Boom, Gloom and the New Normal

Shipping markets are usually a good leading indicator of future economic activity.

They have their own supply/demand balances, of course. Not every uptrend or downtrend can be taken too seriously.

But the Baltic Dry Index of ocean freight costs has done a good job for the blog in the past.

So one cannot simply dismiss its message today.

It is an excellent proxy for world trade and activity in China, as it covers the heavy bulk products (iron ore, grains, coal). It was strong through 2007/8, before collapsing. Last March, it was the first indicator to signal the start of China’s slowdown.

As the chart shows, it has now been falling steadily for over a month. Day by day, every day. So far, it has fallen for 28 days in a row. This is quite remarkable behaviour for any market.

It is now back at the levels seen in December 2008.

Optimists who believe that China is about to see a renewed boom will continue to ignore the Index. They will argue its decline simply reflects the fact that too many ships were ordered at the height of the boom.

But this seems too simplistic a response. The recent price weakness is far too dramatic to be simply reflecting this already widely known fact. The blog suspects that the Index is also reflecting a serious slowdown in world trade. It is yet another sign that a new recession is probably underway.

UPDATE. The Index today fell 2.6% today, and is now at a 25 year low.

‘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”.

Latest data from the IMF shows that the EU remains the world’s largest economic unit. Its GDP in 2010 was $16.2tn, 26% of the global economy. The USA was next with $14.5tn, and China 3rd with GDP of $5.9tn.

So what happens in Europe matters greatly to the global economy.

Equally, petchems are one of the best leading indicators that we have for monitoring the health of the broader economy. So the chart above of ethylene production in the EU 15 (plus Norway), based on APPE data, provides good insight into what lies ahead:

• Q4′s 4.4MT output (red line) was the lowest since 1995, excluding 2008
• Total 2011 output of 19.6MT was the lowest since 2000, excluding 2009
• Q4 operating rate was just 72%, and H2 only 77%

This is not good news, by any standard.

Another way of interpreting the data is to average 2010-2011 volumes. This takes account of 2010′s stock-build as crude oil prices rose, and then 2011′s destocking. It gives an average volume for the 2 years of 19.9MT. This would be the lowest volume since 2001, excluding 2009.

The conclusion is obvious. Demand destruction is underway in the world’s largest economic region. It also seems unlikely that things will improve short-term with oil prices at a sustained record level, and with EU governments committed to an austerity approach.

Producers and consumers have done a superb job over the past few months in reducing output in line with demand. In the short-term, they should hope for a reward in terms of a bounce in orders. H1 should be the seasonally strongest part of the year.

But only an extreme optimist will regard this as a sign that the economy itself is turning the corner. And policymakers’ continuing inability to finalise Greece’s inevitable default is a reminder, if one were needed, of the banana skins that now litter the world’s economic outlook.

The blog’s argument that there is no shortage of crude oil seems finally to be going mainstream.

Equally, its concern over the impact of today’s high prices, especially by comparison with natural gas, is also now starting to be highlighted.

Thus the Wall Street Journal notes:

“Oil inventories in the Western world are now high.

“In Europe, at the sharper end of the (potential Iran) embargo, International Energy Agency data show a less benign, but hardly alarming picture. On a 12-month rolling average to take account of seasonal swings, stocks covered roughly 140 days of net imports in October. That is 10 days less than in mid 2010, but in-line with the average of the past five years.”Meanwhile the New York Times reports:

“Nationwide, the average household using oil spent $2,298 on heat last year, compared with $724 spent by gas users and $957 spent by electricity users, according to the Energy Department. This year, heating oil users are expected to spend 3.7% more than last year, while natural gas customers are expected to spend 7.3% less and electricity users will spend 2.4% less.”

Cars are now the largest single market for chemical sales, as housing markets have slowed globally. Each new US car is worth $3297, for example, according to the American Chemistry Council (ACC), making the US market worth $42bn in 2011.

2011 auto sales were ~59m, up 4% from 2010. The West (EU, USA, Japan) still dominates, with 50% of demand. Developing countries showed rapid growth until recently, but the BRICs (Brazil, Russia, India, China) are still only 35%.

The chart above shows performance in the 3 largest markets since 2007:

• China (blue column) remained in top spot at 14m. But its growth rate collapsed with the ending of stimulus spending – from 49% in 2009, and 30% in 2010, to just 5% in 2011. Q4 growth was only 1%, as the last subsidies were removed in September
• The EU (red) was 2nd at 13m, continuing its recent decline. Sales have now fallen for 4 successive years. Without Germany, whose sales rose 9% to 3.1m in 2011, the picture would be even worse
• The USA (green) remained 3rd with sales up 11% to 13m, hopefully having now bottomed, as the blog noted recently. But they are a long way from the 15 – 17m range enjoyed during the 1995-2007 boom years

• Japan was the next largest market at 4.2m, hit by 2011′s tsunami disaster. The other main markets are small by comparison – Brazil at 2.7m, Russia at 2.6m, India at 2m

Overall, growth in the 3 major markets weakened significantly last year.

2009 had equalled 2008 performance, as China’s massive stimulus balanced the US/EU slowdown. Then co-ordinated G20 stimulus led to 10% growth in 2010. But last year saw growth decline to 4%. Q4 growth was only 2%, versus 10% in Q4 2010.

The blog does not rule out a panic reaction by policymakers, as it becomes more apparent that the world has re-entered recession. Co-ordinated stimulus would work for a period, as it did in 2009/10. But the debt overhang afterwards would be even worse than today’s.

In the absence of further stimulus, it is hard to see much growth in 2012, particularly with oil prices at today’s record level:

• Germany’s economy is slowing fast, so EU volumes are likely to continue their decline
• China’s growth will remain slow, as its primary focus is now on controlling food price inflation, rather than boosting demand
• The USA will probably also see only slow growth, even with further stimulus ahead of the presidential election

It is not all bad news, however, as moves to reduce auto weight will boost chemical and polymer demand. The ACC estimates, for example, that 378lbs (172kg) of plastics and composites were used in the average light vehicle in 2010, up from 286lbs in 2000 and just 20lbs in 1960.

But clearly the days of steady SuperCycle growth are now behind us, as the Western BabyBoomers enter the New Old 55+ generation. With 29% of the Western population already in this cohort, their mobility needs now represent a new and potentially very attractive market opportunity.

We highlight these in more detail in Chapter 8 of ‘Boom, Gloom and the New Normal’, to be published next week.

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 International Energy Agency (IEA) confirmed the blog’s worst fears this week, with its announcement that crude oil demand actually fell by 300kbd in Q4. Not only is this “quite rare” as the IEA noted, but they went on to warn:

“We’re flagging that there are clearly downside risks to the global economy and to oil demand: the world could see zero demand growth if there were further downgrades to global GDP estimates”.

The issue is simple. The world has never before had to live with Brent prices at over $100/bbl ($2012) for so long. Demand destruction is clearly taking place on a wider and wider scale. Even if prices fell sharply tomorrow, demand would now still take a long time to recover.

The IEA data shows that Western demand fell very sharply in Q4, by 700kbd. And Asia, despite all the bullish analyst talk about decoupling and perpetual demand growth, saw just a 400kbd increase. China’s slowing economy meant its demand rose only 1.7% in November versus 2010.

Yet for the moment, prices remain at their record levels. They are supported not only by Iran’s threat to block the Strait of Hormuz, but also by Saudi Arabia’s comment that its “wish and hope is we can stabilize this oil price and keep it at a level around $100/bbl“.

As a former feedstocks and oil product trader, the blog well remembers that the basic rule in oil markets has always been to assume Saudi will achieve its objectives:

• It has the largest reserves, and plenty of spare capacity (Oil Minister Naimi suggested in his interview it could easily produce an extra 2mbd)
• And usually Saudi prefers relatively low prices, as it is keen to be seen as a reliable supplier, helping to promote global growth
• It is equally dangerous to bet against Saudi when it wants higher prices
• It cut production between 1980 – 1985 from 10.3mbd to just 3.6mbd, in its effort to keep prices at ~$30/bbl ($65/bbl in $2012)

But today’s position is less clear-cut. Saudi needs high prices, at least $80/bbl, to balance its budget, following its decision to increase subsidies and handouts following the Arab Spring. But it also (unlike the 1980s) needs high volumes. 3.6mbd at $100/bbl wouldn’t provide enough income.

It is thus hard to see how both its objectives can be achieved:

• US demand is down 1.5mbd since 2007, and its domestic production is increasing rapidly, whilst European and Japanese demand is also reducing
• 2012 seems a bad year to try the experiment, with demand growth under threat from European austerity programmes
• Equally, China imports only 5mbd, so even a major new stimulus programme would not really create much extra global oil demand
• The outlook is even less promising. Spare capacity today is 4mbd, and this volume is already set to rise to 8mbd by 2015

And finally, of course, there is the growth of gas supply. The arrival of shale gas has pushed US prices down to $2.35/MMBTU. As the chart shows, this has led to a record ratio for crude oil prices versus gas of 34 today, when the energy equivalent ratio is only ~6.

This will further reduce oil demand in favour of gas, probably permanently. Whilst today’s record prices mean that other major consumers including the UK, Poland and China, are all hurriedly jumping on the bandwagon.

The blog cannot remember a time in the past 30 years when oil markets have been so uncertain.

History suggests it would be extremely unwise to bet against Saudi, at least in the short-term. The Iranian situation makes this doubly risky. Yet building inventory would also be very risky, if prices did begin to fall. And it is also very expensive at today’s prices.

Thus low inventories and increasing nervousness create the potential for continued price volatility, further adding to the uncertainty.

The blog suspects that the above chart may not feature prominently in the New Year reports about to be published by the main oil market brokers.

These will instead probably highlight the view that oil markets are very tight, and that prices should surely go higher. They have held this view for several years, and made good profits from selling high-priced futures to their pension fund and other clients, as we noted in chapter 3 of our ‘Boom, Gloom and the New Normal’ ebook.

The chart gives the history of US oil demand and inventories on a monthly basis since official US Energy Information Administration records began in 1963. It shows

• Total inventories in terms of combined ‘days of demand’ for crude oil and products (red line, left hand scale)
• Total supply of crude oil & products (kbd, green line, right hand scale)

February 2003′s inventory at 42 days of demand was the lowest-ever level. February 1973 saw 45 days of demand momentarily. Inventory was also at 45 days in December 1999, and between December 2003-April 2004, and at 47 days in December 2007.

But since the Great Recession began in Q4 2008, it has not been below 54 days. Last September, the latest month available, it was at 58 days. This was very close to the average of 62 days for the whole 1963-2011 period.

The reason is that US oil demand actually peaked back at 21.7mbd in August 2005. Since the downturn began, it has never been above 19.7mbd. In September, it was 13% below the peak at just 18.8mbd

But, of course, a story that focused on lower demand, and comfortable inventory levels, would probably not produce too many positive headlines for prices.

A year ago, Petromatrix highlighted the short-term ‘triangle’ that was being drawn by oil prices. This describes a period when sellers and buyers are evenly balanced, and neither side can gain momentum to take prices in their favoured direction.

It usually leads to a sharp move, either up or down, when one side wins.

At that time, Brent was ~$60/bbl. And the ‘triangle’ was eventually broken by the bulls, using liquidity provided by the US Federal Reserve’s QE2 programme. The move led to a doubling of oil prices, as buyers had to scramble to obtain supplies.

Now, as the blog noted back in June, a longer-term triangle is busy tracing itself out. The chart above highlights the peaks from 2008 and earlier this year. Its downside is the green ‘support line’ that has marked the bottom of the range since then.

Last year, the US Fed’s $600bn QE2 stimulus provided the cash to fund the surge in the oil price. So far, its new replacement Operation Twist seems to have provided less firepower, although prices have risen $10/bbl since it was announced last month.

However, demand continues to slow under the influence of today’s high prices, which have always led to recession in the past. In particular, the Reuters chart above shows China’s implied oil demand last month was up only 0.6% versus September 2010.

Traders will clearly try to maximise their year-end bonuses by pushing prices higher again. But the fundamentals of supply/demand are even less supportive than last year. The blog will continue to watch the triangle to see what may happen next.

The blog will publish its fifth annual Budget Outlook next weekend. As usual, it is therefore time to review last year’s Outlook. Past performance may not be a perfect guide to future outcomes. But it is one of the best that we have.

The blog’s 2008 Outlook ‘Budgeting for a Downturn’, and its 2009 ‘Budgeting for Survival’, meant it was one of the few to forecast the Great Recession.

2010′s ‘Budgeting for a New Normal’ was then more positive than most forecasts, suggesting “2010 should be a better year for the chemical industry, as demand grows in line with a recovery in global GDP”.

The 2011 Outlook was titled ‘Budgeting for Uncertainty’. This argued “Scenario planning will give businesses the chance to adopt the wisdom of the Scouting movement. Its motto, ‘Be Prepared’, seems the best possible approach in today’s increasingly uncertain New Normal environment.”

It described its Base Case as being “the classic ‘muddle through’ Scenario”. This suggested we might see 3% global GDP growth, oil in the $60-$80/bbl range and continued financial market volatility. It was broadly similar to the consensus chemical company forecast.

But the blog then suggested that companies should also consider an Upside Scenario based on global GDP growth of >3.5%, “causing oil prices to rise above $80/bbl” and inflation to become a major issue.

It also suggested that plans should be tested against a Downside Scenario, where countries instead “put their own interests first and adopted beggar-my-neighbour policies”. It suggested this could cause “the banking system to come under major strain”.

It looks as though 2011 will see all 3 Scenarios occur at different times.

Equally, the blog’s concern in the Outlook about the potential for ‘currency wars’ has proved well-founded:

• The US QE2 stimulus programme did force China and the other BRICs to allow their currencies to rise, and supported US export growth
• But as the blog warned, “when elephants fight, those around them need to be cautious”. And we have seen increasingly violent swings in major currency values in recent months

The blog’s aim is to ‘share ideas about the influences that may shape the chemical industry over the next 12 – 18 months’. It hopes that its 2011 Outlook again helped readers to better prepare for today’s increasingly difficult economy.

Its underlying viewpoint remains the same as in 2010′s ‘Budgeting for a New Normal’ when it forecast that:

“We will start to see a rebalancing of the global economy. The West will see lower consumption, as people rebuild their savings, and borrow less. In turn, this will mean lower export demand for the emerging economies. The outcome will be a more sustainable world economy, but it will be a difficult journey.”