Market Intelligence - 06.08.13
06/08/2013
Many players on the financial markets are on holiday, but statistical data continues to be delivered and is basically delivering a mixed bag of information and emotion. The figures delivered recently allow everyone to make whatever interpretation they like best. The US seems finally to be recovering now, although slowly, from the long difficult period it went through after the financial crisis. Although many were not happy with the number of new jobs created, the most recent figures show that the unemployment rate continues to decline and more Americans have found jobs in the last quarter. This is also reflected in the modest rise in house prices as well in the impressive number of new cars sold in the month of July. Although definitely not everything is in order again, US consumers are beginning to spend money again and for an economy that is so dependent on consumption this is good news.
However, the Federal Reserve has indicated that the period of easy money might be coming to an end; this is closely tied to the unemployment rate and when further targets have been reached Federal Reserve chairman, Ben Bernanke, will be willing to end the quantitative easing programme.
In Europe many analysts have reported that they also are seeing some improvement in the situation of crisis. However, unemployment in the Eurozone remains well over 10% and if there is any sign of recovery it is slow and very small.
In China people are still worried about the debt situation. In the financial community you find two groups, with one being pretty relaxed and seeing the present situation not as a credit crunch but only as a small slowdown in the economy with no real problem on the credit side. The others are a bit more concerned and see their problem of banks in China as much bigger. They feel that it is still pretty unclear how you should address the problem of credits and possible bad debts and point also to the fact that many in China are tightening credits because of a serious capitalisation problem.
Talking about the global economy one has to have the impression that it has become common policy to talk possible problems down and emphasise the optimism. It might be better to deal with the facts and to consider the real problems once in a while.
On the financial markets not much has happened in the past two weeks. The US dollar hasn’t really recovered very much and one could have the impression that it is actually in some people’s interest to have a slightly weaker dollar at the moment. With the US increasing its own energy production, it is becoming less dependent on imports, for which a weak dollar would be a problem. For other countries dependent on US dollar-based oil imports, a weaker US dollar reduces the import bill. However, most commodities were have been correcting lower, with only oil remaining on a pretty firm footing.
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The global leather business is now on holiday; even some Asian tanners have decided to take a few days off. In Europe and America most are on vacation and, consequently many production places around the globe are closed and even those that are not are affected by the holidays in the northern hemisphere.
Raw material trading activity is pretty slow and we have to assume that most are happy that the present kill is also significantly reduced in Europe. The general market conditions remain pretty complex and difficult. Looking at it and thinking about it leads us to two major situations and topics to look at.
One is the fact that it seems that the (possible) by-product cartel for hides seems to be losing market control for the time being. Some readers may be surprised that we are using the term ‘cartel’, because these are generally forbidden and have, at least in the western world, a pretty bad reputation. However, we put up with them and the best known of them, OPEC, is known to everyone for trying to manage the supply and prices of crude oil. It’s a fact that the money market, globally, is organised in the same way, with major national banks deciding about money supply and the price for the same. Since this is coordinated, it works also like a cartel. Just recently we heard on the news that also the potash market is run by two cartels and one can assume that many other raw materials are managed in the same way.
Why do we assume, that part of the hide market is influenced and managed by a cartel? Well, we have been watching and monitoring the US hide market for a long time; it’s not the largest single supply origin, but it is the best organised and most mature one. It could just be a coincidence that suppliers manage prices independent of the hard facts and that sales and shipments do not cover the production of hides, but this is hardly likely. Traders, normally the link between producers and the industry, have not been willing to take any extended short position to trigger a price adjustment because they have had to learn to accept that short positions can only be successfully covered if the producer is willing to sell to close the position.
Consequently pricing has become more and more decoupled from supply-and-demand balance and prices have been managed by the offer lists and the trades that producers are willing to take and report. The enormous discipline shown by the main suppliers over the past months has been impressive and has held prices steady for a long time and kept the more recent decline under decent control. All of this is an almost classical indication of a working cartel being in place.
Cartels have a bad reputation because their existence is not in keeping with our idea of ‘free trade and free markets’, but if they are properly managed and focus on reducing volatility, concentrate on finding a fair market value and securing adequate and consistent supply, they can be beneficial for all. It can be of benefit in particular to an industry in which supply is almost totally independent of demand, and in which even higher prices do not generate the possibility of an increase supply, unless it is from existing stock. So, if there is any truth in our opinion, everything has worked out well, with the exception of finding a fair market price.
The hope that the price of finished leather might increase has not materialised. Prices for commodity leathers have not seen a big enough increase to justify the cost levels reached in the first quarter of 2013. The reverse trend has occurred and leather demand has slowly but surely declined. Considering the falling kill in Europe and the US, supply for standard raw materials has come down significantly in the first six month of this year and this has not been critical from a supply standpoint. There were always enough hides, and sometimes too many, available. There were not always enough buyers to clear all production.
The production of semi-finished, mostly wet blue, material has had a relieving effect in the short term, but the number of hides piling up and not being taken by the leather industry is still the same.
The second problem is finance. Traditionally the production of leather is a pretty capital-intensive operation and many tanneries do not always have the financial resources to handle short-term increases in demands on cash-flow, such as when raw material prices rise quickly and leather prices do not follow in time. The proportion of companies in the leather industry that are insufficiently financed has always been pretty high.
Some of this problem has been camouflaged by the new markets in Asia. Quick turnover, a lot of cash business, and access to short-term private capital sources have made it easy for many small and medium operators to access finance as long as the market was favourable. However, when things became more difficult and the product flow in the pipeline, in particular in domestic China, started to slow down, capital resources also faded quickly. The limited transparency of company capitalisation makes it difficult to have a full understanding of the financial strengths of individual companies and the sector in general.
It has become obvious that more banks in China are now beginning to struggle open letter of credits on time. Customers blame the banks, while it is not really clear if it is actually a problem of missing collaterals or the capitalisation of banks themselves that is causing the problem. Fundamentally, it has never been complicated to find finance for profitable businesses but always extremely complicated to find finance for businesses that are not achieving profitability. In many cases in the leather industry this is the situation because, as we stated above, leather prices have not made the same advances that raw material prices have. No matter what the real problem is, the fact is that the product flow in the leather pipeline at the moment is also being hindered by insufficient finance on the tanning side.
We opened this issue of Market Intelligence with the statement that suppliers may be losing market control.
Officially, prices for US hides have fallen only slowly and gradually, if we follow official reports and offer lists. However, in past weeks the amount of reliable information stating sales far below the official price lists makes us believe that some suppliers are beginning secretly to break away from the common line. Stocks and the market outlook for the coming months, at least, have deteriorated by so much that a reliable sale to a customer with approved finance is considered to be a better option than to pile up more hides in an attempt to defend price levels. We are convinced this has happened, despite aggressive denials.
The main problem many people are now dealing with is to figure out how much leather demand for the next season had been affected by the situation in the first half of this year. There are still quite a number of optimists who strongly believe everything is just seasonal. The recovery of leather production and demand, which they say will occur from October onwards, is in their opinion going to be strong enough to absorb raw material inventories. Product flow will recover and this will support raw material prices again. All the summer concerns and problems will be wiped away.
Others, and it has never been a secret that we rather support this opinion, have always pointed to the fact that, one way or another, sooner or later, the raw material price can only be justified by the leather price the market is paying. We have made advances, and the split credit has helped a lot. Consequently, from the valuation standpoint, hide prices have no real reason to drop substantially. It is never possible to make a generalisation over what is the right hide price, but a rough calculation has always worked. In our opinion, prices at about 10% below present price levels, would be right.
The remaining question would then be if such a reduction could absorb all the inventories, and if leather demand for next season will recover sufficiently to be in balance with the supply of raw material. This might be the important question to be monitored in September when much more information will be available about the trend of leather demand for the rest of the year.
We can still not trace any particular news in the split market. Collagen demand remains high and actually the price for wet blue splits too. This can easily be explained by the substitution of grain with splits and the declining production in the tanning industry due to sluggish leather demand. However, if one looks at recent price levels for wet blue splits and compares them with a lot of raw material sources of medium-lower quality, the price for splits is definitely not justified anymore. They are in the fashion collections and so they have to be produced, but at the current price splits are overvalued these days. When we consider that the hide market has had very little upward potential for some time, the demand for wet blue splits or splits used in the leather industry should gradually decline in the coming season. It might be good advice to tanneries to try to secure the present price level for their by-product for a bit longer than they would normally do.
The skin market is still pretty much in summer mode. There is a bit more demand from Turkey for double-face skins and the long and cold winter has reduced the new season in Europe by quite a bit. Consequently, prices have been a bit more stable and here and there one hears even about a fraction more money being paid for good quality new season skins. Other than that, the situation is still pretty much the same. Top-quality skins are still selling quite well while those of average quality are facing the same issues as bovine hides. Commodity leathers are facing serious price competition and that makes it extremely difficult. However we should not forget that prices for standard skins have undergone a serious correction since early spring and are not as overvalued as some hides are. When production resumes in September we will have a better view of the market, in particular of demand for the standard nappa garment leather from the Chinese and Russian markets. This will determine the direction of prices in winter.
The coming weeks are unlikely to produce anything particularly new. We think the market still needs to sort itself out and the massive discrepancy between value and market prices needs to be sorted out. Most suppliers will continue to try to hold the market as steady as possible until the All China Leather Exhibition in Shanghai at the beginning of September. Indeed, it would not make much sense to scare the market too much during the holiday season and before the new production season really starts. On the other hand, it is never the right time to bite the bullet and the key question that needs to be sorted out is, in our opinion, what is a fair and realistic raw material price level for the coming leather season. It is also very important to try to figure out the real views of brands and retailers regarding having leather products in their collections and on their shelves. If leather has been substituted more than people expect today, it could become pretty rough in the last quarter. But let’s hope for the best and say that leather demand will have declined only moderately, giving us a more realistic balance between leather production and demand.
We have to stress, however, that leather consumption in the luxury and automotive sectors is not part of the general situation. Recent information on production and sales in the automotive industry will make no one expect a decline in demand for automotive leather in the near future. And despite some reduction in luxury product sales in China, the general numbers in the luxury industry remain high enough to expect top-quality hides and skins to remain in strong demand. Many producers are sold forward and only financial problems will have a negative impact on the situation in this sector. This cannot be expected at this stage.
All of this means that the spread between the top-quality end and the commodity part of the market will most likely widen even further. It will be difficult to make packers understand that while one hide may still fetch a high price, others can barely be sold at steady or even lower prices.
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