Market Intelligence—08.03.11
09/03/2011
Observers of the global economy are presently watching with great care the developments on the commodity markets. The focus is certainly on oil prices; oil is still the blood of the economic organism.
The conflict in Libya has not only cut off some oil production in that country, but is also hitting exports. This is raising fears that the oil supply could be reduced in the longer term. So far, Saudi Arabia is compensating for the missing volumes. So the oil market is not facing any supply shortage at the moment, but there are fears and expectations. The main concern of the market is a spreading of the riots into other oil-producing country on the Arabian peninsula, which could really and seriously influence oil supply.
For the time being, oil product prices are climbing and in markets were energy prices are not fixed or subsidised by governments, consumers are seeing their fuel bills sharply rising.
This leads us to the next issue, inflation! While central banks are playing the risk of inflation down?Mr Bernanke at the US Federal Reserve more, and Mr Trichet at the European Central Bank less ?the markets are showing much more concern. As we all know statistics have many options of interpretation. Only consumers themselves know their own monthly budgets, and there are very few of them around the globe at the moment who do not feel that prices are rising fast. They don’t bother about core rates or other version of the statistics. With rising food and commodity prices it is the essentials of life that are moving up, and if flat screen TVs are still falling it doesn’t really bother people. Rising cost of living is a fact,
This leads us to interest rates. While Mr Bernanke still thinks he should continue to pour cheap money into the market, Mr Trichet in his last speech last Thursday already indicated some concern and risk about rising prices, and despite leaving interest rates at record lows, he suggested that the time of the first rate-hike in the euro zone might not be too far away any more. This gave the euro another boost and the exchange rate was back into the $1.40 region for the first time in months.
Another market-shaker was the announcement from the Chinese government that it would allow a great number of businesses to handle their import and export business in renminbi. This is considered as the first step to let the domestic currency to become free convertible and the first move in the Chinese master plan to let the yuan (its other name) to become the world anchor currency and to substitute the US dollar. Although there are a lot of counter-arguments, it will certainly be a first and major step to attack the US dollar as the leading currency of the world. In particular in Asia where the network of the Chinese is deeply integrated it will allow much easier counter-trading and even in the leather pipeline a number of relations can be considered which could substitute US dollar transactions quickly. It might not have an immediate impact on the global currency flow, but it will not only reduce the importance of the dollar, but also reduce the control of the US and the US dollar’s flow. One should not forget that all dollar transactions need still today be cleared in the US. In future yuan transactions will not pass through New York, but only Beijing, Shanghai or possibly Hong Kong and allow Chinese trading networks a number of better opportunities.
Oil is trading in the meantime at around $120 a barrel, gold is still above the $1.400 for the ounce and all commodity indices are close to or already at new record levels.
Market intelligence
The past two weeks have been a repeat of what we have seen for a while. Prices are edging higher following strong demand, which is in most cases outstripping supply. The beef industry is seeing higher returns for the by-product and the tanning industry is suffering from raw material costs that are rising much faster than strong leather demand can be converted into higher leather prices, which means significant margin problems.
We have always been convinced that a sustainable higher level of hide prices would require a return of inflation. That’s what we are seeing today. Central bankers and economists may still debate whether or not inflation is a subject, but away from political interests, common sense is telling us that inflation is already here, or is definitely on its way. At least it has already paved the way for the higher price levels we have been experiencing for some time now. If inflation continues to be an issue and the global economy sees no break from it, there could be still room for further advances.
It might be time for a rough analysis of the present market situation and the potential for the future. With the 2009–2010 recovery we have reached raw material price levels that are close to historical highs (excluding the times of BSE). One has to go a long time back to see similar or higher prices than the ones we have reached now. The question is if this means anything for the leather pipeline and if the common price ranges still apply for the analysis of the raw material markets.
Comparing the present situation to what has gone before, changes in the markets need to mentioned first. We think that there are two main changes in the situation we see today compared to what we have experienced in the past. In the old days tanneries were less specialised and far more willing and in the position to hold inventories. This made them not only less dependent on constant raw material suppliers and shipments, but also far more flexible in their productions and articles. All this has to do with the up or downstream production rules that apply to the industry. To improve productivity tanneries have become far more industrialised and specialised in their productions. Consequently, they are far more dependent on specific raw material supplies than they have ever been before. To manage working capital means that they also need to reduce inventories to the minimum. This is the model invented by the automotive industry once upon a time, and has been transferred to other industries; the leather industry is no exception.
The above is the main reason why tanneries these days can hardly pull back from the raw material markets, in particular when the leather business is as good as it is today. The market cannot take or get the necessary breaks any more to pause and analyse, and in times of good demand suppliers have a pretty easy time because they can sell and ship their product constantly and possibly at incrementally rising prices. The product and article monoculture seen in many places is adding to the problem.
Another critical problem today is the timing of contracting. We have had volatile markets before, but after the BSE crisis of the 1990s, volatility has been pretty limited and price variations remained within acceptable ranges until the 2008 economic crash destroyed the tranquillity. Prices dropped by as much as 80% and recovered at similar speed to exceed quickly the pre-crisis levels. While the drop was accompanied by a lack of leather orders, the rise came with rising orders. This was not a problem in the beginning because margins were extended due to the low raw material price levels, but it became tighter by the day when prices started to return to average levels and has become a nightmare since prices began rising much faster then the timeframe of finished leather contracts.
Leather manufacturers expect longer term price guarantees and with prices rising constantly and steadily the leather price is always behind. With no breaks or pauses and no correction, tanners are not seeing any light at the end of their calculation tunnels. Looking at the prices graphs of various origins one can also realise that price volatility was low in the US after the V-shaped trend and significantly higher with the currency influence in the non US markets. In any case the quick and constant rise of raw materials is a big threat to the leather industry, unless new pricing systems are accepted by brands and manufacturers.
This leads us to the question what we can expect from now on. The general consensus is that the leather business is strong and good enough to sustain raw material levels. The vast majority is also of the opinion that demand is outstripping supply. We disagree. The logic of the leather pipeline is, that demand and supply can never be in imbalance for any long period of time, and the term ‘demand is outstripping supply’ has been used in our opinion for too long already. If demand is higher than supply the gap has to be closed, because inexistent material cannot be tanned. What can happen is that production capacities are not used up, even though tanners would like them to be. If you cannot fill the drums because the raw material is not available you either turn leather orders down or you cut capacities, but you will never continue for a long period of time to bid higher prices for raw material you will not get anyway. Consequently we find the term ‘demand is outstripping supply’ inadequate if it is used to explain a price rise for a longer period of time. Demand allows suppliers to plant uncertainties and to push their clients towards higher prices, but these higher prices will not create more supply in the hide and skin market.
What is possibly meant is that higher prices force the players and the leather pipeline into selection mode. If there is indeed not enough raw material for all the drums, and raw material is in insufficient supply to satisfy all the interest, the industry will select quickly. The ones that can’t produce success will be sorted out quickly and this will continue as long as supply and demand are back in balance.
Although this logic applies, it has one problem. The system cannot assume and measure inventories along the pipeline. From what we know today, suppliers are not carrying large forward positions as the industry in most cases doesn’t carry much stock. Both for good reasons. Suppliers like to have their warehouses cleaned up, but with the rising prices trend, they don’t want to miss anything and so they don’t sell as much forward as many try to make us believe. At the same time tanners are not willing to carry too much stock or contract commitments, because they feel that the raw material price is too high and they hope there will be chances to reduce price levels to ease their problems.
The number of rumours that importers and traders, in particular in China, are holding larger stock positions is increasing. For an outsider it is pretty difficult to get the real picture, but pundits pretty close to the market in China are reluctantly confirming that there is a fair possibility of truth in it. This definitely does not apply to a number of mainstream raw materials, which are predominantly used in industrial shoe and automotive production, but for more sideline products we have to admit we would not be surprised.
Apart from the fundamentals of supply and demand in the leather pipeline we should not underestimate general economic influences too. Many will have to accept that price levels of more than $100 per barrel could become critical eventually. Periods of high oil prices have always led to significant recessions. The political uncertainties and possible bubble in China could become another serious threat for the general consumer product business around the globe. This will definitely be nothing for the short-term as leather orders and budgets are still full and it would take quite a bit of time for plans to be seriously adjusted.
This makes us believe that after an extended period of constant price rises, the industry will prepare for action to prevent further gains. Whether that is successful will depend on the price of alternative materials. Let’s not forget that cotton and wool, for example, as well as many oil-related fibres, have gone up in price too.
The split market continues to move in sympathy. The stronger the market for hides becomes, the more shelter and support the split market gets. Prices may not jump to the same extent as for full hides, but the trend for splits is definitely firm as well. How splits go in the future will depend on the new decisions of materials in the industry. If designers allow more splits in their articles the support for this by-product will persist.
Also the skin market continues to be pretty firm. In particular the strong demand for wool is supporting the prices for many types of skins. The rest is pushed by session. The last two cold winters and the fashion for natural sheepskin boots has added to the demand, not to mention the return of consumption of double-face garments, in particular in Russia. The strong demand for calf and the high price levels for the same are supporting the prices for goats as well. So, the outlook for skins remains positive as well, and the rising production of lambs around Easter might ease the situation a bit from the supply side.
For the coming weeks we would be surprised to see any major market movements. People are now preparing for their trip to Asia and for the APLF exhibition. With most suppliers not really desperate to sell before the event and buyers possibly hoping for a sobering effect from the show, it is hard to expect any major changes in market prices in the coming weeks.
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