Your ‘A-Z Guide’ to the Brexit Negotiations

The UK is now facing a national crisis”, according to Margaret Thatcher’s former Defence Secretary, Michael Portillo, speaking to a dinner in London on Thursday night.  Brexit continues to tear the UK apart, and places the economy at greater and greater risk.

On Thursday, premier Theresa May had unveiled her draft Withdrawal Agreement with the EU27.  Within a few hours, another 5 Ministers had resigned including her Brexit Secretary.  Over the summer, she had already lost her previous Brexit Secretary and her Foreign Secretary, plus other Ministers.  And 5 Ministers – including Michael Gove and Trade Secretary Liam Fox – are now planning to produce their own revised deal on the Irish question, in opposition to the draft agreement

Businesses are far too complacent about the risks of a No Deal Brexit, as I told BBC News on Thursday:

“If the deal went through Parliament, then we could be reassured that we had until the end of 2020 before anything happened. But looking at what’s happened this morning, it seems less likely that’s going to happen, and therefore the default position is that we leave without a deal on 29 March.  And that, I think, panics SMEs, small businesses, because if you don’t know what’s happening that’s worse than almost anything else. “

If you, or a colleague, now need to get up to speed with Brexit developments – and what they may mean for your business and your investments, here is my ‘A – Z Guide to the Brexit Negotiations’:

Article 50 of the Lisbon Treaty sets out the rules for leaving the European Union.  As with most negotiations, it assumed the leaving country would present its proposals for the post-withdrawal period – which would then be finalised with the other members.  But the UK Cabinet was split on the key issues, and so the 2 year’s notice was given on 29 March 2017 without any firm proposals being made for the future UK-EU27 relationship beyond 7 “negotiating principles and “the desire for a “close partnership”.

Brexit means Brexit“, has been the UK’s core statement since Article 50 was tabled.  But as I noted back in September 2016, Brexit can actually mean a variety of different outcomes – and they have very different implications as the chart shows.  At one extreme, the ‘Norway model’ is very similar to full EU membership, but with no say on EU decisions.  Whereas the ‘Canada model’ is simply a free trade agreement offering some access to the Single Market (qv) for goods, but less access for services (which are 80% of the UK economy).  A ‘No Deal Brexit’ (qv) means working under WTO rules with arbitrary tariffs and regulations.

The European Commission manages the day-to-day business of the European Union (qv) on behalf of the European Council, and is effectively its civil service.  Its president is Jean-Claude Juncker and he appointed Michel Barnier to lead the Brexit negotiations.   Barnier’s first step, as mandated by the Council, was to agree within the EU 27 “the overall positions and principles that the EU will pursue“.  He understood that in any negotiation, the team that writes the drafts and controls the timescale usually has the upper hand. The UK’s failure to finalise its own detailed objectives before tabling Article 50 meant it gave up this critical advantage.

The Default date for Brexit is 29 March 2019.  It has also been agreed that if a Withdrawal Agreement (qv) is finalised, then a Transition Agreement (qv) could operate until 31 December 2020.  Unfortunately, many people have therefore assumed they can wait until 2020 before starting to plan for Brexit.  But as the Commission warned in its ‘Guidelines for Brexit Negotiations on 29 April 2017, “nothing is agreed until everything is agreed“. So No Deal also means no Transition Agreement.

The European Union is a treaty-based organisation of 28 countries.  As its website notes, it was “set up with the aim of ending the frequent and bloody wars between neighbours, which culminated in the Second World War“.  The UK joined the original 6 members (Belgium, France, Germany, Italy, Luxembourg and the Netherlands) in 1973, along with Ireland (qv) and Denmark. Further expansions took place, especially after the end of the Cold War between the West and Russia.  At the suggestion of then UK premier Margaret Thatcher, it was agreed to establish a Single Market (qv) and Customs Union based on 4 key freedoms – free movement of goods, services, people and money – and this transformed trading relationships across the continent.

The Financial Settlement or ‘divorce bill’ covers the costs of the programmes that the UK agreed to support during the period of its EU membership.  Like most organisations, the EU operates on a pay-as-you-go basis and only charges member countries as and when bills actually come due.  The UK calculates this to be between £36bn – £39bn (€40bn – €44bn), depending on the assumptions used.

The Labour Party want a General Election if the government fails to get Parliament’s approval for its proposed Withdrawal Agreement.  But there is considerable uncertainty about what might happen next, if Labour won the election.  Some suggest Labour could renegotiate the deal, others that there could be a second referendum. Either option would mean a new government asking the EU to ‘stop the clock’ on Article 50. As a result, support is rising for the idea of a ‘People’s Vote’, or second referendum, as this might be more able to achieve all-party support. The European Parliament elections in May also complicate the picture as a referendum would apparently take 22 weeks to organise.

A Hostile No-Deal would be the worst of all possible outcomes. But Theresa May has warned Parliament that “without a deal the position changes” on the £39bn Financial Settlement, contradicting her Chancellor, Philip Hammond.  We do not know what would happen if the UK refused to pay, but one fears it could lead to a Hostile No-Deal if the EU then reacted very negatively in terms of future co-operation.

Ireland has proved to be a key sticking-point in the negotiations, as nobody wants to disturb the peace created by the Good Friday Agreement in 1998.  The issue is the potential need to reintroduce a border between Ireland and the North to secure the Single Market.  The draft Withdrawal Agreement devotes a full section to this issue, which remains a potential deal-breaker due to Brexiter concerns about N Ireland remaining in the Single Market and the UK remaining in the Customs Union. This expert Explainer from the impartial Institute for Government highlights the key issues.

June 2016 was the date of the referendum that voted to take the UK out of the EU.

Keeping the UK in “a single customs territory” with the EU after Brexit is a key feature of the so-called “temporary backstop arrangement” designed to avoid a hard border with Ireland.  It is intended to operate until a full free trade agreement is finalised between the UK and EU.  It was the most difficult part of the negotiations, and has provoked the most resistance from Brexiters.

Legal issues are, of course, a critical area in the negotiations as the UK currently operates under the jurisdiction of the European Court of Justice  (ECJ), and the UK wants to “take back control” to its own courts.  However, the Withdrawal Agreement confirms that the ECJ will have a continuing role under the Transition Agreement and potentially afterwards if the “backstop” is activated.

Tariffs on Materials and goods would be introduced between the UK and EU27 if there is a No-Deal Brexit.  Less well understood is that the UK’s trading terms would also change with countries outside the EU27, as the UK currently operates under more than 750 free trade and trade-related agreements negotiated by the EU – and it is unlikely that the UK could continue to benefit from them.

No Deal means that the UK would have to operate under WTO rules after 29 March.  This short Ready for Brexit video explains the complications this would create.  The WTO has also warned that the number of Technical Barriers to Trade “has grown significantly” in recent years, and these can often severely restrict trading opportunities. And EU laws would still have a role under WTO rules for all UK products sold into the EU27 under No Deal.  The EU Preparedness Notices, for example, also suggest there could be a ban on UK banks providing financial services as well as a whole host of other restrictions including on travel.

Preparing for Brexit.  My colleagues and I have set up Ready for Brexit. This is a subscription-based ‘one-stop shop’ and provides a curated Directory to the key areas associated with Brexit – Customs & Tariffs, Finance, Legal, Services & Employment, Supply Chain.  It includes Brexit Checklists; a BrexSure self-audit tool to highlight key risks; a Brexit Negotiation Update section linking to all the key official UK and EU websites; Brexplainer video on WTO Rules; plus news & interviews with companies about their preparations for Brexit.

Regulations can often be a much greater barrier to trade than tariffs, as they set out the rules that apply when products and services are sold in an individual country.  The EU never aimed to harmonise regulations across its member countries, as that would be an impossible task.  Instead it has focused on creating a Single Market via mutual recognition of each other’s standards, along with harmonised rules on cross-border areas such as safety, health and the environment.  Regulations are particularly important in the financial services industry, and many businesses are now relocating relevant parts of their operations into the EU27 so they can remain authorised to trade.

The Single Market seeks to guarantee the free movement of goods, services, people and money across the EU without any internal borders or other regulatory obstacles.  It includes a Customs Union, as this short BBC video explains, which seeks to ensure that there are no Customs checks or charges when goods move across individual country borders.  With a No-Deal Brexit, however, the UK will become a Third Country and no longer benefit from these arrangements.

The Transition Agreement covers the period after 29 March, and would allow the UK to operate as if it were still in the EU until 31 December 2020.  The aim is to give negotiators more time to agree how future EU-UK trade in goods and services will operate, and provide guidance for businesses on how the new deal(s) will operate.  But 21 months isn’t very long, as trade deals are very hard to do and generally take 5 – 7 years. The problem is that they create Winners and Losers whenever a market (large or small) is opened up to new foreign competition – and the incumbents usually complain.  The Transition Agreement will only operate if there is a Withdrawal Agreement and so would not happen with a No-Deal Brexit.

Unblocked, or frictionless trade, is a key aim of the negotiators.  Nobody really wants to go back to the pre-1993 world, before the Single Market arrived, when vast numbers of forms had to be filled in and lorries/ships sometimes stopped for hours for border checks.  As Honda explained in the summer (see chart) it could easily take between 2 – 9 days to move goods between the EU27 and UK without a Customs Union, compared to between 5 – 24 hours today.  The cost in terms of time and money would be enormous given that, as Eurotunnel told the Commons Treasury Committee in June, “Over the past 20 years, warehouses have become trucks rolling on the road“.

The draft 585-page Withdrawal Agreement was published on Thursday and sets out the basis for the future UK – EU relationship after Brexit.  The impartial Institute for Government has produced a expert summary of its key points.  But as the resignations have shown, the deal is contentious, with observers suggesting that MPs may vote it down in Parliament next month.

Zig-zag perhaps best describes the process that has led us to this point.  It began long ago when Margaret Thatcher resigned in 1990, as the catalyst was her position over European monetary union.  Her supporters ignored the key fact that the party needed a new leader if it was to have a chance of winning the next election,  and instead blamed Europe for their loss – soon styling themselves as Eurosceptics in her honour.  Fast forward through many zigs and zags  and as I warned in March 2016, – “Slowly and surely, a Brexit win is becoming more likely“.  We can doubtless expect many more in coming months and years.

“Business as usual” the least likely outcome for Europe

EU Feb17

Europe is heading in to the Great Unknown, as Monday’s post highlighted.  The UK, The Netherlands and France are not the only political uncertainties that we face.  Elections are also due in Italy and in Germany.

   Italian elections. After premier Renzi’s referendum defeat last year, it seems like that Italy will hold elections this year, probably in the next few months. A the moment, the most likely winner is former comedian Beppe Grillo.  As I have discussed before, his main policy is for a referendum to exit the euro, but stay in the EU.  But, of course, it is also possible that the current Gentiloni government might survive until the scheduled election date in 2018.

If Grillo wins, the entire European banking system is likely to go bankrupt, as well as the European Central Bank (ECB).  The reason is that leaving the euro, and returning to the lira, would inevitably lead to a major devaluation of at least 20%.  As the ECB is the main owner of  Italian government debt, thanks to its Quantitative Easing programme, it also would go bankrupt.  As Astellon Capital note, the critical legal issue is that the Bank of Italy is privately owned by the Italian banks – not state owned.  The ECB claims the government would still be responsible for the debt, but investors and other governments are unlikely to wait around for Italy’s slow-moving courts to reach a decision.

   German elections. In October we then have the German elections, where Angela Merkel is seeking a fourth term.  Her credibility has been badly damaged by her handling of the refugee crisis, although most polls suggest she is still the favourite.  Germany also has a growing challenge from an anti-EU party, the Alternative für Deutschland (AfD).  But her main opponent is the new pro-EU leader of the Social Democratic Party (SDP), Martin Schulz.

A win for Merkel would obviously be “business as usual”.  But if Schulz wins, he would bring a new dimension to the political debates over the future of the EU, as he was the President of the European Parliament until he resigned to seek the leadership of the SDP. Whereas Merkel saw herself as a “safe pair of hands”, Schulz is likely to be a more activist Chancellor, if elected. His reputation at the Parliament was of “someone who got things done”.  But his actual policy objectives are unclear at the moment.

COMPANIES AND INVESTORS NEED TO PREPARE FOR VERY DIFFERENT OUTCOMES
Voters have got tired of waiting for change to take place.  As I noted in November, 69% of Germans, 82% of Italians and 89% of French feel their country is going in the wrong direction.  So they are prepared to try different options, just to see what might happen.  In turn, this means that Europe, and the world, is entering a Great Unknown.  At least 4 quite different alternatives could therefore result from this year’s elections:

  Business as Usual.  Perhaps Rutte, Fillon and Merkel will win their elections, Gentiloni survive into 2018, and May get her Brexit deal.  But this seems just a 10% probability today
  A triumph for the Populists. Populist success could continue, with Wilders winning in The Netherlands, Le Pen in France and Grillo in Italy, whilst the AfD wins a strong position in Germany.  This is a 25% probability
  Smörgåsbord. Each country might go its own way, with Wilders winning in The Netherlands, Macron winnng in France, Gentiloni surviving into 2018 in Italy, and Merkel winning in Germany.  This is also a 25% probability today
  A New Broom.  Wilders wins in The Netherlands and Grillo in Italy, whilst Macron and Schulz win in France and Germany.  This is perhaps the most likely outcome, but has only a 40% probability

Each of these outcomes would have radically different implications for companies, investors and us as individuals. The Populist, Smörgåsbord and New Broom outcomes would also give very different outcomes for the Brexit process. It could easily become of only marginal importance for EU leaders, if “business as usual” options disappear.  In turn, this would make May’s position back in the UK, very difficult indeed.

Nor can one ignore the potential impact of events, such as a Greek default, or of further interventions by Presidents Trump and Putin.  Both would be happy to see the EU disappear. These widely differing alternatives highlight the dangers of continuing with a one-dimensional view of the world based on economics.  Political risk has returned, and is likely to continue rising up the agenda for a long time.

We are entering the Great Unknown in Europe over the next 9 months.  Everyone will have their own views of the probabilities.  But the crucial point is that every country in the world is likely to feel the impact, in some way, if “business as usual” fails to occur.  And it will then be too late, at the end of the year, to suddenly wake up to the implications for your business, and for you personally.

ExxonMobil Antwerp to spend $1bn boosting diesel capacity

EM diesel Jul14When the world changes, companies either change with it or go out of business.  The market for stagecoaches was never the same once cars came along.  And not many students use slide rules today, now calculators are available.

Usually, of course, these market changes are slow-moving.  So companies often fail to respond in the hope the old world will somehow return.

That is what had been happening with European petrochemicals.  It has been clear for some time that the ageing population means there can be no recovery back to SuperCycle levels of demand.  But nothing happened in response until INEOS and Solvin announced their JV in PVC, and effectively fired the starting gun on restructuring across the industry.

The depth of the crisis is shown by the fact that the two companies are No 1 and 2 in the PVC business.  Normally market-leading companies do not need to merge.  Nor will the European Commission normally allow them to merge .

Yet as the blog argued in its advice to the Commission, the alternative would have been to risk the closure of major parts of the industry – with an inevitable loss of jobs all along the value chain as a result.

Now another, equally significant move has been made in the refining business, this time by ExxonMobil (EM).  In its typically far-sighted way, it has decided to spend $1bn on reconfiguring its Antwerp refinery in Belgium.  As EM’s European refining head, Steve Hart, told the New York Times:

“From its network of refineries in northwest Europe, Mr. Hart said, Exxon Mobil will collect heavy fuels for which there is no longer much demand – like the so-called bunker used by older ships – and carry it by boat to Antwerp. There, a new refinery unit will distill the gooey substances into diesel and a similar lighter-weight fuel used by more modern ships.”

The reason for the new investment is the major shift from gasoline to diesel that has taken place on cost grounds in Europe’s auto fleet since 1990.  Then, only around 1 in 10 cars used diesel.  But today, more than half of new cars sold are diesel – and more than twice as much diesel is used than gasoline across the entire market.

Of course, the easy answer would be to close down Antwerp.  Most of the analysts would like that ‘solution’, as it would boost earnings short-term.  But how then would Europe obtain the fuel it needs over the coming decades?  Would it really want to become even more dependent on imports from Russia, the US and Middle East?

Equally, what would EM do in the future, if it chose to abandon a market where it is currently has a leading position?

The grass may always look greener on the other side.  But readers with long memories will remember Exxon’s efforts to become a major player in the office equipment market in the 1970s, when oil markets were similarly difficult.

This proved once again that ‘diversification is usually diworsification” as Fidelity’s Peter Lynch used to remark, as:

A business that diversifies too widely, risks destroying their original business, because management time, energy and resources are diverted from the original investment

Europe’s economy is not going to move into recovery mode, no matter what policymakers may wish to believe.  But nor is it going to stop being one of the world’s biggest markets.  As the blog told the NYT in the same article:

European refineries have to invest in a difficult environment if they want to be around for the long term,” said Paul Hodges, chairman of International eChem, a consulting firm in London. “It would be far more expensive to pretend that somehow the world will return to the market conditions of 25 years ago.”

The message, and the challenge, for European petchem producers is the same.

 

WEEKLY MARKET ROUND-UP
The blog’s weekly round-up of Benchmark price movements since January 2014 is below, with ICIS pricing comments:
US$: yen, down 3%
Brent crude oil, down 1%
PTA China, flat 0%.  ”Limited availability in Asia because of production cutbacks and shutdowns because of weak margins”
Naphtha Europe, up 3%. “Market is long, and increased output of naphtha-rich light, sweet Libyan crude oil could lead to a further rise in supply”
Benzene, Europe, up 7%. “4 new benzene units with 2MT capacity expected to come online in Asia by the end of July could help ease global availability and pricing
S&P 500
stock market index, up 7%
HDPE US
export, up 7%. “International buyers are only willing to buy replacement cargos at the moment, and are not interested in building inventory at high prices”

EU cracker operating rates remain near record lows

EU C2 OR Jun14An ageing population and record annual levels of oil prices create massive headwinds for Europe’s petrochemical producers.  One means demand growth is much reduced from the SuperCycle.  The other means these lower volumes cost more to produce.

What a pity, you might say, that the industry is not part of the financial sector.  Then it would have been the sweetheart of the last European Commission, and received massive bailouts as well as special treatment on regulatory matters.

But instead petrochemicals, which are the building block for most of today’s consumer products, see their costs rising to support the banking sector – whilst their regulatory burdens are increased.  Its a funny old world.

The hard facts are in the chart above, based on new APPE data for Q1:

  • Operating rates in what should have been the seasonally strongest quarter of the year were just 82%
  • This was better than the 79% seen last year, but only equalled 2012 levels
  • It was nowhere near the 90%+ level that was normal in the pre-2008 SuperCycle

The only good news is that the US and Middle East move into ethane feedstocks has helped keep propylene and butadiene prices higher than usual.  So European producers, like those in Asia, have been benefiting from higher overall netbacks than would otherwise have been expected.  But, of course, this also helps to destroy downstream demand, as end-consumers find it harder to afford the products being produced.

Thus whilst ethylene production at 4.9MT was back at 1999 levels, propylene volume at 3.7MT was still only equal to 2004 levels, as was butadiene volume at 0.5MT.

One hopeful sign, as the blog discussed yesterday, is that growing crude oil gluts in the US and elsewhere may well be the catalyst for a return of oil prices to a more normal historical relationship to gas prices.  That would cause major short-term dislocation in terms of destocking and working capital.  But it would be very good news longer-term.

However, today’s lack of demand growth will not get better, as Europe continues to age.  Equally, its exports to China are now being reduced as China bursts its property bubble.  This has a double impact, as China is not only buying less, but also exporting more.  It is now becoming a PVC exporter rather than importer, for example.

Similar woes are impacting Europe’s refining sector, which has lost its gasoline export market in the US, and is configured to supply gasoline rather than the diesel that now drives Europe’s transport fleet.  At some point, probably not far away, someone is going to have to start to address these problems.

The modern European economy could live without ‘too big to fail’ banking monoliths.  But it can’t live without the products provided by the petrochemical industry.  The new European Commission will hopefully recognise this fact early in its term of office.  It cannot afford to repeat the mistakes of its predecessors,