Stormy weather ahead for chemicals

Four serious challenges are on the horizon for the global petrochemical industry as I describe in my latest analysis for ICIS Chemical Business and in a podcast interview with Will Beacham of ICIS.

The first is the growing risk of recession, with key markets such as autos, electronics and housing all showing signs of major weakness. Central banks are already talking up the potential for further stimulus, less than a year after they had tried to claim victory for their post-Crisis policies.

Second is oil market volatility, where prices raced up in the first half of last year, only to then collapse from $85/bbl to $50/bbl by Christmas, before rallying again this year. The issue is that major structural change is now underway, with US and Russian production increasing at Saudi Arabia’s expense.

Third, there is the unsettling impact of geo-politics and trade wars. The US-China trade war has set alarm bells ringing around the world, whilst the Brexit arguments between the UK and European Union are another sign that the age of globalisation is behind us, with potentially major implications for today’s supply chains.

And then there is the industry’s own, very specific challenge, shown in the chart. Based on innovative trade data analysis by Trade Data Monitor, it highlights the dramatic impact of the new US shale gas-based cracker investments on global trade in petrochemicals.

The idea is to capture the full effect of the new ethylene production across the key derivatives – polyethylene, PVC, styrene, EDC, vinyl acetate, ethyl benzene, ethylene glycol – based on their ethylene content. Even with next year’s planned new US ethylene terminal, the derivatives will still be the cheapest and easiest way to export the new ethylene molecules.

The cracker start-ups were inevitably delayed by the hurricanes in 2017. But if one compares 2018 with 2016 (to avoid the distortions these caused), there was still a net increase of 1.7 million tonnes in US ethylene-equivalent trade flows.

This was more than 40% of the total production increase over the period, as reported by the American Chemistry Council. And 2019 will see further major increases in volume with 4.25 million tonnes of new ethylene capacity due to start-up, alongside full-year output from last year’s start-ups.

The problem is two-fold. As discussed here in 2014 (ICB, US boom is a dangerous game, 24-30 March), it was never likely that central bank stimulus policies could actually return demand growth to the levels seen in the Boomer-led SuperCycle from 1983-2000:

“Shale gas thus provides a high-profile example of how today’s unprecedented demographic changes are creating major changes in business models. Low-cost supply is no longer a guarantee of future profitability.”

This was not a popular message at the time, when oil was still riding high at over $100/bbl and the economic impact of globally ageing populations and collapsing fertility rates were still not widely understood. But it has borne the test of time, and sums up the challenge now facing the industry.

Please click to download the full analysis and my podcast interview with Will Beacham.

CEOs need new business models amid downturn

Many indicators are now pointing towards a global downturn in the economy, along with paradigm shifts in demand patterns. CEOs need to urgently build resilient business models to survive and prosper in this New Normal world, as I discuss in my 2019 Outlook and video interview with ICIS.

Global recession is the obvious risk as we start 2019.  Last year’s hopes for a synchronised global recovery now seem just a distant memory.  Instead, they have been replaced by fears of a synchronised global downturn.

Capacity Utilisation in the global chemical industry is the best leading indicator that we have for the global economy.  And latest data from the American Chemistry Council confirms that the downtrend is now well-established.  It is also clear that key areas for chemical demand and the global economy such as autos, housing and electronics moved into decline during the second half of 2018.

In addition, however, it seems likely that we are now seeing a generational change take place in demand patterns:

  • From the 1980s onwards, the demand surge caused by the arrival of the BabyBoomers into the Wealth Creating 25 – 54 cohort led to the rise of globalisation, as companies focused on creating new sources of supply to meet their needs
  • At the same time the collapse of fertility rates after 1970 led to the emergence of 2-income families for the first time, as women often chose to go back into the workforce after childbirth. In turn, this helped to create a new and highly profitable mid-market for “affordable luxury”
  • Today, however, only the youngest Boomers are still in this critical generation for demand growth. Older Boomers have already moved into the lower-spending, lower-earning 55+ age group, whilst the younger millennials prefer to focus on “experiences” and don’t share their parents’ love of accumulating “stuff”

The real winners over the next few years will therefore be companies who not only survive the coming economic downturn, but also reposition themselves to meet these changing demand patterns.  A more service-based chemical industry is likely to emerge as a result, with sustainability and affordability replacing globalisation and affordable luxury as the key drivers for revenue and profit growth.

Please click here to download the 2019 Outlook (no registration necessary) and click here to view the video interview.

BASF’s second profit warning highlights scale of the downturn now underway

The chemical industry is easily the best leading indicator for the global economy.  And thanks to Kevin Swift and his team at the American Chemistry Council, we already have data showing developments up to October, as the chart shows.

It confirms that consensus hopes for a “synchronised global recovery” at the beginning of the year have again proved wide of the mark.  Instead, just as I warned in April (Chemicals flag rising risk of synchronised global slowdown), the key  indicator – global chemical industry Capacity Utilisation % – has provided fair warning of the dangers ahead.

It peaked at 86.2%, in November 2017, and has fallen steadily since then. October’s data shows it back to June 2014 levels at 83.6%. And even more worryingly, it has now been falling every month since June. The last time we saw a sustained H2 decline was back in 2012, when the Fed felt forced to announce its QE3 stimulus programme in September.  And it can’t do that again this time.

The problem, as I found when warning of subprime risks in 2007-8 (The “Crystal Blog” foresaw the global financial crisis), is that many investors and executives prefer to adopt rose-tinted glasses when the data turns out to be too downbeat for their taste.  Whilst understandable, this is an incredibly dangerous attitude to take as it allows external risks to multiply, when timely action would allow them to be managed and mitigated.

It is thus critical that everyone in the industry, and those dependent on the global economy, take urgent action in response to BASF’s second profit warning, released late on Friday, given its forecast of a “considerable decrease of income” in 2018 of “15% – 20%”, after having previously warned of a “slight decline of up to 10%”.

I have long had enormous respect for BASF and its management. It is therefore deeply worrying that the company has had to issue an Adjustment of outlook for the fiscal year 2018 so late in the year, and less than 3 weeks after holding an upbeat Capital Markets Day at which it announced ambitious targets for improved earnings in the next few years.

The company statement also confirmed that whilst some problems were temporary, most of the issues are structural:

  • The impact of low water on the Rhine has proved greater than could have been earlier expected
  • But the continuing downturn in isocyanate margins has been ongoing for TDI since European contract prices peaked at €3450/t in May — since when they had fallen to €2400/t in October and €2050/t in November according to ICIS, who also reported on Friday that
    “Supply is still lengthy at year end in spite of difficulties at German sellers BASF and Covestro following low Rhine water levels”
  • The decline is therefore a very worrying insight into the state of consumer demand, given that TDI’s main applications are in furniture, bedding and carpet underlay as well as packaging applications.
  • Even more worrying is the statement that:
    “BASF’s business with the automotive industry has continued to decline since the third quarter of 2018; in particular, demand from customers in China slowed significantly. The trade conflict between the United States and China contributed to this slowdown.”

This confirms the warnings that I have been giving here since August when reviewing H1 auto sales (Trump’s auto trade war adds to US demographic and debt headwinds).

I noted then that President Trump’s auto trade tariffs were bad news for the US and global auto industry, given that markets had become dangerously dependent on China for their continued growth:

  • H1 sales in China had risen nearly 4x since 2007 from 3.1m to 11.8m this year
  • Sales in the other 6 major markets were almost unchanged at 23m versus 22.1m in 2007

Next year may well prove even more challenging if the current “truce” over German car exports to the USA breaks down,

INVESTORS HAVE WANTED TO BELIEVE THAT INTEREST RATES CAN DOMINATE DEMOGRAPHICS

The recent storms in financial markets are a clear sign that investors are finally waking up to reality, as Friday night’s chart from the Wall Street Journal confirms:

“In a sign of the breadth of the global selloff in stocks, Germany’s main stock index fell into a bear market Thursday, the latest benchmark to have tumbled 20% or more from its recent peak….Other markets already in bear territory are home to companies exposed to recent trade fights between the U.S. and China.

The problem, as I have argued since publishing ‘Boom, Gloom and the New Normal: how the Ageing Boomers are Changing Demand Patterns, again“, in 2011 with John Richardson, is that the economic SuperCycle created by the dramatic rise in the number of post-War BabyBoomers is now over.

I highlighted the key risks is my annual Budget Outlook in October, Budgeting for the end of “Business as Usual”.  I argued then that 2019 – 2021 Budgets needed to focus on the key risks to the business, and not simply assume that the external environment would continue to be stable.  Since then, others have made the same point, including the president of the Council on Foreign Relations, Richard Haas, who warned on Friday:

“In an instant Europe has gone from being the most stable region in the world to anything but. Paris is burning, the Merkel era is ending, Italy is playing a dangerous game of chicken with the EU, Russia is carving up Ukraine, and the UK is consumed by Brexit. History is resuming.

It is not too late to change course, and focus on the risks that are emerging.  Please at least read my Budget Outlook and consider how it might apply to your business or investments. And please, do it now.

 

You can also click here to download and review a copy of all my Budget Outlooks 2007 – 2018.

Budgeting for the end of “Business as Usual”

Companies and investors are starting to finalise their plans for the coming year.  Many are assuming that the global economy will grow by 3% – 3.5%, and are setting targets on the basis of “business as usual”.  This has been a reasonable assumption for the past 25 years, as the chart confirms for the US economy:

  • US GDP has been recorded since 1929, and the pink shading shows periods of recession
  • Until the early 1980’s, recessions used to occur about once every 4 – 5 years
  • But then the BabyBoomer-led economic SuperCycle began in 1983, as the average Western Boomer moved into the Wealth Creator 25 – 54 age group that drives economic growth
  • Between 1983 – 2000, there was one, very short, recession of 8 months.  And that was only due to the first Gulf War, when Iraq invaded Kuwait.

Since then, the central banks have taken over from the Boomers as the engine of growth.  They cut interest rates after the 2001 recession, deliberately pumping up the housing and auto markets to stimulate growth.  And since the 2008 financial crisis, they have focused on supporting stock markets, believing this will return the economy to stable growth:

  • The above chart of the S&P 500 highlights the extraordinary nature of its post-2008 rally
  • Every time it has looked like falling, the Federal Reserve has rushed to its support
  • First there was co-ordinated G20 support in the form of low interest rates and easy credit
  • This initial Quantitative Easing (QE) was followed by QE2 and Operation Twist
  • Then there was QE3, otherwise known as QE Infinity, followed by President Trump’s tax cuts

In total, the Fed has added $3.8tn to its balance sheet since 2009, whilst China, the European Central Bank and the Bank of Japan added nearly $30tn of their own stimulus.  Effectively, they ensured that credit was freely available to anyone with a pulse, and that the cost of borrowing was very close to zero.  As a result, debt has soared and credit quality collapsed.  One statistic tells the story:

“83% of U.S. companies going public in the first nine months of this year lost money in the 12 months leading up to the IPO, according to data compiled by University of Florida finance professor Jay Ritter. Ritter, whose data goes back to 1980, said this is the highest proportion on record.  The previous highest rate of money-losing companies going public had been 81% in 2000, at the height of the dot-com bubble.

And more than 10% of all US/EU companies are “zombies” according to the Bank of International Settlements (the central banks’ bank), as they:

“Rely on rolling over loans as their interest bill exceeds their EBIT (Earnings before Interest and Taxes). They are most likely to fail as liquidity starts to dry up”.

2019 – 2021 BUDGETS NEED TO FOCUS ON KEY RISKS TO THE BUSINESS
For the past 25 years, the Budget process has tended to assume that the external environment will be stable.  2008 was a shock at the time, of course, but time has blunted memories of the near-collapse that occurred.  The issue, however, as I noted here in September 2008 is that:

“A long period of stability, such as that experienced over the past decade, eventually leads to major instability.

“This is because investors forget that higher reward equals higher risk. Instead, they believe that a new paradigm has developed, where high leverage and ‘balance sheet efficiency’ should be the norm. They therefore take on high levels of debt, in order to finance ever more speculative investments.

This is the great Hyman Minsky’s explanation for financial crises and panics. Essentially, it describes how confidence eventually leads to complacency in the face of mounting risks.  And it is clear that today, most of the lessons from 2008 have been forgotten.  Sadly, it therefore seems only a matter of “when”, not “if”, a new financial crisis will occur.

So prudent companies will prepare for it now, whilst there is still time.  You will not be able to avoid all the risks, but at least you won’t suddenly wake up one morning to find panic all around you.

The chart gives my version of the key risks – you may well have your own list:

  • Global auto and housing markets already seem to be in decline; world trade rose just 0.2% in August
  • Global liquidity is clearly declining, and Western political debate is ever-more polarised
  • Uncertainty means that the US$ is rising, and geopolitical risks are becoming more obvious
  • Stock markets have seen sudden and “unexpected” falls, causing investors to worry about “return of capital”
  • The risks of a major recession are therefore rising, along with the potential for a rise in bankruptcies

Of course, wise and far-sighted leaders may decide to implement policies that will mitigate these risks, and steer the global economy into calmer waters.  Then again, maybe our leaders will decide they are “fake news” and ignore them.

Either way, prudent companies and investors may want to face up to these potential risks ahead of time.  That is why I have titled this year’s Outlook, ‘Budgeting for the end of “Business as Usual“.  As always, please contact me at phodges@thephreport.com if you would like to discuss these issues in more depth.

Please click here to download a copy of all my Budget Outlooks 2007 – 2018.

Oil prices flag recession risk as Iranian geopolitical tensions rise

Today, we have “lies, fake news and statistics” rather than the old phrase “lies, damned lies and statistics”. But the general principle is still the same.  Cynical players simply focus on the numbers that promote their argument, and ignore or challenge everything else.

The easiest way for them to manipulate the statistics is to ignore the wider context and focus on a single “shock, horror” story.  So the chart above instead combines 5 “shock, horror”  stories, showing quarterly oil production since 2015:

  • Iran is in the news following President Trump’s decision to abandon the nuclear agreement, which began in July 2015.  OPEC data shows its output has since risen from 2.9mbd in Q2 2015 to 3.8mbd in April – ‘shock, horror’!
  • Russia has also been much in the news since joining the OPEC output agreement in November 2016.  But in reality, it has done little.  Its production was 11mbd in Q3 2016 and was 11.1mbd in April- ‘shock, horror’!
  • Saudi Arabia leads OPEC: its production has fallen from 10.6mbd in Q3 2016 to 9.9mbd in April- ‘shock, horror’!
  • Venezuela is an OPEC member, but its production decline began long before the OPEC deal.  The country’s economic collapse has seen oil output fall from 2.4mbd in Q4 2015 to just 1.5mbd in April- ‘shock, horror’!
  • The USA, along with Iran, has been the big winner over the past 2 years.  Its output initially fell from 9.5mbd in Q1 2015 to 8.7mbd in Q3 2016, but has since soared by nearly 2mbd to 10.6mbd in April- ‘shock, horror’!

But overall, output in these 5 key countries rose from 35.5mbd in Q1 2015 to 36.9mbd in April.  Not much “shock, horror” there over a 3 year period.  More a New Normal story of “Winners and Losers”.

So why, you might ask, has the oil price rocketed from $27/bbl in January 2016 to $45/bbl in June last year and $78/bbl last Friday?  Its a good question, as there have been no physical shortages reported anywhere in the world to cause prices to nearly treble.  The answer lies in the second chart from John Kemp at Reuters:

  • It shows combined speculative purchases in futures markets by hedge funds since 2013
  • These hit a low of around 200mbbls in January 2016 (2 days supply)
  • They then more than trebled to around 700mbbls by December 2016 (7 days supply)
  • After halving to around 400mbbls in June 2017, they have now trebled to 1.4mbbls today (14 days supply)

Speculative buying, by definition, isn’t connected with the physical market, as OPEC’s Secretary General noted after meeting the major funds recently:  “Several of them had little or no experience or even a basic understanding of how the physical market works.”

This critical point is confirmed by Citi analyst Ed Morse:  “There are large investors in energy, and they don’t care about talking to people who deal with fundamentals. They have no interest in it.

Their concern instead is with movements in currencies or interest rates – or with the shape of the oil futures curve itself. As the head of the $8bn Aspect fund has confirmed:

“The majority of our inputs, the vast majority, are price-driven. And the overwhelming factor we capitalise on is the tendency of crowd behaviour to drive medium-term trends in the market.” (my emphasis).

OIL PRICES ARE NOW AT LEVELS THAT USUALLY LEAD TO RECESSION

The hedge funds have been the real winners from all the “shock, horror” stories.  These created the essential changes in “crowd behaviour”, from which they could profit.  But now they are leaving the party – and the rest of will suffer the hangover, as the 3rd chart warns:

  • Oil prices now represent 3.1% of global GDP, based on latest IMF data and 2018 forecasts
  • This level has been linked with a US recession on almost every occasion since 1970
  • The only exception was post-2009 when China and the Western central banks ramped up stimulus
  • The stimulus simply created a debt-financed bubble

The reason is simple.  People only have so much cash to spend.  If they have to spend it on gasoline and heating their home, they can’t spend it on all the other things that drive the wider economy.  Chemical markets are already confirming that demand destruction is taking place.:

  • Companies have completely failed to pass through today’s high energy costs.  For example:
  • European prices for the major plastic, low density polyethylene, averaged $1767/t in April with Brent at $72/bbl
  • They averaged $1763/t in May 2016 when Brent was $47/bbl (based on ICIS pricing data)

Even worse news may be around the corner.  Last week saw President Trump decide to withdraw from the Iran deal.  His daughter also opened the new US embassy to Jerusalem.  Those with long memories are already wondering whether we could now see a return to the geopolitical crisis in summer 2008.

As I noted in July 2008, the skies over Greece were then “filled with planes” as Israel practised for an attack on Iran’s nuclear facilities.  Had the attack gone ahead, Iran would almost certainly have closed the Strait of Hormuz.  It is just 21 miles wide (34km)  at its narrowest point, and carries 35% of all seaborne oil exports, 17mb/d.

As Mark Twain wisely noted, “history doesn’t repeat itself, but it often rhymes”.  Prudent companies and investors need now to look beyond the “market-moving, shock, horror” headlines in today’s oil markets.  We must all learn to form our own judgments about the real risks that might lie ahead.

 

Given the geopolitical factors raised by President Trump’s decision on Iran, I am pausing the current oil forecast.

The post Oil prices flag recession risk as Iranian geopolitical tensions rise appeared first on Chemicals & The Economy.

Global auto market heads for 5% fall as stimulus impact wanes

Top 72016 data highlights one startling statistic about the world’s Top 7 auto markets.  They are 85% of total world sales and as the chart shows, their overall sales growth since 2007 has been entirely due to China:

   China’s sales have risen nearly four-fold since 2007, from 6.3m to 24.2m
   Sales in the other 6 markets were exactly the same in 2016 as in 2007, at 43m

This has been very good news for those who were in China.  Everyone has seen their sales rise – the car companies, the component suppliers and all the service-based industries that supported this fabulous expansion.

There have also been good opportunities in other parts of the world over the period, but also major risks:

   US sales hit a new record in 2016, after a great run since 2009 following GM and Chrysler’s bankruptcy
   The 27-member European Union (EU) has done well since 2013, up nearly a quarter to 14.6m, but is still below 2007′s 15.6m.  (The market peaked back in 1999, when 14.6m cars were sold to the then 15 EU members)
   Japan did well to 2013, but has since fallen to 4.2m; well down on 2004′s peak of 4.8m. (It is back to 1992 levels)
   India set a new record at 2.9m in 2016, double 2007′s level, but fell 19% in December as demonetisation impacted
   Brazil did well till 2012 when sales hit 2.8m, but are now below 2007′s level at 2m
   Russia also soared from 2009, hitting 2.8m in 2012, but has since halved to just 1.4m in 2016

Now global sales are likely heading for a fall.  They would already have been much lower without the support of major stimulus measures.  Governments have been desperate to keep auto sales rising, due to their impact on jobs:

   When China’s sales began to slow in 2015, the sales tax was cut from 10% to 5% for smaller cars with engines below 1.6l – which are mostly produced by Chinese manufacturers.  But now China has raised the tax back to 7.5%, leading the manufacturers’ association to forecast sales growth will fall from 21% in 2016 to just 3% in 2017
   Europe has seen widespread and continuous discounting.  Ford’s European profit was just $259m in 2015: it and Fiat Chrysler made operating margins of less than 1% of sales, and GM continued to lose money.  UK sales have relied on $25.8bn ($28bn) of payments since 2011 for insurance mis-selling, as many claimants used their average £3k compensation as a deposit on a car loan.  VW’s diesel scandal will also have long-term negative impact, given that over half of all European new car sales have been diesel vehicles for the past decade.  Paris, Madrid and Athens have already decided to ban diesel cars completely by 2025.
   The USA has seen discounts reach an average $4k in December, up 20% on 2015.  Leasing and financing deals have also been critical in maintaining auto sales.  Experian data shows 86% of new cars were bought with financing in Q3 2016; the average loan amount is at a record high of $30k, and loan terms average 68 months

Logic therefore suggests the consensus is being extremely optimistic in ignoring today’s increasingly uncertain political background, and assuming global sales will continue to grow in 2017:

   China faces political uncertainty ahead of the critical 19th National Party Congress in Q4.  President Xi is almost certain to be re-nominated for a second 5-year term, but cannot currently rely on maintaining control of the critical Politburo Standing Committee – China’s main decision-making body.
   Europe also faces major political uncertainty, with elections due in The Netherlands, France and Germany – and possibly Italy.  In addition, the UK is highly likely to table its decision to leave the EU in the next few weeks.
   In the US, every two-term Presidency for 100 years has been followed by recession.  President Trump is highly likely to take difficult decisions this year, before next year’s mid-term elections and his own re-election bid in 2020

Another key issue is the impact of falling prices for used cars.  Their volumes are already increasing as all the new cars sold in recent years come back for resale.  China’s Auto Dealer Association expects used car sales to equal those for new cars by 2020, whilst Barclays has warned that US new car “prime and subprime net loss rates are close to multi-year highs because of softening used car values.” 

Then there is the growing impact of taxi services such as Uber and Did, and the rise of car-sharing business models and self-driving cars.  Most Americans, after all, waste a week of their lives in traffic jams each year, and many auto manufacturers are now introducing more service-driven business models as BMW have argued:

“Our core business in the ’70s was selling cars; in the ’80s, late ’70s came the great innovation of leasing and financing.  Now you can pay per use of a car.  It’s like the music industry.  You used to have to buy an album, now you can pay per play.” 

It is not yet clear how bad the downturn will be.  But it would seem prudent to plan for at least a 5% global decline this year, given today’s rising levels of uncertainty and global interest rates.  It will be too late to panic later in the year, once the detail of the downturn has become more obvious.