budgeting for uncertainty white paper 012011

8/17/2019 Budgeting for Uncertainty White Paper 012011

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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.comphodges@internationalechem.comwww.internationalechem.comwww.icis.com/blogs/chemicals-and-the-economy

January 2011


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CONTENTS

What next for operating rates? 4

Scenarios 2011 – 13 5

Chemical production gains are

focused on Asia and the Middle East 6

Any recovery in US housingseems a long way off 7

US auto markets are moving

into the New Normal 8

Western consumers focus

on people, not ‘things’ 9

China’s 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

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

The long-term impact of China’s

stimulus programme remains unclear 19

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


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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 anall-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. Today’s 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?

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.

Chart 1. Global Capacity Utilisation


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Scenarios 2011 – 13

The Scenario approach was developed and

popularised by Shell in the 1970’s, 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 operationalplans 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?

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 toimpact oil supply and prices. More far out, perhaps,

is the thought that China’s 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.

Chart 2. Scenarios 2011 – 13


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Chemical production gainsare focused on Asia and theMiddle 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 theneed 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 productionto 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

programmes, which briefly made it the world’s

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 keyuncertainties 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’.

Chart 3. Global Chemical Production


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Any recovery in US housingseems a long way off

Last year’s 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 housingstarts 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.

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.

Chart 4. US Housing Starts


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US auto markets are movinginto 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

Ford’s 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 Toyota’s enforced recall

programme. But Piper’s 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.

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.

Chart 5. US Auto Sales


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Western consumers focuson people, not ‘things’

Last October, I was invited to keynote at the World

Refining Association’s annual meeting in Bahrain.

The above slide comes from a fellow-speaker from

McBride, Europe’s largest own-label manufacturer,

based on consumer research carried out byEuromonitor.

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

• People’s 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 theunderlying 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,

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.

Chart 6. Western Consumer Trends


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China’s focus is moving todomestic 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-orientedeconomies 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 China’s 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

today’s 600m urban dwellers, they are still only

$2271/capita. Net incomes for the 700m rural

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.

Chart 7. China, Disposable Incomes


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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 theNew Normal.

But as the chart shows, the absolute number of

people in India’s 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.

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”. It’s 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”.

Chart 8. India, Demographics


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Emerging markets for autoshave major potential

Another example of the scale of the change

underway is the recent launch of the Nano car, by

Tata, one of India’s 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 Tata’s Nano model

emphasises that the mass-market of the future will

not be in 7-Series BMW’s. 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

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.

Chart 9. Tata’s ‘Nano’ car


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The rise of emerging economygiants is changing the rulesof 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 – theEuropeans focused more on the former, the Anglo-

Saxons 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 country’s 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 China’sfactories fully occupied, and its population

employed.

Sinopec is China’s 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

doesn’t 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.

Chart 10. Sinopec EBIT and EBIT %


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The rise of emerging economygiants is changing the rulesof the game (continued)

Sinopec’s rise typifies the potentially game-

changing business model that is developing in

several emerging economies. It also providesobvious 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 majorproducers 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.



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A move away from free tradeis 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.

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 can’t repay its debts, then it

won’t 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 theglobalisation trend and accompanying movement

to free trade.

Chart 11. The Cycle of Deflation


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Demographic changes in theWest 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 globaldemand 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 whatwas 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

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.

Chart 12. UK, Demographics


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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 downsidewhilst 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.

The above chart comes from the Bank of England,

based on an IMF (International Monetary Fund)

study of 88 previous financial crises. The IMF foundthat 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

operates to recycle short-term deposits into long-

term 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 areluckier, or have better policies, leading to an

Upside performance. Some do worse, leading to

Downside. The UK’s performance to date is marked

in red, showing it is within the Mid-range.

Chart 13. The Length of Financial Crises


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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 stimulusefforts such as ‘cash for clunkers’ only brought

forward sales, and didn’t create new demand.

My scepticism over this in the recent White Papers

seems to have been fully justified. They certainly

didn’t create the ‘escape velocity’, in terms of

restoring consumer confidence, put forward as their

rationale by the now-departed Larry Summers, USeconomics chief.


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The long-term impact ofChina’s stimulus programmeremains 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, wherethe 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.

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, clearlysomething 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.

Chart 14. China, Bank Lending


20/23

20

Speculation on crude oil prices hasbecome 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 theynow 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) andLLDPE 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.

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 China’s 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.

November’s roller-coaster ride on PTA, whereprices first rose 20% in 4 days, and then fell

11%, gives a possible insight into the monster

that has been created.

Chart 15. LLDPE Trading in Dalian Futures Market



21/23


22/23

22


The role of governmentis 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, theseeming 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 chemicalcompany 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 EU’s REACH programme.

What we don’t 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 withdeveloping robust operational plans, that

will cope with whatever may occur over the

next 3 years.

Chart 17. Increased Regulation is on the Way


23/23

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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

Research, India: Chart 8

Bank of England: Chart 13

China Daily: Chart14
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