Boom, Gloom and the New Normal

As regular readers know, the blog regards benzene as an excellent leading indicator for petchem markets and the global economy. Its track record since the start of the crisis in 2008 has continued to be strong.

The reason is probably two-fold:

• It is one of the oldest, and widely used, chemicals. In many ways it is therefore a proxy for industrial production.
• It is close to the feedstock end of the value chain. So it also responds to ‘correlation trade’ activity by the high speed computers that now dominate financial markets

As the chart shows, it provided early warning in December (yellow highlight) that another feedstock price surge was underway. This drove up other petchem markets as cost increases began to be passed through. The correlation trade also led to a major rally in global stock markets.

But the crucial issue with bear-market rallies is that the volume of trading usually fails to increase as prices rise. Instead of more and more buyers jumping into the market, activity remains subdued.

This has been the pattern of recent weeks. Equally, both crude oil and the US S&P 500 have stalled at the top of their trading range. Brent is still at $124/bbl, and the S&P 500 is at 1370. Neither has found new buyers willing to support the rally.

Meanwhile, ICIS pricing reports continue to suggest that end-user demand is slowing. Buyers seem to be simply protecting downstream margins by buying forward. There is no surge of new demand.

Thus benzene’s price fall last week (second highlight) is worrying. So are the reports from China on PTA demand. It never recovered after the Lunar New Year holiday, and now seems to have slowed further.

The blog would like to be wrong. It may be that this week’s slowdown will be quickly reversed. But for the moment, it suggests that – just as in 1973/4, 1979/80, 1990/1 and 2007/8 – today’s sustained high level of oil prices is leading to demand destruction on an increasing scale.

ICIS pricing comments and price changes since the IeC Downturn Monitor launch on 29 April are below:

PTA China (red), down 10%. “PTA demand is likely to drop as a number of downstream polyester yarn/fibre chip producers in China have either shut their plants or lowered their operating rates by 5-20%, starting from last week, to ease high inventory pressure and balance weak demand”
Benzene NWE (green), down 8%. “The market has grown increasingly detached from oil and energy movements, with supply/demand dynamics playing a larger role in driving direction”
HDPE USA export (purple), down 5%. “US Gulf export offers were higher, as producers continue to try to implement an increase of about 3 cents/lb for March. However, traders said they are purchasing very little material, because the prices are too high to work in other regions”
Naphtha Europe (brown dash), down 2%. “Demand for naphtha remains unexceptional, with no shortage of offers but little in the way of bids.”
Brent crude oil (blue dash), no change
S&P 500 Index (pink dot), no change

The March IeC Boom/Gloom Index confirms the blog’s sense that markets are sitting on a fence, waiting for something to happen. As the chart shows (blue column), it has risen back to 4.1, just at the point which divides strong from weak markets.

Similarly the US S&P 500 Index (red line) is stuck at 1369, at exactly the 1370 line which would mark a major breakout. Meanwhile oil markets are also trapped, with Brent at $124/bbl remaining at the top of its triangle.

Interestingly, a number of major institutions now seem close to accepting the blog’s long-standing argument that high oil prices lead to
recession. Christine Lagarde, head of the IMF, is the latest, warning that “higher oil prices” are a major risk for “still fragile financial systems”.

A reader has also kindly drawn the blog’s attention to a paper by Prof James Hamilton of the University of California, San Diego. It notes “All but one of the 11 postwar US recessions were associated with an increase in the price of oil, the single exception being the recession of 1960.”

ICIS pricing comments confirm the supply-driven nature of current markets. Upstream prices are close to the levels at which the IeC Downturn Monitor originally launched on 29 April. But downtream PE/PTA have so far failed to pass today’s increases through to their customers:

PTA China (red), down 10%. “Activity was limited as persistently weak downstream polyester sales continued to weigh on market sentiment”
HDPE USA export (purple), down 9%. “Globally, PE prices increased on mounting energy and feedstock ethylene cost pressure”
Benzene NWE (green), down 3%. “Sources believe that the current bullishness on crude and naphtha numbers will continue to support price levels in March”
Naphtha Europe (brown dash), down 2%. “Interest in naphtha remains mediocre”
Brent crude oil (blue dash), down 1%
S&P 500 Index (pink dot), no change

The Wall Street Journal carried an interesting opinion piece on Friday, assessing current market conditions from the viewpoint of the film character, Forrest Gump. Gump’s key insight is that “Stupid is as stupid does”. Thus the Journal noted:

“Oil staged its last price surge along with other commodity prices when the Fed revved up its second burst of “quantitative easing” (QE) in 2010-2011. Prices stabilized when QE2 ended. But in recent months the Fed has again signaled its commitment to near-zero interest rates first through 2013, and recently through 2014. Commodity prices, including oil, have since begun another surge.” And it went on to add:

“Fed officials….want to take credit for easy money if stock-market and housing prices rise, but then deny any responsibility if commodity prices rise too, causing food and energy prices to soar for consumers. They can’t have it both ways, as not-so-stupid Americans intuitively understand when they buy groceries or gas. This is the double-edged sword of an economic recovery “built to last” on easy money rather than on sound fiscal and regulatory policies.”

ICIS’ Truong Mellor sums up the consequences as far as petchem markets are concerned when he notes with regard to benzene that:

“The push and pull of opposing factors – the upstream bullishness versus the slower end-use demand as well as the sense that the market is currently overheated – is also adding to the confusion.”

Europe and the USA are not the only regions where the Fed’s QE policies are destroying demand. China has record retail prices for gasoline and diesel, and ICIS reported a polyester producer commenting this week:

“General demand is not recovering as well as expected. We are at a very difficult position now: sales are slipping while inventory are increasing”.

All the key sentiment indicators are telling us that financial markets are at a cross-roads. The critical number is 1370 on the US S&P 500. This was the peak of the last rally, and coincided with the blog’s launch of its Downturn Alert on 2 May. Friday’s close was 1366. A rise above 1370 would also mark a recovery to market levels not seen since June 2008.

The chart shows product price changes since then, with ICIS pricing comments below. It shows how stock and oil markets continue to move together, whilst downstream markets have proved increasingly unable to pass through the higher prices due to demand destruction:

HDPE USA export (purple), down 11%. “PE prices were stable in Asia, amid weak demand and high feedstock costs”
PTA China (red), down 11%. “Mounting polyester inventories have restricted the purchasing power of polyester makers in the physical and futures markets”
Benzene NWE (green), down 5%. “Sentiment has softened this week with lower demand from the phenol and cumene sectors.”
Naphtha Europe (brown dash), down 4%. “Reduced supply, resulting from refinery maintenance and shutdowns, is easily able to meet soft demand”
Brent crude oil (blue dash), down 2%
S&P 500 Index (pink dot), no change

This time last year, the petchem industry stood on the edge of an unseen precipice. Life seemed good. Prices were racing ahead and demand appeared buoyant. But in reality the buyers were only buying forward to protect margins, whilst end-user demand was slowing fast.

This year, the blog fears, we may be about to take one step forward.

As last year, the evidence comes from ICIS market reports. The highly experienced Linda Naylor last week reported buyers commenting as follows in European polyethylene and polypropylene markets:

“‘We expect an increase for ethylene in March, so we are buying our full contracted volumes in February, and also in January, even though our demand is poorer than we expected. That way, we won’t have to buy so much in March.”

“‘Our demand is below what we expected but we are taking our full contracted volumes to be able to have a buffer next month.”

Similar warning signs are reported by Becky Zhang in China’s ethylene glycol markets, and Helen Yan in Asian butadiene:

“‘The market is full of offers and this [has worsened the] bearish sentiment’, a major regional trader said. China’s port inventory reached a historic high of over 750KT, with increased import volumes arriving from all over the world. This is almost exceeding China’s maximum storage capacity of around 800KT.”

“‘BD prices are higher than BR and this is not sustainable,’ another synthetic rubber producer said.”

The chart shows how prices for the benchmark products have seen 3 major rallies since 2009. These followed the 3 major stimulus packages.

Today’s rally began with Q4′s US Federal Reserve’s $400bn Operation Twist programme. It is clearly much weaker than those which followed the March 2009 and August 2010 quantitative easing programmes.

Product price changes since the 29 April peak, with ICIS pricing comments, are below:

HDPE USA export (purple), down 11%. “Offers for re-exports from China were heard at lower prices than offers from the US Gulf”
PTA China (red), down 11%. “The current supply and demand balance as well as volatile external markets did not support a solid upturn”
Naphtha Europe (brown dash), down 7%. “Vitol continued its naphtha buying spree, taking 5 cargoes after it bought eight cargoes last week”
Brent crude oil (blue dash), down 5%
Benzene NWE (green), down 4%. “Continued buoyancy on crude and energy numbers counterbalanced by lower demand.”
S&P 500 Index (pink dot), no change

Over the past 18 months, the main investment analysts have argued that high oil prices would have no impact on the global economy. Now, new forecasts suggest their optimism has been misplaced.

The chart above gives the International Energy Agency’s latest forecast of likely oil demand growth this year:

• It has been reduced by a further 0.3mbd since January
• Total 2012 oil demand growth is forecast to be just 0.8mbd
• Global economic growth is now forecast at just 3.3%, down from 4%

Sustained high oil prices are indeed reducing economic growth, and oil demand itself, just as they have done every time in the past.

Even the idea that China would “inevitably” see strong demand growth has proved wishful thinking. The IEA forecasts just a 0.4mbd increase in China’s oil demand this year. And even that may turn out to be over-optimistic, given the clear slowdown now underway.

As the blog has long feared, the chemical industry will now have to pick up the pieces, after the damage has been done:

• Today’s oil and feedstock price levels mean that working capital costs are very high compared to historical levels. This reduces the cash available for product and market development.
• They also increase market volatility. The lack of inventory means small changes in demand can cause major swings in market prices, if producers or consumers have to cover supply chain problems.
• Even more critically, as we are seeing with the Petroplus refinery bankruptcy, there is a real risk of supply disruptions for feedstocks and raw materials, if key plants can no longer afford to operate.

Product price changes since the 29 April peak, with ICIS pricing comments, are below:

HDPE USA export (purple), down 14%. “US spot export prices are still too high for large quantities to be sold in many markets”
PTA China (red), down 10%. “Buying activity slowed down clearly as compared with last week because the persistently weak downstream polyester sales curtailed buying interest”
Naphtha Europe (brown dash), down 7%. The Petroplus bankruptcy led traders to build inventory in anticipation of “stronger demand from both the gasoline blending sector and petrochemical end-users”
Brent crude oil (blue dash), down 6%
Benzene NWE (green), down 4%. “Price ideas edged up in line with stronger US and Asia numbers as well as steady-to-firm energy costs”
S&P 500 Index (pink dot), down 2%

Dow Chemical is usually optimistic. 6 months ago, for example, it reported that “our transformed portfolio, underpinned by our cost-advantaged and flexible operations, is now performing at a new level.”

Last week, however, Dow reported that Q4 operating rates were down from 81% in 2010 to 72%, and warned it faced “headwinds” in all segments apart from agriculture. Dow added that “times like these demand a focused approach and strong resolve, and Dow’s firm operating discipline, cost control and productivity will continue throughout 2012.”

Yet next day, financial markets turned euphoric, with the S&P 500 and oil prices jumping 1.5% in response to the monthly US jobs report.

Demand, as always, will determine whether markets are right to climb today’s ‘wall of worry’. So far this year, it has been relatively subdued, and gives no indication that either Western or Asian consumers are feeling full of confidence about the year ahead.

The chart shows market developments over the past year. Product price changes since the 29 April peak, with ICIS pricing comments, are below:

HDPE USA export (purple), down 14%. “US spot export prices are too high for most markets”
Naphtha Europe (brown dash), down 11%. “Demand from both the petrochemical industry and the gasoline sector have declined”
PTA China (red), down 10%. “Chinese fibre market has yet to resume full production after the holiday”
Brent crude oil (blue dash), down 10%
Benzene NWE (green), down 5%. “There had been an expectation that buyers would enter the market, but this has so far failed to materialise”
S&P 500 Index (pink dot), down 1%

‘Would you buy, or would you sell?’ is always an interesting question in any market. Petchems provide a particularly balanced answer today.

• Buy arguments include – China’s buyers will return from holiday, and will need to restock; gasoline markets are tightening after the Petroplus bankruptcy; bad weather is causing some disruption
• Sell arguments include – US GDP data disappointed with inventories showing a big rise; a blockage of the Strait of Hormuz seems less likely in the short-term; European demand remains slow for the time of year

The ‘safe’ answer to the question would therefore be to buy. And this is what has been happening, especially as consumers need to build inventory ahead of proposed price increases. They cannot pass these on downstream, so their profitability depends on buying forward.

The second question, of course, is ‘would you therefore go long?’ And today the ‘safe’ answer would be to simply maintain prudent inventory levels. Markets have been driven by supply-side constraints for many months now, not by strong levels of demand.

The ‘sell’ arguments above create justifiable concern that one day, perhaps not too far away, fundamentals of demand will come back into play. Going ‘long’ would require either a strong belief that demand is returning, or confidence that supply will remain disrupted.

The blog suspects that crude oil market moves may prove decisive in the end. The bankruptcy of European refiner Petroplus is yet another warning sign about the impact of demand destruction at today’s record prices. But equally, oil is still trading in its ‘triangle’ pattern, so it would be premature to anticipate its future direction.

The chart shows market developments over the past year. Product price changes since the 29 April peak, with ICIS pricing comments, are below:

HDPE USA export (purple), down 16%. “Trading was thin, with the Chinese New Year holiday keeping Asian markets at a standstill”.
PTA China (red), down 13%. Markets were closed for Lunar New Year
Brent crude oil (blue dash), down 11%
Naphtha Europe (brown dash), down 11%. “Restocking, delays in the Mediterranean, and higher propane prices which have finally encouraged buyers back to naphtha”.
S&P 500 Index (pink dot), down 4%
Benzene NWE (green), down 3%. “Some key European producers have been aggressively purchasing benzene instead of pygas”.

There is no arguing with markets when they are being driven by sentiment, either positive or negative. Last week’s news of China’s slower GDP growth gave rise to opposite interpretations in Asia and the West – but news media reported both were seen as firmly positive:

• In Asia, markets “jumped… after news that Q4 economic growth in China had beaten forecasts eased fears of a sharper slowdown there”
• Western markets “rose to a 10-week high…after China’s slowest economic growth in more than 2 years bolstered expectations for easier monetary policy”

News analysts, however, were more cautious, with CBS noting:

“This is the smallest GDP increase in a decade and the consensus opinion is that it indicates China is heading for a soft landing as its economy slows. That would be a reasonable conclusion if there was any chance this number wasn’t a complete fabrication. The actual number is certainly lower, quite possibly by a huge amount”.

The Washington Post added a more detailed warning:

“Real estate accounts for 13 percent of China’s economy, and it has been growing at ~20% a year…The run-up in real estate prices has allowed for massive government spending, as provinces and localities sell land and use land as collateral for large loans, raising the specter of a debt crisis similar to the debt crisis in the United States and Europe.”

Meanwhile petchem markets remained in their recent range. The current optimism in financial markets, even though these also remain range-bound, makes it prudent to restock inventories regularly.

The chart shows how markets have moved since 2009′s rally began, with the recent downturn highlighted in yellow. Product price changes since the 29 April peak, with ICIS pricing comments, are below:

HDPE USA export (purple), down 18%. “Even with higher global prices, US prices were still too high to generate much interest”.
Naphtha Europe (brown dash), down 14%. “Some seasonal restocking, a recent open arbitrage to the US and the current loading of European vessels booked in December for Asia”.
PTA China (red), down 13%. “Transactions were subdued as most market players were away for the upcoming Lunar New Year holiday”.
Brent crude oil (blue dash), down 11%
Benzene NWE (green), down 5%. “Values buoyed by a firming Asian market as well as crude and energy gains”
S&P 500 Index (pink dot), down 4%

The above chart would have seemed unbelievable at any time in the past 30 years. It shows the performance of propylene and butadiene relative to ethylene.

Not because it shows butadiene prices racing ahead relative to ethylene (green line). This happens routinely during a downturn, as tyre demand is more robust than for polymers. If people are not buying new cars, they still have to buy new tyres for existing cars – for legal and safety reasons.

But the record level of the butadiene premium to ethylene, an average of 170% in 2011, does give a clue to the dramatic nature of the disruption that has taken place.

The real shock, however, is that propylene sold at parallel prices to ethylene through the year (blue line). Not only has this never happened before. But it is also contrary to the main rationale for propylene sales, as this developed during the 1980′s.

The blog discussed this emerging trend back in July 2010, in a major series of posts that anticipated recent developments. They were also summarised in its ICB analysis of September 2010. New readers may like to refer to these for background detail by clicking the links:

• Major changes underway on relative olefin pricing
• Propylene prices reach parity with ethylene
• Benzene develops security of supply issues
• Lower Western gasoline demand helps paraxylene
• Major changes underway in chemicals markets

The key is that markets have become supply-driven. Oil production and refinery output have been reduced due to lack of demand. This has reduced ethane availability in the Middle East, and naphtha availability in the West.

Equally, the dramatic increase in the price of crude oil versus natural gas in the USA, due to financial speculation, has prompted a major switch from liquid to ethane feeds on the crackers.

Propylene supply has therefore been reduced both by lower refinery runs, and by the switch to ethane feeds, as these produce virtually no propylene or butadiene. Lower cracker operating rates have also helped to tighten markets, particularly for butadiene.

The question ahead is now twofold:

• Will buyers still be interested in using propylene for its commodity applications such as packaging, if it is no longer price competitive?
• Can crude oil really maintain its current premium to natural gas?

The answers to these questions are really a zero-sum game. Those who get them right, stand to make a lot of money. Those who get their analysis wrong, will likely lose a lot of money.

The blog itself would be extremely cautious about ignoring affordability issues, and simply assuming current trends will automatically continue.