January 2011

Budgeting for Uncertainty

The Difficult Transition Ahead,
as we Enter the New Normal

by Paul Hodges, Chairman,

International eChem

In association with ICIS news

Contact:
www.icis.com
phodges@internationalechem.com
www.internationalechem.com
www.icis.com/blogs/chemicals-and-the-economy

EXECUTIVE SUMMARY
Last years Budget Outlook was entitled Budgeting
for a New Normal. Its main argument was that we
may experience a New Normal as the global
economy recovers, rather than a return to the
previous Boom period. A year later, there seem to
be good reasons to believe that this may prove to
be correct.

adopt a scenario approach to budgeting and

strategy, with an agreed Base Case along with
Upside and Downside variants. This is particularly
useful at creating a consensus amongst colleagues
about the key issues, and capturing the concerns
they may have. In turn, of course, this leads to
more robust planning.

This year, it therefore seems sensible to try and

highlight some of the key issues we may face in
the chemical industry during this transition period.
Unsurprisingly, these are often linked to those
areas where it seems uncertainty is already on the
rise. One can summarise these as follows:

I have, therefore, also included my own view of

what such a Base Case might look like, as well as
Upside and Downside views. I believe, given the
uncertainty, that there is great value in ensuring
that the Upside and Downside Scenarios are indeed
quite different from the Base Case, and from each
other. As we have learnt to our cost over the past
2 years, just because something seems unlikely
and unwelcome, does not mean that it cant
happen.

Chemical industry operating rates and likely

future trends
Likely levels of demand in key sectors such as
housing and autos
Changing consumer trends in the West
New market opportunities in emerging
economies
Rising economic concerns, especially over
currency values and protectionism
The impact of financial markets on crude oil
prices and chemical margins
An increase in regulatory pressure in areas such
as operations and safety

In turn, this has led me to title this years Budget

Outlook, Budgeting for Uncertainty.
This White Paper suggests that in view of these
major uncertainties, it may well be prudent to

I then go on to highlight some of the debates

around these key issues, in order to help crystallise
your own thinking. I am sure you will disagree,
perhaps quite strongly, with some of the analysis I
raise. I regard this debate as very healthy, in that
it will hopefully take the discussion forward, rather
than brush issues under the carpet.
As always, I will be very happy to exchange views
directly with you, or via the Chemicals and the
Economy blog. I hope that you will find this White
Paper helpful, as you plan your course towards the
New Normal, in an increasingly uncertain world.
Paul Hodges

CONTENTS
What next for operating rates?
Scenarios 2011 13
Chemical production gains are
focused on Asia and the Middle East
Any recovery in US housing
seems a long way off
US auto markets are moving
into the New Normal
Western consumers focus
on people, not things

A move away from free trade

is becoming possible

15

Demographic changes in the

West are the key issue

16

There are no quick fixes

for financial crises

17

7
The long-term impact of Chinas
stimulus programme remains unclear 19
8
Speculation on crude oil prices has
become a key driver for polymers

20

Financial trading continues to

influence crude oil markets

21

The role of government is increasing

22

About the author

23

About ICIS

23

Chinas focus is moving

to domestic consumption

10

India offers a similar opportunity

11

Emerging markets for autos

have major potential

12

The rise of emerging economy giants

is changing the rules of the game

13

BUDGETING FOR UNCERTAINTY

What next for operating rates?

Chart 1, using data from the American
Chemistry Council, summarises the current
position of the global chemical industry.
It shows that Operating Rates (OR%) fell
dramatically during the start of the Crisis, to an
all-time low of 77%. Since then, they have
recovered to 87%. Of course, this is a major
achievement. But the overall context is also
important. Todays levels have only taken us back
to the OR% levels seen in the 2001-3 period, and
they are still below those that were considered
normal over most of the 1989 2007 period.
This raises the question to be addressed in this
White Paper, namely What Happens Next?
Will the recovery of the past 18 months continue,
and take OR% back above the 90% level that
would indicate things were really back to normal?
Will they stabilise at current levels? Or will they
slip back, as governments cut back on stimulus
programmes and move towards an austerity diet
of lower spending and higher taxes?

Chart 1. Global Capacity Utilisation

My own view, as expressed in the Budgeting for

a New Normal White Papers, is that we are in a
transition mode. As a result, OR% will probably
fluctuate much more rapidly than in the past.
And given the range of uncertainties with which
we are surrounded from oil prices to currencies,
trade policies and underlying demand patterns,
a Scenario approach makes most sense.

BUDGETING FOR UNCERTAINTY

Scenarios 2011 13
The Scenario approach was developed and
popularised by Shell in the 1970s, when the world
was going through a similar process of transition.
The concept was to accept that not everything
could be known, and therefore to come up with a
mechanism that enabled strategies and operational
plans to be tested in advance, against the likely
extremes that would be encountered.
This was quite different from the more recent use
of Scenarios, which developed during a more stable
period, in which the basic trend of demand was
fairly stable, and so companies simply wanted to
develop contingency plans in case things went
slightly better, or slightly worse, than their main
forecast.
The Base Case used here is an industry consensus,
which sees the global economy in a slow recovery
mode, driven by Asian growth. The Upside Case
essentially suggests Western growth will be
stronger than expected, causing crude oil and
inflation to rise. The Downside Case sees Asian
growth as being slower than expected, with
deflation a more likely option alongside lower
oil prices.
Everyone can draw up their own variations on this
theme. The point is simply to have something that
really challenges current strategies, and asks what
would we do, if this happened? For example, it
might seem easy to respond to higher demand, but
how would it impact supplies of raw materials, and
what would happen to working capital needs?

Chart 2. Scenarios 2011 13

Equally, if growth did slow and oil prices fell below
$60/bbl, what would happen to inventories?
Then, one needs to consider what I would call
jokers. These are not mainstream influences
today, but factors which could easily come to have
a major impact on the markets in which the
chemical industry operates. Some, such as
Eurozone pressures and currency issues, are
already taking a more central role.
Others, such as geo-political issues, have been
quiet recently, but the potential for Middle Eastern
conflict cannot be ignored, with its potential to
impact oil supply and prices. More far out, perhaps,
is the thought that Chinas economy might slow
quite dramatically, leading to a reversal of current
moves to revalue the renminbi. Whilst not very
likely today, it would have an enormous impact if
it did happen, and so cannot be safely brushed
under the carpet if one is taking a 3 year view.

BUDGETING FOR UNCERTAINTY

Chemical production gains

are focused on Asia and the
Middle East
Chart 3, again based on ACC data, shows how
dependent the chemical industry has become on
Asian demand since the Crisis began in 2008. This
highlights the key role played by China, and the
need to consider what might happen if Chinese
growth begins, for whatever reason, to disappoint.
But of course, it also highlights the growth in
production in the region, up 17% versus Q1 2008,
meaning that supply/demand balances are
becoming less dominated by the need to import.
The growth of Middle Eastern production is the
other main feature of the chart. This, of course,
cannot be consumed in the region, due to its
relatively small population. So inevitably, it needs
to find a home in a region with major consumption
essentially Asia (eg China), the USA or Western
Europe. Much of this production is being targeted
at China, via the so-called Middle East China
corridor, whereby China provides preferential
access to its markets, in exchange for increasing
crude oil supplies it is now, for example, a larger
consumer of Saudi oil than the USA.
These two regions have caused global production
to recover above the levels seen in Q1 2008. But
the other regions are still struggling to a greater or
lower extent. N America, for example, is down 8%
even though the combination of the lower US$ and
the growth of low-priced shale gas has provided a
major boost for its exports. There are also
question marks around future W European
performance, given that the major stimulus

Chart 3. Global Chemical Production

programmes, which briefly made it the worlds
largest regional auto market in 2009, have now
come to an end.
Similarly, Latin America has done well due to Asian
demand, but is still only level with Q1 2008
performance. Whilst Central and Eastern Europe
has really only begun to recover in 2010, and so its
future performance cannot yet be guaranteed.
The benefit of the Scenario approach is that it
allows colleagues to express their own hopes and
fears constructively, without feeling that they have
to toe the party line. It therefore enables the key
uncertainties for the business to be discussed, and
plans put in place to mitigate the problems that
deviation from the Base Case might cause.
In a nutshell, it enables businesses to benefit from
the wisdom of the Scouting movement, as
expressed in its motto Be Prepared.

BUDGETING FOR UNCERTAINTY

Any recovery in US housing

seems a long way off
Last years White Papers on the move to a New
Normal economy highlighted some of the changes
taking place in US housing markets. Most
commentators were then expecting a V-shaped
recovery from the all-time low of 600k housing
starts seen in 2009. I instead suggested that an
increase of starts to 800k 1 million this year
would represent a strong recovery. And in fact,
as Chart 4 from thechartstore.com shows, there
has been almost no improvement at all.
Chart 4. US Housing Starts
This was in spite of an extended tax credit of $8k
and generationally-low interest rates. Clearly,
something very significant has happened to this
previously vital chemical market. It used, after all,
to be worth $35bn in 2006, when starts peaked at
2.2 million. Starts have been routinely above 1
million since records began in 1969. Even in the
1975, 1081 and 1001 downturns, starts never fell
below 800k.
So here is a clear example of the New Normal
economy beginning to develop. And there are a
number of factors behind it, which we shall explore
later in this White Paper:

The increasing trend to save more, and

borrow less
The ageing of the baby-boomers, which
encourages demand for smaller houses
Fear of unemployment, which encourages
caution on major cost items like houses

The rising tide of foreclosure, which is creating

a shadow inventory of houses that S&P
estimates will take over 40 months to clear
at current sales rates

In addition, generational changes in attitude

seem to be underway. The Boom years saw
children moving out from the family home, and
grandparents also living in their own home. As a
result, estimates of likely future housing demand
were always increasing. But now, this trend seems
to be reversing, as families (a) seek to reduce risk
and cost by staying together as a unit and (b) the
replacement of a more consumerist approach,
which valued new houses, autos and things, with
a greater focus on values and relationships.
This has enormous implications for future chemical
demand, as it implies that the future may indeed
look quite different from the Boom years.

BUDGETING FOR UNCERTAINTY

US auto markets are moving

into the New Normal
This change in attitude can also be seen in the US
auto market, even more important to chemical
sales as it was worth $50bn until 2007. Since
then, consumers have cut back, unless offered
cheap deals or government handouts such as the
cash for clunkers programme.
The above slide shows how the market has slowed.
And it also highlights the intriguing comment from
Fords lead analyst, George Piper, about the New
Normal being outside our business model. Ford
has been the most successful of the major US auto
companies since the Crisis began avoiding
bankruptcy, and also Toyotas enforced recall
programme. But Pipers comment not only
confirms my own sense that we are moving into a
New Normal, but also the uncertainty that this
creates for forecasting purposes.
At the same time, of course, chemical and polymer
sales into the auto industry should be supported by
the new regulations that will increase auto fuel
efficiency by ~40% by 2016. This can only be
achieved by using less steel and glass, and more
plastics. But it may, of course, also help to reverse
the historical trend towards ever-larger autos.

Chart 5. US Auto Sales

The iconic Hummer vans have very much gone out
of fashion since the Crisis began, and are now seen
to represent rampant consumerism at its worst.
But will Americans really embrace the smaller
vehicles that dominate auto markets in the rest of
the world? This really would be a major change of
attitude in itself. So once again, we are left with a
sense of uncertainty over future demand drivers.
And this is only increased by the fact that
companies such as Ford, have no great confidence
in their own ability to forecast.

BUDGETING FOR UNCERTAINTY

Western consumers focus

on people, not things
Last October, I was invited to keynote at the World
Refining Associations annual meeting in Bahrain.
The above slide comes from a fellow-speaker from
McBride, Europes largest own-label manufacturer,
based on consumer research carried out by
Euromonitor.
This suggests that consumers are certainly seeking
value for money when they shop, as they worry
about balancing their budgets. But they are also
changing their habits.

The drive to the hypermarket is now being

replaced by more local shopping at convenience
stores, which removes the temptation to
over-purchase
Small moments of indulgence are now being
treasured, rather than the previous I want it
all, now mentality
Peoples lifestyles are becoming more focused,
and less complex
Values are continuing to grow in importance,
particularly sustainability

Overall, therefore, this suggests that chemical

companies need to pay close attention to the
underlying changes in behaviour that are occurring
in consumer behaviour, as we move towards the
New Normal. This also creates uncertainty, of
course, as we cannot be sure which trends are
being driven by a shortage of cash, and which by
new lifestyle choices.
One solution would be for companies to evaluate
end-user markets in more detail. This would
mean reversing the trend of the last 30 years,

Chart 6. Western Consumer Trends

whereby many Western companies have become
increasingly focused on silo operation. As a result,
they have focused on reducing fixed costs, and
have lost the wider view that used to inform
strategic thinking.
Such a change might well be in the best interests
of the companies, and in the long-term interest
of their ultimate investors, the pension funds.
But it would require a complete change of
mind-set. Even though the concept of shareholder
value has now been dismissed as a dumb idea
by its creator, former General Electric chief Jack
Welch, the message has not yet got through to
most investors.
Some companies, such as Unilever and DSM,
have begun to move in this direction, however,
with their Boards refocusing on their real task, of
taking stewardship of the business for the next
generation. I suspect that those who do this
successfully will also be those who will profit most
from the changes underway, as they are likely to
be most adept at designing products to meet
future market needs in the New Normal.

BUDGETING FOR UNCERTAINTY

Chinas focus is moving to

domestic consumption
Chemical demand is focused on consumer markets,
and changes in Western consumer habits need
watching very closely. Equally, of course, the New
Normal means that there will be less Western
demand for goods from the export-oriented
economies of Asia. China, in particular, has been
extremely successful in building up its role as the
manufacturing capital of the world. And in turn,
this has driven growth in the urban population, and
a much higher standard of living.
But even so, average Chinas GDP/capita is only a
tenth of that of the affluent Western countries who
currently buy its manufactured goods. Therefore,
a slowdown in growth rates for its exports cannot
simply lead to a like-for-like replacement with sales
into the domestic market. This is particularly true,
as Chart 7 shows, due to the great divide that has
opened up over the past decade between incomes
in the urban and rural areas.
Personal consumption has been deliberately held
back in this period, to help promote exports.
And whilst disposable incomes have trebled for
todays 600m urban dwellers, they are still only
$2271/capita. Net incomes for the 700m rural

Chart 7. China, Disposable Incomes

inhabitants are even lower at $672/capita. So a
change in focus for manufacturing requires a
refocusing on more basic needs, for example the
provision of refrigerators, owned by only 30% of
the rural population.
Of course, there is a top end of the population
that can afford Western goods. But this is not the
major opportunity for the future. Companies who
continue to believe that they should create more
and more specialist and high value products, will
risk marginalising themselves versus more flexible
competitors who instead focus on the mass-market
that is now starting to develop domestically.

10

BUDGETING FOR UNCERTAINTY

India offers a similar opportunity

During the Boom years, it made perfect sense for
companies to focus their sales activities on affluent
Western baby-boomers. And it made similar sense
to focus on similarly affluent segments of the
population in emerging economies. This, of course,
will still be a profitable approach for some in the
New Normal.
But as the chart shows, the absolute number of
people in Indias Affluent segment will only be
11m in 2013, versus 3m in 2003. The really big
opportunity is in the Aspirers segment, which will
be 10 times the size of the Affluents, having grown
from 46m in 2003.
This population will require innovation in
product development, especially as the products
they will be able to afford to buy will need to be
low-cost, as their household income will be in
the $975 $4675 range per annum. But the
opportunities are endless, for example the growing
demand for plastic-wrapped single-serve food
portions for urban dwellers, or single-use
shampoo for rural areas.

Chart 8. India, Demographics

Already, major consumer products companies
such as Hindustan Lever are targeting these
new markets, through their innovative Shakti
programme whose Mission is Doing well by doing
good. Its creating a whole new distribution
channel to reach this new segment. And in the
process it is helping women in rural areas set up
small businesses as direct-to-consumer retailers.

11

BUDGETING FOR UNCERTAINTY

Emerging markets for autos

have major potential
Another example of the scale of the change
underway is the recent launch of the Nano car, by
Tata, one of Indias leading companies. It sells for
I lakh (100,000 rupees), and as the picture above
shows, it is a lot smaller than most Western autos.
But its aim is to progressively replace the
motorbike as the primary transport method for
families in India. As the photo shows, it is quite
usual for father to drive the two-wheeler with
one child sitting ahead of him, whilst mother
rides side-saddle holding on to the other children
and baby.
Currently, 10m motorbikes are sold each year in
India, versus only 2m cars. But Tatas Nano model
emphasises that the mass-market of the future will
not be in 7-Series BMWs. These will remain far
too expensive. And if manufacturers fail to serve
this sector, through innovative new models, they
may well miss major opportunities for future sales
growth.
Small, fuel-efficient cars use a lot of plastics and
coatings, as well as other key chemical company

Chart 9. Tatas Nano car

products. But, of course, it does require a local
presence on the ground to spot these
opportunities, and to build the right relationships
with the local companies involved. Doing
everything from a remote Head Office, according
to existing Western rules, certainly reduces fixed
costs. But it also risks missing the key
developments for the future.
Getting the right balance between these two
sometimes conflicting priorities, represents another
area of uncertainty for the next few years.

12

BUDGETING FOR UNCERTAINTY

The rise of emerging economy

giants is changing the rules
of the game
When I started in the chemical industry, some 30
years ago, the major companies were almost all
Western-based. They had different views about
the balance between sales and profit the
Europeans focused more on the former, the AngloSaxons focused more on the latter. But they all felt
the need to make a profit, in order to be able to
reinvest for the future in new plants and products.
Today, however, the rules of the game are being
changed by the arrival of emerging company
giants, based in Asia, the Middle East, and
potentially in Latin America. These companies
often have stock market listings, and produce
regular quarterly reports for investors. But their
modus operandi is completely different.
Instead of profit, their aim is to help implement
their parent countrys social and other agendas.
Creating employment, and reducing the risk of
social unrest, is the prime focus. And realistically,
how could it be otherwise? If a company such as
Sinopec, for example, focused on profit, then its
production volumes would be lower, and its prices
higher. This would not help to keep Chinas
factories fully occupied, and its population
employed.

Chart 10. Sinopec EBIT and EBIT %

Sinopec is Chinas largest refiner, and currently the
4th largest ethylene producer in the world. By
2014, it will be No 1, and a major player in most
other petrochemicals. Yet as the chart above
shows, based on company data, its EBIT (Earnings
Before Interest and Taxes, green line) has only
averaged 3.7% over the past decade in its
chemicals sector.

This is a long way below the levels required by

Western companies, yet it has not stopped Sinopec
investing Rmb 69bn (~$10bn) over the period,
with more plants in construction. Equally, Sinopec
doesnt reduce output when demand falls. Instead,
its average Operating Rate (OR%) for ethylene has
been 102.1% over the period. Essentially, it is
operating as a utility company, providing raw
materials to downstream businesses to create
employment.

13

BUDGETING FOR UNCERTAINTY

The rise of emerging economy

giants is changing the rules
of the game (continued)

Sinopecs rise typifies the potentially gamechanging business model that is developing in
several emerging economies. It also provides
obvious competitive advantage if the main growth
areas for chemical demand do become focused on
the value-for-money sectors in both Western and
emerging markets. How will Western companies
compete? And if they fail to compete, what will be
the impact on the wider Western economies?

It is easy to suggest that downstream businesses

in the West can still prosper based on imported raw
materials. But China and India are already major
producers of autos and other manufactured goods,
and Saudi Arabia is also considering investment
opportunities in such areas. With raw material
advantage secured, these countries could be very
successful.

14

BUDGETING FOR UNCERTAINTY

A move away from free trade

is becoming possible
The analysis above suggests that the economic and
business models of the past 30 years are starting
to look their age. Is it really conceivable that
Western politicians, dependent on votes, will
continue to allow major industries to be off-shored
to emerging economies, if the current Crisis
persists? It made perfect sense when Western
unemployment was relatively low, and consumers
could benefit from the lower prices charged for
their imported consumer goods.
Chart 11. The Cycle of Deflation
But this virtuous circle now risks turning quite
vicious. Rising Western unemployment does not
help the domestic population to repay the debts
that it incurred during the final stage of the Boom
after 2002. And if it cant repay its debts, then it
wont repay them. This will have consequences for
the people who lent the money particularly those
Asian countries, such as China, who operated
mercantilist policies under which they lent money
to the West, in order to sell them the goods needed
to keep their factories employed.
In fact, as the chart above from Comstock Partners
illustrates, we are now getting towards the really
difficult part of the Cycle. It:

Began with Asia boosting savings and

investment in chemical and other plants as part
of its export-led development model
Whilst the West created overcapacity in
financial services, as it recycled the vast Asian
savings pool into Western debt instruments that
would enable consumers to buy all the goods
being produced.

But in the end, of course, growing overcapacity

then led to a loss of pricing power. In turn, this
led to the Crisis of 2008.

Now we have moved into a new stage, where

countries try to maximise domestic employment
by boosting exports via devaluation of their
currencies. And as it is impossible for everyone
to devalue against everyone else, we risk moving
closer to the next stage of the Cycle, where
countries begin to adopt protectionist measures
to support employment. This would have a
particularly bad impact on the chemical industry,
which has been a major beneficiary of the
globalisation trend and accompanying movement
to free trade.

15

BUDGETING FOR UNCERTAINTY

Demographic changes in the

West are the key issue
At this point, we need to pause the analysis of
chemical markets and changing demand patterns,
in order to focus on a key underlying issue. This is
that the Western babyboomers (those born
between 1946 64), who have underpinned global
demand growth since 1980, are now ceasing to
play this role. The implications of this are massive,
and not just in the field of pensions, which is
already starting to capture major attention.
The chart uses UK data, which is very typical of the
overall picture in the Western economy. It starts
back in 1971, as the babyboomers left the cohort of
under-24s (blue columns), and began to move into
the 25 54 year old cohort (orange column). This,
of course, is the major age for consumption, as
people marry, settle down, buy houses, autos and
other durable goods etc.
It created a seeming Golden Age for the chemical
industry. By 1991, whilst the number of under-24s
had fallen 11%, those in the 25 54 cohort had
grown by 15%. And this positive trend continued
inexorably, as time passed. By 2001, the number
of under-24s was down 15% versus 1971, whilst
the 25 54 year old cohort was up 24%. And what
was true of the UK, was also true of the other
Western economies.
Only Japan, of the advanced economies, had by
then begun to hit the inevitable moment when
these 25 54 year olds reached the over-55 cohort
(green). Politicians, and economists, have since
blamed its policymakers for the subsequent lost
decade, which has now stretched out for 2
decades. They claim to be determined to avoid

Chart 12. UK, Demographics

these mistakes in the current Crisis. But how do
you make people younger again?
The key fact about the babyboomers, of whom I am
one, is that there was a completely unexpected,
and unique, rise in the number of babies born in the
West after the Second World War. And then, the
numbers fell back again to pre-War levels. In
addition, social changes such as the introduction of
the contraceptive pill, and greater affluence, have
led to young people delaying marriage. Equally,
healthier lifestyles have led to an increase in life
expectancy.
It is hard to see how we can alter these facts.
2011 sees the moment when growth in the over-55
cohort starts to overtake that of 25 54 year old
cohort. By 2021, it will have risen 51% versus the
1971 numbers, and in 2026 it will have grown
64%. Almost by definition, over-55s consume less
and save more. And this trend is accentuated by
increased life expectancy, as people worry about
whether their pension will be sufficient for their
needs.

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BUDGETING FOR UNCERTAINTY

There are no quick fixes

for financial crises
This is an uncomfortable message for Western
policymakers, brought up to massage the economy
at regular intervals with interest rate cuts, with
the aim of securing their re-election. Such
short-termism seemed to have little downside
whilst the babyboomers were in their Boom period.
It was equally beneficial for chemical companies.
The trend was remorselessly upward, and those
who rode the wave (wittingly, or unwittingly),
found themselves in the nirvana of steadily rising
volumes and profits.
However, we are now facing the rather unwelcome,
though entirely predictable result (given previous
Japanese experience) that the combination of the
rise of the over-55s coincides with a major financial
Crisis, as the previous focus on short-termist
policies has left a large gap in the planning
process, now it comes to deal with a less benign
environment. This is likely to take some time to
resolve, given the scale of the change in mind-set
required.

operates to recycle short-term deposits into longterm lending, and so individuals and companies
suffer from cash-flow problems, leading to higher
rates of bankruptcy and unemployment.
As one would expect, the IMF found that these
secular problems are not normally solved quickly.
Confidence has been lost, those lenders who
remain in business become more cautious, and
the economy slows. In terms of GDP, it takes time
to recover what has been lost. The blue area
covers the mid-range of those countries studied,
with the dark dotted line showing the Mean position
amongst the 88. Of course, some countries are
luckier, or have better policies, leading to an
Upside performance. Some do worse, leading to
Downside. The UKs performance to date is marked
in red, showing it is within the Mid-range.

The above chart comes from the Bank of England,

based on an IMF (International Monetary Fund)
study of 88 previous financial crises. The IMF found
that these are different from normal cyclical
downturns, generally caused by rising interest rates
acting to subdue demand temporarily. Instead,
they represent a moment when the financial
system itself becomes dysfunctional. It no longer

Chart 13. The Length of Financial Crises

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BUDGETING FOR UNCERTAINTY

There are no quick fixes

for financial crises (continued)
These data confirm that the concept of a quick
V-shaped recovery is most unlikely. It also leads
one to be quite cautious about the improvements
that have been seen to date. We know, for
example, that many Western government stimulus
efforts such as cash for clunkers only brought
forward sales, and didnt create new demand.

My scepticism over this in the recent White Papers

seems to have been fully justified. They certainly
didnt create the escape velocity, in terms of
restoring consumer confidence, put forward as their
rationale by the now-departed Larry Summers, US
economics chief.

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The long-term impact of

Chinas stimulus programme
remains unclear
Western stimulus measures have also not been
self-funding, as governments paid for them by
expanding their debt. Now, rightly or wrongly, they
are moving towards austerity programmes, where
the focus is instead on repaying this debt. The
recent examples of Greece and Ireland, and Iceland
in 2009, provide severe warnings of what can
happen if a small economy finds itself unable to
borrow overseas.
Chart 14. China, Bank Lending
However, we have no such clarity over the impact
of Asian stimulus measures, particularly in the
most important country, China. There, as the
chart illustrates, the government doubled bank
lending in 2009 (red column), in response to the
loss of export markets seen in Q4 2008. It also
launched a $580bn stimulus programme, far
bigger in terms of the size of its economy than
seen elsewhere.
The lending programme amounted to 1/3rd of
GDP, and the stimulus programme to 13% of GDP.
Obviously, they had a major and immediate impact
on demand. Electricity consumption (blue line), for
example, which had been falling at the end of 2008,
was up nearly 25% in Q4 2009 and Q1 2010 versus
the previous year. Chemical and polymer demand
was up by similar amounts, providing enormous
support for producers around the world, helpfully
counter-balancing the problems in traditional
Western markets.
The question is, of course, whether this massive
injection of government money will produce a
sustainable boom in demand? China is not, after

all, going into debt in order to fund the package.

It is also focusing on infrastructure, which should
help to generate economic activity for the future
(unless it follows the bridges to nowhere policy of
Japan in the 1990s).
But equally, one major beneficiary of the lending
boom has been housing, which has clearly now
become a bubble. Prime Minister Wen Jiabao has
recently ordered that it is the key responsibility of
all governments to stabilise housing prices. These
are strong words, but with Shanghai prices 150%
above their 2003 level, and property sales in 2009
reaching an astonishing $560bn in value, clearly
something has to change.
We have already seen in the USA that a rampant
housing bubble can have a major upside, and then
downside, impact on the whole economy. Can
China manage things differently? This is clearly
a major uncertainty, and one which could have
enormous implications for global chemical demand
over the 2011-13 period, even for those who have
no connection with direct sales into China.

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BUDGETING FOR UNCERTAINTY

Speculation on crude oil prices has

become a key driver for polymers
There is another factor, however, to the
importance of China in global polymer markets.
And that is the enormous influence now wielded
by its futures markets. These were only
established in the past few years, but they
now trade vast volumes of product via paper
contracts. In polyethylene, for example, the
largest volume polymer, the Dalian exchange has
traded LLDPE (linear Low Density Polyethylene)
since July 2007.
It saw relatively little volume at first, and the
contract seemed to be going the way of those
launched by the London Metal Exchange and
others, into oblivion. But it then suddenly began
to jump in volume as crude oil began its plunge
from $150/bbl to $30/bbl in H2 2008. In
December that year, it traded 59 million tonnes,
nearly 3 times total annual world production.
And while some months have since been quieter,
any big move in crude leads to a massive
increase in volume, with a then-record 92 million
tonnes traded in July 2010.
The chart above shows the correlation that has
developed between WTI crude oil (blue line) and
LLDPE prices (red). Clearly supply/demand
balances for LLDPE have become irrelevant to
these traders, who are focusing on the bigger
picture of crude oil movements. In turn, Dalian
has now become a major price-setting
mechanism for the Chinese market, and
therefore for Asian and global markets.

Chart 15. LLDPE Trading in Dalian Futures Market

This level of futures volume has never been seen
before in chemicals markets. So we have no real
experience to guide us as to what might happen
to LLDPE and other products now actively traded
on Chinas futures markets such as PTA (purified
terephthalic acid), if crude markets weakened
again. I fear we might see total confusion, and
not just in polymer and polyester markets, as the
traders might well simply dump the contracts,
particularly if credit limits were tightened, as
often happens in a market meltdown.
Novembers roller-coaster ride on PTA, where
prices first rose 20% in 4 days, and then fell
11%, gives a possible insight into the monster
that has been created.

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Financial trading continues to

influence crude oil markets
Chinese traders are not the only ones who are
having an increasingly powerful impact on
commodity markets such as crude oil, and therefore
on chemical markets and margins.
The above chart updates one used in previous White
Papers, showing WTI crude oil prices (green line)
versus those for the US S&P 500 index. Initially, the
argument used by Western traders for correlation
between them was fairly simplistic:

Stock markets are rallying, therefore the

economy is recovering
Oil markets should therefore also rally, as
demand for oil will soon increase

This has been a nonsense all along, as it ignores

supply/demand factors for oil itself. High oil prices,
as we learnt in 1979/80 and again in 2007/8,
destroy demand. Equally, it is clear that they
encourage more oil production itself, whilst also
encouraging the use of substitutes such as natural
gas and alternative energy and feedstock sources.
However, supply/demand balances are too
complicated for the average equity trading houses,
particularly as their real focus is on high-speed
trading, which now accounts for over 50% of US
stock market activity. Their high-speed computers
trade nano-second by nano-second, making
computer programming skills far more critical than
oil market analysis.
More recently, of course, the US Federal Reserve has
joined in the game via its QE2 Lifeboat policy. It
intends to buy $750bn of bonds over the next few

Chart 16. WTI Crude Oil vs US S&P 500

months in the belief, according to its Chairman
Ben Bernanke, that higher stock prices will boost
consumer wealth and help increase confidence,
which can also spur spending.
So now we have the worlds major central bank
explicitly aiming to interfere with the price discovery
role that is supposed to be performed by markets.
And, of course, traders have been only too happy to
build these purchases into their own activities, in
the belief that the Feds real aim is a lower value for
the $US, to pressure China. Thus they are further
encouraged to buy crude oil futures contracts, on
the basis that oil and commodities represent a
store of value.
Pity those responsible for chemicals purchasing,
faced with these pressures. They have to buy,
whether or not they think prices reflect real
value, in order to meet their companys sales
commitments. Equally, it makes perfect sense
for them to buy forward, at a time of rising prices,
in order to try and protect their bottom line.
Hopefully, however, we will not fall into the 2007/H1
2008 trap of believing that these enforced
purchases mean demand is necessarily robust.

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The role of government

is increasing
Markets where possible, governments where
necessary has been the mantra of the Western
economy for the past 30 years. And although
governments in emerging economies have tended
to view this concept with some suspicion, the
seeming success of the Western economies has
helped to encourage them down this path.
Now, however, the financial Crisis has created a
new mood of suspicion. Can financial and other
companies be trusted to do the right thing for the
long-term? Even former Fed Chairman Alan
Greenspan, a key believer in the concept, admitted
back in 2008 that those of us who have looked to
the self-interest of lending institutions to protect
shareholders equity, myself included, are in a state
of shocked disbelief.
It is therefore likely that we will see greater
government interference, at all levels, particularly
if the economy fails to make a full recovery.
The temptation to set more rules, and monitor
more closely, will be almost impossible to resist,
given public disquiet.
This will obviously have an impact on chemical
company plants and their operational reporting.
But it will also affect product safety issues,
where we are already seeing other governments
expressing interest in adopting parts, or all, of
the EUs REACH programme.

Chart 17. Increased Regulation is on the Way

What we dont know is how far this may go, and
how quickly. Clearly, there is another point of view,
which suggests that a time of economic difficulty is
not the right time to be increasing regulatory
burdens and costs, particularly if one wants to
maximise employment levels.
As with the other issues highlighted in this
White Paper, companies will have to form
their own view of what might happen.
Hopefully the Scenario approach, with a
Base Case and Upside and Downside variants,
will be a useful tool for highlighting the key
issues. In turn, this should then help with
developing robust operational plans, that
will cope with whatever may occur over the
next 3 years.

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Paul Hodges is a trusted adviser to major chemical
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He founded IeC in 1995, and has strong
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recognised in the Financial Times and elsewhere for
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Chart sources:
American Chemistry Council: Chart 1, Chart 3
Euromonitor Home & Personal Care Prospects: Chart 6
National Council of Agriculture and Economic

Paul is a Freeman of the City of London. He is a

graduate of the University of York, and subsequently
studied with the IMD business school in Switzerland.

Research, India: Chart 8

Bank of England: Chart 13
China Daily: Chart14

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