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Budgeting for survival

Economic growth, Financial Events, Leverage, Oil markets
By Paul Hodges on 19-Oct-2008

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

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

Companies therefrore need to change their 2009 budget process in response to this challenge. Normally, they would develop a ‘base case’, and then investigate ‘upside’ and ‘downside’ scenarios. This year, companies should instead focus on the key variables around their survival Budget, so that they are prepared for most possible outcomes. Demand. 2009 is likely to see global recession (less than 3% GDP growth). Chemical demand will be badly hit, as it is focused on consumer spending, particularly housing/construction and autos. Hopefully, these areas may begin to bottom during 2009, but any real recovery is unlikely before 2011. Housing is at the heart of the current economic crisis, and it is hard to see demand recovering quickly. Unemployment is likely to rise, and banks will be reluctant to lend when house prices are still falling. Auto sales will also be weak, for similar reasons. Even companies selling into more favoured sectors, such as agrochemicals or pharmaceuticals, will probably see lower demand, and pricing pressure.

Oil prices. The blog has correctly forecast every major movement in oil prices over the past year. This makes it easier to admit that it finds 2009 very difficult to predict. The most likely outcome is that OPEC will cutback production and seek to hold $70/bbl. But there are risks to this outlook. OPEC is bringing on major new production. Cutting production will also unleash a political storm. So OPEC will find it hard to make major cutbacks, and prices could temporarily fall as low as $20/bbl, if the global recession proves deep. Yet supply/demand balances remain very tight. Surplus production is only c6% (5mbd). So a relatively small disruption could easily cause prices to rocket above $100/bbl again.

China and Asia. The blog is most concerned about likely levels of demand in this area. China’s exports were 37% of GDP last year. These volumes will inevitably decline whilst the west is in recession. And although some governments do have the financial reserves to respond by stimulating their domestic economies, many do not. Major over-capacity is also developing in the main ‘building block’ petchem products, which will pressure prices and volumes. Most forecasters suggest that 8% growth could be the low for China’s economy, compared to the 10%+ seen in the past decade. The blog worries that it could fall to 5% at the eventual bottom of the cycle. This would have serious implications for the region.

Credit. Governments have just spent $3.5 trillion to rescue the global banking system. The blog believes they were right to do this, as otherwise the world faced a certain Depression. But governments will have to fund this spending, and so will ‘crowd out’ other borrowers. As a result, credit is likely to remain tight, causing major problems for some companies. In turn, the chemical industry’s well-known inter-dependency means that there is a serious risk of a domino effect, whereby the collapse of one company brings down others in the value chain. We are already seeing this occur amongst suppliers to the US auto industry, with multiple collapses taking place as one company goes under. Those exporting or importing will also have to manage continuing currency volatility. CFOs will need maximum support from their commercial colleagues, in order to correctly identify and manage these risks.

By now, you may be asking whether the blog sees no ‘silver lining’ amidst the storms it is forecasting? Indeed, cash-rich companies will certainly find themselves in a powerful position to negotiate better terms, and to undertake M&A. But the blog would be cautious about M&A opportunities. 2009-10 is not likely to be a repeat of 1997-8, or 2002-3, when there was a strong rebound. Therefore the blog suggests that any opportunity, or ‘rescue’, should be assessed against the possibility that we are now in a multi-year recession which may last to 2011-12.

Last year, the blog challenged the consensus, correctly forecasting the 2008 downturn. Today, it certainly hopes that its 2009 forecast will prove too pessimistic. Its aim is to provide CEOs and business managers with a realistic scenario, so you can ‘test’ your own thinking. It welcomes debate on these key issues, and will be happy to provide further advice on the practical issues raised by its analysis.