The Leather Pipeline - 29.04.14
29/04/2014
Two weeks ago the situation in the Ukraine had been pushed back into the background, but it has begun to make the headlines again in the past weeks. The financial markets were pushed pretty much into the background, and as a matter of fact very little really happened.
Data continues to be published and the financial community is desperately waiting to take new positions, but for the time being there is really nothing happening to make people willing to invest and to take serious positions either on currencies or on commodities.
This is a real surprise and when we think back we have to admit that we think it very unusual that the financial markets and general speculators are taking so little notice of what is happening in the political arena. Considering that this is the first real and serious conflict between the big blocks since the Cold War, one would expect more reaction from the financial community. This is good in a way, because nobody is seriously panicking without having any hard facts, but on the other hand it is also worrying because we have to consider that the balance and stability we have seen for a long time is definitely threatened by this conflict, if not already destroyed.
As far as the financials are concerned the international markets are just waiting for something new and this means a change in the policies of the national banks in Europe and the US. Even any recoveries we have seen in recent years were never strong enough for the national banks to be willing to let interest rates rise again. This is on one side related to inflation, but on the other side it seems still to be a policy of keeping the financing costs of their tremendous negative national budgets low, at the cost of almost negative yields for the simple private saver. There is of course always the option to move into other investments such as stocks, higher-yielding corporate bonds or even commodities, but this is not really the safety deposit box normal households need for their small investment resources. This means consequently that what could have been taxable has just become negative yields to subsidise and to pay for the poor budget management of many governments.
How little the financial markets are willing to take investment risks on the present political situation can be seen in currency rates and commodity prices for energy. In the old days energy prices would have reacted far more quickly considering how much in particular many countries in Europe are dependent on Russian energy supplies. The price for gas has gone up, but the reaction of oil prices is impressively limited.
For general business with Russia it is also common practice at the moment for the potential consequences to be played down. Very cautiously, managers are admitting how serious the consequences could be for their businesses; so far most of them are playing down their exposure to Russia. Considering that Russia is importing around 40% of its consumer products and most of the Russian national income derives from raw material exports, we consider the potential risks far higher than what is mentioned in public. It is not just direct business and trade, but sanctions and trade restrictions always have a much wider impact on the global economy eventually, and make trade flows shift.
The high stability of the euro is also interesting because one would expect this to be the main currency being negatively affected by the problems in the Ukraine. However the value of the euro remains very high, high enough to raise major concerns about exports at the European Central Bank.
Although there is no real indication of any major change, it is a little bit too quiet and this is sometimes just a preparation for a major shift and change in the markets. It is definitely not a bad idea to make a serious risk analysis within everybody’s individual business to make sure that the highest levels of precaution are being taken for whatever might happen.
Market Intelligence
In the past two weeks a lot has changed in the leather pipeline. For almost two years or more there has been a consensus that raw material prices would only go in one direction and that is up. Everyone who might have had a concern, including us, has been proved wrong and any break in the trend was pretty short lived and then prices just went higher.
As usual with such a trend in the markets, the number of pessimists is growing smaller and the number of optimists bigger, which is accelerating the trend. Consequently the market begins just to feed itself, or as is commonly said ‘the trend is your friend’. Let’s not forget, it is just three weeks since we all came together in Hong Kong. Prices for Brazilian hides and splits have been boosted and the last players with doubts have had those doubts wiped away by the vast majority putting money into the story of supply shortage and unstoppable leather demand. The caravan couldn’t be stopped and just jumped to the next cheap opportunity.
The story has now developed a few cracks and those who are just blaming the shutdown of the tanning industry in Hebei province for the decline of cow and split prices and the end to the rise of steers might still be able to close their eyes to a couple of other indications of change. Very often the market just needs an outside trigger to change and to return to reality and balance.
At the moment the market sentiment and valuation is still pretty much determined by the position one has. If you have the privilege of supplying premium hides for large, industrial productions of shoe or automotive leather you may have felt very little of the growing problems in the industry in the past months. Productions that are planned, predictable and reliable, with reliable budgets and to a certain extent even dependent customers, have made it almost a perfect world for suppliers. Even today, not many of these fundamentals have changed and that is why worries in this part of the leather supply pipeline are still pretty limited.
This market segment’s secure position was the determining factor in establishing balance between raw material supply and leather demand and the rest of the industry felt pretty safe about taking risks, even when their calculations did not deliver any profitability. It all came right, if not thanks to the leather price, then because split returns were so attractive.
As early as August last year we saw concerns in the market about the profitability of leather production. This was the time when the leather industry in China shifted a lot of its beamhouse operations away from the coastal areas to the north of China, and in particular to Hebei province and in part to Shandong too. With cheaper tanning costs, the higher raw material prices were financed and the shift to ‘cheap’, which resulted in higher split credits (again, subsidised by low tanning costs), triggered the next set of raw material price rises. Therefore, we know now that this most recent round of price rises for hides was ultimately financed by the environment; cheaper tanning costs, resulting in part from inadequate wastewater treatment, made investment in more expensive raw material possible.
To a smaller extent, excessive tanning capacity in China (and globally) also played a significant role in the trend for raw material prices. Tanning capacities have expanded in the past years more than raw material supply and more than leather demand. While new tanneries were built and existing ones expanded, not enough older tanneries have been closed; this is what the Chinese government is doing now. In view of the recovery in the global economy and rising demand for leather in some sectors, the relationships between supply, demand and capacity have not been adequately estimated and as long as the bull runs nobody can stop him.
To be honest it is also pretty difficult to judge volumes in the markets. The products with high added value have dragged others along, but there is not only one leather market. Products with a high added value cannot be the basis for all the rest, not even considering the massive differences in tanning costs. For some time many were hoping to get a piece of the cake just because of the rising raw material prices and the consistent demand for leather.
The real worry began when we saw that the sudden rise in tanning in Hebei and the demand for splits continued a trend that possibly would otherwise have ended last summer. With the move of a lot of tanning to the cheaper location of Hebei in a sudden move in the second and third quarters of 2013, and strong demand for the cheaper splits, the medium and low-end segments of leather production became a new basis for raw material pricing at the lower end. Suddenly there was scope to pay higher raw material prices due to savings in tanning costs and better returns for splits. A bit of progress in grain leather prices and the cocktail for enthusiasm was complete.
Now the parameters have changed. Capacities are shrinking and tanning costs and other costs are rising, taking a lot of margin away. Apart from the margins, which have turned from black to red or from red to deep red due to the changes, most of the other factors for market valuations are still the same. This is the good news.
The supply pipeline for a certain part of the raw material cocktail is definitely congesting now because customers in the north of China have to analyse their businesses and check carefully to see if the new conditions will allow them to proceed with production as before. The problems in China have not changed global leather demand or existing order books, but they have changed results and these have to be discussed and evaluated and turned into decisions.
In general terms, what is happening is what has always happened in the leather pipeline; the first thing tanners do is try to push problems towards raw material supply. In real terms this means renegotiation of existing contracts to lower the raw material price. Traditionally there are two ways to do this. Either you try to buy so cheap that the new contract, in combination with existing ones and inventories, come to an average that makes raw material costs manageable again, or you try to negotiate a new contract with you supplier at rates between the old, expensive ones and a new one, giving a new average price. In the worst case, tanners could just walk away from existing contracts and let current suppliers down. We are experiencing all of this right now, in particular in relation to hides that had been headed for Hebei province. Suppliers that are involved are really scared because they know it will be very difficult to escape from the problem. In the last week, however, the defence line has been broken in many cases and a number of suppliers have been willing to surrender and to accept one of the above solutions.
The ones who have been most severely influenced by the market situation in China are in particular the suppliers of cow hides, particularly from Europe. One must not forget that lamb and sheepskin suppliers for nappa production could have told their colleagues already what to expect because in the skin market this problem has been evident for some time already.
It is difficult now, because raw material suppliers who were enjoying the full benefit of the positive market segments like some shoe upper, luxury goods and definitely automotive, feel that this situation and these problems should not really have any effect on their businesses, that they are not really involved. However, if we have to assume that the prices for several types of hide have already declined by 10% to 15% from the peaks seen in March, the whole balance of prices in the market is going to change quickly. If dairy cows can be bought significantly cheaper they will quickly substitute other raw materials that have become expensive during the past months.
The real problem for the market is that the new prices are already in circulation and they will decide price settings for some time. With rising temperatures in the northern hemisphere, sellers do not have much of a counter-argument (other than potentially reduced productions) to put up against the aggressive ideas of buyers to bring down their raw material costs. It would not be a surprise if price corrections come in at the premium end at a later stage.
The split market is pretty much a reflection of the hide market. Some of the premium split types remain in short supply and tanners can’t really get what they need to cover their orders. However, the general balance in the market has changed here too. In China the price for lime splits is rapidly falling, because the tanning capacities in Hebei province are missing and the alternatives are far more expensive, which hits low-price product much more than a premium-price product. Lime splits as a raw material base for gelatine production are facing price pressure already because of the cheaper alternatives, in particular from pork.
This means that suddenly the split market, too, has a totally different feel and even suppliers who were being chased around Hong Kong by their customers at APLF at the end of March are reporting now that clients have become very conservative and actually ready to walk away from the market. We do not believe that the split market is, at this stage, in serious trouble, but the massive price rises that we have seen in the last three-to-six months may see a bit of a correction. If this happens it will immediately be reflected in raw hide prices because a lot of decisions to pay the hide prices asked were based partly on split returns, which will no longer be obtainable in the coming months. However, split is still part of the plan for the next shoe and automotive production season and, with the decline in tanning, the output of split in China will also be reduced for some time. This will not save splits from the trend, but it will possibly limit the problem. Everybody is advised to sit down and do some calculations, because some of the recently paid prices for splits are too high and the spread between split and grain leather must return to a more logical level.
The skin market is already much further along this road than the hide market. With the vast majority of global fellmongering operations being in the north of China, a lot of skin supplies have been in trouble for quite some time. The structure of the business is totally different and the quality of customers is certainly not at the same level as hide people. Consequently the supply and shipment of skins have almost come to a standstill, although there are some shippers pretending they were able to conclude some large contracts, even if it was at very low prices. Many of the big buyers in China see opportunities for very low raw material prices and are desperately searching for new tanning capacities to take advantage of the raw material market. Ovine raw material at the medium and low end are presently the cheapest raw material one can buy. With weather conditions getting warmer, it is however pretty unlikely that the situation will be resolved quickly. Buyers in China know that time is on their side.
The next weeks will be decisive for the market. If leather demand is strong enough and tanning capacities that have been closed down can be substituted quickly enough, the situation can still be kept under control and the consequences will be limited. We think that a market correction can hardly be avoided. The situation in China has been a trigger for this, but is not the fundamental reason. Raw material prices and finished leather prices didn’t have a healthy correlation anymore. We are now heading into the low season of leather production and it is difficult to find any seriously good reason to support the raw material market in the short term. As painful as it is at the moment, it is also a good chance for strong and healthy leather manufacturers because lower raw material prices will offer better margins. For others, a correction will give companies time to reorganise their businesses and to take some of the market risk away. For raw material sellers, however, falling markets are always a pain and generally create problems and losses.
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