2018 will see Winners and Losers appear in plastics markets

Two major challenges face petrochemical and polymer producers and consumers in 2018:

  • The likely disruption created by the arrival of the ethylene/polyethylene expansions in the US
  • The growth of the circular economy and the need to dramatically increase recycling capacity

My new interview with Will Beacham, deputy editor of ICIS Chemical Business, focuses on both these key issues and suggests they will create Winners and Losers.

The new US product will likely change the global market. Its ethane feedstock is essentially a distressed product, which has to be removed to enable the shale gas to be sold.  It is also clear that this 40% expansion of USA polyethylene capacity, around 6 million tonnes, cannot be sold into the US domestic market, which is already very mature:

  • US net exports have actually been in decline in recent years, so it will also be a challenge to export the volumes
  • President Trump’s apparent wish to start a trade war with China will make that market difficult to access
  • It is likely, therefore, that a significant volume will end up arriving in Europe, causing a price war

We have seen price wars before, and the “Winners” are usually the integrated producers, who can roll through margins from the well-head or the refinery into ethylene and polyethylene sales.

The economics of this are relatively simple.  In the US, producers will have to absorb lower margins on the small percentage of shale gas that is used as ethane feed into the cracker.  Similarly in Europe, refinery-integrated producers will have to absorb lower margins on the small percentage of oil that is used as naphtha feed into the cracker.

As the chart shows, this development will be good news for ethylene consumers.  As Huntsman CEO, Peter Huntsman noted a year ago:

“There is a wave of ethylene that is going to be hitting the North American markets quite substantially over the next couple of years. I’d rather be a spot buyer than a contract buyer. I can’t imagine with all of the ethylene that is going to be coming to the market that it’s not going to be a buying opportunity.”

In turn, of course, this will pressure other plastics via inter-polymer competition

Non-integrated producers clearly face more difficult times.  And like the integrated producers, they share the challenge being posed by the rise of sustainability concerns, particularly over the 8 million tonnes of plastic that currently finds its way into the oceans every year.

This issue has been building for years, and clearly consumers are now starting to demand action from brand owners and governments.

In turn, this opens up major new opportunities for companies who are prepared to realign their business models with the New Plastics Economy concepts set out by the Ellen MacArthur Foundation and the World Economic Forum.

The New Plastics Economy is a collaborative initiative involving leading participants from across the global plastic packaging value chain, as the second chart illustrates.  It has already prompted action from the European Union, which has now set out its EU Strategy for Plastics in the Circular Economy.  This aims to:

“Transform the way plastics and plastics products are designed, produced, used and recycled. By 2030, all plastics packaging should be recyclable. The Strategy also highlights the need for specific measures, possibly a legislative instrument, to reduce the impact of single-use plastics, particularly in our seas and oceans.”

Clearly this represents a paradigm shift for the industry, both producers and consumers.

It may seem easier to do nothing, and to hope the whole problem will go ahead.  But the coincidence of the arrival of all the new US shale gas capacity makes this an unlikely outcome.  Companies who do nothing are likely instead to become Losers in this rapidly changing environment.

But as I discuss in the interview, companies who are prepared to rethink their business models, and to adapt to changing consumer needs, have a potentially very bright future ahead of them.  Please click here to view it.

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Goodbye to “business as usual” model for plastics

Polymer markets face two major challenges in coming months. The most immediate is the arrival of the major US shale gas-based ethylene and polyethylene expansions. The longer-term, but equally critical challenge, comes from growing public concern over plastic waste, particularly in the ocean.

The EU has set out its vision for a new plastics economy, where:

“All plastic packaging is reusable or recyclable in a cost-effective manner by 2030”.

Similarly, China has launched a ‘War on Pollution’, which has already led to all imports of plastic waste being banned.

Together, these developments mean there is unlikely to be a “business as usual” option for producers or consumers. A paradigm shift is under way which will change business models.

Some companies will focus on being low-cost suppliers, integrated back to the well-head or refinery. Others will become more service-led, with their revenue and profits based on exploiting the value provided by the polymer (virgin or recycled), rather than just the value of the virgin polymer itself.

The next 18 months are therefore likely to see major change, catalysed by the arrival of the new US production, as I discuss in a new analysis for ICIS Chemical Business.

The second chart indicates the potential impact of these new capacities by comparison with actual production since 2000, with 2019 volume forecast on basis of the planned capacity increases. But can this new PE volume really be sold? It certainly won’t all find a home in the US, as ExxonMobil Chemicals’ then President, Stephen Pryor, told ICIS in January 2014:

The domestic market is what it is and therefore, part of these products, I would argue, most of these products, will have to be exported”.

And unfortunately for producers, President Trump’s new trade policies are unlikely to help them in the main potential growth market, China. As John Richardson and I noted a year ago, China’s $6tn Belt and Road Initiative:

“Creates the potential for China to lead a new free trade area including countries in Asia, Middle East, Africa and potentially Europe – just as the US appears to be withdrawing from its historical role of free trade leadership”.

The task is also made more difficult by the inventory-build that took place from June onwards as Brent oil prices rose 60% to peak at $71/bbl. As usual, buyers responded by building inventory ahead of price increases for their own raw materials. Now they are starting to destock again, slowing absolute levels of demand growth all around the world, just at the moment when the new capacity comes online.

SUSTAINABILITY CONCERNS ARE DRIVING MOVES TOWARDS A CIRCULAR ECONOMY
At the same time, the impact of the sustainability agenda and the drive towards the circular economy is becoming ever-stronger.  The initial catalyst for this demand was the World Economic Forum’s 2016 report on ‘The New Plastics Economy’, which warned that on current trends, the oceans would contain more plastics than fish (by weight) by 2050 – a clearly unacceptable outcome.

Last year’s BBC documentary Blue Planet 2, narrated by the legendary Sir David Attenborough, then catalysed public concern over the impact of single use plastic in packaging and other applications. Even Queen Elizabeth has since announced that she is banning the use of plastic straws and bottles across the royal estates, as part of a move to cut back on the use of plastics “at all levels”.

Single use plastic applications in packaging are likely to be an early target for the move to recycling and the circular economy. This will have a major impact on demand, given that they currently account for more than half of PE demand:

    • Two-thirds of all low density and linear low density PE is used in flexible packaging – a total of 33 million tonnes worldwide
    • Nearly a quarter of high density PE is used in packaging film and sheets, and a fifth is used in injection moulding applications such as cups and crates – a total of 18 million tonnes worldwide

Virtually all of this production is potentially recyclable. Producers and consumers who want to embrace a more service-based business model therefore have a great opportunity to take a lead in creating the necessary infrastructure, in conjunction with regulators and the brand owners who actually sell the product to the end-consumer.

Please click here to read the full analysis in ICIS Chemical Business.

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West’s household spending heads for decline as population ages and trade war looms

As promised last week, today’s post looks at the impact of the ageing of the BabyBoomers on the prospects for economic growth.

The fact that people are living up to a third longer than in 1950 should be something to celebrate.  But as I noted in my Financial Times letter, policymakers are in denial about the importance of demographic changes for the economy.

Instead, their thinking remains stuck in the past, with the focus on economists such as Franco Modigliani, who won a Nobel Prize for “The Life Cycle Hypothesis of Savings”, published in 1966.  This argued there was no real difference in spending patterns at different age groups.

Today, it is clear that his Hypothesis was wrong.  He can’t be blamed for this, as he could only work with the data that was available in the post-War period.  But policymakers should certainly have released his theories were out of date.

The chart highlights the key issue, by comparing average US and UK household spending in 2000 v 2017:

  • In 2000, there were 65m US households headed by someone in the Wealth Creator 25-54 cohort, and 12.5m in the UK.  They spent an average of $62k and £33.5k each ($2017/£2017)
  • There were 36m US households headed by someone in the 55-plus New Older cohort, and 12.4m in the UK, who spent an average of $45k and £22.8k each
  • In 2017, the number of Wealth Creator households was almost unchanged at 66m in the US and 11.9m in the UK.  Their average spend was also very similar at $64k and £31.9k each
  • But the number of New Older householders had risen by 55% in the US, and by 24% in the UK, and their average spend was still well below that of the Wealth Creators at $51k and £26.4k respectively

Amazingly, despite this data, many policymakers still only see the impact of today’s ageing Western populations in terms of  likely increases in pension and health spending.  They appear unaware of the fact that ageing populations also impact economic growth, and that they need to abandon Modigliani’s Hypothesis.

As a result, they have spent trillions of dollars on stimulus policies in the belief that Modigliani was right.  Effectively, of course, this means they have been trying to “print babies” to return to SuperCycle levels of growth.  The policy could never work, and did not work.  Sadly, therefore, for all of us, the debt they have created can never be repaid.

This will likely have major consequences for financial markets.

As the chart from Ed Yardeni shows, company earnings estimates by financial analysts have become absurdly optimistic since the US tax cut was passed.

The analysts have also completely ignored the likely impact of China’s deleveraging, discussed last month. 

And they have been blind to potential for a global trade war, once President Trump began to introduce the populist trade policies he had promised in the election.  Last week’s moves on steel and aluminium are likely only the start.

Policymakers’ misguided faith in Modigliani’s Hypothesis and stimulus has instead fed the growth of populism, as the middle classes worry their interests are being ignored. This is why the return of volatility is the key market risk for 2018.

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Global smartphone sales slide 9% in Q4, as China tumbles 16%

Global smartphone sales have seen major growth until recently as consumers fell in love with going mobile, as the chart shows:

  • In the critical Q4 period they jumped from 290m in 2013 to 380m in 2014, 405m in 2015 and 439m in 2016
  • But they then fell 9% in Q4 last year, according to Strategy Analytics data.  They note that:

“It was the biggest annual fall in smartphone history (and) …. was caused by a collapse in the huge China market, where demand fell 16% annually due to longer replacement rates, fewer operator subsidies and a general lack of wow models.”

Even more revealing was that only Xiaomi of the Top 5 vendors increased their volume. Apple lost 1m sales, Samsung lost 3m, Huawei lost 4m, whilst even OPPO only managed to maintain its volume.  And Xiaomi only did well because they were recovering from their 2016 collapse, when their share crashed to just 3.35% from 5% in Q4 2015.

Chinese companies were, however, the real winners during 2017 as the price war intensified, as the second chart confirms:

  • China’s top 3 vendors now supply a quarter of the global market – compared to less than a tenth in 2013
  • Samsung have been the main loser, with their share falling from over a third of the market to less than a fifth
  • They did well to recover from the Galaxy Note 7 problems, but seem unlikely ever to reclaim their dominance

The rise of the Chinese vendors is great news for consumers, but very bad news for their competitors, as the third chart confirms.  It highlights how revenues are now being squeezed for most vendors as the Chinese ramp up their volume.  Only Apple has avoided the carnage by heading defiantly up-market, with its average handset price now close to $800.

The issue is the very different nature of the smartphone market in the major emerging economies, where incomes are much lower than in the West and it is very rare for carriers to subsidise handset sales over the life of the contract.  In India, for example, the typical smartphone sells for less than $200, whilst Apple has less than 2% of the market.

2017 therefore marked a crucial turning point in the market, as I forecasted when reviewing 2016 data a year ago:

“The issue is that 3.1bn people now own smartphones, and the other 4.2bn can’t afford them. So inevitably, the market is going to focus more and more on price. Of course, millions of people will still want to own an iPhone or Galaxy. But price will become the deciding feature for many people.”

2018 seems likely to see pricing pressure intensify, now that the Chinese market has gone ex-growth.  India is likely to be a critical battleground after Xiaomi’s success there in 2017, which was key to its nearly doubling global sales.  As analysts IDC noted:

“Brands outside the Top 5 struggled to maintain momentum as value brands such as Honor, Vivo, Xiaomi, and OPPO offered incredible competition at the low end.”

OPPO is likely to be particularly aggressive as it saw no growth in 2017 after doubling its sales in 2016, whilst Xiaomi is unlikely to risk a second slip-up on volume.  In turn, this makes it likely that Samsung’s mid-market positioning will come under major pressure from Chinese competition in key markets such as China and India.

Apple must now intensify its efforts to move into application-based markets such as healthcare and other services.  It has been building its position over the past 3 years, and has a vast cash-pile from its smartphone profits to fund the necessary shift away from hardware sales.  Samsung’s future looks less rosy, however, given that Chinese vendors have been able to produce smartphones for as little as $20 for the past 2 years.

And as I noted back in May 2015:

“The smartphone market is not alone is facing these New Normal challenges. They are coming to the online and High Street stores near all of us, if they haven’t already arrived.

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Older workers are looking for something more

The Financial Times has kindly printed my letter arguing that we need new policies to help people adapt to their extra decade or more life expectancy.

Sir, There is another angle to Janan Ganesh’s interesting exploration of whether “Liberals risk the charge of complacency” (February 20). This is the question of why the policy elite has failed to go beyond congratulating itself for the successes cited by Professor Steven Pinker in his new book, Enlightenment Now.

Increasing life expectancy is just one example of the policy vacuum that has developed following the vast improvements seen since the second world war. Globally, longevity has increased by 50% since 1950, giving the average person an extra 24 years of life, according to UN Population Division data. In the developed world, life expectancy no longer coincides with retirement age, but instead offers the potential for a decade or more of extra life.

Yet where are the policy changes that would help people to adapt to this unprecedented shift in expectations? Where are the retraining options for people in their fifties and sixties that would help employees take up new careers when they become bored with their existing roles, or physically unable to continue with them? Where are the social policies that would enable them to continue contributing to society? Where are the financial policies to incentivise them to pass on the skills and expertise they have developed to younger generations?

The issue is most acute in the developed world, where the proportion of older people in the 55-plus age range has doubled to 32% compared with 1950. As Mr Ganesh rightly points out, they are looking for something beyond simple economic comfort and the arrival of bus passes and fuel allowances. Liberals should perhaps not be so surprised that their failure to address this critical issue has left the door open for populists to fill the policy vacuum.

Paul Hodges

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London house prices risk perfect storm as interest rates rise


2000 should have been the natural end of the BabyBoomer-led economic SuperCycle. The oldest Boomer (born in 1946) was about to leave the Wealth Creator 25 – 54 age group that drives consumer spending and hence economic growth.  And since 1970, Boomer women’s fertility rates had been below replacement level (2.1 babies/woman).  So relatively fewer young people were joining the Wealth Creator generation to replace the Boomers who were leaving.

But instead, central banks decided that demographics didn’t matter.  They believed instead that monetary policy could effectively “print babies” and create sustainable demand.  So instead of worrying about financial stability – their real role – they aimed to stimulate the economy by boosting financial asset prices – primarily shares and housing markets.

London’s housing market was a key target as the Bank of England’s Governor told Parliament in March 2007:

“When we were in an environment of global economic weakness at the beginning of the decade, it meant that external demand was declining… We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession… That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”

But instead, when the Subprime Bubble burst, policymakers did even more stimulus via Quantitative Easing (QE).

The chart of London house prices since 1971 (in £2017) therefore shows 3 distinct phases:

  • 1971-1999.  Prices were typically Cyclical – (1) up 51%, down 31%; (2) up 37%, down 15%; (3) up 109%, down 43%.  But they averaged around 4.8x average London earnings
  • 2000-2007.  Central banks panicked after the dotcom crash and kept interest rates artificially low – creating the Subprime Bubble as prices rose in more or less a straight line, till they were up 196% from the previous trough
  • 2008-2017.  The market tried initially to return prices to reality, and they slipped 10%.  But then central banks rushed to flood it with liquidity and created the QE Bubble, causing prices to soar 46%

Now, however, the Stimulus Bubble is ending and a “perfect storm” is developing as 3 key myths are exposed:

The end of the ‘London is a global city’ myth.  The house price/earnings ratio averaged 4.8x between 1971-1999.  But it then took off into the stratosphere to reach 11x today, as the myth grew that Londoners weren’t relevant to the housing market.  Instead, it was said that London had become a “global city” where foreigners would set the price.

Chinese and Asian buyers boosted this myth as vast new apartment blocks were sold off-plan in the main Asian cities – often to buyers who never even visited their new “home”.  But the myth ended last year when China introduced severe capital controls – capital outflows collapsed from $640bn in 2016 to just $60bn in 2017.

The scale of the this retreat is overwhelming as The Guardian reported recently:

“The total number of unsold luxury new-build homes, which are rarely advertised at less than £1m, has now hit a record high of 3,000 units, as the rich overseas investors they were built for turn their backs on the UK due to Brexit uncertainty and the hike in stamp duty on second homes….

“Henry Pryor, a property buying agent, says the London luxury new-build market is “already overstuffed but we’re just building more of them.  We’re going to have loads of empty and part-built posh ghost towers. They were built as gambling chips for rich overseas investors, but they are no longer interested in the London casino and have moved on.””

The end of the buy-to-let mania.   Parents of students going away to college began this trend in the mid-1990s, as they bought properties for their children to use, rather than rent from poor quality landlords.  After the dotcom crash, many decided that “bricks and mortar” were a safer bet than shares, especially with the major tax breaks available.

Banks were delighted to lend against an asset that was supported by the Bank of England, finding it far more attractive than lending to a business that might go bust.  And so parents held on to their investments after their children left college – further reducing the amount of housing available for young people to buy.  But as The Telegraph reports:

“Buy-to-let investors now face tougher conditions. A weakening housing market, tough new legislation and the tightening of affordability checks by lenders are but a few problems causing landlords to run for the hills.  According to the National Landlords Association, 20% of landlords plan to sell one or more of their properties in the next 12 months.”

Interest rates will never rise.  Of course, the key to the Subprime and QE Bubbles was the Bank’s decision to collapse interest rates to stimulate the economy.  Monthly payments became much more affordable – and ever-rising prices meant there was no longer any need to worry about repaying the capital.

But some people still couldn’t afford to buy even on this basis, and by 2007 around 30% of mortgages were “interest-only” with no capital repayment at all.  These buyers should have been forced sellers when the Subprime Bubble burst; prices would then have returned to more normal levels.  But instead, the Bank of England stepped in again, as the Financial Times has reported:

“During and after the 2008 financial crisis Britain’s mortgage lenders took a more tolerant approach to non-payers through the use of forbearance ….at the height of the housing market troubles in 2011 Bank of England research suggested that as many as 12% of all UK residential mortgages were in some form of forbearance.  This helped prevent the downturn from developing into a 1990s-style crash, the Bank suggested.”

PRICES WOULD FALL 60% IF THE HOUSE PRICE/EARNINGS RATIO “REVERTS TO MEAN”
All “good things” come to an end, of course. And the London property bubble is probably no exception. Its 3 key drivers are now all reversing, and there seems little sign of any new factors that might help to keep the bubble inflating.

The risk is that interest rates continue to rise, forcing many owners to sell and bursting the Stimulus Bubble.  UK 10-year rates have already trebled from their 0.5% low in Q3 2016.  Most rates seem likely to go much higher now the 30-year downtrend has been broken, as I discussed last week.

Today’s high prices will also make it difficult for sellers to find local buyers, as the number of homes being bought/ sold each year has fallen 25% since the 2007 peak.  Most young people cannot afford to buy.  And if many people do decide to sell, potential buyers might panic, causing the slump to continue for many years – as happened before 2000.

Nobody knows how low prices might go, if they start to fall.  But ‘reversion to mean’ is usually the best measure.  If this happened, today’s average London home, selling at 4.8x earnings, would cost £193k – a 60% fall from 2017’s average price of £475k.  This figure also highlights the risk that policymakers’ denial of demographic realities has created.

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