Chemical industry data shows reflation remains hope, not reality

ACC Jul17Western 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.

FMs Jul17

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
Shadow Jul17The 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.

Sinopec’s results confirm China’s focus on employment and self-sufficiency, not profit

Sinopec May17China’s strategies for oil, refining and petrochemical production are very different from those in the West, as analysis of Sinopec’s Annual and 20-F Reports confirms.  As the above chart shows, it doesn’t aim to maximise profit:

□  Since 1998, it has spent $45bn on capex in the refining sector, and $38bn in the chemicals sector
□  Yet it made just $1bn at EBIT level (Earnings Before Interest and Taxes) in refining, and only $21bn in chemicals

As I noted last year:

Clearly no western company would ever dream of spending such large amounts of capital for so little reward. But as a State Owned Enterprise, Sinopec’s original mandate was to be a reliable supplier of raw materials to downstream factories, to maintain employment. More recently, the emphasis has changed to providing direct support to employment, through increased exports of refined products into Asian markets and increased self-sufficiency in petrochemicals”.

Commentary on China’s apparent growth in oil imports confirms the confusion this creates.  Western markets cheered last year as China’s oil imports appeared to increase, hitting a record high. But they were ignoring key factors:

□   China’s crude imports were indeed 14% higher at 7.6 million bpd – nearly a million bpd higher than in 2015
□   But 700 kbpd of these imports were one-off demand as China filled its strategic storage
□   And at the same time, China’s refineries were pumping out record export volume: its fuel exports were up around one-third during the year to over 48 million tonnes

As Reuters noted:

This broadly suggests China’s additional imports of crude oil were simply processed and exported as refined products.”  In reality, ”China’s 2016 oil demand grew at the slowest pace in at least three years at 2.5%, down from 3.1% in 2015 and 3.8% in 2014, led by a sharp drop in diesel consumption and as gasoline usage eased from double-digit growth.”

The issue was simply that Premier Li was aiming to maintain employment in the “rust-belt provinces”, by boosting the so-called “tea-pot refineries”.  He had therefore raised their oil import quotas to 8.7 million tonnes in 2016, more than double their 3.7 million tonne quota in 2016.  As a result, they had more diesel and gasoline to sell in export markets.

China OR May17

The same pattern can be seen in petrochemicals, as the second chart confirms.  It highlights how Operating Rates (OR%) for the two main products, ethylene and propylene, remain remarkably high by global standards.  This confirms that Sinopec’s aim is not to maximise profit by slowing output when margins are low.  Instead, as a State Owned Enterprise, its role is to be a reliable supplier to downstream factories, to keep people employed.

□   Its OR% for the major product, ethylene, hit a low of 94% after the start of the Financial Crisis in 2009, but has averaged 102% since Sinopec first reported the data in 1998
□   Its OR% for propylene has also averaged 102%, but has shown more volatility as it can be sourced from a wider variety of plants. It is currently at 100%

Understanding China’s strategy is particularly important when forecasting demand for the major new petrochemical plants now coming online in N America.  Conventional analysis might suggest that China’s plants might shutdown, if imports could be provided more cheaply from US shale-based production.  But that is not China’s strategy.

Communist Party rule since Deng Xiaoping’s famous Southern Tour in 1992 has always been based on the need to avoid social unrest by maintaining employment.  There would therefore be no benefit to China’s leadership in closing plants.  In fact, China is heading in the opposite direction with the current 5-Year Plan, as I discussed last month.

The Plan aims to increase self-sufficiency in the ethylene chain from 49% in 2015 to 62% in 2020.  Similarly in the propylene chain, self-sufficiency will increase from 67% in 2015 to 93% in 2020.

It is therefore highly likely that China’s imports of petrochemicals and polymers will continue to decline, as I discussed last month.  And if China follows through on its plans to develop a more service-based economy, based on the mobile internet, we could well seen exports of key polymers such as polypropylene start to appear in global markets.

China’s increase in chemicals self-sufficiency will hit US shale gas expansions

China C2,C3 May17Some years ago, when China was well on the way to becoming the world’s largest importer of chemicals, a reporter asked the chairman of Sinochem, China’s largest chemical company if China intended to keep increasing its imports?  ”Not at all” was Su Shulin’s reply, “This is temporary.  It is not our strategy.  We will become self-sufficient.

China’s current 13th Five Year Plan, covering 2016 – 2020, confirms his analysis.  Wherever possible, China is now moving to increase its self-sufficiency as the above chart confirms:

  In the ethylene chain, it intends to increase self-sufficiency from 49% in 2015 to 62% in 2020
  In the propylene chain, self-sufficiency will increase from 67% in 2015 to 93% in 2020
  Detailed investment plans are already being implemented to fulfill this strategy

China PTA May17Ethylene and propylene are following the pattern set in other major product areas.  In 2014, China was the world’s largest importer of PTA, the key raw material for polyester fibre and PET bottles, as the second chart confirms:

  It imported 1.7 million tonnes in January – March 2014.  But then a series of major new world-scale plants began to come online, and China has since become a net exporter
  NE Asian producers have lost 97% of their export volume to China and SE Asian producers have lost 90%
  NEA and SEA are also now starting to face competition from China in Middle Eastern import markets

China PX May17PTA is not alone in seeing this transition.  There has really only been one major exception, paraxylene (PX) – the raw material used to make PTA.  As the third chart shows, the new PTA plants have had to depend on PX imports for their feedstocks.  The reason is that PX became the target of public concerns over environmental pollution and safety, causing expansion plans to be put on hold for some years.

  China PX imports have risen by a third over the past 3 years to 2.7 million tonnes in Q1 this year
  NE Asia has been the main supplier, with S Korea, Japan and Taiwan all moving major volumes
  This, of course, has helped to compensate for the loss of their PTA exports

But now the logjam on new PX plants in China has been broken, and capacity is set to double from 13.6 MT to 29.7MT over the next 3 years.  This expansion will not only support new downstream capacity in PTA, but will likely also lead to modest exports of PX as well.

This is further evidence, if more was needed, that the 4.5 million tonnes of new US polyethylene capacity will likely have major problems in finding a market, as it comes online later this year.  As I noted back in March, the scope for disappointment with these projects is very high.  US polyethylene exports had already fallen 50% since their 2009 peak – even before China began to increase its self-sufficiency

 

4.5 million tonnes of new US polyethylene exports on front-line as War of Words hits US-China trade

Trump Mar17

There isn’t anybody who knows what is going to happen in the next 12 months. We’ve never been here before. Things are out of control. I have never seen a situation like it.” This comment last month from former UK Finance Minister, Ken Clarke, aptly summarises the uncertainty facing the global economy.

As I note in a new analysis, major policy changes are now underway in both the US and China – the world’s two largest economies. Almost inevitably, they will create structural changes in the petrochemicals and polymers industry. These changes will not only impact the domestic US and Chinese economies. They will also impact every supply chain which has a link into either economy.

Half of Apple’s iPhones, for example, are currently made in the Chinese city of Shenzhen, using products from over 200 suppliers from around the world. Under President Trump’s new “America First” policies, it is highly likely that in the future, more and more iPhones will instead start to be made in the US.

This highlights how the world is now moving into the early stages of a “War of Words” scenario, where both the US and China are preparing to develop a totally new trading relationship:

  Will this develop into an all-out “Global Trade War” scenario, as the new chairman of President Trump’s National Trade Council, Peter Navarro, has been advocating? This was the key message of his 2006 book, “The Coming China Wars: Where They Will Be Fought, How They Can Be Won”?
  Will President Trump go ahead with his proposed 35% border tax on imports into the US?
  Or will the two sides negotiate a less confrontational trading relationship that still takes account of the president’s desire to reshore manufacturing to the US?

Nobody can know at the moment. But we do know that China’s President Xi is equally determined to push forward with his reforms for the domestic Chinese economy. He also seems to have finally sidelined Premier Li Keqiang, who has been responsible for economic policy until now. This is a critically important development, as Li has masterminded the stimulus policies that meant China became the key driver for global growth in recent years.

Instead, Xi is determined to refocus on his $6tn “One Belt, One Road” (OBOR) project – which absorbed $450bn of start-up finance last year. OBOR creates the potential for China to lead a new free trade area including countries in Asia, Middle East, Africa and Europe – just as the US appears to be withdrawing from its historical role of free trade leadership.

It is hard to over-estimate the potential importance of these changes. As President Trump said in his recent Inauguration speech, his aim is to completely overturn the framework that has governed the global economy during our working lives.

Today’s business models based on global supply chains are therefore under major threat, and companies probably have very little time to develop new ones. It seems most unlikely, for example, that the globalisation model of recent decades – whereby raw materials are routinely shipped half-way around the world, and then returned as finished product – will survive for much longer. Companies and investors also have to prepare for the risk that today’s moves are only the start of a more profound shift in the global economy.

The current “War of Words” on trade could well evolve into outright protectionism, with countries reimposing the trade barriers of the pre-globalisation era.

US PE Mar17

The imminent start-up of 4.5m tonnes of new North American polyethylene (PE) capacity confirms the scale of the potential challenges ahead. As the chart highlights:

 US net exports in 2016 were 5,000 tonnes lower than in 2015
 Normally, one would have expected them to be ramping up in advance of the new capacity coming on line
 Even more worrying is that they were 22% lower than their 2009 peak
 Exports to China were down by 50% due to its self-sufficiency having increased

The scope for disappointment later this year – and in turn the potential for the “War of Words” to be replaced by a “Global Trade War” – is obvious.

I analyse the risks in a new feature article for ICIS Chemical Business with John Richardson.  Please click here to download a copy (no registration required)

No conspiracy on raw materials pricing – the business model has changed

FTThe Financial Times kindly prints my letter this morning on pricing policies for polyethylene.

Sir, Conspiracy theories are always good fun, and Robert Bateman’s views on the polyethylene market are no exception (Letters, December 29). But there is a much more prosaic explanation for the pricing structures he describes.

The key issue is that until recently, lowest unit cost was the key driver for industry profitability. Soaring demand from the baby boomers rewarded business models based on the theme of “If you build it, they will come”, as highlighted in Field of Dreams, the blockbuster baseball movie of the late 1980s. In turn, this led companies to build ever-larger plants, and to develop a shrewd appreciation of the difference between full and variable costs. Local customers paid full price, to reward the investment made. Foreign customers were then supplied with anything left over on the basis of marginal cost economics. Not for nothing were these markets often known as “Rest of World”. It was this dynamic, rather than any conspiracy, which led prices in far-off emerging markets such as Asia to be much lower than in the home markets of the major producers.

Today, however, this business model is long past its sell-by date, as concepts of sustainability and the circular economy come to the fore. Asian countries are also rapidly becoming self-sufficient and no longer depend on low-cost imports from the west. Yet old habits die hard. The excitement over shale gas economics has blinded many North American producers to the outlook for future demand growth and encouraged them to sanction major capacity expansions. Mr Bateman and his fellow manufacturers can therefore look forward to receiving increasingly attractive prices as 2017 progresses, without any need to lobby for new antitrust legislation.

Paul Hodges, Chairman, International eChem

 

Industry needs new strategy to spread benefits of globalisation

Opportunities

The Brexit vote, and Donald Trump’s election, confirm that we are in a New Normal world.  In the interview below with Will Beacham, Deputy editor of ICIS Chemical Business, I highlight some ideas about how industry needs to adapt.

BARCELONA (ICIS)–The global chemical sector needs to stimulate demand for innovative products and services in mature economies so that the benefits of globalisation are felt by people who have been left behind, a leading consultant says.

Globalisation is a very efficient method of production, but it shifts manufacturing to low-cost areas, leaving workers in mature economies at risk of under-employment.  The chemical sector should adopt more service and solution-oriented business models which will boost demand and employment in high-cost regions, says International eChem chairman.

This innovative approach is particularly important for a country like the US where the election of Donald Trump has highlighted anger among voters about falling incomes and hostility to the effects of globalisation.

On 21 November, Trump confirmed that he plans to exit the proposed Trans-Pacific Partnership as soon as he is inaugurated. This indicates he does intend to follow through with a protectionist agenda which could result in higher tariffs against US-made chemicals and polymers if a trade war develops.

Hodges says the US industry can harness unmet domestic polymer demand to help swallow up the wave of new shale-based capacity due onstream over the next 2-3 years.

“It’s highly likely that all the new capacity will come onstream at a time when the US is pushing towards protectionism. This makes it critical for the US industry to move away from wishful thinking about selling all the new PE capacity into Asia and other foreign markets. They will have to refocus on creating domestic demand.”

Hodges believes it is critical to look at new opportunities in areas such as water and food; otherwise the industry will not be able to sell these new volumes. “Companies will move towards being designers of materials and solutions. There are opportunities as well as threats for people who can revise their business models. It’s critical for people to take decisions now.”

He highlights the example of California which has been in drought for the last five years. “Why not sell more PE pipes as we know that 40% of water is lost before it reaches the consumer. Why waste capital on new reservoirs when you are going to lose 40%?”

He also suggests developing materials for intelligent packaging to tell people when food is really out of date because 35% of food is currently thrown away.

“There must be a big focus on being efficient: these are enormous markets and the industry needs to become more demand-focused. Some of the new [wave of ethane-based] plants will struggle but in principal there is a lot of new demand that could be generated by taking a demand-orientated approach.”

Looking globally, a new political and trading power block will develop as a result of China’s “One Belt One Road” policy which includes countries representing 40% of global GDP, says Hodges. This strategy aims to boost cooperation and trade between China and around 60 countries including Russia, much of eastern Europe, Asia including India and Indonesia, and parts of North Africa and the Middle East.

Hodges also believes the chemical industry should adopt the use of smaller, leaner and more efficient manufacturing systems.

“In an uncertain world the biggest risk is that you can’t sell product: this was always the risk before and it is today. We need smaller, more flexible, cheaper production with units located next to customers, as well as a greater focus on sustainability in the plastics chain.”

“We won’t return to a world of unbridled production – services and solutions are the way smart companies will make money in the future.”