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The chemical industry in 2013: A Q-and-A with Paul Hodges and Kevin Swift

Paul Hodges is chairman of International eChem, commercial advisers to the global chemical industry. He also writes the ICIS blog Chemicals and the Economy, which aims to share ideas about the influences that may shape the chemical industry over the next 12-18 months. Kevin Swift is the chief economist and managing director at the American Chemistry Council in Washington, D.C., where he is responsible for economic and other analyses dealing with markets, energy, trade, tax and innovation, as well as monitoring business conditions and identifying emerging trends for the domestic and global chemical sectors. I recently asked each of them about U.S. and global economic and chemical-industry trends to look out for in 2013.

Globally, how worrying is the U.S. “fiscal cliff,” especially for chemicals firms? And even if the immediate crisis is solved, does that do much to relieve broader uncertainty about the economy?

Paul Hodges: Clearly it is very worrying. My discussions with senior U.S. executives suggest that they see two key issues. One is the short-term threat facing us on Jan. 1, if no agreement is reached. The other is perhaps a more critical issue, which is what the emergence of the “fiscal cliff” tells us about the deep divisions within U.S. politics.

I was working in Houston, Texas during the Reagan era, when the president was often accused of high-handedness and ignoring his opponents. But he crafted bipartisan deals such as the Tax Reform Act of 1986, which was sponsored by Democrats as well as the White House. It did some remarkable things, such as reducing the top tax rate from 50% to 28% whilst increasing the bottom rate from 11% to 15%.  It also simplified a tax code that had become almost impossible to understand for ordinary people.

I think that a lot of today’s uncertainty is caused by a sense that politicians have stopped focusing on solving the big issues, and are no longer providing the leadership we have a right to expect.  U.S. politicians are not alone in this, of course, but the importance of the U.S. to the global economy means that the seeming lack of real purpose at the heart of U.S. government creates more uncertainty than it would in a smaller country.

There’s a lot of uncertainty in the economy and with regulation, especially concerning shale gas. Despite that, many companies are planning domestic shale-related projects. What key developments in 2013 might bring that to a halt; conversely, what key regulatory or economic developments could accelerate chemical-industry investment?

Kevin Swift: There is an incredible amount of uncertainty, centering on the state of the economy and its direction. Rising uncertainty leading up to the recent election, coupled with uncertainty over the “fiscal cliff” and likely first-quarter negotiations over raising the debt ceiling, as well as future tax reform, are factors hindering business confidence.

The uncertainty is resulting in a paring of business investment and hiring decisions, which are already being felt and eroding economic growth. Whether the nation falls off the “fiscal cliff” is a matter of conjecture, but the adverse effects of the possibility have already served to stifle the economy. Remove that uncertainty, and overall business investment should re-engage.

The advantages of shale gas on the competitive position of the U.S. chemical industry make the industry a special case, but we aren’t immune to this anxiety of the direction of the economy. There are over 50 major projects (valued at over $40 billion) that have been announced. Add in potential regulatory and other policy initiatives restricting hydraulic fracturing and drilling, mandating renewables or restricting the use of coal in electricity generation, favoring one sector over another (e.g., subsidies to use natural gas in transportation), adverse tax initiatives or other onerous policies, and these projects could go on hold.

Remove the uncertainty and, with an improved outlook for the economy, they should proceed.

Much of the public buzz is about the larger companies that might build ethane crackers or other large-scale production facilities. What should the focuses in 2013 be for smaller chemical companies, and those elsewhere along the supply chain, with regard to U.S. shale gas?

Swift: The shale gas revolution isn’t just about lower-cost feedstocks. Lower natural gas prices are resulting in lower fuel costs for specialty chemical and other downstream companies as well as stable electricity costs. These aid the competitiveness of these segments, as well.

In addition, a number of economists are examining how the shale gas revolution may affect U.S. economic growth potential much as the IT revolution did in the 1990s. It would be a positive supply shock, and some of the estimates are that it will boost long-term U.S. economic growth by 0.3 to 1.0 percentage points.

This is positive for the nation and for these companies, as faster economic growth will lead to the greater demand for things (light vehicle, houses, appliances, etc.) that contain chemistry, including both basic and advanced materials and the specialty chemistry that enhances operations and performance. Shale gas is a real game-changer.

We’re already seeing the domestic effects of U.S. shale gas, as well as some other parts of the world attempting to explore their assets. How might China, Europe and the Middle East compensate for this U.S. advantage in 2013 and into ’14, especially for areas that lack shale assets?

Hodges: So far, the arrival of U.S. shale gas has enabled everyone to be a “winner.” Greater use of ethane has also been a boost for oil-based producers, who have seen record margins for their products such as propylene and butadiene.  But the longer-term question is really whether crude oil prices can maintain their current premium to natural gas. Oil’s energy content is six times higher, and this has always provided a floor value, with the historical ratio around nine times gas prices.

Today, of course, the ratio is at 25, after peaking at over 50 earlier this year. Oil-market fundamentals provide no support for this record level of disparity. Inventories are at comfortable levels in all major regions, demand growth is slowing as consumers cannot afford to pay today’s high prices, whilst supply is booming, as we see in the U.S. and elsewhere. The only reason for today’s oil price bubble is the influence of financial players — primarily the pension funds and hedge fund investors who see crude oil as a “store of value.”  They have flocked to invest in oil futures markets because they worry that the Federal Reserve is trying to boost inflation and reduce the value of the dollar. But this situation cannot last forever.

According to Barclays Capital, financial players now have $439 billion invested in commodity futures markets, up from $160 billion in 2008 and just $10 billion in 2000. They are no longer providing liquidity to the market, but have become the market. According to the Financial Times, they account for 70-75% of all U.S. commodity market trading.  Thus oil markets have lost their traditional price discovery role, due to industry players being overwhelmed by the financial flows.

Yet “reversion to the mean” is a very powerful investment concept. So we must expect to see fundamentals reassert themselves at some point, and take the ratio back to its normal level. Companies in the U.S., as well as in China, Europe and the Middle East, need to prepare very carefully for this event and develop robust scenarios for surviving it.

Your blog includes a lot of charts and data points, such as the recent decline in chemical operating rates. What index or data are currently being overlooked that might be crucial to understanding what 2013 will bring? 

Hodges: One very simple piece of data, really. I would suggest people focus on the paradigm shift caused by the aging of the Western baby boomers. Everyone knows that demographics drive demand — one can’t have an economy without people.  But a lot of policy makers and companies have so far failed to “join the dots” between today’s economic slowdown and the aging boomers.

Our research for the “Boom, Gloom and the New Normal” e-book turned up some remarkable facts.  Everyone knows, for example, that U.S. births jumped 26 million (52%) between 1946-64 versus the previous 18 years and then fell 11 million (14%) in the following 18 years. Yet few realize that this boom occurred right across the Western world, and lasted between 1946-70, creating the largest and wealthiest generation that the world has ever seen.  If we then match the dates, we can easily link cause and effect between the 1982-2007 economic SuperCycle and today’s slowdown.

The average Western boomer entered the Wealth Creator 25–54 age group in 1983. These are peak consumption years, when people typically settle down, have kids and need to buy lots of new things.  Now, in 2013, we move into a new stage of the cycle as the average boomer turns 55 years old. U.S. Bureau of Labor data confirms that this is the period when consumption begins to slow quite dramatically — people no longer need new things, but instead move into replacement mode.  So slower growth is more or less inevitable, especially as the younger generation is simply too small to compensate for their parents’ slowdown.

What I don’t understand is why everyone seems to think this entirely natural event is somehow a serious problem. We should instead be celebrating the fact that a whole new generation is still alive today, when they would have been dead in any previous period of history! Western life expectancy has risen from just 50 years in 1900 to 80 years today, thanks to developments such as the use of chlorine in drinking water and healthier lifestyles. We are surely missing the bigger picture here if we spend our time worrying about the slower growth part of the equation.

I would much rather see companies refocusing their energies on this major new growth market.  Where are the products and services to support this New Old generation — which already accounts for a record 272 million people (29% of the Western population) and is growing all the time? We really do seem to be doing our absolute best to snatch defeat from the jaws of victory.

This question-and-answer session was produced as part of SmartBrief’s 2012 Best Of reports, which capture the year’s most important stories in each industry. Sign up now for ACC SmartBrief to get tomorrow’s report on the top must-read stories from the chemistry industry.

Images courtesy of Paul Hodges and Kevin Swift.