Western central bankers are convinced reflation and economic growth are finally underway as a result of their $14tn stimulus programmes. But the best leading indicator for the global economy – capacity utilisation (CU%) in the global chemical industry – is saying they are wrong. The CU% has an 88% correlation with actual GDP growth, far better than any IMF or central bank forecast.
The chart shows June data from the American Chemistry Council, and confirms the CU% remains stuck at the 80% level, well below the 91% average between 1987 – 2008, and below the 82% average since then. This is particularly concerning as H1 is seasonally the strongest part of the year – July/August are typically weak due to the holiday season, and then December is slow as firms de-stock before Christmas.
The interesting issue is why these historically low CU% have effectively been ignored by companies and investors. They are still pouring money into new capacity for which there is effectively no market – one example being the 4.5 million tonnes of new N American polyethylene capacity due online this year, as I discussed in March.
The reason is likely shown in the above chart of force majeures (FMs) – incidents when plants go suddenly offline, creating temporary shortages. These are at record levels, with H1 2017 seeing 4x the number of FMs in H1 2009.
In the past, most companies prided themselves on their operating record, having absorbed the message of the Quality movement that “there is no such thing as an accident”. Companies such as DuPont and ICI led the way in the 1980s with the introduction of Total Quality Management. They consciously put safety ahead of short-term profit and at the top of management agendas. As the Chartered Quality Institute notes:
“Total quality management is a management approach centred on quality, based on the participation of an organisation’s people and aiming at long-term success.”
Today, however, the pressure for short-term financial success has become intense
The average “investor” now only holds their shares for 8 months, according to World Bank data
This time horizon is very different from that of the 1980s, when the average NYSE holding period was 33 months
And it is a very long way from the 1960s average of 100 months
As a result, even some major companies appear to have changed their policy in this critical area, prioritising concepts such as “smart maintenance”. Such cutbacks in maintenance spend mean plants are more likely to break down, as managers take the risk of using equipment beyond its scheduled working life. Similarly, essential training is delayed, or reduced in length, to keep within a budget.
ICIS Insight editor Nigel Davies highlighted the key issue 2 years ago as the problems began to become more widespread around the world:
“The situation in Europe has exposed underlying trends and issues that will need to be addressed. Companies appear not to have sustained an adequate pace of maintenance capital expenditure. That has been for economic as well as structural (cost) reasons. Spending in high feedstock and energy cost Europe has certainly not been considered de rigeur….Having maintained plants to run at between 80% and 85% of capacity, suddenly pushing them hard does little good. Sometimes, they fail.”
The end-result has been to mask the growing problem of over-capacity, as plants fail to operate at their normal rates. This has supported profits in the short-term by making actual supply/demand balances far tighter than the nominal figures would suggest. But this trend cannot continue forever.
THE END OF CHINA’S STIMULUS WILL HIGHLIGHT TODAY’S EXCESS CAPACITY
The 3rd chart suggests its end is now fast approaching. It shows developments in China’s shadow banking sector, which has been the real cause of the apparent “recovery” and reflation seen in recent months:
Premier Li began a major stimulus programme a year ago, hoping to boost his Populist faction ahead of October’s 5-yearly National People’s Congress, which decides the new Politburo and Politburo Standing Committee (PSC)
Populist Premier Wen did the same in 2011-2 – shadow lending rose six-fold to average $174bn/month
But Wen’s tactic backfired and President Xi’s Princeling faction won a majority in the 7-man PSC, although the Populist Li still had responsibility for the economy as Premier
Li’s efforts have similarly run into the sand
As the 3-month average confirms (red line), Li’s stimulus programme saw shadow lending leap to $150bn/month. Unsurprisingly, as in 2011-2, commodity and asset prices rocketed around the world,funding ever-more speculative investments. But in February, Xi effectively took control of the economy from Li and put his foot on the brakes. Lending is already down to $25bn/month and may well go negative in H2, with Xi highlighting last week that:
“China’s development is standing at a new historical starting point, and … entered a new development stage”.
“Follow the money” is always a good option if one wants to survive the business cycle. We can all hope that the IMF and other cheerleaders for the economy are finally about to be proved right. But the CU% data suggests there is no hard evidence for their optimism.
There is also little reason to doubt Xi’s determination to finally start getting China’s vast debts under control, by cutting back on the wasteful stimulus policies of the Populists. With China’s debt/GDP now over 300%, and the prospect of a US trade war looming, Xi simply has to act now – or risk financial meltdown during his second term of office.
Prudent investors are already planning for a difficult H2 and 2018. Companies who have cut back on maintenance now need to quickly reverse course, before the potential collapse in profits makes this difficult to afford.
The unseen costs of the proposed Dow-DuPont merger are certain to be much larger than those we can currently describe. Both companies will effectively be more reactive to external developments, rather than pro-active, due to the internal focus that will be required to develop and implement the merger and divestment processes. This cost could well be large, given today’s chaotic world of feedstocks and product demand.
Just think for a moment about what is going to happen. These 2 great businesses will require many of their best and brightest people to ignore what is happening in the outside world – the collapse in the oil price, China’s New Normal direction, major fluctuations in currencies and interest rates, climate change developments after COP 21 – and instead divert their focus internally onto an endless stream of “Who does What” type questions. The chart above, from the Wall Street Journal, gives a taste of the complexity involved.
How many opportunities will be missed as a result? How many problems will be ignored? There must be a major cost from having so many key people being distracted from their real purpose over such an extended timeframe. These are the costs that are always conveniently ignored when plans of this kind are proposed. Even supposing the promised $3bn/year of savings will be achieved – how much more value could have been created by simply allowing people to run the existing businesses without such major distractions taking place all around them?
And, of course, deliberately, I have left the really critical issues till last. Most so-called “activists” believe that businesses can effectively be run by spreadsheet – one even said to me once, that he didn’t see the point of having a CEO. Instead, they focus on refining the algebraic formulas that will supposedly drive delivery of the numbers. But life is rarely that simple, particularly when the outside world is as uncertain as today:
- Farmers are already complaining about a potential loss of competition amongst their suppliers – and their worries are understandable, given that their incomes are already in decline as commodity markets collapse.
- Suppliers will also be more reluctant to invest in joint development of new products, once cost-cutting emails demanding price reductions start arriving in their InBoxes
- Employees know that the word “synergy” is code for job losses, and are well aware that these will likely increase quite quickly to demonstrate early success to Wall Street
Competitors, of course, will be laughing all the way to the bank. Christmas has come early for them, and will keep coming for the next few years. They will know they now have an inbuilt advantage, no matter how difficult things might become as the Great Unwinding continues, as Dow and DuPont move into semi-reactive mode for the duration.
Back in July 2008, I expressed major concern over the proposed merger of Lyondell and Basell – and within 6 months, my fears were confirmed by their $22bn bankruptcy. Dow and DuPont will not go bankrupt in this way. But my experience at ICI, and since then, leads me to worry that both companies will be weakened by the 3 years of internal upheavals that now appear to be inevitable.
And I am not alone in my concerns. One senior chemical company executive contacted me this week, after reading Monday’s post, to give his experience of a similar large-scale merger:
“Our CEO did a very good job on the integration front and delivered the synergy savings promised to the investors. But the cost and distraction of the “armies of consultants” was huge. The entire management became introverted, with the result that our momentum of growth more or less evaporated and we cane to rely on the savings to keep our profitability even flat.“
All the evidence suggests that most mergers fail to deliver the promised value. So those who propose them, especially when they involve such critical companies for the US and global economy as Dow Chemical and DuPont, must expect some hard questions to be asked.
Here are my 5 top questions in logical order – Why?, What? How? When? and Will it be worth it?:
Why is the deal being suggested? A close reading of the merger proposal, as described in the press release, provides no grand vision for the deal. Instead, the driver seems to have been pressure from two recent shareholders – Daniel Loeb’s Third Point at Dow, and Nelson Peltz’s Trian at DuPont. Each currently own around 3% of their target company’s shares. 2 headlines in the Wall Street Journal, no soft touch in financial matters, tell the story:
What type of merger is this? Successful mergers, the minority, create value by creating critical mass in specific market sectors. The others, which normally fail, simply add scale for scale’s sake. This merger mixes the 2 outcomes: its first stage is simply to add scale by creating the largest chemical company in the world. Then Stage 2 aims to align with the first outcome by creating 3 new world-scale businesses – in agriculture, specialty chemicals and commodities/materials. So it is hard to judge the likelihood of success, given the lack of detail on the new businesses’ portfolios and their market positioning.
How difficult will it prove to achieve the promised results? High-powered integration teams have already been assembled to start mapping out the process to be followed, and to identify which bits of the businesses will go where. Other teams will focus on the mechanics – the tax and organisational issues, regulatory and political risk, and confirm the timescale for Stages 1 and 2. Armies of consultants will be drafted in to help – although most will have no real understanding of either business or its component parts. So we can only guess at the results that will be achieved.
When will all this take place? Dow’s less complex acquisition of Union Carbide took 18 months from August 1999 – February 2001 to complete, and its initial failure to produce the expected results led to the firing of CEO Mike Parker in 2002. The current plan envisages the more complex Dow-DuPont merger could take up to 3 years:
- 2016 will be occupied in working out what to do, and identifying the barriers that need to be overcome
- 2017 will be focused on implementing the merger of the 2 companies, and finalising plans for Stage 2
- 2018 will see the separation of the 3 businesses, who will then need to do more M&A to tidy up their portfolios
Even this timetable could prove over-optimistic if unexpected challenges emerge as details of the deal are finalised.
Will it be worth it? Given the above, it is hard to see why anyone would want to spend the next 3 years engaged in this exercise. The $3bn/year of claimed synergies sounds a lot at first glance – but then there is the cost of achieving those synergies. The army of lawyers, tax experts, investment bankers, other advisers and consultants won’t come cheap – total costs could easily reach several $bns over the 3 years- and then there are all the costs of integration such as the IT systems, without which the new companies will be unable to properly function. Plus the whole issue of integration risk, which cannot be ignored in a deal of this size and complexity – Dow and DuPont have radically different cultures, and there will also be a lot of different regulators to keep happy.
On Wednesday, I will look at the hidden costs of this proposed merger – those that never figure in the analyst reports. The most critical is that both managements will inevitably become internally focused for the next 2 – 3 years, due to the need to develop and implement the Stage 1 and Stage 2 processes. They have already spent 4000 hours putting together just the 7-page outline document. This means both companies will risk becoming reactive to external developments, rather than pro-active, at a time when chaos is beginning to reign in feedstock and product markets.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 62%
Naphtha Europe, down 56%. “Naphtha remains well supported by exports to Asia, although long-range vessels are in short supply because of slow discharge of distillates imports.”
Benzene Europe, down 57%. “The usual upturn in consumption expected in January could be dampened by the wider economic unease”
PTA China, down 43%. “Downstream polyester market had started reducing operating rates beginning from the second week of December.”
HDPE US export, down 37%. “Ample supplies with little trading activity”
¥:$, down 18%
S&P 500 stock market index, up 3%
By now, companies should be reordering for the New Year. CFOs have achieved their working capital targets for year-end. And the commercial people should be planning Q1 sales.
So far, however, it seems that this restocking has proved rather weak. This parallels September’s disappointment, when the return from the summer holidays also failed to produce a major recovery in order flow.
Business managers have indeed been increasing their list prices, in preparation for a wave of orders. And China’s PTA producers have postponed planned commercial shutdowns. But DuPont, often a bellwether company for the global industry, summed up the general nervousness in their profit warning on Friday, when CEO Ellen Kullman noted:
“We are seeing slower growth in certain segments during Q4, driven by global economic uncertainty. This uncertainty is contributing to ongoing conservative cash management in some supply chains. The earnings revision reflects destocking across polymers and certain industrial supply chains that has accelerated during the fourth quarter. Consumer electronics demand has further softened, and housing and construction markets remain weak. Other markets remain as expected.”
Kuhlman went on to add that “with customer inventories at very low levels, we are staying close to our customers to assure that we are ready to respond when demand returns”. But she prefaced this with a reference to DuPont’s “aggressive productivity initiatives“. Companies expecting a quick recovery are not usually focussing their efforts on cost reduction.
ICIS pricing comments this week, and price movements for the benchmark products since the launch of the IeC Downturn Monitor on 29 April are below:
Benzene NWE (green), down 23%. “Market firmed though fundamentals still weak”.
HDPE USA export (purple), down 22%. “Producers began to implement price increases but with falling Asian and Middle Eastern prices, trade to Asia was all but impossible.”
Naphtha Europe (brown dash), down 21%. “Oversupply eases slightly on demand from Asia.”
PTA China (red), down 18%. “PTA producers had initially planned a large-scale production cutback because of negative margins, but have not done so yet as they expect margins to improve in December”
Brent crude oil (blue dash), down 12%
S&P 500 Index (pink dot), down 8%