Hebei clampdown will bring raw material prices back into order
There is only one topic that has dominated headlines in the leather business over the past two weeks: the situation in the north of China. Although it is a limited region and capacity, it is beginning to affect a greater part of the pipeline.
Fortunately, it is not directly affecting leather production at the industrial and medium to higher-quality tanneries and it is having no impact on leather demand. However, everything in this business is in one way or another connected, and the closure of the majority of tanners in Hebei province is beginning to have a knock-on effect.
One begins to realise the massive volume of certain raw materials that had been depending on the cheap tanning capacity in that region: head hides, bellies, horses, donkeys, low-grade bovine hides, cows of all kinds and origin and ovine skins, which are used for nappa leather. It is difficult to say what percentage of the global production of these kind of products had been running out there, but it is definitely fair to say that we are dealing with a large proportion.
Most of the supply chains of these articles are now congested, with many containers either stuck in the inventories of the customer, stuck in ports, on ships or in the warehouses of suppliers. The players in this segment are not far away from panic. The problem is not only the market, but also that it is difficult to redirect these kinds of raw materials and the cost of demurrage [charges to the ship owner for its extra use] plus the risk of deterioration of the products are tremendous.
Those who have material in ports or afloat are now desperately trying to find solutions in the form of resales. The problem is that even potentially interested buyers also need tanning capacity to get the raw material handled.
Tanners that have been closed by the government in Hebei province are losing confidence that they will be opening any time soon. It is becoming clear that the government is serious about certain issues: environmental issues, but also tax evasion. This means the problem is not just related to tanners but also to many importers that have businesses in ports in the north of China. This is now intensively controlled by the officials and consequently adding to the difficulties.
However, despite the negativity, all of this is good news for the future, because it is protecting the environment and moves tanning away from being thought of as a seriously polluting industry. It is also preparing the way for fair competition for those tanneries in China which are already complying with international standards of waste water treatment and working conditions for the labour force.
For the moment though it is turning a lot of production in China upside down. It is hitting products that used to be processed with at a very low cost. For many of these, it means they might now be substituted, because it doesn’t make sense turn them into leather at a higher cost. For those who were achieving reasonable returns it might be a painful period.
This applies in particular to very cheap splits, bellies and trimmings, but also to various low-quality raw material origins. In the case of bellies and trimmings, as well as certain local splits, from China, it means the value for the tanner in buying the entire hide is deteriorating and this needs to be reflected in the price. One can already feel this situation in the European markets, where people are cutting hides and selling the bellies and shoulders to international destinations. For splits, the effect is limited and so far just related to Asian productions. The problem is that many containers of raw material are stranded and contacts in China are reporting that low-grade items have been given away for free just to free warehouse space or to avoid any additional cost.
In the case of cow hides, the situation is also pretty dramatic but easier to calculate. Hebei was one of the main destinations for European and Australian cow hides. Its dominance rose at an accelerated rate in 2013. As well as tanners in the area, tanners from the coastal regions were shifting beamhouse operations there because of the low cost. This increased production significantly, but has left the market without immediate alternatives.
Over the past weeks many suppliers had to surrender and most of the standard cow hides have lost about $10 of their value - 10% to 15%. However, this is good news, because the price reduction is reflected by the increased cost of tanning and the decline of split value. This means that if alternative tanning capacity can be found, one has to calculate about $5 to $6 higher tanning cost and a decline of split revenue of about $3 to $4. The market reaction and price reduction is consequently only reflecting the difference in economics and nothing more, so far.
There are also still buyers to absorb the hides at a discount which means that there are still players with enough leather business, confidence and money to see the discounted levels as an opportunity. Whether these ‘deals’ are large enough to absorb the surplus of material congesting the pipeline is questionable and we believe it will need more volume to restore confidence and to secure a regular product flow for the coming months.
The important question is how much influence the situation in Hebei will have and how the decline of medium-quality raw material is going affect the market. The prices for steers in the US and heavy bulls in Europe are falling slowly and in the case of the extra heavy, high-quality hides, hardly at all. Leather demand hasn’t slowed for many of the standard products. We are in the low season but production is based on budgets and inventory and raw material has still to be replenished. Consequently, many tanners still to have to make purchases and to negotiate prices with their suppliers.
With tanneries outside China managing stocks carefully and not holding too much extra inventory they can stay out of the market for now - if production plans remain unchanged.
In this regard, it is interesting to see that hides sales and production is shifting out of China to other destinations. Apart from the problems, the rising cost of production in China plus customs duties on shoes made in China have made the mainland far less attractive than it has been in previous years. Tanneries in Vietnam, Indonesia, Pakistan and others are increasing their output and exports while China is stagnant, and this applies in particular for exports. Local demand is not meeting expectations and so are the many Chinese tanners’ targets are not being met.
This leaves questions to be answered:
a) By how much and for how long will the tanning capacity in Hebei be reduced?
b) By how much will tanning cost in China rise?
c) How much raw material is congested and in surplus? How long will it take until the physical balance is restored?
d) What is the future of split prices and how are they going to influence hide prices?
e) Will the massively widened spreads of prices between cows and males shift demand from more expensive hides towards less expensive hides and invite leather producers and manufacturers to shift towards cheaper raw materials?
f) How much will the trend for cheaper leathers affect the balance of demand? How much will demand for medium/higher-end hides diminish and demand for lower-priced raw material increase?
g) What is the future of the global economy and will how will political issues (such as Ukraine/Russia) weigh on total sales of consumer products?
h) How is the global beef production going to develop?
i) Will the high-priced raw materials of the first quarter strain cash-flow resources of tanneries by so much that we could face further payment issues?
The list of questions points for us in the direction of lower prices in the second and third quarter, increasing pressure on inflated prices for standard higher priced items and the gap closing between prices of lower-cost hides and the favoured standards.
In Europe, good-quality suede splits are still considered to be in short supply. Lime splits, trimmings and gelatine-related material are however under pressure. Asia is being affected by situation in Hebei. Lime splits are suffering from the reduction of tanning capacity and rising cost in China, and low-price wet blue splits are being dragged down in sympathy. Contracts have been delayed and some have not even been honoured, which is making a serious market valuation pretty difficult and many buyers are scared about what will happen next. We are not as concerned. Splits seem to be in the collections for the next season in good volume and so the supply needs to be covered. This should protect good quality, regular productions from too much drama no matter how excitable the market is at the moment.
The market still needs some time to sort itself out. The problems in Hebei cannot be generalised for the entire leather business. The excessive production capacity and the deflated production cost which are now missing will definitely change the price structure for raw materials and will leave those who had been relying on this market busy sorting their problems out. This situation will create some casualties, but generally the leather pipeline must appreciate the situation as it is offering a fair chance to bring raw material prices back into order. Prices should remain under a certain pressure, but in general we believe it is more a question of sorting out and readjusting rather than a major risk for a market collapse.
