Another two fairly uneventful weeks have passed in the financial markets. The $ continued to trade within the narrow exchange rates we have seen for quite a while now and, with the Fed leaving interest rates unchanged, there was also little reason for speculators to push the American currency either way. The American trade deficit remains the big worry for the currency market, having reached a record $68 billion in July.

Fortunately for all of us, oil prices have continued their slide and fell below $60 per barrel. Many are now predicting a further reduction, to levels between $40 and $50, but these could well be the same people that predicted prices of $100 per barrel in the near future. The futures markets are continually adding a premium to a certain trend so reality will be affected much more by speculation and individual incidents, such as hurricanes, rather than just the balance between supply and demand. At least low oil prices will temporarily ease inflation and this is good for the firmer trend of interest rates.

Many people in the US are becoming more concerned about the housing market and there are more and more stories in the media about individuals that are finding it difficult to sell their house or to obtain the price they paid. With the US consumer depending heavily on mortgage payments this could eventually have some effect on consumption, as could the large layoffs in the auto-industry forecast for the near future, which would have a negative effect on economic growth which is so reliant on the private consumer.

With less enthusiastic expectations in Europe for 2007—in terms of the old economies at least—a slowdown in private consumer spending would not come as a surprise and we must wait and see whether this can be compensated by the continuing sharp growth in the emerging markets.

Market intelligence

Once again, the last report could more or less be copied into this one. Reading our statements from two weeks ago, when we summarised the situation in the leather pipeline after the Shanghai leather fair, the first impression is that there is nothing to add.

When the general situation is so clearly defined and hardly any news and trends can be determined, we have to approach the situation with fine tuning to evaluate the situation more clearly and in detail.

Let's resume with our current position at the end of September.  Fundamentally, we are suffering from a raw material supply shortage. Contrary to the situation some years ago, this is not only a result of an overcapacity in the tanning industry, but a reflection of the very strong and growing demand for leather products all around the world. This has been proved by the fact that tanners are not complaining about insufficient order books for the time being.

As a result of times when there has been overcapacity in the tanning industry, and the constant pressure on leather and finished product prices, tanners have become too afraid of losing customers and business to ask for adequate finished product prices. The shift to lower cost countries and the disinflationary ‘China effect’ has led people in the pipeline to believe that product prices will never have the chance to rise again. The concentration of production, the cost-cutting projects and the purchasing power of the multinational retailers, brand names and general industries have left a deep impression on management teams and their pricing strategies. We cannot remember any tanner anywhere in the world in recent years talking about pricing strategy which considered the end of rising levels of revenues.

Change in fundamentals

The many reasons why leather prices cannot remain steady or even decline further have been discussed this year. In the first half of the year, discussions were mainly focused on production costs. The cost reduction effect shifting production to lower cost countries had come to an end and, as every tanner in the world has been hit by higher energy costs, higher chemical costs and in most cases also higher effluent treatment costs, there is no further room for reductions, indeed, quite the reverse. The calculations in China and the Middle East were being squeezed so much that even tanners in this part of the world started to see the need for a turnaround in the price trend.

The first solution to the production cost problem was to shift raw material purchases to lower price origins. Of course, this applies only to the mass production of general consumer products. Consequently, low price origins benefited most, as we explained in our last issue two weeks ago.

We are now presented with two entirely changed fundamentals. Low price origins have risen disproportionately and can no longer represent price-worthy alternatives. And, second, the change in the drawback policy of the Chinese government has also changed the calculations in China considerably. Consequently, many Chinese tanners now have to consider a calculation which is at least 5% higher than what it was before. For those of our readers who have not followed the discussion about the drawback policy it is worth mentioning that the Chinese government has extended the customs books until the end of 2008 but has reduced the drawback policy by 5%, from 13% to 8%. This ensures that import permissions will stay stable for the next 27 months, as far as the volumes are concerned, but for many calculations are burdened by the above-mentioned 5%. This is good news for competitors of the Chinese industry abroad, but it is having a serious effect on the calculations of probably the most competitive production area in the world.

Survival of the fittest

These two major changes, which occurred over the summer, have also changed the fundamentals for the price of leather and leather products. If we now assume that there is a certain time lag before the demand for leather products actually slows down and while at the same time the raw material supply which is presently available around the globe remains stable, then we find even more arguments for the logic that the balance between raw material availability, production capacity and demand for leather products can only be returned to balance by reducing the production capacity in the short term. This can be done by either production cuts or tanning capacity shutdowns that actually has nothing to do with the price of leather itself. In the end it is, as usual, a case of survival of the fittest.

One can already see some of the early symptoms caused by the rumours: payment delays are slowly but surely becoming more commonplace (particularly in Europe) and the speed of incoming letters of credit and the amount of sales and shipments to China are no longer meeting the levels we saw in the first half of 2006.

Struggling producers battle with high raw material prices

The survival of the fittest also means that those productions that are still financially viable have protected themselves reasonably well against the present raw material price situation. They traditionally continue to purchase on a regular scale against their production needs and can handle the present price situation much better with a more favourable average price for their raw material. Others that have been struggling for a longer period stepped out of the raw material market in the hope that raw material prices would fall and re-enter their production and calculation levels in the future. In this case, they are being hit pretty badly and we hear from many of our regular sources that they are seeing a lot of buyers paying full market levels, which cannot be considered the normal customer base.

Under these circumstances, buyers have tried to escape the price pressure both from the low side and the high side. Buyers that had been shifting their raw material procurement to the more economical origins are now shifting back after the recent price rise to the next quality level, while others who had been in the high price segment are the last ones trying to average down and are trying interesting cheaper raw materials in the attempt to lower their raw material costs. As we all know, none of these are actually the solution, as these attitudes cannot resolve the fundamental problems.

Repeating ourselves again, we strongly believe that the present tensions in the market will be sorted out by the financial resources more than anything else, again meaning the survival of the fittest. Raw material supply is not elastic to demand; we have no speculative premium on prices from futures markets, and global growth, particularly from the emerging markets, persists and will keep demand for leather in consumer goods high. So, a correction in the price trend can only derive from a change in production capacity—voluntarily or enforced—or by unforeseeable incidents within the global economy or leather as a product.           

So, everybody must keep a watchful eye for signs of an adjustment in production as this could be the great chance to replenish raw material stocks for a while.

Confusion over splits market

The news on the splits market couldn’t be more conflicting than it has been the last two weeks. While some continue to report that prices for standard wet blue splits remain under pressure and that they are still finding it quite difficult to move the quantities they would like to, others are far more enthusiastic. Mainly for specialty products, such as heavy substance, the latter claim that even sharp increases are obtainable in the market. We are unable to obtain a really clear picture and will try to monitor the market more closely in the coming weeks.

The skin market is slowly showing some better conditions for the origins which had been suffering for some time. Nappa skins and the less desired heavy double face skins are starting to receive a bit more interest. This may just be a result of the premium skin price, but it could also be the first market reaction to the sampling seen at the recent fairs. If the world is really as price conscious as we all believe, it is hard to understand why there are still raw materials available at close to the historical lows, while others are trading at record levels. It is also interesting that increasing numbers of suppliers are reporting growing interest from the Russian industry for skins.

Russia turns attention to imports

This comes as a surprise as few have had Russia on the agenda as an importer following the crumbling of the Iron Curtain and the policy of the Putin administration has finally had the anticipated effect. Due to the imposition of export duties on raw materials, the domestic industry was nicely protected and competitive on the domestic market as long as it was using domestic raw materials. Under this shelter, factories were growing and expanding their capacities, but the local agro-industry did not and does not thrive in the same way. The population of cattle, as well as sheep and goat, has been radically reduced and herds are not replenished as people are busier filling their pockets with expensive resources rather than rebuilding a healthy agro-industry. As a result, production capacities in Russia, during the months when the kill is seasonally low, are higher than raw material supplies and this spread could continue to widen. In any case, Russian factories turn up more and more frequently among the global markets in the search for raw materials. At the same time they are shocked when they see the prices they will have to pay when they enter the ‘real world’.

Raw material shortage continues to affect pipeline

We have to believe that tensions during the next two weeks are going to grow. The industry will be awaiting results from trade fairs which are to be held at the end of October. With the general situation we explained above, the industry will now fight hard for rising leather prices and we are quite convinced that a gradual increase will be achieved. However, as we explained before, this will not rectify the fundamental problem we have at the moment. Without a severe disruption in demand or production, fundamental change in the price trend cannot be expected. We will see fluctuations and we still believe that there is a fair chance of a market correction at the end of the year, but this does not alter the situation of the general scarcity of adequate raw material for the production of leather.

Considering that most sellers around the world remain very well sold, they will have no reason in the coming weeks to change much in their offer list. The key factor if we are going to see some kind of the correction is going to be the demand from the Chinese leather industry and whether they have built a cushion of inventory with the significantly higher imports we have seen in 2006 so far. Another influence to dampened raw material demand could be financial problems within the industry. In the case of more financial failures, sellers may become more sensible about their selection of customers and it could free some raw material available for the pipeline.

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