Chemicals & The Economy

Crude oil prices are climbing again. $100/bbl is not impossible, if current geo-political concerns continue. And today's tightly balanced market could persist to 2010.

Consumer attitudes have shifted sharply in recent weeks. This could have big implications for chemical companies, and they need to respond quickly.

Central bankers are like generals. They seem to prefer fighting their last war, rather than preparing for the next one. How else to explain their continued reluctance to recognise that higher food and energy prices are here to stay? As a result, interest rates now need to rise more than expected. Pity those who have to forecast demand levels for 2008 Budgets

The US dollar has been falling steadily in recent weeks. It is particularly weak against the euro, having fallen almost 5% since January. OPEC countries buy much more from the eurozone than from the US, and the OPEC President has said they are ‘concerned’ about dollar weakness. We probably need to start monitoring oil prices in euros as well as dollars.

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

An interesting thing has happened to benzene markets, which I haven’t seen noted elsewhere. According to ICIS pricing, average prices last week in Europe, US Gulf and Asia were $1053/t, $1052/t and $1040/t respectively.

And is the fact that benzene prices have only increased by 26% since July 2005, whilst Brent crude oil prices have moved 34%, also telling us something about the growing difficulty of passing higher oil prices down the chain?

Two of the largest US auto manufacturers, GM and Ford, have now followed Wal-Mart and Tesco’s lead in detecting a change in consumer sentiment. GM, after announcing particularly strong Q2 Asian and emerging market sales, added that US sales declined 7% as a result of ‘increasing fuel prices and concerns about housing’. Ford said that their US sales had declined 19% in July, and talked of ‘sobering’ economic challenges.

This is bad news for chemicals demand, if it continues. 70% of US GDP is consumer-related. Housing and autos are two major components – if they continue to deteriorate, then we could be in for a sticky patch in Q4. Those CEO’s now working on the cost leadership programmes that I proposed in mid-July will not feel inclined to relax their preparations after this news.

When I worked with ChemConnect in the halcyon days of the dot-com era in 1999-2000, we had a fantastic PR lady called Linda Stegeman. Linda ignored conventional wisdom about 'bundling' all your best news together to gain maximum impact. Instead, she released the stories one by one, and let them build. First Dow and Rohm & Haas investing; then BASF, BP, Borealis and Bayer; then SABIC; then Mitsui and Mitsubishi, and so on. The impact was extraordinary, particularly for a new company with neither sales nor income to report.

Linda called the technique 'rolling thunder', and I was reminded of her when I read this morning that Goldman Sachs were now having to invest $2bn to bail out their Global Equities Opportunities hedge fund. Over the weekend, the papers had been full of reports that US banks were refusing to lend to anyone without a '212' (eg New York) telephone area code, after last week's losses in Europe and Asia. But yesterday, the 'rolling thunder' of the subprime story returned to N America again.

And, of course, every time it completes a circle around the globe, it takes a new twist. First time around, it was about poor Americans losing their homes. Then it became one of central banks trying to avoid a credit crunch. What's next? Maybe what has been, until now, a purely financial story, is about to impact the real economy? As my wife commented over breakfast - '$2bn is a lot of shoes and handbags that the bankers won't be buying this autumn'.

The subprime parallel then wouldn't be with LTCM or other 'financial' problems. It would be with major disasters such as Penn Square Bank, which went bust in 1982 and nearly brought down much of the US banking system with it. A wonderful book by Mark Singer called 'Funny Money' was written in 1985, just as I arrived in Houston, Texas, to trade petrochemicals. Its dust cover reads 'For the better part of a decade, there had existed a virtually global belief: the price of petroleum and everything that depended on it would go no way than up'.

I have the feeling there may well be a similar book written in a few years time, when the dust has settled on subprime, which simply changes the word 'petroleum' for 'housing'.

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

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

The war of words between OPEC (the oil producers’ club) and the International Energy Agency (the rich countries energy watchdog), has intensified this week, ahead of the next OPEC Ministerial meeting scheduled for 11 September.

Claude Mandil, director general of the IEA, told Arab Oil and Gas ‘the market has become aware’ that OPEC ‘has set an implicit new objective of keeping prices at or around $70/bbl and that the organisation is trying to defend this level.’ If true, this would be a further significant increase on the presumed previous target of around $50/bbl. In turn, of course, this is a long way from OPEC’s targets of $28-30/bbl a few years ago, or $18-20/bbl a decade ago.

Mandil went on to say that the current price ‘could, as we have often said, weigh on global economic growth. It is from now that the refineries must start working harder to satisfy winter demand. We therefore need more crude oil but, unfortunately, signs from OPEC do not give us much hope of this’. These are strong words, and clearly part of a co-ordinated lobbying campaign, as Mandil’s deputy then went on to tell the Financial Times that ‘$70/bbl was too high and a threat to the world economy’.

However, OPEC’s Secretary General Abdulla el-Badri told Bloomberg ‘there's enough oil in the market, we don't know what to do with it. I assure you that if there's any shortage, we will supply more crude to the market, but I think the market is really stable at this time.’ Putting this comment in context, the Financial Times commented that ‘before the US subprime lending crisis, oil-consuming countries had hoped OPEC would raise production next month’.

OPEC is, of course, haunted by the echoes of its decision in November 1997 to increase oil production just as the Asian financial crisis began to hit demand. This took oil prices down to a $10/bbl low in 1999. They do not want to make the same mistake again. And the fact that the Chinese economy is likely to grow at high rates, at least until after next year’s Olympics’, means that Chinese demand for oil may also rise strongly, irrespective of any problems in the US.

The role of financial speculators also complicates the issue. Hedge funds have been selling oil recently to pay margin calls on their subprime investments, and if this pattern continues, then prices could fall further in the short term, irrespective of the underlying supply/demand balance. As recently as early July, as I commented at the time, hedge funds were still buying crude, and went on to drive it to a $78/bbl peak by early August, from its $51/bbl low in January.

Whatever OPEC and the IEA would like, volatility will continue to be the name of the game in oil markets for the next few months. There are just too many unknowns for consensus to develop.

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

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

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

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

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

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

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

OPEC are sounding a note of concern about the impact of high oil prices on the world economy. Hasan Qabazar, OPEC’s chief economist said yesterday ‘We are trying, hopefully, to reduce high oil prices, to have prices that are more conducive to economic development’.

Qabazar also emphasised OPEC’s desire to help counter any impact from the subprime downturn in the US, stating that this had put ‘some clouds’ over the forecast for global GDP growth of 5% next year. ‘We are trying to avert a slowdown’, he added, as ‘we are afraid that prices may play a part in the slowdown, and we want to avert that if possible’.

Oil traders ignored OPEC's comments today, sending NYMEX prices to a new record $79.29/bbl. They also ignored OPEC’s two agreements to increase quotas by 500,000 bbls/day, and to ‘normalise’ the basic quota in line with recent actual production (which effectively added another 900,000 bbls/day to the quota). Even the International Energy Agency’s (IEA) decision to reduce its Q4 demand estimate by 250,000 bbls/day, and its 2008 demand estimate by further 180,000 bbls/day, had no impact on the euphoria.

This does support the CGES view, mentioned here on 5 July, that players in oil futures markets are trend followers rather than leaders. Most of the ‘technical charts’ appear to show that oil prices remain in an upturn, and are poised to break $80/bbl. This supposed ‘momentum’ drives the ‘paper’ traders to buy more, encouraged by the widespread consensus that the oil price doesn’t matter any more to the world economy.

The IEA has played a key role in sustaining this idea, with its continuing forecasts of large increases in demand. So it is interesting that it has now begun to reverse itself on this critical point. Having just been in Asia, it would certainly seem that higher oil prices there are already affecting demand in those countries where subsidies don’t exist. And they are also prompting subsidising governments to review the level of support that they can afford to provide.

My own view is that the liquidity boom in financial markets and the high oil price may well have been inter-connected. The ready availability of credit meant that consumers (and governments) could borrow, instead of having to cut back expenditure as the higher costs of oil reduced their cash-flow. Now, however, we are entering a credit squeeze, and growth in US gasoline demand has already begun to slow.

Futures traders may well continue to ignore OPEC for a while, and the risk to supply from geo-political events remains very real, so one cannot discount the potential for even higher prices, if circumstances conspire together. This could make an already difficult situation worse. Higher oil prices have always slowed the world economy in the past. Their impact may have been deferred this time, but it is hard to believe that it has been avoided.

Well, now we know. Interviewed by the Financial Times on Monday, Alan Greenspan rejected the widely-held belief that central banks are now independent. Throwing aside his normal caution, the former US Federal Reserve Chairman said quite bluntly that ‘the presumption that we were fully independent and have full discretion was false’.

This is a worrying statement, as the concept of independence from political control is integral to the market’s confidence in the ability of central banks to control inflation. It is therefore perhaps not too surprising to find Greenspan also commenting in the same interview that he ‘sees oil going to $100/bbl’.

Coincidentally, on the same day, Goldman Sachs (GS) provided a potential rationale for this scenario when they issued a report that raised their 2008 oil price target to $95/bbl. They see the key driver for this increase as being the fact that ‘the oil industry has added very little new, low-cost, production capacity as it has run into technological and political bottlenecks that will likely take years to resolve’.

GS also believe that ‘costs have continued to rise, pushing marginal costs closer to $70/bbl’. If they are correct, this represents a sea-change in expectations. All through the early 1980’s, we in the chemical industry argued that with marginal production costs only $5/bbl, it was inconceivable that oil could remain at the then current level of $30/bbl in an over-supplied market.

But if Goldman’s analysis is right, then we will soon be in the opposite situation. Heavy crude now accounts for much of the world’s current spare oil capacity. Many refineries cannot process it, making effective supply/demand for lighter crudes much tighter. And in these circumstances, it is the marginal cost that will again set the price.

This could have ‘severe’ implications for polymer producers, as Goldman’s James Yong notes. He foresees a potential ‘squeeze coming from both the feedstock as well as the polyolefins side’, as feedstock costs rise just as the new Middle East/Asian capacity starts to arrive next year.

Shell and Saudi Aramco have now confirmed plans to spend $7bn to build what they term ‘the first new refinery in the U.S. in more than 30 years’. They will achieve this by adding 325,000 barrels per day (b/d) to their existing Port Arthur, Texas, facility, taking total capacity to 600,000 b/d. It is scheduled to come on stream in 2010.

Refining capacity has been tight in the US for many years, due to historically low refining profitability and environmental difficulties in siting new refineries. Both these factors have changed over the past couple of years. Post Hurricane Katrina, refining profitability has been very strong, whilst President Bush recently even offered to allocate military land to help overcome environmental issues.

When completed, the Port Arthur refinery complex will be the largest in the US, ahead of Exxon Mobil’s 562,000 b/d at Baytown, Texas. It will be able to process ‘heavy crudes’, for which refining capacity is currently short around the world, and will supply Shell’s 7700 gasoline outlets in the Eastern and Southern USA.

There are two elements of this announcement that are of particular interest to the petchem industry. The first is the degree of cost escalation now taking place in major construction projects. In April 2006, Shell estimated that the expansion cost would be around $3bn. But this has now more than doubled over the past 18 months. One assumes also that Bechtel/Jacobs will be taking much less of the risk of cost over-runs as well.

The project also confirms gasoline’s increasing importance within the major oil companies. And with new gasoline-focused refineries being planned all round the world, there is a clear danger of naphtha production becoming a ‘poor relation’. This could keep petchem feedstock prices relatively high, even after gasoline margins return to more normal levels.

Dow CEO Andrew Liveris has spelled out very clearly his concerns about the impact of the US subprime crisis and high energy prices. He said that last week’s Fed Funds cut ‘flirted with danger’ in terms of the risks it took with inflation, although it was clearly necessary in order to tackle other problem areas.

Liveris’ comments echo those made here in recent weeks, and are striking for their clarity. Speaking to a Credit Suisse investment conference yesterday, he said that ‘the jury is out as to what next year will look like’ and added that:

• ‘The trend line in US housing is still in the wrong direction – it will be the end of next year before we see any flicker of improvement'.
• There is a real fear that the US housing crisis and high energy prices will ‘more than trickle over into consumers’ spending’
• ‘The future of the US ethylene industry is uncertain’. He believes that recent private equity deals are 'being done on a run for cash basis’, and that it is ‘almost impossible to compete on the basis of $6/MMBTU gas’ versus $2/MMBTU in the Middle East.

Liveris has been warning of potential problems in housing and autos for a year. Yesterday’s presentation made it clear that recent developments have only added to his concerns about the economic outlook.

It seems likely that this week’s European Petrochemical Association annual meeting in Berlin will mark a turning point in the petchem cycle.

Looking back over 2007, Boy Litjens, CEO of Sabic Europe, told ICIS@EPCA that performance this year had been ‘excellent’, and that they would ‘definitely report the best results ever’. He was also hopeful about the outlook for 2008, but thought that 2009 onwards might prove to be ‘difficult years’ for the industry.

Litjens went on to add, however, that ‘I am realistic enough to say that somewhere in 2008 and 2009 the economy is going to turn down’. But in his view, the pressure from new Middle Eastern and Asian capacity won’t really begin to be felt ‘until the fourth quarter’. So the key issue is whether demand begins to turn down before this.

The views that I picked up on this issue over the 4 days were mixed. The US market definitely seems to be weakening, and although European and Asian demand is still robust, industry margins are coming under pressure:

• There seemed no doubt in the minds of US delegates that the US housing market will get worse (some thought a lot worse) before it bottoms. This means there will be a lot less demand for chemicals/polymers in this important sector.
• However, US producers were encouraged by the decline in the US dollar, and hoped that this would enable them to compensate for lower domestic sales via increased exports to Asia, and Europe.
• European producers generally saw demand continuing to be strong, although many noted that the major downstream buyers were taking a more aggressive stance on pricing.
• Asian delegates, particularly those from China and India, remained very confident. They see strong demand in their domestic markets out till at least 2010.
• Feedstock pricing and availability was a major concern for everyone with whom we spoke. The volatility seen during 2007 is expected to continue, and this makes margin forecasting much more difficult.

It used to be said that ‘if America sneezes, the rest of the world catches a cold’. My sense from our EPCA meetings is that we may find ourselves needing to rewrite this phrase, if housing and subprime problems do tip the US economy into recession next year. This might cause us to discover instead that ‘when America catches a cold, the rest of the world sneezes’.

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.

The ‘consensus forecast’ for 2008 is very optimistic, as I commented in my post-EPCA note. It says oil will remain at $70/bbl, that debt market problems will be contained, and that petchem margins will remain at 2007 levels. This is unusual, as the consensus is normally a base case scenario, with upside and downside variants.

And since EPCA, oil has already increased to around $90/bbl. Back in early July, when it was still ‘only’ $70/bbl, I noted that it had the potential to approach $100/bbl, and this still seems a real possibility. In these circumstances, it is perhaps no surprise that we are seeing an apparent ‘boom’ in demand, as downstream consumers rush to cover themselves before product prices move higher.

I first saw this effect happen in 1979, when the industry had a record year. It was only in 1980 that we discovered that the apparent ease with which the economy had weathered a rise in the oil price to $30/bbl (around $95/bbl in today’s money), was a mirage. Could the same be happening today? I think it is worth considering very carefully as a possibility.

After all, whilst history never repeats itself, the underlying position in financial markets is clearly deteriorating. Bank of America (the 2nd largest US bank), came out with truly shocking Q3 results on Thursday, whilst on Friday Caterpillar’s CEO Jim Owens said the US was already ‘near to, or even in, a recession’. And new housing starts and US house prices were already very weak, even before the recent credit crunch.

There must surely be a real possibility that this latest upward rush by the oil price will be the catalyst that finally causes the US consumer to cut back on non-essential spending. Equally, the continuing problems in the banking sector may well turn off the tap of consumer, and maybe even corporate, lending.

If I was drawing up budgets for 2008, I would be putting in place contingency plans for just such an outcome, even whilst crossing my fingers that I would not have to use them.

Oil prices last week rose to an all-time, inflation-adjusted, high in New York at over $92/bbl. Meanwhile food and commodity prices have continued their upward march. In China, the rate of consumer price inflation hit a decade-high of 6.5% in August. So why are we still seeing rates of around 2% reported in the USA and Europe?

Part of the answer is that China, like other developing countries is less energy-efficient than the West. Equally, as the world’s leading manufacturer, it is first in line to suffer higher prices for metals (the steel industry is expecting a 50% increase in the iron price next year, on top of 145% increases this year). But freight costs get passed straight on to buyers, and the Baltic Index for dry goods such as iron, coal and grains has risen 135% this year alone.

Yet current official Western inflation figures still appear benign. As I commented back in July, central banks such as the US Fed conveniently focus on ‘core’ inflation, that excludes food and energy costs. Similarly, the Bank of England now focuses on consumer price inflation (CPI) instead of retail prices (RPI). What’s in a name, you might ask? 2.1% is the answer. The new CPI registered just 1.8% in September, but the older and more comprehensive RPI clocked in at 3.9%, and is clearly on an upward trend.

Central banks also use ‘hedonics’ as a way of avoiding the hard decisions to raise interest rates when economies are over-heating. But one can’t eat or drive a mobile phone or a laptop, so although these are more powerful today than earlier models, this may not impress union negotiators when they plan tactics for next year’s wage round.

Thus there is a strong argument that investors may have been lulled into a dangerous sense of complacency. A double whammy may be just around the corner. Not only may ‘official’ inflation rates finally start to rise, just as the housing-dominated economies are slowing sharply. But chemical companies’ earnings may also suffer from margin compression if, as seems very possible, consumers prove less willing to accept the latest round of price increases.

Since posting yesterday, oil prices have moved further ahead, with WTI closing at $93.53.

I have also had an interesting dialogue with Paul Satchell of ING Bank, one of the leading chemical analysts, who has kindly allowed me to summarise his comments. Paul believes that investors have become 'dangerously complacent' about the industry's ability to cope with increases in oil prices, following the success of companies such as BASF at passing-through input cost rises since 2004.

He sees a growing danger that commodity chemical producers may suffer the same fate as specialties companies such as Ciba and Clariant, who 'seem to have suffered a major loss of pricing power'.

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.

Christophe de Margerie, the new TOTAL CEO, has burst the bubble of complacency that has surrounded discussion of future oil supply.

The ‘business as usual’ forecasts of both the International Energy Agency and the US government assume that the world will be producing c120m bbls/day by 2030. But de Margerie said he wished to ‘speak clearly, honestly and not just try to please people’ on this topic. In his view, ‘it would be difficult to reach even 100m bbls/day’.

Yet the world is already using 85m bbls/day. And demand has been growing very fast. 5 years ago, it was only 78m bbls/day. This is because of new demand from the emerging economies such as China and India, as well as the Middle East, where oil consumption is subsidised by the government. So higher world prices have little impact on domestic demand in these countries.

de Margerie said the problem was NOT with the amount of oil in the ground. He believes that ‘reserves have never been so big’ as a result of new technology. But he DID highlight the practical problems in the way of reaching 100m bbls/day, saying:

• ‘We (in the oil industry) have been over-optimistic on geology, in terms of how much time it takes to develop reserves’
• The industry has also ‘misunderstood’ the willingness of resource-rich countries to allow production today from their best oil fields. Instead, these countries are often only offering smaller and more difficult fields to foreign investors.
• Political and security problems were also holding back supplies in countries such as Iraq, Nigeria and Venezuela. ‘We know these developments are not underway’.

Only 3 years ago, under the influence of Wall Street, the major western oil companies were still spending more money on share buybacks than on finding new sources of oil and bringing it to market. This lack of investment is about to catch up with us. In de Margerie’s view, ‘100m bbls/day is now an optimistic case’.

His conclusion is that the increasing tightness of supplies will keep oil prices relatively high in the future. This is a very worrying message for the chemical industry, which depends on oil-based feedstocks for most of its products.

Our annual European conference, organised with ICIS, always provides an excellent opportunity to gain a snapshot of industry views as we move into a new year. At this week’s event in Antwerp, Belgium, the prevailing mood was uncertainty, for the first time since 2002:

• Oil prices are high, and volatile. This makes it difficult to plan ahead with any confidence.
• Feedstock markets are in a perfect storm. Shell described the major pressures on refiners, which have kept naphtha markets tight, and prices high.
• End-user demand may be weakening. Artenius and Scott Bader see increasing difficulties in passing through higher feedstock prices to end-users.
• Credit worries are increasing. Our financial speakers from ING and Barclays Capital both warned that the sub-prime crisis is far from over.

Petchems have had a great run since 2003. It is not at all clear that this will continue into 2008. Our delegates are probably very wise to be developing contingency plans, in case the next few months turn out to be the start of the long-awaited downturn.

English children have a card game called ‘Beggar my Neighbour’, where the aim is to win all the cards from your opponents. Central bankers seem to be learning its rules, and applying them to currency trading. OPEC’s weekend summit showed it is clearly worried that it will have a losing hand if oil remains priced in US$.

US exports have been booming recently, whilst imports have been falling, as can be seen from the chart below produced by the American Chemistry Council (ACC). In a recent note, the ACC estimated that US chemical exports are up 18% versus last year, whilst imports are down 6.7%. As a result, the US trade deficit in chemicals has fallen from $6.7bn to just $0.6bn through September.

In the background is 2007’s 16% fall in the value of the US$ against a basket of currencies. This is making it much easier for US-based chemical companies to boost exports, and so compensate for the housing/auto-led sales decline in their own domestic market. But the US’s trading partners are now expressing unease.

Last week, Japanese PM Fukuda followed the European Central Bank in complaining about the soaring value of the yen versus the US$. Whilst UK central bank governor Mervyn King explicitly warned that the UK pound would need to fall, in order to close the UK’s £7bn/month trade deficit in goods.

Now OPEC has joined the chorus of dissent. Ignoring a warning from Saudi Arabia that any currency discussion might cause the US$ to ‘collapse’ (a warning that was ‘accidentally’ broadcast to the media!), OPEC members pointed out that in euros, their average netback is actually lower in euros this year than in 2006.

Any move by OPEC to price oil in a basket of currencies, rather than the US$, could cause major feedstock cost increases for the global chemical industry, as well as disrupting US chemical exports.

Fluctuating currency values look set to be another cause of uncertainty about the prospects for 2008.

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.

How thick is the ice cap at the North Pole? Will it melt within our lifetime, or will it take a century? Will its major oil and gas reserves become available for exploitation? These are the questions which may be answered by the Vanco Arctic survey, due to take place between February – June next year.

A blog reader has kindly sent me details of the proposed expedition. It will aim to resolve, via a 1000 mile survey, current scientific controversy over the precise thickness of the ice. This has apparently proved impossible to assess either by submarine or satellite till now. Then we will know whether the ice will melt within 15 years, at current rates, or within 100 years.

As and when the ice cap melts, global warming is expected to accelerate. The Arctic covers almost 3% of the Earth’s surface, and reflects approximately 80% of the incoming solar energy. If it disappears, the newly exposed ocean could cause a 70% increase in energy absorption, and an additional 0.4-1.0m rise in sea level through the inevitable thermal expansion of the ocean.

On the positive side, the Vanco organisers claim it will enable us to reach new sources of oil and gas, accounting for 25% of the earth’s known reserves. These are already the subject of claims, and counter-claims, by Russia, Canada, Denmark, Norway and the US. 10 billion barrels of oil are thought to be at stake. The new northern ocean will also offer much shorter trading routes.

Will investment bankers one day be preparing their prospectuses for potential new Arctic petrochemical plants?

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.

The US Congress is currently close to finalising a Bill that would aim to tackle climate change. This follows the EU model by establishing a carbon price via a cap-and-trade system, and is very welcome news.

However, there is a sting in the tail, as currently drafted. For it also calls for a border tax on carbon-intensive goods. Chemicals would inevitably be a prime target for such a tax, and ‘The Economist’ rightly devotes an editorial to attacking this concept.

Proponents of the border tax argue that it would encourage other countries to reduce their carbon footprint. It would also stop American producers being disadvantaged by the higher costs imposed by the new higher US standard. But its costs could be huge.

As ‘The Economist’ comments, not only would a ‘massive bureaucracy be needed to certify the carbon content of different goods imported from different factories in different countries.’ But the indirect cost could be even higher, as ‘such a tax would be a dangerous weapon in the hands of America’s growing gang of protectionists’.

‘The Economist’ is not prone to exaggeration. It says that if these measures are passed, America risks starting ‘a global trade war’. Chemical industry executives need urgently to get themselves up to speed on this issue. And the trade associations need to monitor developments very carefully.

Are we seeing just a dip in economic growth? Or are we at the start of a downturn that may run for months, or even years? The answer to this question lies in the US, which still accounts for 25% of global GDP, and where US consumer spending is 70% of US GDP.

Optimists maintain that central bankers have the power to stimulate the economy via interest rate cuts. And certainly, as we saw again last week, the merest hint of further US reductions is enough to send stocks soaring worldwide.

But from a chemical industry viewpoint, the answer is not so simple. Kevin Swift’s excellent weekly report for the American Chemistry Council (ACC), gives a mixed picture. November’s US railcar loadings remained strong, as export activity continued to compensate for weakness in the housing and auto sectors.

But as the chart shows, global chemical industry production growth (ex-pharma) has slowed significantly since the summer in all regions. And the ACC notes that US leading indicators are now negative, and at a level usually associated with recession.

US housing data is very worrying from a chemical industry viewpoint. Each US housing start generates an average $16k of chemical demand, according to ACC calculations. And the massive fall in building permits does not bode well for H1 demand next year

November’s figures for new and existing US home sales are just awful, compared to 2006:

• New home sales are down 24%; median prices down 13%; housing starts down 16%; building permits down 25%. Inventory is 8.5 months sales.
• Existing home sales are down 21%, median prices down 5%. Inventory is 10.8 months sales.

A further worrying sign is that in the wider economy, US inventories are increasing rapidly, adding a full 1% to US GDP growth in Q3. This is perhaps not surprising, given the recent rapid rise in oil prices. Crude was only $71/bbl in early July, when I first suggested it could reach $100/bbl, and it would not be surprising if chemical/polymer buyers have been building even more stock in recent weeks as prices rose.

The optimists may still be right, and central bankers may be able to wave the magic wand that restores us to a growth path. But with US housing/auto sales so critical for the global economy as well as for chemical demand, and with feedstocks remaining tight, it is hard to imagine that the chemical industry can now avoid a serious downturn.

There is some interesting material on the OPEC website, following this week's Summit, which clarifies their current strategy. The key points are:

• OPEC is currently targeting inventories, not prices. Their policy is to keep OECD crude stocks within the 5 year average. OPEC says its previous production cutbacks ‘minimised the excessive overhangs that existed at the beginning of the year'. Saudi Oil Minister, Ali Naimi, added that ‘inventories (are now) at a healthy level within the 5 year average’.
• In keeping with this approach, OPEC made no comment on current prices. Instead, it focused on the issue of volatility, blaming this on ‘fear of future shortages’, ‘increasing speculation in the futures market’, ‘continuing geopolitical tensions in some oil-producing regions’ and ‘downstream bottlenecks’. This is quite different from September's meeting, when they tried to talk prices down.
• Naimi reiterated OPEC’s commitment to ‘stability and reliability of supply in oil markets’. But he also raised a warning flag over the negative impact of any Western initiatives to move away from fossil fuels, commenting that OPEC’s investment in future production increases will be ‘assuming in good faith that the demand will be there’.

OPEC, in public at least, thesefore seems much more relaxed about the impact of today’s high prices on economic growth than it was in September. Then, the IEA had suggested that OPEC was targeting a minimum $70/bbl price, compared to today’s level near $90/bbl. Or maybe, with a mild winter forecast for the US as a result of the La Nina effect, they are just hedging their bets until they next meet in February.

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

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

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

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

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

CFOs are paid to worry, but their worries seem to be increasing quite rapidly, according to the results of the quarterly CFO survey by Duke University/The Economist. This showed:

• Record pessimism about the US economy, with US CFOs worrying about ‘weak consumer demand, high fuel costs, rising labor costs and credit markets’.
• European CFOs are ‘dramatically more pessimistic’, and expect employment to fall 0.6%
• Asian CFOs are still optimistic about growth, but almost all CFO’s with Western multinationals said they were being told to increase revenue growth to compensate for slower Western growth.
• A third of Asian CFOs see Chinese growth as likely to slow, whilst 61% of Chinese CFOs expect a US recession to hurt their firms.

Credit market worries are particularly painful for US CFOs, with around half saying that credit has become less available, and that they have experienced an increase in the cost of credit. A third of European CFOs have seen the same impact. US CFOs also noted an increase in ‘hardship withdrawals’ by employees from their 401K savings account, as a result of a need to make mortgage payments or avoid personal bankruptcy.

In recent days, 3 respected commentators on oil markets have raised concerns about the near and medium-term prospects for oil supplies:

• Goldman Sachs has raised their 2008 WTI price forecast to $95/bbl from $85/bbl. This is driven by their expectation that cost inflation, plus continuing technological and political uncertainty, will ‘increase the price required to motivate capacity investment’. They point out that there has recently been a ‘large rise in long-dated prices to the $80-85/bbl range’.
• CIBC have pointed out that ‘soaring rates of consumption’ in Russia, Mexico and the OPEC countries will reduce their exports by 3.5mb/day by 2010. This equates to 3% of world demand. High oil prices are stimulating rapid growth in car ownership in many of these countries, whilst subsidised gasoline prices make driving cheap.
• The International Energy Agency (IEA) said yesterday that ‘we are on the eve of a new world order’ in energy, where China and India ‘now drive global energy demand’. The IEA chief economist, Faith Birol, projects 35mb/day of new demand by 2015, but worried that only 25 mb/day is currently being planned. Equally, the IEA says major energy consumers, including the USA, are doing very little to restrain demand growth.

My reading of all this is that dialogue between oil producers and consumers is starting to break down. As I noted after the OPEC meeting, even the Saudis are questioning whether they should invest the billions of dollars needed to bring major new fields on stream.

The price and availability of oil is absolutely critical to the chemical industry. Growing uncertainty around these key issues is already leading to increased price volatility, which in turn will reduce margins and profitability.

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.

Oil prices touched $100/bbl today, a new record in nominal and inflation-adjusted terms. At the same time, the US Institute of Supply Management (ISM) index signalled that the manufacturing sector ‘failed to grow in December’, with ‘industries close to the housing market struggling more than others’. All the ISM’s main indicators were negative, with inventories also reported to be moving in the ‘too high’ direction.

It is difficult to underestimate the psychological importance of oil reaching the $100/bbl level. I first identified the potential for this to happen 6 months ago on 5 July (just as this blog began), when I suggested $100/bbl could be reached ‘early next year’. But at the time, this was a distinctly minority view. The price then was only $71/bbl, and many expected it to retreat to the $50/bbl level seen at the start of 2007.

I noted on 14 July, as oil rose to $79/bbl, that leading retailers Wal-Mart and Tesco were already reporting that consumers had become more conscious of value-for-money issues. I commented that CEO’s needed to develop ‘a major cost-leadership programme’ for September rollout, in order to respond to this twin challenge of higher feedstock costs and increasing consumer price resistance.

By August, I had also become concerned that the combination of the subprime disaster and high oil prices could provide ‘a distinctly unhealthy cocktail’ for the global economy. With OPEC proposing only a small increase in oil supplies as we came into the northern winter, plus ‘weakening US demand and credit markets’, I worried that chemical company profits could well be hit.

I repeated this concern in mid-September, when prices were still at $79/bbl, and concluded that ‘higher oil prices have always slowed the world economy in the past. Their impact may have been deferred this time, but it is hard to believe that it has been avoided’.

My EPCA posting confirmed this concern. I found myself worrying that the consensus forecast was too complacent, expecting $70/bbl crude and reasonable chemical demand and margins for 2008. Instead, I suggested that the meeting ‘will mark a turning point in the petchem cycle’.

By mid-October, I was pointing out that crude had risen to $90/bbl, and worried that ‘this latest upward rush by the oil price will be the catalyst that finally causes the US consumer to cut back on non-essential spending’. I suggested that companies should develop contingency plans for a 2008 downturn, even whilst hoping these would not be needed.

By the end of October, crude had reached an all-time high in inflation adjusted terms of over $92/bbl. And I questioned the reliability of Western inflation figures that sought to portray inflation at ‘only’ 2%, despite massive increases in the prices of food and energy. I worried that we would see ‘margin compression’ in the industry, as central banks belatedly woke up to the risk that inflation might become a real problem again.

Paul Satchell, chemicals analyst at ING shared my concerns, believing that investors had become ‘dangerously complacent about the industry’s ability to cope with increases in oil prices’. Whilst TOTAL’s CEO added to my worries in early November when I reported his view that ‘increasing tightness of supplies will keep oil prices relatively high in the future’.

By December, I noted that ‘the dialogue between oil producers and consumers is starting to break down’. I suggested that ‘the price and availability of oil is absolutely critical to the chemical industry. Growing uncertainty around these key issues is already leading to increased price volatility, which in turn will reduce margins and profitability’.

During December, we had a significant fall in the price to below $90/bbl. But the experience of previous oil price surges in 1973-4 and 1979-80 was that when the rally finally ended, prices stabilised at the new, higher, level. They did not collapse. It would therefore be a triumph of hope over experience to expect the 2007-8 surge to be different. And, of course, the worst of the northern winter is possibly still to come.

Reaction to $100 oil has been swift. Yesterday, the Chinese State Council decided to freeze the prices of oil products, natural gas and electricity, as well as public transportation. A measure of the government’s concern is that the meeting to approve the freeze was attended by premier Wen Jiabao.

Chinese inflation is now at 6.9% and the Council noted that ‘China faces relatively large pressures of further price increases (as) prices of crude oil, grains and other primary products are still rising on the international market’.

So as expected, $100 oil prices are already having an impact on psychology. The Chinese government has been most aggressive in searching for new sources of oil imports. But even they are now starting to worry about the implications of unlimited consumption of oil and oil-based products.

Earlier this week, the State Council also announced a decision to ban ultra-thin plastic bags, and to charge customers for thicker plastic bags. China uses around 3bn plastic bags a year, which requires 37m bbls of crude per year. But even if the ban is totally successful, it will save less than two days of total oil consumption.

If major energy importers such as China have decided to prioritise oil use, and have started by banning plastic bags, what other petchem products will be next affected? And if other countries follow this lead, what will be the impact on petchem demand generally?

Financial investors are already quite disruptive in crude oil markets. And their influence is set to grow this year. That’s the message from surveys by Barclays Global Investors and JP Morgan. $120bn is now invested in commodities as a class, with oil a major target. Even your own pension fund may be about to invest, or to increase its exposure, after the stellar returns posted in 2007.

As a result, crude oil prices are becoming more volatile. Over the past month, they have been over $100/bbl on several occasions. Yet they were below $90/bbl on 18 December, and are currently back around $93/bbl. This is a major issue for petchems, making pricing and margins most uncertain.

Nothing has changed since mid-December in the ‘real world’ of oil supply/demand to justify this recent volatility. The mild weather forecast for the critical NE USA area seems to have been accurate. There have been no new geo-political tensions.

The cause is simply the behaviour of financial players. As I noted back in July, these do not set underlying trends. Rather, they jump on them after they have developed. The ‘weight of money’ then exaggerates any minor changes in either direction.

Worryingly for petchems, this influence seems likely to grow in 2008. The US pension fund, Calpers, is poised to invest $13bn (5% of its $250bn portfolio). It sees oil markets as a good ‘hedge’ against inflation and slowing stock markets. Calpers adds that ‘we believe energy will offer investors opportunities in coming years’.

In Europe, JP Morgan found that 31% of major investors were planning to invest in commodities this year. Belgium, Netherlands, Germany and Austria were particularly keen, with only France having zero interest. Europe is following the US pattern, with the largest Dutch pension fund ABP increasing its investment to 3% of its portfolio, matching Hermes (the UK’s largest fund).

There is little point in petchem producers or consumers trying to stand against this wave of new money entering the oil markets. And with a profits downturn probably already underway, it is instead important to ‘lock-in’ margins as much as possible. Companies routinely ‘hedge’ their currency exposure these days. Use of the LME futures contracts may well need to become a similarly essential tool.

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

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

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

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

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

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

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

I have often wondered how the major investment banks arrive at their forecasts for long-term crude prices. Last night I found out how it is done at the biggest player, Barclays Capital.

Dr Paul Horsnell, Head of Commodities Research, said that when he started in the role in 2003, he began by keeping close to the mainstream with a forecast of $24/bbl. Since then, as the market price has risen, he has simply doubled the previous price, deducted $1/bbl, and this number has become his new long-term forecast.

So from a starting point of $24/bbl, he then moved to a $47/bbl forecast, and is currently forecasting $93/bbl. When he next revises the forecast, he expects it to go to $185/bbl.

The interesting thing was that in a room full of eminent energy economists, as well as many senior oil industry people, nobody took issue with his methodology.

I had the opportunity last night to learn current thinking within the oil industry on the current outlook for oil markets, by attending the annual lecture of the British Institute of Energy Economists, kindly hosted by BP.

A year ago, at the same event, the crude price was $51/bbl. Last night, the headlines were ‘major fall in oil price to $91/bbl’. This captures the extreme volatility that now exists in oil markets, and which makes life an absolute nightmare for anyone who buys or sells oil-based chemicals.

The consensus emerging from the discussion was that markets will remain strong, and that the activity of speculators will continue to create volatility. High oil prices are not likely to stimulate new supply in the short-term, as most reserves are in areas that are difficult to access due to politics or geography. Equally, demand will continue to grow in the Middle East and Asia, due to massive government subsidies on domestic prices.

The new ICIS Weekly Margin report on polyethylene is a goldmine for those who want to track the fortunes of the petchem industry.

The recent issue contains good news and bad news for producers:

• The good news is that PE margins have improved during January for integrated producers as a result of lower feedstock costs, higher cracker co-product values and higher PE prices.
• However, non-integrated producers are not yet seeing much improvement, as they have not been able to fully pass on the ethylene contract price increase.
• And the bad news is that the recovery in margins is starting from a low base. LDPE margins were down a massive 47% in Q4, versus the same period in 2006, whilst HDPE margins were down 55%.

Overall, though, 2007 was a reasonable year. Margins were down 9% for both LDPE and HDPE versus 2006, but this was mainly because of the Q4 downturn. As the chart shows, there was a dramatic fall towards the end of the year. Both European LDPE and ethylene contributions (the blue and yellow lines) hit lows in December that were last seen in early 2002 and late 2005.

Producers will certainly be hoping that today’s massive US Fed interest rates cuts, combined with the proposed Bush tax rebates, halts the current slide in consumer confidence and helps volumes and margins to recover.

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.

China’s ethylene and propylene imports have surged in recent months, as the country has diverted naphtha to supply gasoline and diesel needs.

ICIS news, reporting official China Customs figures, says 2007 ethylene imports were over 400% higher at 510KT, versus just 117KT in 2006. Ethylene exports also more than halved to 50KT in 2007, from 129KT in 2006.

Altogether, China’s net ethylene balance was therefore 472KT worse than in 2006. Propylene shows the same picture, with imports more than doubling in 2007 to 728KT versus 321KT in 2006.

Strong growth ahead of the Olympics is obviously part of the explanation. As is the fact that most of the country’s major new crackers won’t come online until 2009/10. But another key factor is the government’s need to prioritise gasoline and diesel production to ensure social stability.

As ICIS news reported last year ‘China has asked Sinopec and PetroChina to beef up their gasoline and diesel output to help relieve the country’s oil shortage since October’. And they quoted refinery sources as adding that ‘Diesel is tight in China. Reduced production of one tonne of ethylene would mean adding five tonnes of diesel.’

China’s dilemma highlights a wider problem for petchems. Crude supplies look to remain tight. This is driving up naphtha prices. But gasoline and diesel demand is continuing to grow strongly in many emerging countries, as governments such as China's instead subsidise domestic consumers.

Demand for transport fuels is therefore likely to stay relatively strong, as the world adjusts to a tighter oil supply/demand balance. Those petchem producers without access to advantaged feedstock may well face a difficult few years.

OPEC’s decision to hold its production quota at last Friday’s meeting came as no surprise to the markets, which were busy taking prices down $2/bbl on renewed fears of a US recession. But it did produce a warning from the International Energy Agency (IEA) that OPEC’s policies ‘threaten the strength of the global economy’.

The decision also tells us something very significant about current oil market politics. Because it was only last month that President Bush had made a direct appeal to the Saudis to lift oil production. And there have only been two previous occasions when a sitting US President has failed to influence OPEC discussions via the Saudis.

The first was in 1973-4, in the aftermath of the ‘Yom Kippur’ war, which resulted in OPEC oil embargoes. The second was in 1979-80, during the Iran hostages crisis. At all other times, the relationship between the US and the Saudis has been based on the close personal linkages established at the famous Valentine’s Day meeting 62 years ago between Saudi Arabia’s King Abdulaziz and then US President FD Roosevelt.

Saudi Oil Minister Naimi was typically Delphic in his comment after the OPEC meeting, commenting that ‘supply and demand are equal, and global reserves are fine’. And it is true that the Saudis have increased their own production to 9.2mbd in response to US requests. But probably two factors caused this historic rebuff to take place:

• Pragmatic. As noted at the time of the last OPEC meeting, the La Nina weather system generally produces mild winters on the US East coast. This has happened in 2008. Equally, the severe winter storms in China (attributed by government meteorologists to La Nina), will reduce demand still further, just as it normally takes a seasonal dip.
• Politics. It is probably hard for the Saudis to force through an OPEC increase with so much political tension around the Middle East. The US threat to bomb suspected Iranian nuclear facilities is clearly creating major tension in the region, and it would be difficult, if not impossible, for the Saudis to respond to a US appeal at the moment.

Quite why, in the light of these factors, President Bush chose to issue his personal appeal must be a matter of debate. History, as well as the IEA, is warning us that its rejection implies that oil markets are likely to stay difficult for some time.

Chemical companies tend to trade on ‘open book’ terms with long-established customers. They are also supportive when those customers are facing problems in their end-markets. In a recession, these admirable qualities can become expensive.

ICIS news reports tonight that the bankruptcy of Plastech Engineered Products in the US has led to debts of nearly $5m for 4 of the major US polymer producers. Plastech was a supplier of door panels and other items to Chrysler, and got into difficulty due to the alarming auto industry downturn chronicled here in recent months. Dow are apparently owed $1.57m, Basell $1.4m, BASF $1.02m and SABIC $970k, according to bankruptcy court documents.

CFOs and sales heads need to look urgently at their terms of trade with companies in recession affected industries such as housing and autos, as Plastech will probably not be the last company to fold. For example, as I commented 2 months ago:

“I would not be surprised if ‘cash before delivery’ soon becomes the norm for some companies. This may seem a harsh requirement, and may lose some sales in the short-term, but it is far better than standing in line for repayment after the worst has happened.”

These decisions are not taken lightly, but no chemical company can afford to take losses on this scale on a regular basis. I fear that a new generation is about to learn what some of us had the misfortune to go through in 1980-83 and 1990-2. If they can learn from our experience, and avoid some of the most extreme disasters, then everyone will benefit.

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.

Quietly, oil has moved back to the $100/bbl level.

This is quite different from January, when it first hit the magic $100/bbl number. Financial players had jumped on the trend from November as crude rose above $80/bbl, and then wanted to ‘get out at the top’. Their thinking was that a US recession would reduce demand for oil, and so prices would fall. Now, however, more fundamental forces seem to be taking prices higher, and causing the 'shorts' to cover their positions.

The problem for the chemicals industry is that this purely speculative behaviour creates additional volatility. And with $120bn already ‘invested’ by financial players in commodities, much of it in oil, companies must assume that ‘speculative volatility’ will increase.

The behaviour of financial players is not the only uncertainty currently driving oil prices. Apart from the impact of geo-political issues such as Iran, Nigeria and Venezuela, four key questions will influence the direction of oil prices in 2008:

• Does OPEC care that higher oil prices will damage the western economy? In the past, the answer would have been ‘yes’, but recent signs (their decision to ignore President Bush’s plea for lower prices last month) imply their thinking may have changed.
• Can net non-OPEC supply increase as much as expected this year? Production from existing fields in Mexico and the N Sea has recently been decreasing faster than expected. This means more new oil has to be produced, to make up the difference.
• Will Asian and OPEC countries continue to subsidise oil products? If they do, then higher world prices will have no effect on the countries where fastest demand growth is taking place.
• Will financial players and pension funds see oil as a hedge against a falling US$? Some are already viewing the ‘US recession’ argument from a different angle, and believe it will force the Fed to cut interest rates back to 1%, causing the US$ to fall further.

The downturn in the global economy has been impacting chemical margins since the summer. Profits have been hit, as key customer industries such as housing, autos, and retail became more price conscious. Demand has also been slowing, as higher oil prices acted as a tax on Western consumption. Now feedstock volatility is likely to increase, due to the growing influence of financial players. CEOs and CFOs therefore need to ensure that proper risk management tools are in place to protect margins.

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.’

Its not often that one gets clear statements from central bankers. Today’s comment from the Bank of England’s Deputy Governor that the credit crunch was ‘an accident waiting to happen’ is truly remarkable for its clarity. She also gives the best one sentence summary that I have seen on the background to today’s credit crunch. :

‘The US housing crisis has acted as the trigger for an overdue correction in financial markets, after a long period of plentiful liquidity during which risk premia of all sorts had become unduly compressed, asset prices had become detached from reality, financial innovation had run ahead of risk management, and unsound business models had led to a deterioration in credit monitoring and, in some areas, underlying credit quality.’

She summarised it as ‘the largest ever peacetime liquidity crisis’.

China’s move last month to charge for plastic bags has now been followed by the iconic UK retailer, Marks & Spencer.

Whilst the environmental angle is clearly important, the move also represents a reaction to higher oil prices. Plastic bags are not ‘free’ to retailers, and their cost is now escalating. Restricting this cost, whilst also gaining ‘green’ credentials, is a ‘win-win’ for them. Similarly, its a ‘lose-lose’ for polymer producers. They have to pay the higher feedstock cost, and will now have lower volumes, so unit costs will increase.

Even worse, it probably marks the start of a more general movement to restrict ‘non-essential’ uses of crude oil. Gordon Brown, UK premier, has now said the UK government will force all supermarkets to charge within a year. Other governments will no doubt follow. The benefits of plastics are not well understood by the general public, and represent a soft target. Operating rates for producers and converters will suffer as a result.

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

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

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

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

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

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

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

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

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

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

OPEC today decided to hold oil production at current levels, even though prices are at a level which clearly threaten economic growth. They even recognised this risk in their statement, ‘highlighting the economic slowdown in the USA, which together with the deepening credit crisis in financial markets, is increasing the downside risks for world economic growth and, consequently, demand for crude oil’.

Normally, faced with this outlook, OPEC would have flooded the market with crude, in order to bring prices down and help support the world economy. Clearly their priorities have changed, and we appear to be back to the difficult times of 1973/4 and 1979/80, when OPEC similarly held production whilst the world economy went into a downturn.

OPEC’s statement seems to reflect a growing hostility towards the US over a number of issues, including the weak US$ (as noted by the New York Times). Saudi Arabia, the leading OPEC moderate, clearly feels let down by the lack of progress in the Middle East peace talks. And OPEC also decided to support Venezuela’s ‘sovereign rights over its natural resources’ in its dispute with ExxonMobil, calling on EM to hold back from further legal actions to support its claims.

Faced with this background, chemical company planners need to rethink their crude oil scenarios for the year. I argued back in October that the consensus $70/bbl forecast looked too optimistic. Now, with OPEC taking a hard line, and western investors starting to panic over the value of the US$, we are in uncharted and potentially dangerous territory.

Central bankers are slowly recognising that inflation is becoming a serious problem. But their responses differ. So chemical companies will find it harder to predict interest and exchange rate policies.

China announced yesterday that inflation had soared again last month, reaching 8.7%, versus the government target of 4.8%. Part of the increase is clearly due to the effects of recent major storms. But with the US Fed likely to cut rates soon, China remains in a difficult position. If it increases interest rates, then the currency will rise further, making it a target for ‘hot money’. If it doesn’t, then inflation (particularly in food and energy) will continue to rise.

Meanwhile, Bloomberg has analysed developments in US fixed income markets and suggests that bond traders now believe that the US Fed is about to ‘lose control of inflation’. Since 29 February, the yields on US Treasury Inflation-Protected Securities (TIPS) have been negative. Buyers are apparently prepared to give up ‘real yield today’ for the security of inflation-proofing in the future.

Against this background, it is perhaps not surprising that traders pushed up crude prices yesterday to a new record of $107.91/bbl, as they continued to search for a ‘store of value’. US natural gas prices have also strengthened recently, and are now over $10/MBTU.

The US$ had now fallen through the ¥102 level, which has held since 1995, and went straight to the psychologically important ¥100 level. The dollar peaked 9 months ago at ¥124, and so it has now fallen 19%. This is dramatic by any standards. I forecast back in November that an ‘old-fashioned currency crisis’ could be just around the corner. With the dollar falling against both the yen and the euro, I think this crisis has probably now arrived.

My other recent forecast, that crude would hit $110/bbl, has taken only a week to occur. Yet a month ago, crude was 'only' $90/bbl. Part of the rise was caused by speculators having to unwind short positions, but there is also increasing interest in call options at $150/bbl. I have even heard people talking seriously about the chance that $200/bbl could be seen before the end of the year. As I commented after the OPEC meeting, we are now ‘in uncharted and potentially dangerous territory’.

The 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:

Benzene prices may be about to tell us something quite important about future profitability trends for the chemical industry. As the chart shows, benzene has hit a price ceiling at around $1200/t over the past 4 years in European markets. Yet crude has been climbing, from an average $38/bbl in 2004 to average $95/bbl so far this year.

Equally benzene prices, normally the most volatile of all the petchems, have suddenly become quite ‘normal’. Volatility was typically above 100% between 2001 – 2004, using average European monthly spot prices reported by ICIS pricing. But so far this year, they have moved within just a 12% range, after a range of only 27% in 2007.

The $1200/t price ceiling suggests that it has now become very difficult to pass on today’s higher crude/feedstock prices. Equally, it seems unlikely that benzene prices will remain unnaturally stable for very much longer. If they start to slip, whilst naphtha stays strong, then we will know that the outlook for commodity petchem profitability itself has also weakened.

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

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

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

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

After 5 months, ExxonMobil is once again the world’s largest company by market capitalisation. PetroChina had overtaken it last November, but has since lost half its value in China’s stock market decline. Today, PC is worth $453bn, versus EM’s $455bn.

China’s stock market has lost 25% so far this year. But PC has been particularly badly hit by its inability to raise product prices to compensate for higher oil costs. Its refineries are losing $54m a week as a result. With inflation at a record high of 8.7%, the government is determined to insulate Chinese consumers from the impact of $100/bbl oil.

In turn, this means demand is not being restrained by higher market prices, with all oil product prices frozen last January. The same is true in many other emerging countries, and in the OPEC countries. This means the West is facing the bulk of the adjustment process, which is bad news for those petchem producers without access to advantaged feedstocks.

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 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.

Car sales are of major importance to the chemical industry. The ACC calculates each new car uses $2441 worth of chemistry. The declines reported below for March and Q1 do not, therefore, make pretty reading.

March Q1
GM -13% -11%
Toyota -3% -4%
Ford -14% -9%
Chrysler -19% -16%

Even more discouraging is that none of the main auto manufacturers expect to see any pick-up in sales in the near future. Ford, for example, described the environment as being ‘very challenging’ and said their strategy was to focus on ‘being profitable at lower volume’.

There are also indications that the current downturn has spread from individuals to the wider economy, with Chrysler referring to an ‘industry-wide slowdown in large pick-up truck’ sales.

‘The sharp drop in housing starts and the developing credit crisis will flow into the cracker business’, according to Shell Chemical’s CEO Stacy Methvin. She added that ‘the housing crisis is more far-reaching than anyone anticipated’.

Similarly, BASF is now more cautious about the potential impact of the US recession on its petchem business. Peter Cella, VP petchems N America, told ICIS news that the ‘impact thus far has not filtered down to demand for our products (but) it could be coming. There could be a delayed effect three, six, nine months out that we’re just not seeing yet.’

The ACC’s weekly report also notes that JP Morgan’s global Manufacturing Index has slipped to its lowest level since May 2003, as America’s recession impacts the rest of the world. As the ACC comment, ‘so much for decoupling!’

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

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

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

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

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

I am currently lucky enough to be visiting Asia every month. This also gives me a chance to ‘check the temperature’ as regards people’s outlook on the economy. And I think its fair to say that the mood has moved from optimism to caution. Good news is tempered by its potential downside.

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

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

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

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

Russia is the world’s 2nd largest oil producer. And it has been the main source of increased crude production in recent years. Its output rose 58% between 1999-2006, from 6.2mbd to 9.8mbd. Now Lukoil’s VP, Leonid Fedun, has told the Financial Times that he thinks 2007 output will be ‘the highest he will see in his lifetime’. He also believes that Russian oil production may now follow the sharp declines seen in the North Sea and Mexico.

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

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

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

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

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

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

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

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

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

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

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

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

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

I noted back in February that China is no longer exporting price deflation, and is instead causing global prices for commodities and manufactured goods to rise. A reader has now kindly sent me an interesting report from Credit Suisse, commenting on the potential inflationary impact of new labour laws in China. This is particularly important for the chemical industry, given the volume of foreign investment that has taken place in China.

It features the above chart, showing how wages have increased by 70% since 2004. And its analysis claims that the new Labour Contract Law, in operation since January, will increase manufacturing costs by a further 15%-20%. CS argue that this under-reported measure raises China’s labour rights to international standards, requiring extra pay for overtime, employer contributions to social and pension funds, and severance pay.

CS note that the new law is part of a package of measures aimed at stimulating domestic demand and reducing export-dependency. VAT export rebates were lowered three times in 2007, whilst corporate tax rates for Foreign Direct Investors are being raised from 15% to 25%. They argue that as well as increasing global inflation, the new measures ‘will also affect margins of many listed foreign companies using China as a production base’.

Please contact me at phodges@internationalechem.com if you would like a copy of the report.

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

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

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

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

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

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

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

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

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

I am in Tallinn, Estonia, where the Petrochemicals Feedstocks Association has kindly invited me to talk about 'Feedstocks for Profit', our forthcoming Study on feedstocks supply and demand. Much discussion, as you wouild expect amongst oil and naphtha traders, centred around the potential for $200/bbl oil. None of them thought it unlikely, and many thought it inevitable.

This led to thoughts about the changes that might take place in behaviour if this level was reached. Walking around Tallinn perhaps provides some clues. At this time of year, it is light till nearly midnight, and local people like to sit outside - even though a cold wind blows from the Baltic Sea. But not for them are the comforts of gas-fired patio heaters. Instead, as you can see from my photo, local bars and restaurants provide plenty of home-made blankets.

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

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

The excellent 'ICIS Weekly Margin Report - PE' is starting to tell a very sad story about polymer margins. The chart (above) shows that the ethylene margin, in yellow, has been falling steadily since the start of the year. The same is true for the HDPE margin, in blue. And the Report notes that if market conditions don't improve, then Q2 performance 'will see the weakest quarterly result since 2003'

The Report focuses on European markets, but its conclusions apply to all major regions. It calculates the average Q2 margin for integrated HDPE producers is currently €312/tonne, and for standalone producers it is just €61/tonne. It also calculates that margins for the month of May are now as bad as they were at the trough last December. And with feedstocks costs still rising, producers and consumers clearly face a most difficult position next month.

Update, 27 May. The latest Report, just published, shows that the current margin for integrated HDPE producers is now just €118/t, as naphtha prices rose over 6% last week.

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

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

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

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

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

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

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

Some minor relief may be at hand for hard-pressed cracker operators, particularly those in Asia. Sinopec announced today that it will reduce ethylene output by 65 KT in June (the equivalent of 1 cracker's output), in order to allow it to boost fuel production by 200 KT. This will be done by bringing forward planned cracker maintenance at Zhongyuan, Dongfang and Shanghai. The aim is to respond to government directives to ensure fuel supplies after last month's earthquake.

Balancing petchem and fuel needs seems to be becoming a recurring factor in China. I noted back in January that olefin imports had surged in late 2007, as the government stockpiled fuel in advance of the Olympics. 1 tonne of ethylene production equates to an extra 5 tonnes of diesel. But before we get too cheerful, we have to remember that there is a cloud to this particular silver lining. The International Energy Agency is now forecasting that China's 2008 oil demand may rise 4.7 percent to 7.9 mbd, which will help support today's already high energy prices.

US economic conditions are 'ominous", and may worsen into 2009, according to Dow CEO, Andrew Liveris. "A month ago we might have said ... the US slowdown could be bottoming, but I don't think it is bottoming," Liveris said in response to analysts' questions at an investor conference in New York. He added that "I think we are in for a tough 2008 and maybe even a tougher 2009."

Central bankers had it easy over the past decade. Now they are going to have to earn their money. Inflation is rising rapidly, and growth rates are falling. But unfortunately, as I first noted back in March, they still seem to have differing ideas about what policies will best counter these twin challenges.

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

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.

The blog usually focuses on news items and analysis. But just occasionally, anecdotal evidence seems worth reporting. My colleague, John Keeley, is well known to many readers from his days at Shell Chemicals, as well as more recently with IeC. Just back from chairing the ICIS Phenol and Acetone Conference in Budapest, he reports that he 'had never seen American colleagues so downbeat in his 40 years in the industry'. John is by nature one of the world's great optimists, so his concern is particularly powerful.

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

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

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

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

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

There seems to be remarkably little information about Saudi Arabia's planned oil 'summit' next Sunday in Jeddah. The first news of it seemed to be released rather informally, via a 'junior official' at the Oil Ministry. Since then, various rumours have been reported, but nothing very substantive. All we seem to know for certain at the moment is that King Abdullah told the UN Secretary General over the weekend that he thinks oil prices are 'abnormally high'.

In the past, a clear Saudi view such as this would be a prelude to a major decrease in price. But at the moment, there seems little clarity as to what, if anything, the King might be planning. And the main media have differing views on the key short-term issue - the potential for extra Saudi production:

• Bloomberg reports that Saudi Aramco will start pumping an extra 500kbpd from the new Khursaniyah field 'next month'
• The Financial Times, however, only suggests this will start 'soon'.
• The Wall Street Journal takes a different line altogether, suggesting there might not be any additional net production increase at all, as 'the plan for that field was to ramp up its production slowly, while using the new stream to allow some of the country's older fields to rest'.

It looks as though we may have to wait till next weekend to find out what King Abdullah is really hoping to achieve from his summit.

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

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

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

Linda Naylor, ICIS's polymers guru, has just written a market analysis that took me straight back to 1980. She described how current feedstock prices meant that 'many of Europe's cracker operators were losing money', and noted that Dow was being 'very firm' in trying to recoup these losses via higher polymer prices. However, her research suggested that other sellers were showing more 'flexibility' in their negotiations. And she quoted one buyer who forecast that 'Dow will lose an awful lot of volume'.

In 1980, I was a young sales rep, working for one of the then world majors (ICI). And I went through the same experience that Dow is now suffering. At the start of Q2, we were told to 'hold the line' on pricing, in order to recapture margin caused by rising crude prices. (Does this begin to sound familiar?). Oil prices had moved above $30/bbl, or to around $95/bbl in today's money. Competitors, of course, undercut us. By the end of the quarter, we had lost around 20% of our volume - which we had to reclaim in Q3 by lowering prices still further.

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

I've read several reports on the outcome of the Jeddah oil 'summit', and still feel no wiser than last week:

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

Higher oil prices will change the way that Procter & Gamble operates its supply chain. The world's largest consumer products company describes its current operations as being 'upside down'. 'They were implemented in the 1980s and 1990s, when oil was 10 bucks a barrel', according to Keith Harrison, P&G's head of global supply.

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

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

Alexei Miller, CEO of Gazprom, believes 'that OPEC doesn't have any real influence on the global oil market nowadays'. Interviewed by the Financial Times, he claimed that 'not a single decision has been passed of late that would really influence the global oil market'. And he repeated his suggestion that oil could reach $250/bbl, noting that 'the last 10 years saw Chinese energy consumption almost double and India's grow over 1.5-fold'.

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

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

'Collapse' is not a word that should be used lightly in business. But there is no other way to describe June's US auto sales figures:

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

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

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

European refining margins are falling, as the US's need for gasoline imports reduces. Margins have reached a 4 year low of minus $6.21/bbl, according to Bloomberg. And the problem is likely to get worse, as the US moves towards greater self-sufficiency in gasoline via refinery expansions and increased biofuels usage.

This trend could have important implications for European petchem producers, who are currently suffering from an inability to pass through today's high naphtha prices.

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.

Business travel occupies a lot of time for many people in the chemical industry. So I thought I might pass on details of 2 websites that I find particularly useful when travelling:

• www.skyscanner.net does a very job of comparison shopping on airline fares.
• www.weatheronline.co.uk provides excellent local weather forecasts around the world.

Please add a comment below, if you'd like to pass on details of any sites that you find helpful when travelling.

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

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

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

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

Yesterday's US government data on gasoline consumption gives the clearest picture yet of what is happening to US demand. The data compares the 4 weeks covering the July 4 Independence Day weekend, with the same period last year. And it shows gasoline demand was down just 2.1%, even though oil prices have doubled since last year. Demand still averaged 9.3 mbd, about equal to Saudi Arabia's total oil exports. This tends to confirm the argument that US demand is relatively inelastic, in the absence of a major economic recession.

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

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

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

A new debate about increasing US energy security, by reducing gasoline dependence, may be getting underway. Leading the move is Andy Grove, the man who made Intel into the leading global chip company. His key phrase, and the title for his 1996 book, was 'Only the paranoid survive'. Now he is taking this approach into the energy sphere, commenting that the US may end up 'starving to death economically', if nothing is done to reduce US gasoline consumption.

Grove's focus is on developing electric cars that can cover 40 miles (65km) before switching to gasoline. He is calling for 10 US million vehicles to be converted within 4 years. And he already has some powerful backers, in the shape of the big Silicon Valley venture capital firms who helped power Intel to its current $38bn of sales.

Europe is the world's largest auto manufacturer, accounting for 32% of the global market. So news that European auto sales fell 8.3% last month, compared to 2007, is worrying. Italy's sales fell 20%, and were today described as 'disastrous' by CEO Sergio Marchionne, who announced that 4 of their 6 plants will shut for 3 weeks later this year. Fiat's truck plant will shut for 6 weeks, due to lack of demand. Spain was even worse, with sales down 31%. Whilst Irish sales halved.

The situation has echoes of how US auto sales began to fall away this time last year. Last August, I noted how the US majors were starting to report a fall in consumer confidence. Similarly ACEA, the European manufacturers association, is now warning of 'difficult economic circumstances' in its latest monthly report. The auto industry is a very important market for chemical sales. This new trend towards falling home market sales is therefore not good news for European chemical companies, already facing a difficult H2.

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.

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

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

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

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

BMW, the world's largest luxury car manufacturer, warned today that it is no longer immune from the global downturn:

'Business conditions for the automobile industry deteriorated sharply again in the second quarter due to further ongoing steep rises in oil and raw material prices, the weakness of the US dollar, the impact of the international financial crisis and a weaker US economy,' it told investors.

BMW is now planning to cut costs and reduce production. Both actions will have a major impact on chemical companies' sales and profit. Most worryingly, BMW Chairman Norbert Reithofer also believes '2009 will be another difficult year, full of challenges'.

Paul Ray's excellent ICIS PE margin report provides plenty of food for thought this week. The chart above shows that European LDPE prices (the red line) have moved up quite sharply since June. But almost all of this improvement has been captured by cracker operators. Margins for integrated players (in yellow) recovered quite nicely, but standalone producers (in blue) have seen only a slight improvement.

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

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

I noted in June that P&G were reviewing their global supply chain strategy, as a result of higher oil prices. Now a study by Canadian Bank CIBC suggests the rise in shipping costs equals a '9% tariff on trade', adding that 'the cost of moving goods, not the cost of tariffs' is now the 'largest barrier to global trade'.

Chemical companies have pioneered globalisation over the past 20 years. But the cost of shipping a 40 foot container from Shanghai to the US has more than doubled in recent years, from $3k to $8k. Ships are also travelling slower, to reduce fuel costs. Whilst consumers worry about the carbon footprint caused by global product movements.

Unlike gasoline, which is generally produced for local use, most chemicals made in Asia are actually consumed in the West. So although any move to repatriate production would take years to fully implement, the impact on exporting countries could be large. Currently high Asian growth rates could reduce substantially - by some estimates, for example, 80% of Guangdong's GDP is actually export-related.

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.

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

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

Another policy maker has decided realism is the best policy when talking about the current credit crunch. China's Liu He started the trend earlier this month, by talking about the need for 'economic restructuring'. Now the UK's Finance Minister, Alistair Darling, has become the first western official to abandon reassurance and instead to focus on the reality of current problems.

His analysis is stark in tone, and acknowledges that the depth of the crisis is far worse that he had previously understood. He says:

• Today's economic times 'are the worst they've been in 60 years'
• The downturn 'will be more profound and long-lasting' that most people had expected

Some research in yesterday's Financial Times yesterday also highlights the depth of today's problems. Its shows that Merrill Lynch has already lost 25% of all the profits it has ever made, since it became a listed company back in 1971. And, of course, there are probably still more losses to come, as global housing markets remain weak.

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

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

China's Sinopec has taken a lead in reviewing its petrochemical expansion plans. Speaking to employees last week, Wang Tianpu, CPC division President, noted that 'global crude prices may remain high and the petrochemical industry may become even more competitive'. Today, he gave more details, saying that they plan to lower 2008 petchem expenditure by 4.6bn yuan ($675m). This is certainly a small step in the right direction. But it is probably 'too little, too late'.

All the 'building block' petchems (ethylene, propylene, benzene and paraxylene) face major over-capacity between 2010-14, even if Global Boom conditions return. Our newly-released 'Feedstocks for Profit' Study sets out the detail of the challenges ahead. Hopefully, its analysis will become required reading in the industry. Please contact me at phodges@iec.eu.com if you would like a copy of the Executive Summary, for discussion with your colleagues.

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

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

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

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

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

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.

The latest American Chemistry Council report on global production growth makes sombre reading for anyone outside the Middle East:

• Global growth (dark green) is now only 1.4%, versus 4.1% in January
• N American growth (dark blue) declined by 2.4% in August
• European growth (light green) was down 1.5% in July
• Central/Eastern European growth (light blue) went negative in July
• Asian (brown) and Latin American growth (pink) are both falling

By contrast, Middle Eastern growth (purple) is starting to ramp up, as the new plants come on line. Its advantaged cost base on feedstocks means, as suggested recently in our Feedstocks for Profit study, that it can still operate successfully whilst other regions have to cut back.

ICIS news reports that polymer demand is falling sharply in two key markets, China and Europe. This is a bad omen for demand in other chemical markets, as polymers are closely tied to GDP growth. Linda Naylor reports that PE volumes in Europe may be down 7% in 2008. Meanwhile, John Richardson and Malini Hariharan report that PE and PP demand in China 'could be flat or even negative'.

The cause is almost certainly the distortions caused by the run-up in crude prices since 2006. The blog has warned many times that 2007-8 was likely to prove a repeat of 1979-80, when oil prices also rose sharply. Last October, it suggested that the 'apparent boom in demand' was in fact just downstream consumers rushing 'to cover themselves before product prices moved higher'. The rest of 2008 and 2009 could be very difficult indeed, as consumers destock down the value chain.

A blog reader has kindly pointed out the potential impact of GM's new Volt car on the chemical industry. The Volt will have an operating range of 40 miles (64km), when it becomes available in 2010. According to GM, it will enable 75% of America's daily commuter journeys to take place without using gasoline. And US drivers currently use over 9mb of gasoline every day.

So if Volt sales take off, chemical companies should benefit. Refiners would be encouraged to make more naphtha instead of gasoline, and this increased supply could also lead to relatively lower prices for the industry's largest feedstock.