The Leather Pipeline - 09.12.14
09/12/2014
We are heading quickly towards Christmas and the end of the year but the financial markets have delivered quite a number of interesting pieces of news.
Most commodities remained on a downward trend and one that is making most of the headlines is the oil price. The OPEC group of oil-producing countries decided not to cut production, resulting in another sharp decline in the price of oil. All related products went down too and this is good news for the consumer at the petrol pump and for the refill of heating oil for the winter season in the northern hemisphere.
Depending on the local price policy and taxation in various countries, prices for the consumer have significantly declined, in some cases by as much as 30%. This is freeing up a lot of purchasing power as heating bills at the end of the winter season in the northern hemisphere will be substantially lower for many consumers. One can only hope that the stimulation is going to boost other consumer spending and help the economy in general. However what is good for the consumer is bad news for the producer and countries that depend pretty much on the revenues of oil production will have to take extra care of their budgets in 2015.
The Chinese government is concerned about the domestic economy and has cut interest rates once again. Chinas Purchasing Managers’ Index is close to 50, said to be the barrier between expansion and contraction in the economy. To improve savers’ confidence the Chinese national bank declared also that bank deposits are now guaranteed up to 500,000 RMB.
The protests in Hong Kong returned and the protesters continue to be in the street. Most of the Hong Kong people, despite suffering from the negative effects on local business, are still trying to protect their independence to guarantee unrestricted business and personal liberty.
Stock markets remain on a roller-coaster ride, but in pretty narrow ranges close to record levels, which is directly related to the low interest rate policy all over the globe. Investors have few opportunities, especially as commodity prices have taken a sharp nosedive. Low energy costs will definitely help a lot of companies with their costs, some benefiting more than others; low interest rates, easy access to money and low energy costs are generally a dream for anyone running a company.
The European Central Bank continues to indicate that it will aggressively support the market with cheap money, keeping the euro under pressure, and the magic level of $1.20 to the euro, which many saw as a possible target for the end of the year is actually getting pretty close now. For European exporters this is an additional help in dragging the EU economy towards recovery, in particular in the south where the biggest problems are. However, others in Europe will welcome the currency trend too.
The Ukraine crisis is making fewer headlines without being resolved. Reading between the lines one gets the impression that politicians on both sides are seriously trying now to de-escalate the situation, although it is difficult to find a solution with the positions taken.
Market Intelligence
We are less than one month away from the end of 2014. For the vast majority, the year will end before December 31 and this means that many are already preparing for the festive season and a break from work rather than thinking too much about business.
This might not be completely correct, because we are also winding the year down for the end of the fiscal year; thinking about budgets and the outlook for next year is definitely business too. In Asia people are still about two months away from their break for the Chinese New Year holiday (mid-February in 2015), but their businesses are also influenced by the Christmas and New Year holidays and, with longer lead-times, businesses in Asia are far less active than at normal times.
The important fact is not that the businesses are slowing down due to the holidays, but much more that we have never really reached the activity levels one would expect in the last quarter of a normal business year. Although the same stories are repeated again and again, we would say that we have an entirely different market situation at the end of 2014 compared to the end of 2013. After such a long period, actually since the end of the second quarter, it might be time to deal with the realities.
The world is different: the logic that product prices can be controlled by supply and the fact that cheap and easy money can ease the problems and buy time but not change the fundamentals have to be realised. All this has been discussed numerous times since the summer, but many market participants are still trying to deny that we are in a new cycle. At least, this is what our analysis tells us.
There are many reasons why leather demand has changed significantly since the beginning of this year. We believe that price is a major factor, the cooling down of private consumption in certain areas around the globe is another one and last but not least the Ukraine crisis has curtailed global consumption too. All this has led to the fact that the budgets and expectations for leather consumption have not been met and the high prices for raw material and leather have invited many consumer product manufacturers to look for alternatives. What started as a cautious approach in the first half of the year has seen strong acceleration in the second half and since oil prices are falling many oil-based alternative materials are becoming increasingly attractive.
It always takes a little while before this materialises itself in demand and the markets. So far financial issues, low profitability and cash flow problems have been the drivers with many players along the supply chain reducing their inventorying positions and living hand-to-mouth, according to their financial resource.
The financial restrictions and the deflated utilised capacity, due to reduced demand and failing confidence in the markets, have led to a ‘picking of the cheapest option policy’, wherever the finished leather articles allow this. This has shifted demand and created wide spreads that cannot be justified economically. Carrying out a per-square-foot calculation and considering the currency fluctuations it becomes pretty clear that the prices of many hide types and origins have no justification. With the present demand structure it is unlikely that the comparatively cheap items will go higher and it looks more likely that the expensive ones will come down eventually. For those who are still in possession of a comfortable order book for this season, the present situation may turn out quite comfortably.
Why do we now think that we are in a new cycle? As usual there are a number of reasons. Those who are spending the time to read our bi-weekly publication regularly will remember that since the first quarter we have been sceptical about the raw material prices, failing to see how these could be explained by the real facts. The market was made by speculative money and the hides that had been put aside along the supply chain; it had been so comfortable to buy hides and skins and to see them become more valuable every month. However, you should always watch the average leather price, season by season, too and this is not only far less elastic, it has not climbed at the same pace for more than two seasons now.
The final lap of the market rise started in the last quarter of 2013 with the sudden appearance of cheap tanning capacity in Hebei province in China and the rapid increase of split prices. Cheaper tanning costs and higher split returns allowed a lot of players in China to pay above market levels for hides and triggered the speculative move of prices under the lead of the gamblers in China, which dragged the whole market higher. Split prices in our opinion had also to be a mirage because they had just been pushed higher because of seasonal demand and as a consequence of inflated prices for grain leathers. Grain was too expensive, so many manufacturers escaped to splits for a season. They had to be covered to fulfil the orders, but the values went up too quickly and too far. So, the correction of split prices in the late spring should have been a warning, but was generally ignored by many hide suppliers until autumn. We may mention skin prices at this stage too which are in limited correlation with bovine raw material, but followed a similar pattern.
These are the fundamentals of the general leather pipeline and are in themselves enough to explain the reason why we think we are in a new price cycle. However, there are many others.
It all started with the shut down of many tanneries in Hebei province, which suddenly took a whole tranche of cheap tanning facilities out of the market. This has changed the balance of cost and utililisation of hides and skins in the market. Suddenly many hide types (in particular medium- and lower-priced ones) had no ‘cheap tanning’ operators to go to any more, suddenly making a revaluation of many hides necessary. Those who were dependent on this market and on long-term programmes with industrial tanners in other regions underestimated, in our opinion, the extent to which everything is connected. For a number of months it even seemed that with the support of the automotive, luxury and high-price shoe brands parts of the market could disconnect.
It all may have lasted longer if it were not for the Ukraine crisis. Sanctions, the fall of oil prices and the fall in value of the ruble not only wiped away a lot of consumer demand in Russia and the Ukraine, but also changed the market balance. Leather substitutes which had been an option even with far higher oil prices have become far more attractive in the last three months. Medium term this will also become beneficial for tanning costs, but the impact on material use should note underestimated.
To draw a bottom line we come to the conclusion that raw material and leather prices are at the beginning of a correction or re-adjustment phase. The interest to hold out against such a trend is understandable. In particular tanners have been fighting so hard to push leather prices higher that the last thing they want is to learn that they are coming down. It usually takes double the time to get them up than it takes to bring them down. We wish the tanning industry the discipline to withstand major correction, however the present prices seem not to be creating enough demand to keep everyone in full production. All who think we are too pessimistic may want to have a look at the present price levels. They are still well above the long term averages and even another decline of 10% would still not make them look cheap in the long term.
Those who are pointing their fingers at the positive sectors, such as automotive, may have to take a rational look at the growth potential in this sector after the boom years and compare this with the reduction potential in the others. It is true that automotive tanners and leather users appear to have a good outlook for profitability in 2015 and some of the large public company producers are already reporting excellent results for 2014; this should become even better with every percentage they can take from the price of raw hides and leather, at least until the big price war begins when demand declines, which is usually what such a situation leads to.
The rest of the market is in a period of adjustment. Leather is and will always be a material that is used. How much it is used depends on the price and this also determines the capacity. The leather industry is not so different from others, with the exception that it still consists of a larger percentage of mid-sized companies. They are an endangered species. They are too small to play in the big field of global business and to meet the financial requirements involved, and too big to be a local niche player to serve a specialty demand at adequate prices.
In times of strong demand and rising prices the midsize company can still find customers to serve and market risks are limited. Working capital can be a restriction, but in general they can thrive in such a market and total capacity utilisation is a consequence of raw material demand and raw material prices. This is added to by speculative demand from traders who try to take advantage, as we saw until the summer of 2014.
When prices exceed their ‘justification level’ it just needs a trigger for the market balance to change or for players pull out, forced or unforced. In our opinion this is what we are seeing now and prices are readjusting to levels that are more in keeping with the situation in the wider economy. It’s hard to know if this represents an orderly and controlled retreat or a ‘sudden death’, but so far it seems that the large suppliers and the industrial operators have done a good job of keeping things under control. How long and how deep such a correction phase is going to be depends a lot on financial resources and psychology and is therefore not something that can be rationally analysed. A little trigger can cause a big reaction.
The split market continues to be in a stable situation. However, further adjustments could be on the horizon if the trend we discuss above materialises. Also splits could and should feel the price competition of other materials and have to adjust if it comes. For the moment splits are still doing well in high-quality niche production and mainstream products are still benefiting from the early price correction they underwent some time ago. New directions and decisions will have to be taken in 2015 though.
The next and final issue of 2014 of the Market intelligence will be published just before Christmas. For most, year 2014 is already finished and they are busy wrapping up rather than taking any further decisions. Consequently, we do not expect much market activity and it will be up to sellers if they want to try to promote sales by teasing buyers with lower prices. If there is any major interest it could come from Asia, but the impression is really that most of the tanning industry is pretty well covered until and possibly even beyond the holiday break in February, especially as people will still have time to return to the market and replenish their inventories for the production period of March and April.
On the other hand it doesn’t seem likely that hide sellers will want to see another sharp correction in prices before the end of the fiscal year. This leads us to believe that, while prices may slide a little further, major changes and corrections should not be expected. The first two months of 2015 will tell us more about the long-term trends towards lower prices; perhaps leather demand will pick up quickly in response to more disposable income due to the sharply falling energy prices. We do not put too much emphasis on such a scenario and are generally of the opinion that a moderate and controlled price slide is what we have to expect.
Share this story:
