. After Iceland, however, it is clear that nothing can be ruled out, if the 5 governments do not quickly start to put their house in order.
Moody's, the global ratings agency, is today forecasting a 70% chance of a U-shaped recession, and a 15% chance of either a V or L-shaped downturn. This broadly agrees with the blog's own view, set out a month ago. Moody's also singles out the chemical industry as being one of those most at risk from a lengthy downturn. It highlights 2 key risks as being higher crude oil prices, and a major downturn in commodity margins.
It also worries about the impact of the "weak credit environment" on "financially stressed companies". It points out this will make it difficult for them to "sell assets and generate liquidity", and could force them "to sell their best businesses". Moody's worries that this "would greatly impair their ability to recover in a weak operating market". CFOs will also be be worried when they read the report (Moody's credit risks Jan09.pdf).
In the soccer world, the UAE has been making headlines this week. It is proposing to fund the first-ever £100m ($150m) transfer - of the Brazilian player, Kaka, to Manchester City. But behind the scenes, the collapse of the oil price has been playing havoc with the economies of the Gulf countries (GCC).
HSBC, for example, is warning that the region faces its most severe downturn in 20 years. It expects only the UAE and Kuwait to balance their budgets this year. Other countries will have to use their reserves to finance spending plans. And even the UAE is exposed to the major downturn now underway in Dubai.
Patrick Townsend of Instrata Capital tells the blog that "the mood in the GCC has become more despondent and redundancies are a fact of life - but not much reported. There are not many banks in the Middle East that have any lending appetite, and there is a large overhang of projects (especially power projects) waiting to get financed."
Current petchem projects in the Region are already financed, but as Patrick notes, future projects will only go ahead once the lending backlog has cleared. He also adds that clients now expect "to achieve meaningful cost savings" from their engineering contractors, and "are delaying orders" until these have been achieved.
Bond markets are a good place to look if you want to understand the outlook for major companies in the chemical industry. A key market is in 'credit default swaps' (CDS), which offer insurance against the possibility that a company might default.
The way they work is that the owner of a bond, or a speculator, can buy a CDS to insure against the possibility that a company might default over the next 5 years. Today, Bloomberg is suggesting that "trading in their bonds shows" that "Ineos Group Holdings, Georgia Gulf Corp. and Chemtura Corp. are crashing on a mountain of takeover debt and may follow Lyondell Chemical Co. into bankruptcy".
Bloomberg reports that "credit-default swap traders are demanding €8.2m upfront plus €500k a year to protect against default on €10m of Ineos bonds for five years". It adds that "the upfront cost soared from €4.8m two months ago. A year ago, it was €716,000 a year with no upfront payment". Bloomberg's conclusion is that this latest trading in INEOS "credit derivatives priced in almost certain odds the company will default".
Bloomberg also notes that Georgia Gulf's 9.5% bonds due in 2014 were trading at 28c on the dollar, to yield 45.8%. It says CDS buyers for Chemtura are having to pay $5m upfront and $500k a year to protect $10m of debt for 5 years. Whilst online news service 'Capital Structures' (CS) says INEOS reported an operating loss of €301.6m for November, and an operating profit year to date of €361.5m versus a budget of €1.35bn.
CS also says INEOS is seeking "new equity from 3rd party investors", and that an "asset sale process is ongoing". They add that "senior management has visited the Middle East as part of this process and has plans to return there". CS claims trade sales had earlier been discussed for two businesses at prices of c$1.5bn and c$1bn, but that "deteriorating conditions in the chemical sector made achieving fair value even harder".
A month ago, after the collapse of the K-Dow deal, the blog suggested that Dow would need to move quickly to a Plan B. It added that "nobody would be very surprised if it now sought to renegotiate the proposed Rohm & Haas acquisition". This now seems to be underway, judging by two pieces of evidence:
• An interview with Dow's CEO, Andrew Liveris, in the Wall Street Journal (WSJ) where he says that Dow are "unable to complete the deal without stable financing".
• An analysis by the New York Times' (NYT) legal expert that suggests "Dow is worried about compliance with its $13bn bridge facility (and)...is using this worry to attempt to force Rohm to the table".
The issue is one of leverage. The Bridge facility has a covenant that requires Dow to maintain its Total Leverage Ratio below 4.25: 1.00, if Dow's debt ratings reduce to a certain level (BBB- from S&P, for example). At the moment, S&P rates Dow just one notch above this at BBB, but the NYT notes that "more downgrades" are possible.
At this point, the NYT suggests Dow "conceivably gains a solvency argument" to use in any negotiations with R&H. Was Liveris preparing the ground for this, when he told the WSJ, "Why would you put two more American companies at risk in this most horrible of markets?"
A year ago, the International Monetary Fund rightly warned that the world was facing a "serious economic slowdown". This week, it has updated its forecasts, and now "expects the global economy to come to a virtual standstill in 2009". This will be "the lowest rate of global GDP growth since World War II". As the chart shows, the IMF expects all countries and regions to suffer:
• USA growth will be -1.5%, Eurozone -2%, UK -2.8%
• Japan growth will be -2.6%, China just +6.7%, Middle East +3.9%
The IMF has reduced its global growth figure by 1.75% since November, because of the global financial crisis. It says this "has weakened consumer and business confidence, raised uncertainty and destroyed wealth, leading to much lower consumption and much lower investment". Emerging economies have been hit by 3 extra factors:
• A collapse in exports
• An inability to borrow overseas
• A decline in commodity prices
The IMF is, however, still forecasting a V-shaped recovery at the end of 2009. It argues that this could occur if a "comprehensive framework for restoring financial health" is put in place, including liquidity provision, capital injections, and the disposal of bad assets". It also advocates large fiscal stimulus by governments to promote spending.
Clearly the IMF has to remain optimistic, as it attempts to persuade governments to adopt its policies. And the blog hopes the IMF is right. But it would be unrealistic for chemical companies to plan on this basis. Today's demand slump, plus the growing risk of deflation, means that a U-shaped recession, lasting till 2011/12, is a more sensible Base Case.
The blog hopes that its recently published "CEO's Survival Guide" will be useful, as companies start to update their 2009 forecasts.
One example this week comes from the USA, where Jim Cramer is one of the most well-known business TV commentators. He suggests that Dow's CEO, Andrew Liveris, "may be the single worst CEO ever to run a major company". You can see the full version by clicking on the picture, and then scrolling down to start the video (it begins with an advert).
Prof David Blanchflower, of the Bank of England, is not optimistic that the current recession will end soon. He notes that "few macro-economists actually spotted the greatest financial crisis in a hundred years". And in the chart above, showing OECD forecasts for the UK economy during the last recession, he demonstrates that forecasters kept predicting a "V-shaped recovery" for the whole 3 years of the downturn.
The financial fallout from the Lyondell (LBI) bankruptcy continues, as the banks slowly begin to acknowledge their losses.
According to Bloomberg, RBS has taken a $1.47bn hit, Citigroup $1.4bn, and Goldman Sachs $850m. UBS are also believed to have lost at least $500m. But like Bank of America (new owners of Merrill Lynch), they have yet to reveal any details. Nor have hedge fund Apollo, who are believed to have bought $1.9bn of senior debt from Citi last April.
The final losses could be much larger. LBI's net debt at the time of the deal was reportedly around $22bn. And whilst investors comfort themselves with the hope that LBI's senior debt (first lien) will eventually be worth over 70c on the $, the current market value is reportedly just 22.6c. In addition, $8bn of more junior debt could well end up worthless.
Update 10 February. UBS disclosed a loss close to $1.2bn.
Yet again, as in October, 'buy on the rumour, sell on the news' has been the financial markets' reaction to the latest efforts to solve the financial crisis. A 5% fall on Wall Street last night, in response to the Geithner plan, tells its own story. The blog is also unconvinced that this further $2.5 trillion will solve the problem.
Back in September/October, it raised 5 questions about the spending plans. None have yet been properly answered. And crucially, for the chemical industry as well as for the economy, nothing has yet been done to solve the root cause of today's problems, namely "the excess supply of homes and the large number of mortgage borrowers in dire straits".
Today, however, former Treasury Secretary Brady has put forward a plan to address this issue. Brady was the man who gave his name to the Brady bonds, issued during the first Bush administration to resolve Latin American banking problems. He has a good track record, and the blog agrees with his diagnosis and proposed solution. His plan focuses on the two key issues that are currently depressing the US economy:
Deleveraging. Brady argues that this process has to be eased. One key step would be to abandon 'mark to market' accounting. This creates a vicious circle, whereby today's low value becomes the norm tomorrow. In turn, this destroys the banks' capital base, forcing them to further reduce lending, and causing more bankruptcies.
Foreclosure. As Brady notes, you can't begin to rescue the US financial system without first confronting the mortgage problem. His first step would be to make a realistic calculation of the "true scope of the problem". At the moment, neither the public nor the financial markets believe that this has been done.
The essence of Brady's plan is that the authorities need to get a handle on the amount of money that needs to be written off, as a result of the reckless lending that took place in the housing sector. People then need to be given support to help them stay in their homes, rather than being pushed onto the street, leaving their property to become derelict.
At the same time, the financial system needs to be given time to begin to repair itself. The US Treasury will need to pick up the tab, and the US taxpayer will end up paying the bill. But as Brady says, quoting General George Patton, " a good plan, violently executed now, is better than a perfect plan executed next week".
In December, the blog noted that Japanese policymakers saw clear parallels between the mistakes they made during the 'lost decade' of the 1990's, and those being made today in the USA and other Western countries. The New York Times now has a fascinating article on this subject, which notes that:
"The Japanese crisis of the 1990s and early 2000s had roots similar to the American crisis: a real estate bubble that collapsed, leaving banks holding trillions of yen in loans that were virtually worthless. Initially, Japan's leaders underestimated how badly the real estate collapse would hurt the country's banks. As in the United States, a policy of easy money had fuelled both stock and real estate speculation, as well as reckless lending by banks.
"Many in Japan thought that low interest rates and economic stimulus measures would help banks recover on their own. In late 1997, however, a string of bank failures set off a crippling credit crisis. Prodded into action, the government injected 1.8 trillion yen into Japan's main banks. But the injections -- too small, poorly planned and based on little understanding of the extent of the banking sector's woes -- failed to stem the growing crisis."
It adds that "One reason Japan's leaders were so ineffectual for so long was their fear of stoking public outrage. With each act of the bailout, anger grew, making politicians more reluctant to force real reform, which only delayed the day of reckoning and increased the ultimate price tag."
Depressingly, the NYT concludes that, "so far, the Obama administration's plan avoids the hardest decisions, like nationalizing banks, wiping out shareholders or allowing banks to collapse under the weight of their own bad debts." Denial, however, is not a viable policy, and the NYT notes that "in the end, Japan had to do all those things".
Vita Group has chemical sales of €1.5bn, 5000 employees, and manufactures in 20 countries. In December it announced that it was in talks over restructuring, to avoid breaching covenants on the €663m of debt taken on in 2005, when it was bought by private equity group, Texas Pacific (TPG).
It now looks set to emerge with a new structure. This provides an important first example of what may happen to other over-leveraged chemical companies, as the recession intensifies.
The basic principle in restructuring is that debt gets exchanged for equity. The 'class' of debt is critical, and in Vita's case it seems that the debt-equity swap may end up as follows:
• 'Junior' debt of €200m will be exchanged for 2% of the equity
• 'Senior' debt of €300m will be exchanged for 32.5% equity
In addition, a further €95m of working capital is being provided by senior and junior debt holders, in exchange for further equity.
Vita's restructuring was relatively simple from a legal point of view, as it just involved European rules. But Lyondell Chemical's bankruptcy filing last month under the US Chapter 11 process seems to have thrown up some very complex legal issues. This is because it involves two different sets of bond-holders - those who bought the European debt issued to fund the original Basell purchase from Shell/BASF in 2005, and those who bought LyondellBasell debt in 2007 to fund the Lyondell purchase.
The Lyondell Chemical Chapter 11 filing had also included 1 German subsidiary. According to today's Financial Times, this was to enable the new 'Debtor in Possession' funding (raised as part of the US process) to be used to "service the European debt while the restructuring took place". However, the rules governing European and US restructurings are quite different, and the FT quotes one lawyer who argues that some European creditors do not want companies to "stretch the reach of Chapter 11 to European companies".
The FT says the issue could lead to a battle over jurisdiction between US and European courts. At the moment, Lyondell has "secured a temporary injunction against a group of European creditors to prevent them from enforcing their claims, as it feared this could push the European business into insolvency". But the creditors are contesting the injunction, on the grounds that "the Chapter 11 filing is an event of default under the terms of the bonds in question".
Now the US courts will have to decide on Monday whether to make the injunction more long-lasting. The legal wrangling is potentially very serious, as Lyondell has also told the court that "the potential loss of control to a foreign liquidator would be disastrous to the debtors' reorganisation efforts".
Update 27 February. Al Greenwood reported last night for ICIS news that the temporary injunction has been extended by the bankruptcy court to give 60 days protection to LBI.
Nova's CEO, Jeffrey Lipton, has always been the great optimist of the petrochemical industry. As recently as December, he was arguing at the GPCA meeting that "demand forecasts will prove to be too low", and forecasting a shortage of ethylene and polyethylene in 2012.
However, optimism isn't a business strategy, particularly when it leads to over-leveraging the business. As the chart shows, Nova's shares had fallen 95% since September. According to Bloomberg, Nova needed "to secure $100 million in additional financing by Feb. 28 and $100 million more by June 1". So yesterday, Nova was instead forced to accept a $2bn offer from Abu Dhabi's IPIC. Lipton himself acknowledged that "it was pretty clear that this was the best alternative, you have to deal with today".
Nova's strategic mis-step is Abu Dhabi's gain. Nova benefits from advantaged feedstocks in the shape of Albertan ethane, has several excellent facilities and a highly professional workforce. With a sensible debt structure, it should now survive the present downturn. It should also be complementary to IPIC's existing investments in Borealis and OMV. The blog wishes Nova well under its new owner.
At a time of uncertainty, its sometimes helpful just to frame the questions that need to be answered about the future. Pimco, the world's largest bond fund managers, have done just this in two separate analyses. Their answers mirror those advanced by former Treasury Secretary Nicholas Brady, and make good sense to the blog:
Q1. How bad could this get?
Answer: "No one knows for sure, but common sense would provide a good guess. If the government cannot substitute credit to the same extent that it is disappearing from the private system, then the U.S. and global economies will retreat. If the economy is viewed as a bathtub filled with water (credit), then draining it back down might reduce economic activity proportionately. Liquidate credit to 2003 totals and you just might reduce economic activity (GDP) to 2003 numbers as well. Whoops! That would mean a 10%+ contraction in the US economy with unemployment approaching the teens."
Q2. What can be done?
Answer: "Keeping the tub sufficiently full means advancing policies in content and magnitude never contemplated since the days of FDR. The U.S. and global financial systems require credit creation and foreclosure prevention, not bank nationalization as currently contemplated by some. Trillions will be required in the U.S. alone and it is critical that there be a high degree of policy coordination among all nations, which avoids protectionist measures reflective of failed policies in the 1930s."
Q3. What is the new credit paradigm?
Answer: "Expect to see lower levels of liquidity (making price discovery harder), more corporate defaults (and restructurings), and lower recovery values. You can no longer assume a 40% recovery rate as a bond investor. Government bailouts will likely be based on political parameters, rather than commercial reasoning."
The blog has always had enormous respect for Dow. This was due to their ability to manage unconventional risks, in a way that other chemical companies (such as the blog's former employer, ICI), found impossible. Even when things went wrong, they always had a Plan B, which allowed them to exit on a sensible basis.
This time, however, there was clearly no Plan B with regard to the K-Dow JV and R&H purchase. This seems very strange, given that it was increasingly obvious through H2 that the value of chemical assets was declining very fast. Equally, there was always the awful warning of ICI's attempted transition from petchems into downstream businesses in the 1990's. This became a classic example of how to "buy high, sell low".
Now Dow is faced with making the best of a very bad job. As ICIS news notes, it is paying $78.97/share versus the original $78/share. Plus, there is always the worry that, like ICI, an 'efficiency-driven' Dow may not really understand that R&H's innovation-driven businesses rely on R&D for their long-term profits. Dow's announcement of the "additional consolidation of 6 R&D facilities" is a very worrying sign.
The blog wishes 'new Dow' well, but its confidence has been badly shaken by the events of the last few months. Restoring it will take time.
The G20 represents over 85% of the world's economy. And there is certainly no shortage of major issues for government leaders to discuss when the G20 meets next month in London.
But the blog is not over-hopeful about their ability to make things happen. In November, the G20 promised "concrete policy outcomes" from its meetings. But the rather bland weekend communiqué from the preparatory meeting of finance ministers suggests there is still little of substance behind the words.
Human beings go through a number of stages when confronted by major change. As first described by Elisabeth Kübler Ross, the process starts with:
• Denial that any change is taking place
• Then anger at the implications of the change
• Bargaining to reduce its magnitude
• Depression as reality begins to be confronted
• Finally acceptance of what has happened.
John Authers notes perceptively in today's Financial Times that Kübler Ross' model is likely to be a good guide to the evolution of the financial crisis. He suggests that the world is now moving on from Denial, into the Anger stage. Some still deny we are facing a major downturn. But public anger over the bonus payments issue is now on the rise around the world.
Authers suggests that Bargaining will be the next stage, as players try to develop a solution to the crisis. Then we will go through a stage of Depression, at what has been lost, before reaching the Acceptance stage, and moving on. Moving through the Denial stage has taken almost 2 years. So the blog fears we may still have a long journey ahead.
ICIS Chemical Business has just published my article, 'Low-cost operation key to survival', which discusses business strategies for surviving the downturn. Please click here if you would like a copy.
Last month, the blog supported former US Treasury Secretary Brady's argument that 'mark to market' accounting rules were helping to worsen the current financial crisis. It therefore welcomes the decision by the US Financial Accounting Standards Board to revise its rules with effect from April 2. It applauds Paul Kanjorski, chair of the relevant House sub-committee, for forcing this change through so quickly.
It is less optimistic that current Treasury Secretary Geithner's new plans for dealing with 'toxic assets' will work. These seem to be based on the belief that people want to buy these 'toxic assets', but can't find the cash. The blog fears they are 'toxic', simply because they will never be repaid.
The blog still finds it hard to adjust to Dow Chemical's current financial status, following the K-Dow/Rohm & Haas episode. But facts speak for themselves. Earlier this week, S&P lowered Dow's debt rating to just above junk grade, on completion of the R&H deal.
However, news that Dow has sold R&H's Morton Salt to Germany's K&S, for a cash payment of $1.675bn, shows that the company hasn't forgotten all its negotiation skills. K&S are paying 6.2 times 2008 EBITDA of $270m, a reasonable multiple. And whilst salt is less cyclical business than polymers, Morton's 2006 EBITDA was only $138m.
The blog has been reading the G-20 communiqué, and various news reports, to understand whether the London summit answered the 5 key questions it raised in advance of the meeting.
Reuters provides a good summary of the outcome in terms of 3 blog questions:
• Global trade. "The Summit 'reaffirmed' commitment from previous summit last year to refrain from raising new barriers to investment and trade. In practice, however, many of the G20 countries have adopted protectionist measures since the Washington summit in November to defend domestic companies." On the positive side, the Summit also provided $250bn to support new credit lines for international trade.
Blog conclusion: more talk than action.
• Fiscal stimulus. "The United States, Britain and Japan had been strong proponents of concerted action around the world to pump more government funds into stimulus packages; France and Germany led calls to hold off, preferring to wait for results from funds already committed. The Summit set no obligation for further fiscal measures."
Blog conclusion: talk, but no new action.
• Regulation. "Clear Summit commitment to extend regulation and oversight to all systemically important financial institutions, instruments and markets. Credit rating agencies will also be covered."
Blog conclusion: clear action plan.
The summit communiqué covers another question:
• Role of Governments: Leaders have "committed ourselves to work together with urgency and determination to translate these words into action. We agreed to meet again before the end of this year to review progress on our commitments."
Blog conclusion: much talk, no clear action plan.
• Plan B: The final question, of a contingency plan in case the global economy does not begin to recover, seems not to have been addressed.
Blog conclusion: No sign of a 'Plan B' being developed.
The blog is delighted that the Financial Times' Gillian Tett has been named Journalist of the Year, in the annual UK awards. She was the first journalist to call attention to the dangers developing in financial markets, and has been an invaluable source of information.
Two postings, from March 2008 and December 2007, illustrate her ability to spot potential problems long before they became major issues:
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'?
Helpfully, Gillian Tett has separately summarised the 3 major scenarios that describe how the current crisis might play out next year:
Consensus. The US narrowly escapes recession. US housing and banking markets stabilise in Q1, and there is little spillover into the rest of the economy, although auto sales growth and jobs growth decline. Emerging markets continue to boom, helping to balance slower Western growth.
Muddle through. The credit crunch slows global growth. Western economies come under pressure, and high levels of debt reduce corporate and individual flexibility. The US$ remains under pressure, as investors reallocate portfolios to other currencies.
Downturn. Today's credit worries spread. Banks severely restrict lending as their current business model of securitising loans to 3rd parties stops working. They also suffer losses in other consumer areas (eg credit cards). A US recession leads to a second wave of financial turmoil, as highly indebted companies go bust.
What worries me about the consensus view, as with the consensus on oil prices that I discussed in October 2007 in 'Budgeting for a Downturn', is that it is not a true base case. It is easily the most optimistic scenario. The other outcomes are both downside cases in terms of the 2008 outlook for the 'real world' in which the chemical industry operates.
The need for chemical companies to develop robust contingency plans, in case the consensus is wrong, is looking ever stronger
Tom Hicks was a major player in private equity, but then moved on to sports investment via his Hicks Sports Group (HSG). He owns the US Texas Rangers baseball and Dallas Stars ice hockey franchises, as well as a 50% stake in the UK Premier League's Liverpool FC.
Now The Guardian reports that HSG has missed $525m of payments on 3 separate loans, and soon needs to refinance a £350.5m Liverpool loan. Hicks has also confirmed he is searching for "partners that share my long-term vision".
The blog noted in October that many major Premier League teams were loss-making due to excess leverage. Even Manchester United may be impacted. Its US owners seem set on selling Cristiano Ronaldo to Spain's Real Madrid next month for £75m, to help pay their debts.
Benzene is the blog's favourite leading indicator of chemical industry demand. It is one of the most widely used products and, as a liquid, it is also widely traded.
Its recent successes as an indicator include calling a peak on industry profitability, when its prices peaked a year ago. And then it provided early confirmation in October of the downturn, since when it has been at a sustained, and unprecedented, discount to naphtha.
But very recently, prices have begun to recover, with European benzene now trading around $575/t according to ICIS pricing, versus naphtha at $450/t. US benzene prices are at similar levels, around $1.85/gal. Asian levels are over $630/t. Thus benzene is once again trading at a healthy 'spread' to naphtha around the world.
This suggests that, finally, destocking down the value chains may be coming to an end. But the blog remains very cautious about whether this will then lead to a full-scale V-shaped recovery by the end of the year. The prudent policy is still to hope for recovery, but to plan for an extended downturn.
To misquote the famous HL Mencken phrase, "nobody ever went broke under-estimating the losses caused by the credit crisis".
Initially, Fed chairman Ben Bernanke estimated the losses at just $100bn.
Then, a year ago, the IMF said its estimate was $1 trillion. Now, the IMF is raising its estimate even higher, this time to $4 trillion.
According to The Times, the Fund expects $3.1trn of these losses from US-originated assets, and $900bn from EU lending. Even more worryingly, as Nouriel Roubini points out, these estimates do not include prospective losses from corporate loans to highly-indebted companies. According to respected analyst Mike Mayo, the banks are still carrying these loans at close to face value.
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Recently the blog has identified a number of signs that US housing and auto markets are stabilising, at least temporarily. This should feed through into chemical demand during Q2, and enable production volumes to show some improvement.
What happens next? In order to answer this critical question, we have to understand where we are today, and where we have been:
Downturns are difficult times. There is always the hope that markets might improve, and this can delay the implementation of tough decisions on plant closures. Nobody wants to shut down, and then see a competitor benefit from an improving market.
But if markets do stay depressed, then precious cash is being wasted whilst plants operate at a loss. This can put other businesses at risk. So it is important to get the balance right. There are no easy options.
The position of LyondellBasell is particularly difficult. It became the largest-ever chemical company bankruptcy in January (with $26bn of debt), and Lyondell Chemical is now operating under Chapter 11 rules. This has already given rise to major legal issues, as different sets of creditors fight for their position.
This led to a worry that financial and legal issues might over-shadow the equally essential need for major business restructuring. Therefore it was very positive when the company announced it was appointing a COO to consolidate management of the worldwide businesses, including its manufacturing divisions.
Ed Dineen was also an excellent choice for the role, given his extensive industry experience and understanding of the LBI businesses. Since October, when the blog published its 2009 Outlook, 'Budgeting for Survival', it has been clear that we were facing one of the worst crises in the industry's history. It is important in these conditions for management to lead from the front, and be open and honest about the problems.
It is also critical that implementation is effective. Since Dineen's appointment was announced, the company has confirmed a target of 4800 job losses amongst employees and contractors, plus the closure of 14 plants, with around half of these already underway. The aim is to achieve $700m fixed cost savings by year-end 2010, with a further $600m of savings targeted by other business improvement measures.
The blog knows and respects many LBI employees, and is saddened by these job losses. But as Dineen noted yesterday, "March and April have not given indications of any significant change in market conditions." In these circumstances, delaying the inevitable would be an abdication of responsibility.
The last 6 months have been traumatic for many parts of the chemical industry. The next 2 or 3 years may well continue to be very difficult.
How should your company best position itself to survive?
That is the key question I will discuss on Thursday 14 May in my Webinar, 'A Checklist for Survival'. Please click here for details, and to register.
The blog was never convinced by US Treasury Secretary Paulson's efforts to manage the financial crisis. Its view was that Paulson avoided the real issues, and focused instead on trying to boost market sentiment. Worryingly his successor, Tim Geithner, seems to have inherited the same mindset.
2 months ago, Geithner announced that 19 major US banks would be subjected to a 'stress test'. The idea was to check whether their balance sheets were strong enough to withstand more losses on their loans, if the economy continued in recession.
Soon afterwards, global stock markets took off on a major rally. Clearly some people believed that the tests would encourage investors to turn positive on financial companies again. This theory was confirmed when news 'leaked' that all 19 banks would, indeed, pass the test.
However, party-pooper Prof Nouriel Roubini now points out the test is "meaningless". He says this is because actual data for the 3 variables being tested (GDP, unemployment and house prices), "are already running worse than the (so-called) 'worst case scenario'".
You can read the full details on Roubini's blog. But it poses an interesting question. Will the Administration still have the nerve to suggest that all 19 banks are in the clear? Or will it, as the Financial Times suggests, now have to revise the tests to make them more credible?
Either way, the banks will still be in trouble. Their problems now include not just dodgy sub-prime housing mortgages, but also credit card debt and corporate loans. Rising unemployment means consumers will increasingly default on their credit cards, whilst continuing recession will force more companies into bankruptcy.
The blog's chemical career began with selling raw materials to the paint industry during the recession of the early 1980's.
Since then, it has always regarded the decorative paint sector as an excellent real-time indicator of underlying economic conditions.
Today's results from Akzo, one of the global leaders, confirms the sector's reputation. Akzo said decorative paint volume was down 16% during Q1. EBITDA was down 41% in constant currencies.
Chrysler. Yesterday, Chrysler entered bankruptcy. It will idle most of its US plants during the court proceedings. The government hopes the bankruptcy can be finalised in a "quick visit" of just 30-60 days. But even if this can be achieved, there is little doubt that Chrysler's suppliers will suffer major write-offs.
Bank 'stress tests'. Widespread criticism of these as being "meaningless" has led to a tightening. Apparently at least 6 of the 19 banks, including Citi and Bank of America, will now need new capital.
Deflation. The Bank of Japan is now forecasting that prices will fall for the next 2 years, even though it still expects the economy to begin a recovery next year.
The International eChem team are very experienced in turnarounds and restructurings. We have undertaken these both as employees within our former companies, and then as advisers. This has taught us to be alert for the 'tipping point', when a situation begins to change, for better or worse.
The blog believes the Chrysler bankruptcy is one such 'tipping point'. Before it happened, one could still hope that pre-2008 US demand levels might return one day. Now, it is clear we are on a different path. Two factors lead to this conclusion:
Auto plant closures. Chrysler will shut most of its plants for the duration of the bankruptcy. GM have also announced major closures. Both companies have massive inventory (Chrysler 86 days, GM 122 days). Closing so many plants, so abruptly, risks bankrupting many suppliers. But the Obama administration seems to have now decided that there is little alternative. Average auto sales incentives in April increased by 29%, or $680 per vehicle, as companies fought for survival.
Future market size. US autos/housing are core to chemical demand:
• Each new auto consumes $2.7k of chemicals, according to the American Chemistry Council. US auto sales averaged 15m - 17m from 1995 - 2007, worth $41-46bn of chemical sales. Today they are running at a 9m rate, worth only $24bn. And GM's new business plan forecasts the future US market will be just 10m vehicles a year.
• Each new home consumes $16k of chemicals, according to the ACC. In 2006, starts were running at a peak rate of 2.2m, worth $35bn of chemical sales. Today they are running at a 500k rate, worth just $8bn. Even in 1975, 1981 and 1991, starts only fell to 800k.
Why, then, is this a 'tipping point'? The blog has long argued, here and in the Financial Times, that recent housing market growth (in the US and elsewhere) was based on the "illusion that house prices would always rise". And rising prices also allowed home owners to extract mortgage equity - supporting a whole range of consumer markets, particularly autos. Now this illusion is well and truly shattered. Banks are no longer able to make the loans that made the dream appear possible.
Chrysler's bankruptcy therefore marks the 'tipping point', when the first major company is finally forced to adjust to a permanently lower level of demand. A similarly brutal restructuring is probable in US housing markets, where new home inventories are 11 months of demand.
Chemical company CEOs will need to carefully consider the implications of the Chrysler bankruptcy for future levels of global demand.
The European Commission has again reduced its growth forecast for the EU. It now sees a 4% decline in GDP this year, and for the first time is suggesting that recovery will be delayed until mid-2010. As a result, it expects unemployment to reach 11%, which will further slow consumer spending.
'Across the pond', banks are busy increasing interest rates at a furious pace to both commerical and individual borrowers. The US Federal Reserve says 80% of banks have increased the rates they charge on commercial loans, whilst many banks have apparently doubled, or even tripled, credit card rates.
The only good news is that the Fed says bank lending criteria are finally starting to stabilise after 2 years of tightening. It reports that 'only' 40% of banks tightened their criteria in Q1, down from 55% in Q4.
In July 2007, the US Federal Reserve warned that "credit concerns were spreading" and estimated that total bank losses due to US sub-prime loans could reach $100bn. Yet now, after the conclusion of its "stress tests", the Fed says total bank losses could reach $600bn.
In most companies, a 6-fold change in a key financial assumption would prompt concern that the underlying issue was not being properly addressed. But this has not happened at the Fed, which says its new tests have still focused on residential lending (including sub-prime). The potential impact of a serious economic downturn has been ignored. Only minor losses have been assumed from corporate lending.
This omission also means that the Fed is able to forecast a very sharp recovery in bank earnings of $415bn over the next 2 years. It is therefore able to reduce the banks' requirement for extra capital to $75bn. Without this heroic assumption, many of the banks would already be insolvent, as they would have to raise $185bn - a clearly impossible figure.
How does the Fed expect this wonderful recovery to occur? Conveniently, it assumes that the banks will be able to charge higher interest margins on their loans to corporate and personal borrowers. But in the blog's view, this policy is simply a short-term 'fix', and will make the overall economy worse, not better.
US unemployment, according to Friday's figures, is already at 8.9% - the peak rate in the 1974/5 downturn. And private sector payrolls are now falling at an annual rate of 4.7%, worse than at any time since 1958. This is therefore exactly the wrong time for banks to be charging higher margins on their loans. Bankruptcies will increase as a result.
The Fed's focus is still on the needs of the financial economy, as defined by Wall Street. It is ignoring the developing problems in the wider 'real economy' on Main Street, where chemical companies (and many others) are battling with lower volumes and margins.
This makes it likely that, before too long, the Fed will be back to announce even higher estimates for loan losses, as the banks are forced to make further write-offs, this time in respect of corporate bankruptcies.
It is now generally accepted that reckless lending has helped cause the greatest collapse in the global economy since the Depression years of the 1930's. Yet many bankers still maintain it is vital they continue to pursue "innovation" of the type that has brought about this collapse.
Martin Wolf, a former EPCA speaker, makes a good riposte to this argument in today's Financial Times. He notes that "maximising innovation is a crazy objective. As in pharmaceuticals, a trade-off exists between innovation and safety".
Dow and Ineos are two of the world's largest chemical companies. Both found themselves in tight financial situations at the start of the year. Dow's debt rating was cut to just above junk, whilst Ineos had to ask for covenant waivers.
Since then, Dow has moved to tackle its debt issues very energetically. First it sold Morton Salt for $1.7bn. Then it sold $2.25bn of new equity, whilst successfully refinancing $4.65bn of long-term debt. Now it has announced further sales of its calcium chloride and TRN refining businesses for $925m.
Ineos has not yet announced asset sales. And the company has had to ask lenders for an extension to July for its covenant waivers, whilst discussions continued on its proposed new business plan. However, CFO John Reece told Reuters last week that 'there was "a lot of activity" in the company's plans to sell assets, with proceeds to be used to pay off debt'.
My fellow-blogger, Barbara, cleverly spotted this week's 'Global Traders Summit' in Singapore. Had this blog been there, it would have mentioned the latest, apparently fool-proof, way to determine stock market turning points, based on bankers' interest in adultery.
According to Bloomberg, the Illicit Encounters website has a major increase in traffic when either the market collapses, or has a sudden rise. Apparently, when markets are up, traders "think they can have an affair because they feel they can get away with anything. When the market hits the bottom, they are looking for a way to relieve the pressure."
The site first came to the blog's attention in December, when the Financial Times reported on its rather lucrative business model - a male membership fee of £119/month ($190). Now it appears to have forecasting potential too.
The 3 most popular posts in May were:
The blog will be celebrating its 2nd birthday at the end of the month. I would welcome your comments on what you value about it, and what you would like it to cover in the future. Please either post these below, or email them directly by clicking here.
By the end of May last year, 6.2m autos had been sold in the US market, each containing $2700 of chemicals (according to the ACC). The total sales value to the chemical industry was $16.8bn. So far this year, just 3.9m autos have been sold, with a value of $10.7bn.
Recent downturns have always seen a temporary dip in US auto sales. But annual volume between 1995-2007 still stayed within a 15m - 17m range. This time has been different. Annualised volume is currently just 9.9m.
The chart provides some comfort, as it is clear that sales have bottomed recently, as expected. Inventories are also being reduced, with both GM and Chrysler shutting their plants during the Chapter 11 process, although this is very painful for chemical sales in the short-term.
Chemical company boards therefore have some difficult decisions ahead:
• Short-term, they must plan for major capacity cuts, in line with expected auto industry demand. Volume is most unlikely to rebound to the previous 15m-17m range. GM's new business plan assumes a US market of just 10m/year. And the Obama industry taskforce is clearly keen to encourage the industry to focus on profits in the future, rather than volume.
• But they need to target such cuts very carefully. In the medium-term, the move to increase auto fuel economy by 42% could well compensate for at least some of this lost volume. Lighter-weight, more fuel-efficient, autos will require more chemicals and polymers, not less.
Getting this balance right will be complicated, to say the least. CEOs might like to dust out their copy of the blog's 'CEO survival guide' for its advice on how to move forward.
A senior figure in the investment community told the blog recently that companies' views on the outlook for the economy seemed to vary according to their own financial position: "the stronger the balance sheet, the more realistic (and worse) the view on the economy".
This analysis was confirmed at an interesting M&A Round Table organised last week by Pilko & Associates. Some key insights from the event were:
• Risk analysis. Many CFOs are organising up-front strategic reviews to better understand not only their own corporate risk profile, but also those of their major counter-parties (eg suppliers, customers etc)
• Scenario analysis is becoming much more common. Few people believe in a quick V-shaped recovery, and the risk of an L-shaped 'lost decade' is perceived to have increased (as seen by Japan in the 1990's). The base case is increasingly a 3 - 5 year U/W-shaped downturn.
• Refinancing. A large number of businesses will need refinancing over the next couple of years. Banks like this type of business, due to the high fees involved. But their credit committees are being much more cautious than during the 'boom years'. It now takes 12-18 months to achieve a refinancing, versus 6-9 months in 2006-7.
• Business analysis. Investors cannot now 'flip' businesses for a quick profit after 12-18 months, and instead need to be committed to running them for several years. They therefore need to understand the business's fundamental drivers, and to evaluate its operational skills.
• M&A timescale. It is much harder to auction businesses via the use of a generic Information Memorandum and a timetabled sale process. Instead M&A is often a 'one-on-one' process, where finding a qualified buyer can require months of patient effort. And the total 'package' has to be right, to fit the buyers' own strategic needs.
• The buyer's process now starts by understanding the key drivers and issues for the business, and how its acquisition might fit with their overall strategy. They then develop realistic scenarios for the future outlook, as a means of highlighting key issues for testing during due diligence.
• Leverage. Lack of liquidity in financial markets means deals often require much higher equity levels (>50%). Equally, banks are more concerned about the strength of warranties and parent company guarantees, and how enforceable these might be in a continued downturn.
• Restructuring will need to bring in new investors, who will be focused on cash-flow risks, because of refinancing problems. This will benefit acquirors with capital, and a long-term view.
M&A activity is therefore much lower than in the past, as players adapt to the new environment. At the moment, a lot of deals are stalled due to sellers adopting a V-shaped outlook, and expecting a quick profits recovery, whilst buyers are worried about the potential impact on profits of a prolonged L-shaped downturn.
Today's high levels of uncertainty also led participants to emphasise "the huge opportunity for high quality advice". Major value could be added by those who had correctly foreseen the downturn, and could now describe the likely key issues ahead.
The 'Falkirk Herald', based close to Ineos's Grangemouth facility in Scotland, is not normally the place that the blog would look for news of the potential sale of a major part of the world's 4th largest chemical company.
However, that is what happened today, when the 'Herald' reported that Grangemouth site manager Gordon Grant had confirmed Ineos was looking for "partners", and "had some interest from PetroChina". Being questioned by the local community council, Grant then reportedly added that "Ineos has stated very clearly we are committed to the Grangemouth site, but nothing is forever. We will see what comes out of these discussions with PetroChina".
Rumours of potential INEOS sales have been around for some months. And whilst a deal may not be quite as close as the Herald suggests, INEOS is certainly under intense pressure from its lenders, as it seeks to agree a new business plan by a revised deadline of 17 July. A sale of part or all of the Grangemouth refinery could bring in significant cash, given the $725m that Dow achieved recently for its TRN refining business.
The blog's close eye on Scotland's media has again been rewarded this morning, as 'The Scotsman' reveals that Ineos have appointed Morgan Stanley, the investment bank, to advise on the sale of Grangemouth.
It suggests that a company such as "PetroChina could buy the refinery, while Ineos would retain the polymer and petro-chemical processing plants located on the same site". But worryingly from Ineos' point of view, it quotes a PetroChina official as saying that "downstream business has a poor margin nowadays and talks can take a really long time".
The great wave of destocking is finally coming to an end. And it is clear that underlying global demand is well below previous "normal" levels.
The evidence for this can be seen in the above chart, based on American Chemistry Council data, which shows global chemical production down 12.8% in April versus 2008. And as Nigel Davis noted in ICIS Insight last week, BASF (the world's largest chemical company), has said that it is "operating worldwide at less than 75% of operating capacity".
The ACC's data covers 33 key countries, who probably have slightly better competitive positions that other producers. Thus a decline of 15 - 20% is probably a reasonable estimate, and would also correlate with the BASF data (as effective maximum operating rates are c95%).
This is not a good starting point as we enter H2. Not only will more capacity be starting up for many products in the Middle East and Asia (particularly China). But also Q3 is normally seasonally slow, whilst year-end cash management is likely to mean December demand will be weak.
The chemical industry is always a leading indicator of the global economy. One of the blog's oldest friends used to be a central banker, and he made no secret of the fact that our discussions about demand levels were often an important factor in his overall analysis.
So it is no great surprise that the World Bank has issued a rather gloomy new forecast for the world economy. It is now predicting a 2.9% decline in 2009, compared to a 1.7% fall in March. And it is only expecting a modest 2% rebound in 2010.
The Bank also warns that "developing countries are expected to grow by only 1.2% this year, after 8.1% growth in 2007 and 5.9% growth in 2008. When China and India are excluded, GDP in the remaining developing countries is projected to fall by 1.6%, causing continued job losses and throwing more people into poverty."
Economic recovery can't come soon enough for Ineos. After 7 months of negotiation, it has finally agreed new covenants for its €7.3bn of debt with its major lenders. These will now be put to all 230 lenders for approval by 17 July. But the price is high:
• Initially, Ineos was paying c2.5% over euro base rates (Euribor)
• Now this premium is to rise to 6.50% on €5bn of loans
The Financial Times estimates that this will cost Ineos €260m a year, as well as €82m in one-off fees.
And in spite of the agreement, bond markets remain nervous about the company's ability to eventually repay its debt. According to Bloomberg, it now costs €6.16m to insure €10m of Ineos debt against default, plus €0.5m a year. In January 2008, the upfront cost was just €716k, with no annual payment.
The blog is now 2 years old. Its readership is very loyal, and continues to grow. 64% of current readers bookmark the blog, and read it regularly. And it is now being read in 2088 cities and 111 countries - versus 1244 cities, and 89 countries, 6 months ago.
Its regular readership is also very international. The UK, USA, Germany, The Netherlands, Turkey, China, India, France, Japan and Singapore make up the Top 10 countries. Other major chemical producers including S Korea, Italy, Brazil and Saudi Arabia all feature in the Top 20.
The blog aims "to share ideas about the influences that may shape the chemical industry over the next 12 - 18 months", and so it focuses on:
• The major companies
• Key consumer industries, including housing and autos
• Economic data such as GDP, industrial production and exports
• Developments in oil and financial markets
553 posts have been made in total, with 147 written in the past 6 months.
The blog is also aware that English is a 2nd language for many readers, who speak 46 different first languages. Even so, a long-standing American colleague told me recently that he sometimes had to look up the meaning of words via Google. I will try harder to keep it simpler in future.
Thanks you very much for your continued support.
Last month, the blog introduced its new Boom/Gloom Index, designed to track sentiment in financial markets. The chart above now updates it to reflect the whole of June.
The Index has continued to move up, and is close to the levels last seen in October 2007. Equally remarkable is the performance of the Green Shoots Index, which has hit another all-time high. There is little doubt that the performance of the two indices is related. Investors clearly want to believe that recovery is 'just around the corner', even though there is little hard evidence to support this belief.
Chemical companies have done well in exploiting this improved sentiment. Dow managed to raise nearly $10bn to repair its balance sheet, via asset sales and equity/debt issues. Ineos are well on the way to agreeing new covenants with their lenders. Neither looked easy to achieve before the market began its March rally.
Now, of course, comes the hard part. Will the current restocking process turn into a real recovery? The blog maintains its doubts, and fears the green shoots may wither to become yellow weeds.
The chemical industry has benefited from a benign paradigm over the past 25 years:
• Demographics in the west have encouraged consumption, as the baby-boom generation reached middle age
• Globalisation meant this could be achieved at lower cost, by outsourcing production to lower-wage countries in the east
• Workers in the east saved their money, which allowed banks to make good profits by lending it back to consumers in the west
Now, all three pillars of this paradigm are under threat:
• The baby-boom generation is starting to retire and a new, more frugal, type of consumption is emerging in the west.
• Asian countries are trying to rebalance their economies, to promote more domestic demand and replace lost exports.
• And many banks are amongst the ranks of the walking wounded, unable to resume lending at previous levels
What happens next, is therefore a key question. The Bank for International Settlements (BIS), the central bankers' bank, suggests that "A financial crisis bears striking similarities to medical illness. In both cases, finding a cure requires identifying and then treating the causes of the disease."
Its analysis, in its newly-released Annual Report, suggests that investors, consumers and policymakers have been "fooled into thinking that trend growth was higher than it really was". And the BIS's conclusion is that "countries have been left with bloated financial sectors, the ability to build more cars than their populations need and, in some cases, surplus housing stocks."
Housing and auto demand have, of course, been a key support for chemical demand in the past few years. If the BIS are right, then considerable downsizing awaits the industry over the next few years, as it adjusts to the new realities.
In 2007, Sweden was the largest private equity market in Europe, as a percentage of the country's GDP. And the local banks lent freely, as elsewhere, to fund investments. Now they, and other Nordic banks, are struggling to minimise their losses.
According to Bloomberg, Sweden's second-biggest bank, Handelsbanken, "seized parts of Plastal Group and Plastal Holding AB on July 2, after a cash infusion from Stockholm-based private equity firm Nordic Capital failed to save the plastic-parts maker from bankruptcy".
75-year old Plastal had sales of €1.3bn in 2007, and 6000 employees in 10 countries. But since then, it has been badly hit by the downturn in its core automotive market. Now "Handelsbanken, which loaned the company 2.1 billion kronor, plans to merge Plastal's Belgian, Norwegian and Swedish units into a new company".
Sadly, Plastal is unlikely to be the only company whose ownership moves from private equity to their bankers, as the downturn continues.
As expected, Ineos have today confirmed that their proposed new covenants have now been accepted by their lenders.
For those unfamiliar with the mechanisms used in the world of high-yield debt, this does not involve any new money, or a refinancing. Instead, it means that the lenders have agreed to provide Ineos with more head-room in terms of its day to day operations. Thus the company have confirmed that there will be a "reset of the Leverage, Interest Cover and Debt Service Cover covenant levels, effective from September 2009".
This sounds like financial small print. But it means Ineos and their lenders have agreed to make an adjustment to the conditions of existing loans, rather than to change the whole capital structure of the business. So Ineos employees, as well as their customers and suppliers, will no doubt be very reassured that everything has now been finalised.
There are "lies, damn lies, and statistics" according to Mark Twain, the famous American humorist. His argument was that statistics are often (a) untrue* and (b) used without the necessary context.
Last week provided a perfect example of the latter. As the blog's own Boom/Gloom Index© shows, sentiment is currently very positive in global financial markets. And so US markets rallied 4%, on the basis that reported company earnings were "above estimates".
Yet in context, this "outperformance" disappears. The above chart from ChartOfTheDay.com (COTD) shows 12-month, 'as reported' S&P 500 earnings, adjusted for inflation. And COTD highlight that these are now down over 98% since peaking in Q3 2007. Equally, they say this is "by far the largest decline on record (the data goes back to 1936)".
Also ignored last week was S&P's own report on Friday that forecasted total S&P 500 earnings for the 12 months to September "to be negative ($-1.01 EPS), for the first time in index history". Howard Silverblatt, S&P's senior equity analyst noted that any recovery in earnings will depend on a recovery in sales, as "you can only cut so much, and for so long".
*The blog carefully checks all those it uses with reputable sources
Cerberus' timing was clearly not very good with its Chrysler acquisition in Q3 2007.
And Steve Feinberg, Cerberus co-founder, admitted this when he told the New York Times "we were too optimistic on timing. Maybe what we should have done was not bought it."
So far, they have lost $6bn of their original $7.4bn investment. But the interview makes clear that their mistakes were not just due to timing, or over-optimism at the top of the 2003-7 credit bubble. They are also a warning sign of how new influences are starting to shape the investment landscape in the 'new reality'.
Steve Lewandowski of Total Chemicals wisely pointed out to the blog recently that Political, Environmental, Societal and Technology (PEST) issues are moving up the agenda around the world. The blog shares his view that careful study of these should be high on the list, when companies look at producing SWOT (Strengths, Weaknesses, Opportunities, Threats) analyses.
ExxonMobil Chemicals was 6th in the ICIS list of Top 100 companies in 2002, during the last downturn. By last year, it had risen to 2nd place, according to the latest ICIS list.
One of the secrets of its success was set out in an interesting Bloomberg interview yesterday with Basic Chemicals SVP, TJ Wojnar. This made it clear that EM is focusing ever more intensively on optimising production along the refining/petchem interface. Thus Wojnar noted that "the company would only consider buying plants that can be connected directly to Exxon Mobil oil refineries", in order to ensure that "by-products of the refining process can be turned into chemicals when fuel demand and prices are low".
Wojnar also gave an interesting example of this strategy in action, revealing that over the past 3 weeks, EM has been increasing the amount of refinery-produced vacuum gasoil (VGO) used in ethylene/polyethylene production, due to slowing gasoline demand. As he noted, the rationale for this move was simple, that "VGO is in surplus", and so it made sense for the company to take advantage of the lower feedstock cost..
The blog believes that the landscape has changed during the current downturn. We came into it on the back of a major boom in consumption, supported by reckless lending and borrowing. This mind-set seems unlikely to return quickly.
Instead, as the period of destocking/restocking comes to an end, we may face a "new reality". This probably involves a paradigm of higher savings, lower consumption, and global GDP growth of perhaps 2.5% rather than the historical 3.5%.
This scenario is more challenging than the consensus view of a quick V-shaped recovery. But if correct, it will also present a number of major opportunities for those companies who recognise that the basis of industry competition has now changed.
I outline some of the key issues in a new article for this week's ICIS Chemical Business. Please click here if you would like to read it. As always, I would welcome your insights on the points discussed.
The blog is now preparing its annual Budget Outlook for 2010. Before this is published next weekend, it makes sense to assess the blog's credibility by looking back at last year's Outlook, to see how well it performed. Past performance may not be a perfect guide to future outcomes. But it is one of the best that we have.
The 2009 Outlook was titled "Budgeting for Survival". Once again, as with the 2008 Outlook, "Budgeting for a Downturn", the blog was in a small minority of forecasters who had the courage to go against the optimistic consensus. Its main forecasts were:
• "Survival, not growth, is the prudent objective".
• "2009 is likely to see global recession".
• "Chemical demand is likely to be badly hit, as it is focused on consumer spending, particularly housing/construction and autos".
• "These areas may begin to bottom during 2009, but any real recovery is unlikely before 2011".
• "Unemployment is likely to rise, and banks will be reluctant to lend".
• "Companies selling into more favoured sectors (agrochems/pharma) will probably see lower demand and pricing pressure".
• On oil prices, "the most likely outcome is that OPEC will cutback production and seek to hold $70/bbl".
The blog's aim is to 'share ideas about the influences that may shape the chemical industry over the next 12 - 18 months'. It therefore feels very proud of having correctly forecast these key areas correctly.
It hopes that its 2009 Outlook enabled readers to better prepare for today's more difficult economy.
2010 should be a better year for the chemical industry, as demand grows in line with a recovery in global GDP.
But a quick V-shaped return to the 2003-7 Boom years in terms of volumes/margins seems unlikely.
Governments will worry about budget deficits, and may well scale down support for critical end-uses such as autos and housing. Equally, major amounts of new capacity, planned during the Boom years, will start to come onstream in the Middle East and Asia.
In effect, therefore, 2010 will be a year of transition to a 'new normal'. The blog expects global GDP growth rates to average around 2.5%- 3% for the next few years, the 1980-2000 average. This will be a significant reduction from the 3.5%-4% levels seen in the Boom years.
The rationale for this change is that we will start to see a rebalancing of the global economy. The West will see lower consumption, as people rebuild their savings, and borrow less. In turn, this will mean lower export demand for the emerging economies. The outcome will be a more sustainable world economy, but it will be a difficult journey.
Growth Forecasts. Most chemical markets are mature, and growth rates are therefore tied to GDP. The blog would therefore suggest that companies review their forecast growth rates for individual businesses in the light of their expectations for global GDP growth. One of the problems of the Boom years was that arbitrary growth rates (often of 5% or more), were assumed for many products. This also led to a perception that major amounts of new capacity were needed to meet this assumed demand. A more realistic view of demand would highlight potential problems of over-capacity, and perhaps encourage companies and governments to address the problems this will bring.
Demand. On a global basis, chemical output is now back at 2006 levels, having lost 3 years of growth. If GDP now grows as the blog expects, then demand from key sectors such as construction/housing, autos and electronics should improve next year. But the impact of government stimulus measures will make for a bumpy ride. The end of specific measures will cause major falls in perceived demand, whilst new stimuli will create short-term upward fluctuations. Excellent supply chain management will therefore be required, and Boards will need to keep a very careful eye on underlying trends.
Protectionism. Unemployment is set to become a key political issue in the West, as economies adjust to the 'new normal'. Hopefully, it should peak in 2010, but is unlikely to quickly return to previous levels. Arguments about the 'export of jobs' will therefore increase, and lead to a rise in anti-dumping activity. In turn this will cause job losses in emerging economies. Chemical companies will need to keep a close eye on the political arena, as they operate in a complex value chain, and may not otherwise appreciate the potential impact of a development in a key supplying or consuming industry.
Credit issues. A recovery in demand puts great strains on cash-flow, and many companies go bankrupt as a result. This could be a particular problem in the current recovery, given the underlying fragility of large parts of the banking system. CFOs will need to institute robust monitoring mechanisms, and be prepared to keep customers on 'cash before delivery' terms if they have grounds for concern. New customers represent a particular risk, if their credit history is weak, even though their promised volume may be attractive.
Oil prices. These are likely to remain volatile in 2010, as speculative price movements linked to traders' bets on the US$'s value will continue. Neither $100/bbl, nor a return to $40/bbl, would be a great surprise on a day-to-day basis. But underlying supply/demand balances may well remain weak in 2010, in spite of the expected economic recovery. Thus we might see prices coming under more pressure during 2010. $50/bbl might be an average price, in the absence of major geo-political events.
Overall, the blog expects 2010 to be a transition year. Full economic recovery is unlikely to take place much before the 2011/13 timeframe. But the return of economic growth will offer companies the opportunity to identify likely future market needs. Those that focus on this new reality, rather than simply hoping for a quick return to the Boom years, will position themselves for future success.
"Never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform."
Bank of England Governor, Mervyn King,
proposing that banks should be split up.
He argues that high-risk trading activities should be split off from low-risk utility banking (eg payment systems). Then, next time the investment bankers go bust, only their shareholders will suffer. The blog imagines most people in the chemical industry would support the Governor's argument.
Over the past year, much of the Western financial system has been on life support. Now the European Central Bank (ECB), like its peers, is grappling with the question of 'What happens next?'
ECB Board member Lorenzo Smaghi set out the key issues yesterday:
• "Our role (as a central bank) is limited to the provision of liquidity to solvent banks.
• "This role does not include the recapitalisation and restructuring of the banking system.
• "We expect banks to take a more active role in the process of recapitalisation.
• "The banking system cannot be supported indefinitely by the extraordinary measures taken by central banks. An exit strategy will inevitably need to be implemented in due course.
He highlights the issue with the above chart, which shows the collapse of all forms of financial activity in the eurozone over the past 2 years. And he argues that nothing will change unless "individual incentives, those of bank managers and shareholders, are aligned with the collective incentives to support the economy."
Currently, of course, most banks are instead pursuing their own agendas to maximise short-term bonuses and profits. The blog therefore shares Smaghi's concern that unless politicians and regulators act quickly, the eurozone may well repeat "the experience of Japan over the past decade, where delays in restructuring and recapitalising the banking system undermined the recovery after the crisis".
LyondellBasell (LBI) yesterday confirmed the rumoured takeover bid from Reliance. In a statement posted on its website, it says it has "received a preliminary non-binding offer from Reliance Industries Limited to acquire for cash a controlling interest in the company contemporaneously with the company's emergence from Chapter 11 reorganization".
It noted "this offer is in addition to the previous non-binding equity financing proposals received by the company and represents a potential alternative to the initial plan of reorganization previously filed by the company."
On Sunday morning, the Financial Times reported that Reliance are offering c$10bn for a majority stake in the world's 3rd largest chemical company. 2 weeks ago, the FT had said Reliance were considering a $6bn bid for LBI. At $10bn, the $51bn turnover LBI would certainly be a major step-out opportunity for India's leading chemical company, if problems exiting Chapter 11 can be overcome.
It would be a good fit in terms of product mix, and also provide Reliance with access to LBI's excellent technology portfolio and its global market coverage. Both could be key building blocks as Reliance moves to become a fully-fledged global player.
The deal, if consummated, would represent a remarkable contrast in fortunes. The blog first did business with Reliance in 1984, when the company was a small producer of polyester yarn. At that point, they were seeking a licence to move upstream into PTA production. Since then, of course, they have become the world's largest PTA producer, and also successfully back-integrated into refining and oil/gas production.
LyondellBasell was created via acquisition, first through the €4.4bn purchase of Basell from BASF and Shell, and then the $22bn purchase of Lyondell in July 2007. The blog commented at the time that this was an "extraordinary price for a commodity chemical business", and so it has proved, with Lyondell sadly falling into bankruptcy last January.
By coincidence, the blog's friend Rajen Udeshi, now President of Reliance's Polyester Chain and a Senior Executive VP of Reliance Industries, will be speaking on Thursday in Amsterdam at our annual European Conference, co-organised with ICIS. It should be an interesting morning.
UK Finance Minister Alistair Darling is widely reported today as being about to announce a 'super-tax' on bonuses paid to bankers working in the UK.
The government's argument, notes the BBC's Robert Peston, is that "Investment banks are making exceptional profits, as a result of the intervention of government and the Bank of England to limit the economic damage from the mess caused by those very same banks. So it would be outrageous if they paid those profits to employees and bonuses. We are determined to prevent that."
Darling was the first western minister to warn of the likely end of the Boom period in August last year. He was widely derided at the time for suggesting that the downturn "will be more profound and long-lasting" that most people had expected. But he was, of course, proved right by events.
Similarly, it will be argued that bankers can easily retain their bonuses by moving abroad. But those who relocated last year to Dubai might now regret their decision. And given popular anger at the mess caused by the banking crisis, and the need to raise taxes, the blog suspects that other countries may well follow his move in coming months.
For most of this year, the banks' trading houses have been earning vast sums of money promoting the "correlation trade" (sell the US$, buy crude oil, gold and equities). As a result, around 150mbbls of oil and oil products is now in floating storage, with much more on land.
Next year, the same traders and brokers might well decide there was more money to be made from promoting a different trade. They might argue, for example, that the world economy was still too fragile to afford $80/bbl oil, and instead suggest oil should be sold, not bought.
These things happen. But they can cause problems for those who have to budget forward. Governments dependent on oil revenues, for example, find it difficult to simply 'turn off the tap' on spending, just because prices on the NYMEX futures exchange have fallen.
This is behind Mexico's decision to hedge its entire crude oil output for 2010 at $57/bbl after costs. All 230m bbls have been hedged, as a follow-up to 2009's successful hedge at $70/bbl. This added $5bn to government revenues in H1, a critical sum for any organisation.
Hedging often gets a bad name, when it is used to describe a trading activity. But as Mexico's Finance Minister, Agustin Carstens, noted ""We want this as an insurance policy. If we don't collect any resources from this transaction, it's OK with us. That would mean the oil price had remained above $57 a barrel".
The blog suspects that Mexico's $1bn insurance premium for its hedging strategy may again prove money well spent in 2010.
The blog is now 2.5 years old. Readership continues to grow, both within the chemical industry and its investment community. It is now read in 121 countries, and 2735 cities, versus 89 countries and 1244 cities a year ago. Readers are also very loyal, with 23% reading it twice a week.
Its readership covers all the major areas of chemical production. The UK, USA, Germany, Netherlands, Turkey, China, India, France, Singapore, Belgium make up the Top 10 countries, with Japan, S Korea, Italy, Brazil, Saudi Arabia and Russia all featuring in the top 25. English is a 2nd language for most readers, who speak 55 different first languages.
The blog aims "to share ideas about the influences that may shape the chemical industry over the next 12 - 18 months", and so it focuses on:
• The major companies
• Key consumer industries, including housing and autos
• Economic data such as GDP, industrial production and exports
• Developments in oil and financial markets
698 posts have been made in total, with 142 written in the past 6 months.
The blog's annual Budget Outlook continues to attract strong interest. This year's, 'Budgeting for a New Normal', was also the subject of a well-supported Webinar, and will shortly be published as a White Paper.
Thank you very much for your continued support.
Extended downturns, of the type that we are now suffering, generally mark a transition period from one set of business conditions to another.
I look at what might be in store for us during this transition, in this week's edition of ICIS Chemical Business. The analysis focuses on the key areas in the chart - Restructuring, Supply Chain, Technology, Financial Size and Commercial.
It suggests that companies need to balance today's immediate priorities with future needs, under the motto 'Think about tomorrow, and act today'. I hope you find it helpful.
The Financial Times reports today that Ineos has postponed plans for an initial public offering. It says this "was one of a range of options that had been considered by the company to strengthen its balance sheet, which was burdened with more than €7bn ($10bn) of debt". It adds that Ineos is still looking at "full or partial sales of operating businesses to help reduce its debt", as noted last month by the blog.
The FT says that the possible IPO was discussed with Barclays Capital, one of Ineos' main lenders. But it notes that in today's investment climate, "highly leveraged companies such as Ineos may find it difficult to float". It says Ineos' net debt "was €7.49bn at the end of 2008, roughly seven times last year's expected EBITDA" and compares this with "a survey of investors by RBS Hoare Govett in the summer (which) revealed investors' reluctance to support IPOs for companies whose net debt after flotation would be more than three times their EBITDA".
Blog readers have a wide range of interests.
That is clear from the list below of the Top 10 posts in 2009.
It also confirms the complexity of the chemical industry, and its fascination.
In alphabetical order, it is as follows:
• Bubble, bubble, toil and trouble
• Companies remain cautious on the outlook
• "Green shoots" likely to be "yellow weeds"
• IEA warns on economic downturn, lower oil demand
• 'It's the price that matters': Wal-Mart and Tesco signal a major change in consumer priorities
• New US auto fuel standards provide chemical companies with major opportunities
• OPEC worries about weak oil market fundamentals
• Rotterdam oil storage running out of space
• Russia's chemical production tumbles
• The nudist beach on Wall Street
Interestingly, the list includes 2 'classic' posts from 2007 and 2008, which are obviously still valued by many readers as reference points:
• The insight from Tesco and Wal-Mart which pinpoints the moment at which consumer priorities began to shift from 'wants' to 'needs'
• Warren Buffett's then controversial views on financial markets, just before they began to implode.
Pity your poor Purchasing Director this week. They know the West is having a cold winter, but they have done their analysis and can show you slides, such as the one above from Petromatrix, that indicate the US has the highest stocks of distillates since 1999. In addition, the world has 75mb of distillate in floating storage. So there is no shortage of product.
So why are oil prices above $80/bbl?
• Is it because crude oil is somehow short, or gasoline? No. We have high stock levels for these as well, plus plenty more in floating storage.
• Is it instead because higher prices are needed to justify sufficient E&P investment in finding more oil for the future? Perhaps, but then we have to ask the related question, namely 'what level of global GDP growth can be maintained if oil is going to be $80/bbl or higher'?
Or to put the issue another way, can industries such as chemicals successfully pass through such prices, and maintain previous growth levels? We all know, after the experience of 2007-8, that the perception of today's high prices being easily absorbed is not the same as reality. Purchasing managers are virtually forced to buy forward, if they see higher prices round the corner. But this doesn't mean their sales colleagues can sell the same volume, or maintain the same margins.
And in reality, as will likely become clear as and when prices fall again, high oil prices (as we first saw in 1973-4, and 1979-80), in fact cause demand destruction. They effectively act as a tax on the general population, who have to heat their homes, and travel to work and the shops. This gives them less to spend on other products and services.
So, then, why are oil prices so high? The answer is very simple - 'money talks'. As the Wall Street Journal notes this weekend, banks "including Citigroup Inc., Bank of America Corp., J.P. Morgan Chase & Co. and Morgan Stanley are offering levels of borrowing--known as leverage--that they haven't provided in more than two years". But this money is not flowing into loans to industry.
Instead, its going straight into trading activity in financial markets. And in so flowing, it has the remarkable effect of creating the illusion of recovery, as outsiders look at high oil prices, and assume that demand levels must have recovered. This could become a very dangerous assumption indeed, if it becomes shared by policymakers.
CEO's are now preparing their comments on 2009 performance, and the 2010 Outlook. It would be very helpful indeed, if they included a paragraph that noted what is happening in oil markets, and questioned why this is being allowed to continue.
One by one, Western political leaders are coming to the conclusion that taxes on the banks need to rise. Last month, the UK proposed a 50% 'super-tax' on bonuses, on the grounds that "investment banks are making exceptional profits as a result of the intervention of government".
At the time, the blog thought it spotted an emerging trend, even though the US administration was critical. And so it has proved. Today, President Obama has proposed a $90bn tax to recoup the costs of the bailout.
Even more interesting was his comment during the announcement that "What I say to (bank) executives is this: Instead of sending a phalanx of lobbyists to fight this proposal or employing an army of lawyers and accountants to help evade the fee, I suggest you might want to consider simply meeting your responsibilities."
It is a long time since the blog last heard a Western politician, let alone a US politician, suggesting that investment banks were part of the problem, not the solution. Clearly, the zeitgeist is indeed changing.
A year ago, the Dow Chemical stock price was below $6, giving the company a total market capitalisation of just c$7bn.
Since then, Dow has regained the initiative in a very focused way.
First, it sold Morton Salt for $1.7bn, then it sold $2.25bn of new equity and refinanced $4.65bn of long-term debt. Next, it sold the calcium chloride and refining businesses for $925m. And now Tuesday saw the disposal of the Styron business to Bain for $1.63bn. Plus Dow puts a $400m value on the long-term supply/purchase deals attached to the sale.
The stock price has, of course, responded to these successes. It is now trading at c$29, giving a market capitalisation of $33bn. The blog congratulates those responsible in Dow for this major turnaround, at a time when market conditions have remained difficult.
A week ago, the BBC carried a report that PetroChina had completed "preliminary work" on a possible bid to buy a stake in Ineos' Grangemouth refinery.
The BBC quoted Ineos as confirming it was in talks with "a number of parties" over the future of Grangemouth, whilst cautioning that "the discussions with interested parties are exploratory and it would be premature to speculate on whether any might lead to investment in the site. The Grangemouth petrochemical and refining facility remains a strategic part of the Ineos Group and the company is committed to its long-term development."
The BBC report came after a rare interview in The Times last December with Ineos chairman Jim Ratcliffe, who noted that "Under our agreement with the banks, we need to generate levels of cash which it is difficult to imagine the business doing. At some stage there has to be an asset sale".
This still seems a sensible strategy, even though the blog understands that Ineos doubled EBITDA to €1222m in 2009, versus €594m in 2008, and is currently trading ahead of its business plan. Its liquidity has also improved by c€100m via the Ineos ChlorVinlys divestment, whilst the $350m fluorochemicals sale should complete later this month.
Then 2 days ago, the Sunday Times newspaper reported "that Ineos has recently held exploratory talks with Sabic, and Kuwait's Petrochemical Industries Company." It added that Ineos CEO Tom Crotty had refused to disclose the identity of the potential suitors, but had said "we are in talks with several parties that may lead to us bringing someone in, either as an equity partner in the group or on certain assets".
Yesterday, the Daily Telegraph added that the "proposals discussed with the Middle Eastern players are thought to have included the possibility of the company hiving off its petrochemical commodities business." It quoted an Ineos spokesman as saying that the company had been open about its plans to "further strengthen its balance sheet", although it had "no pressing need to do any deals given our current performance".
Morgan Stanley, the investment bank have reportedly been advising Ineos on Grangemouth since last June, when 'The Scotsman' newspaper suggested that "PetroChina could buy the refinery, while Ineos would retain the polymer and petro-chemical processing plants located on the same site". Perceptively, however, the paper had also quoted PetroChina as saying that "talks can take a really long time".
The blog congratulates Brenntag, the leading distribution company, on its successful flotation yesterday.
Its shares were issued at €50, and rose to €52 in early trading, giving it a market capitalisation of €2.7bn ($3.6bn). New private equity owners BC Partners sold 4.45m shares to raise €223m, and now own 71% of the company.
Brenntag itself also raised €525m by selling 10.5m shares. This enabled it to repay expensive mezzanine debt, and will also finance potential acquisitions in Asia and Latin America.
As distribution industry expert Marc Fermont of DistriConsult noted in a recent speech, the "IPO is a major industry event whose success was essential for the whole sector". He added that Brenntag was a relatively safe investment, as "distributors tend to bring regular cash flows measured as EBITDA, including in period of crisis (whilst) financial risks are limited as very few bankruptcies are reported in the sector".
We are often told that investment bankers are much cleverer than the rest of us. But sometimes, they do seem to lack common sense.
Their behaviour since the Crisis, in paying out $bns in bonuses to the lucky few, seems no way to appease understandable public anger over the cost of the banks' bailout. The International Money Fund (IMF) today calculates this cost at a staggering $862bn, c1.5% of global GDP.
Thus they shouldn't be too surprised that the IMF is today proposing two new taxes. One is aimed at financing any future bailouts, whilst the other is a more general Financial Activities Tax, or FAT. And when the IMF bothers to think up an acronym like this, you know it means business.
Equally, chemical companies should also be concerned at the way bank profits routinely tower above theirs. As the above Financial Times chart shows, UK banks Return on Equity (the purest measure of profitability), has been consistently over 20% in recent years. Other Western banks have been similarly profitable. By comparison, BASF's ROE between 2000-9 averaged 16%.
The easiest way to start restoring the balance might be a more cautious response when taking investment bankers' calls re prospective M&A targets. This activity accounts for a high proportion of banks' profits, yet all the evidence suggests that most M&A destroys value for the acquirer.
Being smarter at M&A, and only doing higher quality deals, might therefore be an excellent way to boost companies' ROE whilst reducing that of the banks.
The past 15 months have been an expensive lesson for those debt-holders who financed Basell's purchase of Lyondell in July 2007, at the peak of the market.
LBI entered Chapter 11 with $24bn of debt. It will now exit with just $5.2bn of net consolidated debt. Holders of senior secured debt will receive 93% of the new Class A shares in exchange for their claims. The value of these will depend on the outcome of LBI's proposed IPO in Q3. Most other original lenders are wiped out.
LBI is the world's 3rd largest independent chemical company, with 2009 sales of $30.8bn. Its predecessors, Lyondell and Basell, were also excellent companies. This has been demonstrated by the way in which employees have maintained their morale during an immensely difficult time. The blog congratulates them, and LBI itself, on their successful exit.
The chemical industry is a well-known leading indicator for the world economy. Yet 18 months after the financial crisis began, the blog's review of quarterly company results reveals few signs of optimism that a sustained upturn is underway.
Q1 has certainly seen the forecast seasonal boost. But Asia, particularly China, remains the real focus of growth. PetroChina, Reliance and Sinopec all see a continuing boom underway, with Sinopec highlighting the importance of "state stimulus measures".
Dow Corning is certainly bullish, seeing "recovery in nearly every industry and geography". Whilst Cognis, also focused on 'green markets', detects improved demand in Europe. But although Dow sees "demand growth returning in developed markets", it notes significant "challenges" remain.
Equally, Akzo Nobel seems typical of the majority when noting it remains "cautious about the strength of the recovery". BASF also notes that "recovery is not certain". And several companies, including Rhodia, worry about the "uptrend in raw material and energy costs".
Air Liquide. "In a context that remains contrasted, this first quarter of 2010 marks the return to growth".
Akzo Nobel. "Expect pressure from further raw material cost increases during the year and remain cautious about the strength of the recovery".
Ashland. "Asia-Pacific remained the most difficult market for recovering raw materials costs; Europe remains tough due to the competitive environment".
BASF. "Limited supplies of certain chemicals as well as restocking of inventories among customers buoyed demand.... We expect that national stimulus programmes around the world will wind down. Further recovery is therefore not certain and surprises cannot be ruled out for 2010."
Bayer. "The decline in business momentum at HealthCare and CropScience was being offset by the recovery at MaterialScience".
BP. "Petrochemicals margins would come under pressure due to new capacity coming on stream".
Celanese. Asia is "the only region in the world that's growing".
Cepsa. "A more buoyant global operating environment with better product prices".
Clariant. "We expect the economic recovery to remain fragile and raw material costs to further rise heading into the seasonally weaker second half of the year".
Cognis. "Business conditions improved due to a pickup in worldwide demand, especially in Europe".
ConocoPhillips. "Chemicals experienced improved market conditions."
Cytec. "There is still some uncertainty about the recovery, and higher energy prices will show up in our costs for the second quarter."
Dow. "Demand growth was returning in developed markets, with strengthened consumer spending in areas such as electronics, appliances and automotive ...balancing out challenges in residential and commercial construction, inflation in emerging markets and sovereign debt issues in southern Europe".
Dow Corning. "Seeing this recovery in demand in nearly every industry and geography we serve".
DSM. "Uncertainties remain in the medium-term economic outlook."
DuPont. "Expected stronger sales growth operating margins as global economic improvements continued, with particularly strong demand in Asia Pacific.
Eastman. "Expected continued volatility in raw material and energy costs".
ExxonMobil. "Q1 chemical product sales were 6.488MT, up by 961KT in Q1 2009, primarily due to improved global demand".
Honeywell. "The timing and shape of the recovery is uncertain and we remain conservative in our planning assumptions".
Idemitsu Kosan. "Demand for petrochemical products recovered, assisted by China's economic stimulus package."
INEOS. "Just as the orders dried up suddenly in August 2008 so they have abruptly resumed in the past couple of months".
Kemira. "Uncertainty remained regarding the development of demand".
Lubrizol. "Do not expect full recovery to our 2008 volume level until 2011...also expect tight supply conditions for some of our raw materials that will result in upward cost pressure."
Occidental. "Significant margin erosion in 2009 carried over into the first quarter of this year."
Olin. "Had a Q1 operating rate of 75%, compared with 65% in Q1 2009."
PetroChina. "Ethylene output surged 37% year on year in Q1, with production of other petrochemicals also strong.
PPG. Saw continued "moderate recovery" in several of its global end-use markets over the quarter."
Quaker. "Anticipate somewhat lower product volume in H2 ...due to credit-tightening actions in China, seasonal factors, the ending of inventory restocking and the conclusion of tax incentives for auto purchases in several countries".
Reliance. "Domestic demand for most petrochemical products remained strong in the January to March period, with polymers demand up by 19% and demand for polyester and fibre intermediates up by 15%".
Rhodia. "The upward trend in raw material and energy costs is expected to continue".
Rockwood. "Difficult to determine what impact customer inventory rebuild is having on our sales."
SABIC. "Overcoming the impacts of the global financial crisis, as well as continuing our strategy of growth and investment in new industrial plants".
Shell. "Industry refining margins had significantly declined reflecting reduced demand for refined products".
Sherwin Williams. "Sales were slightly stronger than we anticipated, although domestic demand remains soft".
Sinopec. "In light of state stimulus policies, demand... grew steadily and the company took various proactive measures to expand the market and optimise the product mix".
Syngenta. "Expects volume growth from Q2 onwards".
Tessenderlo. "Visibility on H2 remains low".
TOTAL. "Chemicals has benefited from the economic recovery since the start of the year."
Trelleborg. "Warned that the demand scenario remains uncertain".
Unilever. "Commodity costs will increase in the second half, economies remain sluggish and competitive intensity will remain high".
Vopak. "We notice the first signs of structural recovery of the European chemicals market."
Wacker. Focused on " improving our cost structures and increasing our competitive edge."
Sell in May and Go Away" is the oldest rule in stock market investment. This week has certainly provided further support for it:
• The major Western stock markets are down c8%
• The major emerging markets are down between 4% - 13%
• Crude oil prices are down 13%
This May panic may well also mark the markets move into their 3rd, and most destructive phase. As originally identified by Merrill Lynch's analyst guru, Bob Farrell, "bear markets have three stages - sharp down, reflexive rebound, a drawn-out fundamental downtrend".
Greece, of course, and its debts, has been the catalyst for this week's panic. And the chart above (from the Bank of International Settlements), highlights the core problem. European banks have collectively lent $2663bn to the 5 euro countries at most risk of default, the PIIGS (Portugal, Ireland, Italy, Greece, Spain).
The vertical axis identifies the debt held by each country, showing that France has lent $79bn to Greece, and Germany $46bn. As my fellow blogger, John Richardson has noted, "if the whole of Greece suddenly vanished into the ocean, it wouldn't make that much of a difference to the global economy...including chemicals". Nor would Portugal, or Ireland.
But Spain and Italy combined are 6% of the global economy, with GDP of $3.6trn. Between them, they owe $1.8trn to banks in the rest of the EU. If markets become seriously worried about the prospects for economic recovery, then they will clearly be near the top of everyone's concerns. US banks, for example, have $3.6trn of loan exposure to Europe.
This suggests the world economy is now approaching a cross-roads:
• In one direction lies economic recovery, as argued by Larry Summers, US economics chief. His view was that government stimulus would provide, like a 3-stage space rocket, the "escape velocity" to stabilise the major economies and encourage consumers to begin spending again
• The blog, however believes with Pimco (the world's largest bond fund managers) that we face a "new normal" of lower spending and less debt.
As we move into Budget season, Boards will start to debate their outlook for 2011-3. Clearly they will hope, with Summers, for better times. But prudence suggests they should also plan for a less favourable, Pimco-type Scenario. Markets may well rally again short-term. But if Bob Farrell's analysis is right, the third phase of the Crisis still lies ahead.
The blog gained some key insights into the current M&A landscape this week, at the annual Pilko & Associates Round Table, co-organised with Shell Chemicals and leading law firm Allen & Overy:
• M&A has become a 'buyer's market', and this is not expected to change in the near future.
• Credit markets remain cautious. Liquidity exists for big corporates, but investors are not confident there will be a sustained profit rebound for petchems, given the amount of new capacity about to come online.
• Maximising the competitive advantage of their own specific operations is the only way for companies to counter this perception.
• Working capital is tight down the value chains, with banks still reluctant to lend, and this is adding to market volatility for many products, as CFO's seek to reduce inventory.
• Companies in emerging economies are looking to establish 'gateways' into developed economies, with a focus on acquiring routes to markets.
Significantly, a major amount of time was spent discussing the potential implications of the Deepwater Horizon oil rig disaster in the US Gulf. This is expected to create a sea-change in risk management. There are clear parallels being drawn with the banking Crisis, where self-regulation has also seemingly failed to provide the results expected by government.
Companies can therefore expect to see increased regulation, as part of the public's increasing distrust of business ethics. Regulators will probably set more rules, and become more pro-active in ensuring the required measures are being carried out. This will increase costs, and limit operational freedom.
The blog has sometimes despaired of the cheer-leading and wishful thinking of too many leading policy-makers. As I argued in the Financial Times in March 2007, before the Crisis began, "they seem to confuse being market-friendly with being friendly to markets".
It therefore welcomes the realism being shown by the UK's new coalition government. Today, David Laws, Chief Secretary in the Treasury, argues that "we are moving from an age of plenty to an age of austerity in the public finances". And coincidentally, Nobel Prize-winning Paul Krugman suggested yesterday that most Western countries aren't really like Greece, but "are looking more and more like Japan".
The blog's own chart above, showing the relative movements of the US S&P 500 index, and Japan's Nikkei 225, illustrates Krugman's point:
• The black line and axes show the % monthly changes (basis September 1985) in the Nikkei 225, to 2004
• The red line and axes show the % monthly changes (basis September 1995) in the S&P 500, to today
The chart shows the parallel market tops in November 1989 for the Nikkei, and in August 2000 for the S&P 500. It highlights a remarkable parallel, first noted by market guru Alan Shaw in Barrons in July 1998, and this continued until early 2003.
The parallel then disappeared, before re-emerging briefly last year. And the recent market falls may well be a first sign that the two lines are reconnecting again. The rationale for the parallel is simple, that Japan and the West both face the problem of an aging population, with Japan's demographics being some 10 years ahead of the West's.
The difference since 2003 can also be explained by this "cheer-leading" by Western policy makers, who have tried to maintain perpetual growth in their economies. Every time markets dipped, their response has been to cut interest rates and inflate speculative financial bubbles,.
With a G7 government instead now talking about an expected 'Age of Austerity', chemical company Boards will clearly want to revisit their planning Scenarios. They need to ensure their strategies are robust enough for them to be confident of surviving a continuing Downturn.
The blog's White Paper, 'Budgeting for a New Normal', proved enormously popular when it was published earlier this year. ICIS therefore suggested that it would be useful to update it, 6 months later.
This Update is now published. It looks at the current state of the global economy, six months on, and then covers the outlook for key chemical markets such as construction/housing and autos, as well as the latest views expressed by chemical companies themselves on the outlook.
Please click here if you would like to download a free copy.
The latest in the American Chemical Society's 6 monthly 'Chemicals and the Economy' webinar series took place last week. It was moderated by former ACS President, Bill Carroll, of Occidental Chemical, and again proved very popular.
ACS reported high levels of satisfaction from participants. Comments included: "This speaker is one of my favorites." "This was a very useful topic!" "Very informative, very interesting, very sobering, very good presentation. " "Presentation had great depth, in short time. Easy to understand graphics w/ presenter's help." "Excellent seminar, very up to date. Thanks!"
If you would like to view the 1 hour webinar (you can fast-forward!) please click here.
The US Institute for Supply Management (ISM) has also released an article summarizing the content of the latest White Paper for their chemical industry members. Please click here to read it.
The US Federal Reserve and the American Chemistry Council (ACC) have joined the blog in expressing concern about the outlook for the US economy. And as the chart above of the US S&P 500 shows, financial markets have continued to weaken since the blog's advice on 8 May to "sell in May and go away".
The latest minutes from the Fed's monthly meeting show it worries that the economy may take up to 6 years to fully recover:
"Participants generally anticipated that, in light of the severity of the economic downturn, it would take some time for the economy to converge fully to its longer-run path as characterized by sustainable rates of output growth, unemployment, and inflation consistent with participants' interpretation of the Federal Reserve's dual objectives; most expected the convergence process to take no more than five to six years."
It also highlighted the real risk of deflation emerging:
"Some participants judged the risks to the outlook for inflation as tilted to the downside, particularly in the near term, in light of the large amount of resource slack already prevailing in the economy, the significant downside risks to the outlook for real activity, and the possibility that inflation expectations could begin to decline in response to low actual inflation. A few participants cited some risk of deflation."
As Al Greenwood notes in ICIS news, this week's data also showed that "US capacity utilisation for manufacturing fell to 71.4% in June, down from 71.7% in May. From 1972-2009, the average was 79.2%."
The American Chemistry Council has also raised a yellow warning banner in its latest weekly report. Chief Economist Kevin Swift notes:
"The economic reports were generally negative this week. Retail sales, industrial production, trade, and the regional business surveys all disappointed. There was potentially good news, however, in that initial claims for unemployment insurance fell to a two-year low."
"Overseas, the recovery of industrial production appears to be slowing, with the year-earlier comparisons in the Eurozone, China and India, for example, still strongly positive but moderating. This confirms earlier signals emanating from the purchasing manager reports and composite leading indicators. A second half slowdown or soft patch is clearly in order. It's not clear yet if this is a metamorphosis into a double-dip or not. The risks, however, are clearly rising."
The blog would strongly advise Boards to consider developing a Downside Scenario in respect of their Budgets for H2. It hopes, like the ACC, that the economy will maintain H1's improvement. But there are growing signs of renewed economic weakness in all major Regions. Companies without a detailed contingency plan could be badly hit.
Over-capacity is going to be a major issue for the petchem industry over the next few years.
Asian producers, in particular, are likely to be worst impacted. The reason is that they have relied on exports to China taking up to 50% of their production.
But now China's own production is ramping up, reducing the potential for these imports. And, of course, Middle East exporters to China will have a clear cost advantage in gaining the remaining volumes, versus most Asian plants which run on liquid feeds.
Asian producers therefore only only two alternatives, to attempt to:
• Export to the West or
• Close other regional competitors
The third alternative, of course, would be to shutdown themselves. But this is likely to be a last resort given the social implications on employment, and the impact on associated refineries and customers.
Exporting to the West is also likely to prove difficult, due to logistic costs and the close linkage between local producers and their customers. It will undoubtedly happen as the downturn continues, but at this stage it makes good sense to focus on inter-regional opportunities.
Equally, attack is often the best form of defense. And the new move by S Korea's Honam to acquire Titan in Malaysia is clearly based on this strategy, as Honam seeks to realise their Vision of 'global leadership'. Titan will provide them with a strong local base from which to attack SEA markets. And as my blogging colleague Malini Hanrahan notes today, they are losing no time in considering major expansion of Titan's facilities.
Singaporean producers will be tough competition, given their close links with China. But other SEA producers will quickly find themselves in the firing line. They urgently need to update their own strategies for the future, in the light of Honam's move.
The blog has had a letter published in the FT this morning, which readers might like to see.
It focuses on the problem of using EBITDA measures when analysing a company's performance. It suggests that analysts should move away from their current reliance on this measure, which ignores the impact of important areas such as interest and tax payments. Hopefully, the letter may help to spark some debate in this critical area.
Sir, I was delighted to see Lex reminding readers that they should assess company profits after payment of all significant costs such as "staff or technology" ("Price/earnings multiples", August 24).
Could, perhaps, Lex take this principle a stage further, and revert to its former policy of including the impact of interest, taxes, depreciation and amortisation when commenting on earnings?
The widespread use of the ebitda measure, which ignores these critical components of company performance, has fully justified the concerns of those who worried that it would simply be used as a way of expressing Earnings before the Bad Stuff. Investors, as they have found to their cost over the past two years, really do need to know how much interest and tax are being paid, and also whether sufficient money is being set aside to replace current plant.
It would be excellent if Lex would return to basing its valuable analysis on a company's real bottom line. This would then help your readers to assess who is swimming naked, before the tide goes out.
London N7, UK
With the Chairman of the US Federal Reserve saying the outlook is "unusually uncertain", its time to summon the chemical market genie.
Of course, rubbing the lamp is not always successful. And if the genie does arrive, one can only ask 3 questions.
So rather than risk wasting them, the blog has learnt to spend the first question in asking him to decide the other two questions.
And this is what the genie said:
"They should be obvious, even to you, blog. Ask me what is happening to the US economy? It dominates the global economy, as you have written many times".
So I asked, and the genie answered, laughing:
" You have wasted a question. You already know what is happening to the US economy. It is heading back into the downturn, now the stimulus programmes are ending.
"In Q3 last year, GDP grew by 1.6%, and by 5% in Q4. But then it slowed in Q1 to 3.7% and now Q2 is estimated at just 1.6% again. But I can understand that you have been hoping a proper recovery might be underway, particularly after the industry has had such a strong H1."
Thank you, O genie, I replied, and so what should be my second question? The genie sighed, and I thought for a moment he was going to disappear back into his lamp.
"Ask me about the US housing market? You surely know that this used to be a $35bn chemical market in 2006, when there were 2.2m housing starts? But you can start by answering my two-part question:
"How many new US homes sold last month for over $750k, and how many for over $500k?
The blog knew the answer, and replied "zero, and 1000".
"So, said the genie, the rich aren't buying. And as 23% of all homeowners owe more on their mortgage than the home is worth, and sales in July were an all-time low of just 276k annualised (worth just $5bn), then this major market will provide little support for future chemical sales"Chastened, I waited for him to reveal my 3rd question.
"Again, it is obvious", he replied. "Even you have been writing about it since February 2009. Ask me about the potential impact of deflation."
"But if I can interject, O genie, all the commentators suggest that we are in a 'bond market bubble' and that we should really worry about inflation?"
At this, the genie laughed for a very long time.
"You amuse me, blog", he finally replied. "So I will allow you this extra question. Ask all of your friends if they have read an article about this so-called 'bond market bubble'? And then ask them if their own pension fund is now even 50% in long-term G7 government bonds? You will find there is indeed a bubble in articles about a 'bond market bubble', but very few people actually own them".
So the genie then answered his 3rd question, reminding the blog of an analysis in Barrons, the US investment magazine.
"Today, if you're a Western baby-boomer (born between 1946-64), you now need to save $1.42 if you want to have $2 in 10 years time, with interest rates at 3.5%.
But when rates were at 7%, you only needed to save $1 to achieve the same result.
"Now, blog", he then added. "You wrote about the baby-boom generation only last week. You can surely see why they are beginning to panic about their future income level in retirement?
"After all, a 1% fall in interest rates has the same impact on a pension fund as a 15% fall in the stock market. So it is very likely that the collapse of the housing market is just one sign of the change that is taking place in the wider economy.
"And don't forget, blog, that the EU, USA and Japan (whose populations are filled with ageing baby-boomers), have a combined GDP of $36trn, or 62% of the total world economy.
"If their baby-boomers stop spending and start saving, which they must do to protect their retirement income, then clearly global chemical market growth rates cannot go back to the levels seen before 2008."
And with that, the genie disappeared back into his lamp, leaving the blog to ponder on the implications of his answers for chemical sales in the rest of 2010, and in future years.
Many readers have been taking a well-deserved break over the past few weeks. As usual, therefore, the blog is highlighting key posts during August, to help you catch up as you return to the office.
August has been surprisingly busy:
Force Majeure reports show worrying increase highlighted the worrying rise in force majeures, which may be linked to cutbacks in training, and maintenance spend.
US consumer demand growth stalls. The US economy seems to be heading back into the downturn, as the stimulus programmes end, with unemployment still high, housing starts at all-time lows and GDP slipping.
5 tips for surviving a period of deflation covered advice from the Wall Street Journal on managing a personal investment portfolio.
Speculative mania continues to drive oil markets. The impact of futures market trading disguises the weak fundamentals of the oil market, and has also been driving speculative activity on polymers in China.
US junk bond issue hits record as GDP slows worried that investors were piling into high-yield corporate bonds, just as the slowing economy was increasing their risk.
Lower refining rates support EU petchem margins described how lower oil product demand, and hence refining rates, was reducing naphtha availability, and so helping to keep petchem markets tight.
The" real bottom line" in the Financial Times featured the blog's letter to the FT.
The blog remains very concerned that, overall, the economic policies adopted during the current Crisis are leading the world economy to the worst possible outcome. This outcome is totally predictable. Indeed it has been predicted by reputable experts for some years. Yet most policymakers still seem intent on dealing with symptoms rather than causes.
As evidence for this argument, the above chart first featured in the blog 18 months ago. It was developed by Comstock Partners, but many others identified the same logic. And sadly, we continue to move through exactly the cycle it defines:
• Originally, China/Asia boosted savings and investment, whilst the West ran up huge debts in creating demand to utilise this investment eg in housing, autos.
• Equally, the West created huge over-capacity in services, particularly financial services, in order to recycle Asia's savings into Western debt.
• Inevitably, the world then reached a position where this excess capacity led to growing weakness in pricing power - causing the Crisis which is now with us.
Did Western policymakers stop at this point, and ask themselves what was happening? Not as far as the blog has observed. Instead, they focused on short-term measures such as stimulus programmes to boost demand, in the mistaken belief that the problems were caused by a lack of market liquidity, rather than solvency.
The EU's efforts to avoid debt default by Greece are just one example of this. Equally, Germany's weakening of the new Basel bank capital rules to avoid problems for its bankrupt state banks. Or, indeed, the Obama administration's apparent belief that their stimulus programmes would produce 'escape velocity', with the US consumer quickly returning to full spending mode.
Meanwhile in Asia, China has begun quietly devaluing versus the trade-weighted average of partner currencies, spending $1bn a day in the process. It has also been forcing up the value of the Japanese yen, buying $12bn of government bonds in June-July.
China's premier, Wen Jiabao, has also ruled out any "drastic appreciation of the renminbi" against the US$. Noting that China's factories receive only $6 for each $299 iPod sold, he warned, "you don't know how many Chinese companies would go bankrupt. There would be major disturbances. This is the reality."
Yet in the USA, the administration seems increasingly keen on a 'weak dollar' policy, to support its desire to double US exports over the next 5 years.
Now, Japan has publically signalled the move to the next stage of the Crisis, with its decision to competitively devalue, to try and maintain its exports. Its export-driven economic model simply can't survive with the yen above ¥95: $1.
As before, this short-termism clearly cannot work long-term. With world trade no longer expanding, nobody is now able to take on the role of 'importer-of-last-resort' that has been adopted by the USA and Western Europe in recent years. Instead, the politicians are all mindful of the increasingly protectionist mindset of their electorates, with unemployment at high levels.
So the stage is now being set for the next phase of the Crisis, namely protectionism and tariffs. The first signs are already beginning to appear. And they will undoubtedly increase in volume next year, if the major developed economies (Europe, N America and Japan) continue to stagnate. These regions, after all, do account for two-thirds of global GDP.
In the meantime, more and more governments are planning to further reduce demand by imposing austerity programmes, in the mistaken belief that their previous policies have delivered economic recovery. The outlook therefore does not seem very optimistic, even to the blog.
Investors on Wall Street are no longer bothering with the boring detail of company performance.
That's the conclusion from a new study by Barclays Capital, on the correlation between movements in the S&P 500 and individual stocks.
Instead, they are piling into the 'correlation trade', as high-speed computers now often account for over 60% of daily trading.
Until 2006, the daily correlation between stocks and the index was just 27%. It was only in exceptional circumstances, such as the Iraq War in 2003, that correlation rose to 60%.
Since then, correlation has become the name of the game. It was 80% at the height of the financial crisis, and again in Q2 during the European debt crisis. And it is still high today, at 74% in August and 60% today.
According to the Wall Street Journal, "such high correlation levels were seen previously only during the Great Depression". The blog, not being a fan of correlation trading anyway, likes the sound of that parallel even less.
The blog's former ICI colleague, Tom Crotty, aptly summarised the mood of most petchem players at this week's meeting in Budapest, Hungary, when telling ICIS' Nigel Davis that "2011 is a very tough call to forecast".
Crotty is this year's president of EPCA (European Petrochemical Association), and it was clear from the blog's discussions that uncertainty is the key factor in current petchem markets. In particular, people have different viewpoints based on their geographic location:
• Asian, Middle Eastern and Latin American players have had a good year, supported by China's demand. They hardly recognise that a recession has been underway, but worry China may slow next year.
• European players have seen tight markets, with feedstock supply limited by refinery cutbacks, as I describe in the above interview with ICB's Will Beacham. But they worry that government cutbacks and austerity programmes will hit demand next year.
• US players have also been supported by Asian demand, and domestic stimulus spending. But the upcoming mid-term elections, and lack of clarity over future economic policy, create their own uncertainty.
In addition, there is the strange case of crude oil prices.
Petchems always do well when these rise, as players build inventory down the value chain (as in 2007-H1 2008). And as in 2008, the blog fears that today's high prices will also choke off demand, as they reduce discretionary spending.
Equally, oil prices have not been supported by tight supply conditions. Inventories of crude and oil products are at near-record levels. It is only the efforts of financial players, selling the US$ and buying commodities such as oil, that has led to today's $80+ levels.
Scenario planning seems essential when looking forward to the 2011-12 Budget period, with companies faced by extreme levels of uncertainty over future demand levels, government actions, currency movements and feedstock prices.
The blog will take up this issue in more detail, when presenting its annual Budget outlook later this month.
The blog will publish its annual Budget Outlook for 2011 next weekend. And so as usual, its now time to review last year's Outlook. Past performance may not be a perfect guide to future outcomes. But it is one of the best that we have.
The 2010 Outlook was titled 'Budgeting for a New Normal', and it argued that over the next few years:
"We will start to see a rebalancing of the global economy. The West will see lower consumption, as people rebuild their savings, and borrow less. In turn, this will mean lower export demand for the emerging economies. The outcome will be a more sustainable world economy, but it will be a difficult journey."
Today, this still seems to be an accurate view, particularly the sense that it will be a "difficult journey".
The blog's 2008 Outlook 'Budgeting for a Downturn', and its 2009 'Budgeting for Survival', meant it was one of the few to forecast the Crisis. Last year, however, the blog was more positive about the outlook than most forecasters, expecting that "2010 should be a better year for the chemical industry, as demand grows in line with a recovery in global GDP".
It also correctly balanced this optimism by warning that there would be no "quick V-shaped return to the 2003-7 Boom years", and suggesting that:
"Governments will worry about budget deficits, and may well scale down support for critical end-uses such as autos and housing. Equally, major amounts of new capacity, planned during the Boom years, will start to come onstream in the Middle East and Asia."
This led it to fear that "unemployment is set to become a key political issue in the West". Unfortunately, this has also been proved correct. So have its concerns that the expected recovery in demand would put "great strains on cash-flow", and that speculative bets on "oil prices linked to traders' bets on the US$'s value will continue".
However, although it identified this latter factor, it clearly underestimated its likely longevity, with oil so far averaging around $75/bbl versus its suggestion that "$50/bbl might be an average price". The blog will keep this lesson in mind when posting its Outlook next weekend.
The blog's aim is to 'share ideas about the influences that may shape the chemical industry over the next 12 - 18 months'. It hopes that its 2010 Outlook again helped readers to better prepare for today's more difficult economy.
When elephants fight, those around them need to be cautious. And this is the prospect for 2011-13, as the Western countries try to force the BRICs (Brazil, Russia, India and China) to export less and import more, the so-called 'rebalancing' strategy.
Thus Budgeting for Uncertainty seems the right title for the blog's annual Outlook for the chemical industry.
Key factors that will contribute to this uncertainty include:
• The USA is aiming to rebalance the world economy by forcing the BRICs to reduce exports and instead focus on expanding domestic demand. This proposed rebalancing represents a major change from the past 20 years of export-driven development by the emerging economies, and will not be achieved overnight.
• Europe is making a 180 degree shift in policy, by abandoning previous efforts to stimulate its economy. It is instead planning to achieve budget balances by reducing spending and increasing taxes. It is also lining up alongside the USA in hoping to increase its exports to the BRICs, whilst reducing imports from them.
• The BRICs themselves are between a rock and a hard place. They were not the cause of the financial Crisis, but they are the ones on whom the major burden of adjustment may fall. The principal instrument of change will be the exchange rate, as the West aims to force China and others to revalue their currencies quite sharply.
These macro factors clearly raise more questions than answers. Even the issue of timescale is unclear, with the US suggesting it might take a full Budget cycle of at least 3 years for real changes to be observed. Plus, of course, there is absolutely no guarantee that the West will get its way, or that the whole exercise may not end in tears.
On the other hand, everything might go extremely well, with a renewed burst of co-operation as seen immediately after the Lehman collapse in Q4 2008. If the G20 Group of the major economies really worked together, then chemical demand could easily be stronger, rather than weaker.
The blog's view is that Scenario planning is the only solution when faced with so many different variables. The idea is to establish a Base Case, and then develop Upside and Downside Cases which are reasonable projections of what might happen if everything went very well, or very badly.
The blog's own effort to help kick-start this process is shown above:
BASE Case. This suggests we will see global GDP growth of 3%, with oil staying in the $60 - $80/bbl range of the past 18 months. We will still see financial market volatility, but no major collapses. It is the classic 'muddle through' type of Scenario.
UPSIDE Case. This assumes that the G20 achieves a 'grand bargain' to rebalance the world economy, allowing GDP to grow at above 3.5%. Inflation would probably become a major issue under this Scenario, causing oil prices to move above $80/bbl.
DOWNSIDE Case. Instead of increased international co-operation, countries put their own interests first and adopt beggar-my-neighbour policies. GDP growth would probably fall to 2.5%, and the oil price below $60/bbl, with the banking system under major strain as Deflation took hold.
The slide also suggests a number of 'Jokers' that companies may want to consider. These include changing demographics, such as the ageing of the Western baby-boomers. And, of course, one can never ignore the potential impact of geo-political events, such as a bombing of Iran's nuclear plants, or new tensions with N Korea.
Of course, it would be possible to simply adopt a Base Case Scenario, and assume that this will work out. But the chances of this occurring are probably less than 50%, so it would be highly risky. Instead, the blog would strongly recommend businesses to adopt a version of the above framework, using their own ideas for Base, Upside and Downside Scenarios.
By adopting this process, businesses can then test out key assumptions in advance. They can also develop mitigation strategies, in case events begin to diverge from the Base Case view. As always, the blog will be very happy to advise on the process, if this would be helpful.
2010 has been a suprisingly good year for many companies. We can certainly hope that current performance will continue, but hope is not a strategy.
Scenario planning will give businesses the chance to adopt the wisdom of the Scouting movement. Its motto, 'Be Prepared', seems the best possible approach in today's increasingly uncertain New Normal environment.
Now, in another sign of the New Normal, it is a former quality control manager who has become $96m richer, after making a 'whistleblower' call to GlaxoSmithKline's (GSK) then CEO, JP Garnier.
Her call, in July 2003, was not returned. And this proved a costly mistake. She was trying to warn him, after failing at lower management levels, that quality in the Puerto Rico factory which she had been auditing, was not up to standard.
The result, 7 years later, is that she will now get a $96m share of the $750m settlement made between US regulators and GSK. As The Guardian newspaper notes, this is "an extraordinary sum, but the failings in GSK's factory were also extraordinary".
DuPont taught us all, back in the 1980's, that safety was the top priority for management. The arrival of the New Normal, with fines like this, will no doubt help to remind us.
The styrene business has been increasingly difficult in recent years:
• CD and video sales went online, removing the need for polystyrene (PS) packaging
• Prices for the main feedstock, benzene, leapt in the mid-2000's, due to US gasoline market changes, forcing convertors to look at alternatives such as polypropylene
• Recycling became an essential part of the packaging 'offer', leaving PS behind
• Increased POSM/SMPO capacity meant styrene prices came under pressure
And one could go on.
The result has been, as discussed at our Conference last week, that the two 'inventors' of styrene, BASF and Dow, felt forced to establish new business models. Dow sold Styron to Bain Capital for $1.6bn earlier this year. BASF announced it would 'carve-out' its business as Styrolution from January 2011. And separately last month, Nova announced they would sell their share of the current INEOS Nova styrene joint venture to INEOS.
Now comes news that Styrolution will become a BASF/INEOS joint venture. Unlike Styron, it will not include the 'sexier' parts of the portfolio - such as expandable PS (widely used in insulation). Nor will it own the Nanjing activities in China. But, assuming anti-trust clearance, it will still be a €5bn ($6.8bn) business and large enough to control its own destiny.
Clearly Styrolution, like Styron, will have to do things differently in the future, if it is to regain a reasonable level of profitability. But both Roberto Gualdoni and Chris Pappas, the CEOs of the two new businesses, have solid track records in the petchem industry, and good teams alongside them.
The blog wishes them well, and hopes they succeed triumphantly.
We face more uncertainty today than I have ever seen over the past 30 years.
Will last year's strong performance in terms of profit continue? Or will higher oil prices ruin the party?
Might China's demand slow, as the government there worries about rising inflation?
How will European demand be impacted as governments switch from stimulus programmes to austerity?
Equally, what will happen in the USA, where we will have a Republican Congress up against a Democrat President for the first time in a decade?
Demographics are also likely to play a key role as we move towards the New Normal. The majority of the BabyBoomer generation (those people born between 1946-70), will soon be in the 55+ age group, when people typically spend less and save more. How will this massive shift by the wealthiest generation in history impact demand?
The Blog's new White Paper aims to help your company manage this uncertainy, as we transition to the New Normal. It focuses on the benefits of Scenario Planning, as a way of highlighting the key issues. Please click here if you would like to download a free copy.
I hope you will find it helpful.
US crude oil and product stocks have started the year where they finished in 2010. As the black dot on the above chart from Petromatrix shows, they are at yet another seasonal record. In terms of numbers, they are 101 million barrels above 2008 levels, and even 8 million barrels above last year.
It is clearly a nonsense that prices are still rising, when inventories have been so high, for so long. It is also bound to cause serious problems for the chemical industry when these stocks begin to be unwound, and prices fall.
In the short-term however, it is also leading to political instability in emerging economies, as food prices rocket. As the Financial Times has noted, "intensive agriculture is effectively the extraction of food from petroleum":
• India's government is facing serious problems over the rising cost of onions, an essential cooking ingredient
• China is now allowing vegetable trucks to travel toll-free on motorways, to try and keep costs down
• S Korea has released emergency supplies of cabbage, pork and other staples
The blog can't help feeling that this state of affairs can't continue for too much longer.
Recent days have seen some signs that the tectonic plates under current chemical and polymer markets may be starting to shift.
The most important has been the rapid rise in inter-bank lending rates in Shanghai. As the chart shows from Petromatrix, these have begun to rocket. A year ago, the rate at which banks could borrow from each other (SHIBOR, Shanghai InterBank Offered Rate), was 1.74%. Last night, it closed at 7.94%.
Inter-bank lending is core to liquidity in financial markets, as we all learnt during the early part of the Crisis in 2007-8. It allows the major banks to balance their books at the end of each day, as demanded by regulators. So a sudden jump like this, if maintained, will slow lending very quickly.
It suggests that the central bank has finally decided to tackle the rampant speculation underway in property markets. Last week, it also announced tough bank lending targets for the rest of Q1. China Daily reports the target could be 40% lower at just RMB 1.5trn ($225bn), versus 2.6trn in 2010.
Separately, it seems Saudi Arabia is finally starting to worry about the possibility of demand destruction taking place, with oil at today's high prices. Oil Minister, Ali Naimi, whilst maintaining his "optimistic" view on oil markets, indicated yesterday that some OPEC countries might increase output if oil hit the $100/bbl level.
The problem with moves like these is that they are usually too little, too late. Certainly, in the case of China, the time to rein in speculation was a year ago, when bank lending had already doubled versus the 2009 level. Equally, with oil prices now at $90/bbl, the damage has already been done.
Q1 was a very strong quarter for Western companies operating at the upstream end of the chemicals value chain:
• Plants were generally operating well, with few force majeures
• Most importantly, the crude oil price jumped 20%.
Many buyers had reduced inventory in December for working capital reasons. Then they found they had to restock in a rising market.
The boom is captured in the record reading on the IeC Boom/Gloom Index in February (blue column). But significantly, it fell back to earlier levels in March.
At the same time, the Austerity reading (red line) started to rise again. This highlights the growing number of problems in the global economy:
• December's US payroll tax reduction has helped to spur some job creation. But rising oil prices have caused consumer confidence to fall at near-record levels.
• Japan has not yet solved the nuclear crisis at the Fukushima Daiichi plant. French scientists believe it suffered temperatures of 2750°C (5000°F) around the reactor cores.
• China's economy seems to be slowing, as interest rates and reserve ratios are increased. This is described in detail in John Richardson's latest post on the Asian Chemical Connections blog.
• The Middle East is seeing continued unrest. Libya is still the current flashpoint, but pressures continue to build in Yemen and Syria.
• And, of course, in the shadows, the financial crisis in Europe is building towards a climax. Greece, Ireland and Portugal are in serious trouble, with Spain next in line.
Companies closer to the consumer are thus seeing increasingly difficult conditions. Wal-Mart, the world's largest retail group, does not exaggerate. And its CEO is now warning of "serious inflation" as "cost increases are starting to come through at a pretty rapid rate".
Overall, it is clear we are now facing the same situation as 1973/4, 1979/80 and 2007/8. So we know how this story will end. After the party, comes the hangover. It is a simple fact that the world economy has never yet been able to operate successfully with oil prices at today's levels.
And as all investors and business people know, the most expensive phrase in the English language is "this time its different".
Financial markets are different from other markets. And the way we relate to them is different too.
Shops, for example, would never seek to win new customers by advertising 'Prices increased 10% last week'. Instead, they splash red signs across their windows featuring their 'new, lower prices'.
But sellers of financial products do the exact opposite. Their advertising focuses on funds that have recently moved up in price. Neither they, nor share tipsters, spend much time on companies whose price has recently fallen.
CEO's are just the same as the rest of us. None got out their cheque book to make an acquisition 2 years ago, when most shares were dirt cheap during the height of the Crisis. But now prices have doubled, or more, they are lining up to buy.
As Bloomberg note:
• Specialty chemicals have seen deals worth $25bn so far this year
• This is the highest M&A (Mergers & Acquisition) level for a decade
• In 2010, just $3bn of deals were done in the whole of H1
Are specialty chemical prospects suddenly that much better than a year ago, or 2 years ago, when expectations and prices were very much lower? The blog, being a good contrarian, rather thinks not.
Lubrizol, Danisco, Rhodia and the other recent acquisition targets are all good businesses. But the current frenzy of deal-making is perhaps yet another warning sign that the top of the market is not far away.
The blog has an incredibly loyal following around the world. 24% of its readers visit twice a week, or more.
They also recommend it to colleagues. Visitor numbers jumped 50% last month.
The issue is the rising uncertainty over the outlook for the world economy. This has clear potential to cause problems for the chemical industry.
The White Paper, Budgeting for Uncertainty, discusses this in more detail.
Now the blog is delighted to announce two major new developments. Both are with ICIS Asia director, John Richardson, co-author of the Asian Chemicals Connections blog:
• June 16-17 will see the 2nd New Normal seminar, in Frankfurt, Germany. This follows February's very successful Singapore launch. It will cover the major changes taking place in chemical demand patterns around the world. The focus will be on:
The Value Proposition for both initiatives is very clear. The past 20 years have seen managers able to focus on developments down their vertical silo. Demand growth has been very stable, as the vast Western BabyBoom generation moved into the 25 - 54 age group, when consumption peaks as people marry, settle down and have children.
This generation, born between 1946-70, is now entering the 55+ age group. The oldest are 65, and the median are 53 years old. 55+ is the age when people typically save more, and spend less. And this generation will need to save more, as its life expectancy has increased by 10 years versus the 1921-45 generation.
This means that we cannot rely on consumption growth, in the developed and emerging economies, to continue in a straight line. Managers instead need to refocus on understanding developments up and down the chemicals Value Chain. This will enable them to identify the challenges ahead for their businesses, and exploit the opportunities that will arise.
Further details of the e-book will be available soon. Please click here for more details of the Frankfurt New Normal seminar in June.
They don't ring bells at market tops, to warn about what might happen next. But the above chart may turn out to be the next best thing.
It shows the relationship between WTI crude oil prices (blue line) versus LLDPE (linear low density polyethylene, red line) on China's Dalian futures exchange.
The exchange has been a hot-bed of speculation for the past 2 years, powered by China's easy money programme. LLDPE has been the main proxy for those betting on the direction of oil prices. In some months, the volume traded has reached nearly 100 million tonnes.
Critically, since Q3 2008, price moves for WTI and LLDPE have mirrored each other, up and down. But now LLDPE has failed to follow the latest upward move on WTI. The last time this happened was during WTI's final run to $147/bbl, as demand destruction intensified.
And as Petromatrix note, China's own diesel and gasoline prices are now 30% higher than in July 2008, due to the removal of price controls.
The blog's friends in the trading community have been correctly bullish for the past 2 years. They say it is still too early to go short on crude oil, given the momentum that has built up. But the forces behind this speculative mania may be ending:
Central bank liquidity has been the life-blood of the rally over the past 2 years. As and when it slows, trouble lies ahead.
The blog spent much of 2007/8 warning of the likely impact of high oil prices on chemical demand. It was then renamed 'The Crystal Blog' in November 2008, as the full extent of the problems finally became clear.
Today we are back in the danger-zone. The chart above shows annual oil prices since 1970 - in $s of the day (blue dotted line), and $s adjusted for inflation (red line) - with extra points for H2 1990 and Q1 2011. The red shaded areas mark periods of recession in global chemical demand.
Every sustained period of oil prices above $50/bbl in real terms has been followed by a sharp slowdown in chemical demand:
• As oil prices rise, so consumers cut back on discretionary spending
• This reduces demand for those products which drive chemical demand
• Yet chemical buyers have to start buying forward, to protect supplies
• The eventual oil price peak is thus followed by destocking
• Operating rates then collapse down the value chain.
The blog saw this process at first-hand in 1979-80, as a young sales rep. Then, as in 2007/8 and today, it was assumed that the combination of tight markets with rising oil prices, meant demand was still robust. But the evidence of history makes this assumption very doubtful.
Every speculative mania, such as today's, has its own illusion. As the blog pointed out in the Financial Times in September 2007, the myth behind the sub-prime disaster was that US house prices would never fall. Now they are down 30%, and still falling.
The myth behind the crude oil rally has been that the liquidity provided by central banks is the same as capital. It isn't.
The blog is delighted to announce the title of its new eBook, jointly authored with fellow blogger, John Richardson.
It explains how Western BabyBoomers are changing chemical demand patterns, again. We believe it will become vital reading for all those working in the global chemical industry.
The first chapter of the book will be published online by ICIS next week. John and I look forward to bringing you more details then.
Q1 results were very good. But do they mean we are in a SuperCycle, as some analysts have suggested?
In a major 3 page article for this week's ICIS Chemical Business, the blog looks in detail at the risk from developments in China, Japan, the debt crisis and high oil prices.
It concludes that the outlook is most uncertain, and recommends that chemical companies develop robust contingency plans, in case H2 disappoints.
Please click here if you would like to download a free copy of the article.
There is worrying evidence that the US may be close to recession.
This may seem unlikely to those who have only known the world of the past 25 years. Between 1982-2007, US recessions were very rare. They took place just 5% of the time, as the wealthy Western BabyBoomers led to a SuperCycle of 'pent-up demand' during any slowdown.
But before 1982, the economy was in recession for 35% of the time.
Now, the US's best forecaster fears it may be close to a new downturn.
Readers may remember that in May 2008, the blog championed Martin Feldstein's view that recently released US GDP data was "grossly misleading". It felt he was in a good position to know, as chairman of the official panel that dates US recessions.
In July 2009, the US Commerce Dept finally admitted Feldstein had been right. The recession had indeed begun in December 2007, as he had said. The Commerce Dept noted that "the first 12 months of the US recession saw the economy shrink more than twice as much as previously estimated". Grossly misleading, indeed.
Now, Feldstein has been analysing the details of the US Q1 GDP report. His conclusions are alarming:
• Q1 GDP growth dropped to 1.8%, from 3.1% in Q4
• "Two-thirds of that 1.8% went into business inventories"
• "Final sales growth was at an annual rate of just 0.6%"
• "The actual quarterly increase was just 0.15%"
Feldstein then goes on to note that "after a temporary rise in March, the economy began sliding again in April". He adds that so far, May's data "are even worse than April's". Equally, the blog's own Downturn Alert suggests companies have been destocking for the past 6 weeks, since oil prices peaked.
It is still too early to be sure that we are entering a recession. But the evidence of the past 40 years would suggest Feldstein is right to worry. The above chart shows US recessions (shaded areas) and the oil price in $2011 terms (red line). A recession followed every time the oil price rose above $50/bbl. This happened in 1973/4, 1979/80, 1990/1 and 2007/8.
Today, as in May 2008, the consensus is ignoring Feldstein's argument. Most companies still have a strongly bullish outlook, and some even believe a new SuperCycle may be underway. But Feldstein was right before, and his new warning deserves to be taken very seriously.
Speculators, assisted by the US Federal Reserve, have driven crude oil prices to unsustainable levels over the past year. Now, the Fed is withdrawing the liquidity that has financed this rise.
The above chart from Petromatrix shows the surge in crude oil speculation on the Chicago futures market since August. The light blue line shows it taking off from net length of 50k contracts, to reach 200k by the end of the year.
The dark green line then shows it going even higher this year, to an all-time peak of nearly 300k.
It is no surprise at all that this 6-fold increase in futures demand powered crude oil prices higher. They jumped from $75/bbl in August to $125/bbl at their peak. Every chemical purchasing manager in the world had to buy forward as far as possible, to try and preserve margins.
But now the Fed's liquidity programme, QE2, has come to an end. Markets anticipated its arrival from August (it officially started in November). Now, since April, they have begun to anticipate a world in which supply/demand balances, not liquidity, determine prices.
How far has this move to go? One clue can be found from the fact that net length is still around 175k, compared to 50k in August. And, of course, there is nothing to stop it going negative, as it did in 2008 (light green line) and 2009 (red).
The Fed's aim with QE2 was to boost risk assets, and drive down the value of the US$. It thought this would kick-start consumer confidence. How wrong can you be?
Greece is about to become the first developed country to default on its debts since 1964.
On Thursday night, Eurozone leaders finally agreed to reduce Greece's €350bn debts, if only by 21%. They also agreed to take the first steps towards the creation of a European Monetary Fund.
After more than a year of defying the inevitable, this marks some progress towards recognising reality.
But will it prove 'too little, too late'? The blog hopes not. But the signs are not promising:
• The European Central Bank resisted the default until the very end
• It took a 7 hour French-German summit to finally broker the agreement
Yet as Pimco's Bill Gross warned on Thursday, "debt is the disease, growth is the cure". Pimco, the world's largest bond fund managers, originally developed the New Normal concept back in 2009. And in their view, Europe and the USA now share the same problem:
• The burden of debt is still far too high
• Commodity prices have been allowed to spiral out of control
• Growth has become dependent on China
As a result, Pimco continue to warn that Western growth rates will reduce to 2%, or 'stall speed'. This creates a vicious circle. Companies don't invest, because growth is so low. Unemployment therefore remains too high. Central banks then create liquidity in place of the missing capital.
The ancient Greeks, of course, had a myth that describes the position. It is of Sisyphus (pictured) endlessly trying to push a massive rock uphill.
If policymakers recognised we are entering the New Normal, new forms of growth could be encouraged. The Shared Value concept is one powerful example. But if they stick with current thinking, the outlook for the next few years is not promising.
Many readers have been taking a well-earned break over the past few weeks. The blog also continues to gain large numbers of new readers, as the financial crisis intensifies. As usual, therefore, it is highlighting key posts during August, to help you catch up as you return to the office.
Boom/Gloom Index suggests markets on the edge presciently forecast the recent volatility. Markets fall as politicians argue, US Fed policy may be going Back to the Future, Investors rush to save with the JUUGS, and US GDP still below 2007 levels explore the key issues
European cracker margins at 'top of cycle levels', China's PE market down 2.5% in H1 and Q2 chemical results raise concerns about the outlook look at the current state of chemical markets
China's power consumption hits new record looks at the strains now impacting China as it struggles to cope with an overheating economy. China's auto market goes ex-growth covers the same theme, as does China's bank lending nears its Minsky Moment
Policymakers remain in the Denial phase suggests the crisis is a long way from its end, as does Recession may now be very close and Towards a New Normal, not a new Supercycle whilst Goldman halves global ethylene growth estimate shows the analysts are slowly starting to recognise reality
Plus, of course, Chapter 4 of Boom, Gloom and the New Normal was published this week, and focuses on how the world may look in 2021
The chemical industry has a turnover of $3.4trn, and is the world's 3rd largest industry. It matters to the global economy.
Many of its leaders are about to meet next weekend in Berlin for the annual European Petrochemical Association (EPCA) meeting.
The blog strongly believes that this should not be seen as a 'business as usual' meeting. We cannot simply assume that the global economy is in fundamentally good shape:
• IMF head, Christine Lagarde, has warned the global economic situation is entering a "dangerous place"
• World Bank president Robert Zoellick has described world finances as being in a "danger zone"
These are not sound-bites being made for effect.
The danger signs have been building for months. The blog, after all, introduced its IeC Downturn Alert nearly 5 months ago, on 2 May.
Coincidentally, this matched the peak of the US S&P 500 Index, since when financial markets and crude oil prices have fallen dramatically, as shown in the chart above.
• First we saw customers around the world buying 'hand to mouth'. They tried to run down inventories built up during the 50% rise in crude oil prices between December-April
• Then everything went quiet during the summer. The retailers destocked after seeing end-user consumption fall due to the impact of higher oil prices
• Then it became clear that China's economy, the previous motor of the global economy, was slowing fast, as the government reduced credit to combat high inflation
• Now, in September, it is clear that demand has not returned after the holidays. And the wider economic outlook is getting worse, not better.
The blog made similar efforts to alert the industry to the issue of demand destruction before the 2008 downturn, and was later awarded the title of 'The Crystal Blog'. But sadly, its warnings were not taken seriously at the time when they could have had an impact.
The industry's leaders need to ensure that 'this time is different' in Berlin. It is no exaggeration to say that the very future of some companies, and of important sectors of our industry, may be at stake.
Price movements since April, and ICIS pricing comments this week are below:
Benzene NWE (green), down 26%. "A swathe of imports coming into the ARA region were also keeping supply ample as demand struggled amid weak end user confidence."
Naphtha Europe (brown dash), down 19%. "The impact of refinery run cuts is starting to show, and it is thought that the naphtha oversupply would have been more severe if not for these".
HDPE USA export (purple), down 18%. "The Asian market has slowed down, in part because of a national holiday, and in part because of concerns about the global economy. Asian prices were expected to fall in China because of tightening credit rules."
S&P 500 Index (pink dot), down 17%.
Brent crude oil, down 14%.
PTA China (red), down 4%. "Most buyers were adopting a wait-and-see stance because of the unclear market trend. Only a few end-users purchased cargoes on a need-to basis."
Today's economic situation is getting worse, not better. The blog believes this is because most policymakers still refuse to accept the wisdom contained in the Beatles' 'When I'm Sixty-Four' song on their iconic Sgt Pepper album.
The Western BabyBoomers (those born between 1946-70) are the largest and richest generation that the world has ever seen.
But last year, the oldest Boomer reached the age of sixty-four. And ageing Boomers simply don't need more housing or new cars, as they no longer have to provide for growing families.
So demand patterns are changing, radically, just as they changed in the 1970's. This was when the arrival of the Boomers set off the economic SuperCycle, as they entered their peak consumption years between the ages of 25 - 54.
Chemical companies are therefore not only facing an imminent economic slowdown, as the blog has chronicled over the past 5 months with its IeC Downturn Alert. They also need to change their business models, to adapt to this New Normal.
This month's Chapter 5 of the blog's free 'Boom, Gloom and the New Normal' eBook, co-authored with John Richardson, aims to help with this process. The first step is for CEOs to establish a high-powered team, operating with the support of their Board and line managers, to quickly put in place the necessary Action Plan.
The team needs to answer the 4 key questions required for any successful plan:
• Why. The Board needs a clear view of the likely impact of an economic downturn, combined with the demand changes caused by the ageing of the Boomers.
• What. The team needs to highlight the key issues which its plan aims to tackle. Speed is essential, and only the really super-critical issues can be addressed short-term.
• How. Implementation plans are critical. Resources need to be available, and key managers must 'buy-in' to the process, otherwise it will fail.
• When. Timing is also critical. Short-term priorities (credit control, working capital) have to be balanced with the business model changes needed to adapt to the New Normal.
The outlook is very uncertain. Tomorrow's post will discuss the relevant Scenarios that need to be addressed. And on Thursday, it will highlight the Critical Success Factors against which plans need to be measured.
The blog will be happy to provide any support or advice that may be helpful to readers as they develop their Action Plans.
International eChem/ICIS are also running three training courses in Houston, Singapore and London in Q4, to help with detailed implementation issues. Please click here for further details.
The transition to the new Normal is likely to be painful and long-lasting.
Future demand growth will be slower as the ageing Boomers spend less and save more.
More regular and deeper recessions are likely to become a feature of the global economy once more, in contrast to the relatively smooth growth seen during the Boomer-led Super Cycle.
Successful companies will also have to venture into the unknown, as until recently the 55+ generation had no real existence as a separate economic unit.
Previous generations usually found their needs at this age were focused on health-related issues - the Zimmer frame of popular mythology.
So as we venture into the unknown, Action Plans can't be too prescriptive about what we might expect to see over the next 20 years. Chapter 5 of the blog's free 'Boom, Gloom and the New Normal' eBook, co-authored with John Richardson, aims to help with this process.
As discussed yesterday, the Chapter outlines some potential Scenarios to highlight the key variables that need to be considered:
'All's Well that Ends Well'. In this scenario, the key dynamic is that there is a rapid adaptation to the New Normal. This may be driven by the observation of the major pain being suffered in countries already at the sharp end of some most unwelcome restructuring - Greece, Portugal, Ireland and Spain, for example. This gives Western politicians the courage to talk seriously about the issues that society now faces, whilst the wider population becomes prepared to listen to their messages and to accept that major changes need to be made.
'Muddle Through'. In this scenario, there is no rapid adaptation to the New Normal, and although a higher quality of dialogue takes place between policymakers and the electorate than in the past, no firm agreements are reached on key policies and objectives. However, and importantly, social cohesion is retained, and so society does not fragment into warring groups.
'If You Don't Know Where You're Going, Any Road Will Do'. A third scenario is based on the potential for politicians to remain more focused on sound-bites than on formulating policies that will drive long-term success for their populations. In this Scenario, the current dysfunctional state of many Western political systems, and their alienation from the wider electorate, is not a temporary phenomenon but a sign of the future.
'Don't Worry, Everything will be Just Fine'. This is the scenario under which the West had been effectively operating for the past few years, ignoring the demographic changes which are taking us in a new direction. It is characterised by an increasingly desperate belief that everything is just about to 'return to normal' (i.e. the former SuperCycle), via the magic elixir of either tax cuts or yet more stimulus.
Tomorrow's post will provide its view of the Critical Success Factors against which Action Plans need to be measured.
The blog will be happy to provide any support or advice that may be helpful to readers as they develop their Action Plans.
International eChem/ICIS are also running three training courses in Houston, Singapore and London during Q4, to help with detailed implementation issues. Please click here for further details.
Yesterday's Scenarios hopefully provided valuable insight into the challenges ahead for companies and individuals. They also suggest some Critical Success Factors for achieving a successful transition to the New Normal, as set out in the chart above:
1. Flexibility. This involves adapting to new circumstances and being willing to compromise rather than battling for an impossible nirvana.
2. Change management. The next 20 years will likely see rapid and unpredictable change in the business environment in contrast to the remarkable stability of recent decades.
3. Scenario Planning. Companies need to adapt their planning processes to cope with the greater uncertainty that will come from operating in a more 'events-driven' world.
4. Real needs. Over the past 20 years, Westerners have often confused 'wants' with 'needs'. In the New Normal, mere 'wants' are unlikely to be reliable market drivers for the future.
5. Action orientation. Uncertainty can breed a loss of energy, and so companies will need to encourage their employees to experiment creatively if they are to move forward.
The positive news is that most Boomers are likely to lead active and healthy lives well into their 60s and 70s. So the opportunities to capture their interest and their business are very large indeed. We will highlight some valuable case studies to help with this process in Chapter 7.
Companies focusing on the emerging economies face similar challenges, as we will discuss in Chapter 6 next month. Their core market will also consist of a currently underserved demographic, those just moving out of poverty and able to afford a bar of soap, or a bra and pair of panties, for the first time.
But the Beatles provide a reliable guide, if we are prepared to listen to their message from 'When I'm Sixty-Four'. The megatrends such as an ageing population and the need for improved food production provide the key to future success.
The blog will be happy to provide any support or advice that may be helpful to readers as they develop their Action Plans.
International eChem/ICIS are also running three training courses in Houston, Singapore and London during Q4, to help with detailed implementation issues. Please click here for further details.
Financial markets have become increasingly nervous in recent weeks, since the blog last reviewed developments in global bond markets.
Its conclusion then was that investors are worrying more about return of capital, than return on capital, as we transition to the New Normal. This is because 272 million westerners are now over 55 years old, and they need security of income as they prepare for retirement.
The chart above updates market moves in the JUUGS (Japan, UK, USA, Germany, Switzerland) and the PIIGS (Portugal, Ireland, Italy, Greece, Spain). Since August (blue column), the 2 groups have seen very different interest rate trends for 10-year government bonds (red line):
• Rates in the JUUGS have been extremely stable. UK and Swiss rates have edged down 0.1%, whilst German rates moved up 0.1%. US and Japanese rates are unchanged.
• The PIIGS have been much more volatile. Greece is now paying 34% vs 22% in August: Portugal's rate is 12% vs 11%: Italy's is 6.4% vs 5.7%: Spain's is 5.5% vs 5.3%: only Ireland's reduced, from 8.8% to 8.3%.
This suggests Portugal will also need to default on its debts, alongside Greece. Otherwise the burden of interest payments will simply become too large, particularly as austerity programmes lead to recession.
Italy, of course, is the real problem child. It is a rich and large G7 country. But its interest rate is now also close to being unaffordable. Two key questions are looming on the horizon:
• Will it really now allow the IMF to dictate its economic policy?
• What will happen to French and German banks if investors start to question Italy's ability to repay its debt?
Italy currently owes $416bn to French banks, and $162bn to German banks. It owes a total of $788bn to European lenders. This is the concept of 'contagion':
• If Italy's rates move into the 6.5%-7% area, and remain there, then its default becomes almost certain.
• France, another G7 member, would then be in the firing line.
• Its 3.3% interest rate is already 50%+ higher than those of the JUUGS. This suggests underlying nervousness amongst investors.
The blog will continue to monitor the situation closely.
It is 5 months since the blog launched its IeC Downturn Alert, using prices from 29 April. It wrote then that:
"They don't ring bells at market turning points. Otherwise, we could all retire to the Bahamas."
But its argument was that a peak was likely, as crude oil had remained stable at $125/bbl for 4 weeks.
Buyers had previously bought forward as prices rose, to protect downstream margins. Now they would try to reduce this unwanted inventory. Equally, oil prices at April's level had always led to recession in the past, and it was unlikely that 'this time it may be different'.
Evidence that a Downturn is now underway is all around us:
• European cracker operators are mostly at 70-75% operating rates
• A major naphtha surplus has developed in India and the Middle East
• Crackers in Japan, Taiwan and parts of SEA are running at 80-90% rates, with S Korea set to join them
• The US Federal Reserve is forecasting GDP growth of just 1.6%, half its June estimate
Coincidentally, as the chart shows, financial markets such as the US S&P 500 Index also peaked on 29 April, although their decline has so far been less dramatic. The high frequency traders who dominate these markets, have no interest in the fundamentals of supply and demand.
Today, however, the only question is 'how long will the downturn last, and how deep will it be?' Mario Draghi, the new head of the European Central Bank, forecasts "a mild recession" in Europe. We can all share this hope, but hope is not a strategy. Sensible Boards will develop scenarios that also include a worst case of a sustained and deep recession.
The blog was in a small minority when it launched its Downturn Alert.
Having run major businesses in the past, it knows that buyers always give seemingly convincing reasons when cancelling or deferring orders. It therefore felt it might be helpful to present a global overview, covering benchmark products and regions, to highlight that the problems were general, and not specific.
The industry's current laser-like focus on year-end inventories means that we should avoid the problems seen in Q4 2008, when inventories piled up around the world. Instead, lower operating rates will mean that buyers occasionally find themselves short of product, as has happened this week in China on polyethylene.
But these short-term issues should not be confused with the potential for a quick recovery.
The Downturn Alert has hopefully helped the industry to navigate the last few difficult months. It will now be renamed the IeC Downturn Monitor, to reflect its new role of charting the problems that lie ahead.
ICIS pricing comments this week, and price movements since the IeC Downturn Alert launched on 29 April, are below:
Benzene NWE (green), down 29%. "Demand remains subdued for the current month".
HDPE USA export (purple), down 24%. "Prices were rising, as global buyers began to restock, including in China and S American markets."
Naphtha Europe (brown dash), down 20%. "The market continues to suffer soft demand, and has lengthened from the previous week.".
PTA China (red), down 18%. "Most players were worried that the downturn may extend into the rest of the year because of the poor demand for polyester in China, India and parts of SEA."
Brent crude oil (blue dash), down 12%.
S&P 500 Index (pink dot), down 8%
As promised, the blog looks today at the USA's trade position in polyethylene (based on data for the January-August period from Global Trade Information Services, the leading global supplier).
The chart shows US net trade (exports less imports). This peaked in 2009 (green column), with net exports of 1.6 million tonnes. Volume had risen 69% versus the 2007 level of 0.97MT (blue). But volume in 2011 has been just 1.03MT (light blue), only up 6% versus 2007.
The main reason is an overall decline in export volumes from 3.3MT in 2008 to 2.9MT in 2011:
• Mexico peaked in 2009 at 734KT, but is 679KT in 2011
• Latin America has been volatile, but peaked at 771KT in 2008
• China peaked in 2009 at 585KT, but is 192KT in 2011
• NEA peaked in 2008 at 178KT, but is 107KT in 2011
• SEA has been volatile, but 2011's 292KT is a new high
Meanwhile, net imports in 2011 at 1.85MT are equal to 2007's 1.83MT. These come mainly from Canada, whose volume of 1.19MT in 2011 is also similar to 2007's 1.17MT.
Of course, many Western readers would have expected the USA's exports to have risen since 2008, not fallen. Its cost position has improved remarkably since then, due to its new source of advantaged ethane from shale gas. The reason is that many of its major competitors do not share its financially oriented approach.
As the blog highlighted last week, most emerging economies also prioritise social and political criteria, whereby employment and strategic geo-political issues have an important role.
The blog's own research on China's Sinopec demonstrates how it effectively operates as a utility, supplying raw materials to the factories to keep people employed. Employment is also a key driver for the Middle East and many other Asian countries.
This is why an understanding of Prof Michael Porter's Shared Value approach is so important for the future. Western companies can no longer rely on the use of purely financial criteria to guide their strategy, as the world transitions to the New Normal.