The Leather Pipeline - 23.12.14
23/12/2014
The final weeks of 2014 turned out to be pretty hectic on the financial markets. Normally the final weeks of a calendar year are rather quiet because investors want not to take any particular risk and most are trying to safeguard their annual performance into the year-end.
This year the market movers were not the investors, but political matters and their influence on commodities and currencies.
It began with a continuation of the massive drop in prices of oil. The barrel went down well below the US$60 mark in many ways to remember that it was not too long ago that many so-called experts were predicting oil would never be below hundred US dollar for the barrel again. Never trust any experts or forecasts. Depending on taxation levels in different countries, the price at the petrol pump and for heating oil is now substantially declining and this may actually become a positive stimulus for several of the economies that are in crisis.
However what is good for one is bad for another and many of the oil-producing countries will now get into serious trouble with their financial budgets. This is also the reason why many of the international analysts cannot really decide if the decline in oil prices is generally good or bad.
The financial markets were pretty clear in their response to the drop in the price of oil and most stock markets have fallen rapidly. Various indices wiped all their annual gains away in a few days.
Hardest hit is the Russian economy. In addition to sanctions, the drop in oil prices and other commodities is causing big trouble to the economy. As a consequence the ruble crashed and the Russian central bank had to raise interest rates to 17% in an attempt to stabilise the currency. Russian consumers were packing into the shops to buy things as long as their currency still had any value. We must be aware that the destabilisation of the Russian economy could become a pretty serious headache in the year to come.
Terrorists were active again:one person took hostages in a cafe in Sydney while others attacked a school in Pakistan and killed more than 100 innocent students and teachers. One can’t really say that the world is going into the Christmas season and the year-end on a peaceful note and we can just hope that this is not indicative of what we have to expect in 2015.
The economic downturn in many countries was also not positive. In Greece there was the euro crisis and a general downturn in industrial production in France and Germany contributing to less positive numbers than expected. In China neither production nor the purchasing manager index gave any indication that performance will be above expectations in the near future.
In the currency market the euro was able to recover a little, despite the negative news.
Market Intelligence
In this final issue of the market intelligence for 2014 it is not easy to take a relaxed view on the year which has passed, knowing what has happened.
The year 2014 delivered all kinds of market scenarios which used to be normal ‘once upon a time’. High market volatility did not use to be noteworthy and normal ups and downs were really the spice of the trade. However, in recent years the raw material markets have gone almost exclusively in only one direction, moderately upwards. Producers gained control and met a constantly expanding global economy and even when some regions were in trouble it was compensated for by emerging markets and the new economic giant, China.
Consequently, raw material suppliers to the leather industry were riding the wave and did not become concerned when the market and the demand took a temporary break. Limiting offers and controlling supply, resisting price setbacks and providing core producers with the necessary support allowed raw material prices to reach record levels until the first half of this year, 2014.
At this stage we have to mention that the raw material market for the leather industry could never and still cannot be totally generalised. Bovine hides and sheepskin have had many times in the past when they were not walking hand-in-hand. This year we saw not only this, but we learned also that the bovine raw material market is now far more segmented and fragmented and here, too, one can see different price trends at the same time.
Returning to the market situation in 2014 the tone began to change after the APLF exhibition in Hong Kong in early April and the decision of the Chinese government to become absolutely serious about effluent problems and to make leather producers in Hebei province serve as an example of the new policy of the central government. Roughly 80% of the tanners in Hebei province had to close down for a period that lasted at least until the end of September and, in some cases, continues today. In particular this affected skin tanners and the fellmongering industry. Historically such a big volume of wool-on skins have been dewooled in that area that the international supply pipeline came almost to a total standstill. The nappa garment business hadn’t been brilliant before this, but the shutdown of the industry in that region was the last nail in the coffin. While bovine tanners found it much easier to source alternative tanning capacity, the situation for skin tanners was almost impossible to resolve. With the hot summer ahead, demand slow and stock that could not be processed any more, it became a pretty poisonous cocktail for the market for many sheep and lambskins. The trade for many items, which had been so dependent on Hebei province, came almost to a standstill for quite a long period of time. Prices dropped by almost 80% within three to four months and only in December saw a bit of a revitalisation.
Over the summer a bit of the problem had been cushioned by some of the alternative markets, mostly Turkey. However, with the start of the Ukraine crisis, the sanctions, the drop in oil prices and the crash of the ruble, business in Russia and Ukraine disappeared and many suppliers are still waiting today for payment. The practice of shipping material without payment guarantee was, once again, a lethal business strategy for the industry in Turkey. Although the reasons were different the consequences were the same in 2014 as they were on previous occasions when this happened, with only a few exceptions who have placed themselves more in the international high market for double-face products coming through well.
The supply pipeline in bovine has followed a similar pattern, but the supply base here is not as fragmented as the sheepskin sector. Warning voices that the price of much bovine material was not justified were ignored. However, the problem in Hebei province hit the bovine market too, but with different consequences. The directly influenced market section was generally commodity products made from cheaper raw materials. In addition a lot of the furniture tanning industry had also moved with their productions into the region. Also many of the import traders selling wet blue domestically in China were using the cheaper tanning capacities in Hebei province too. More industrial producers, in particular for the big brands for shoes and higher-end products, were not really manufacturing in that region. Most of these productions are actually based on long-term supply chains and so many suppliers were relaxed and thought the problem in Hebei would actually be none of their business.
By May and June the directly influenced hides, mainly dairy cow hides from Europe, some hides from Australia, products from Africa and generally a lot of cheap raw materials took a quick nosedive in prices. Generally we saw a drop of about 10% to 20% depending on the product and in some cases even more when it came to the very cheap and economic raw materials.
We must not forget that a lot of this material was dependent on something that could be called ‘grey imports’ and so they were not able to find a quick and new outlet in China and many importers were sitting without their customers for several months. Nor should we forget that ‘grey imports’ through Hong Kong were negatively impacted too. A lot of tax- and duty-evading operations and individuals disappeared or were even jailed. The way through Hong Kong into the mainland was also hindered and has not returned to full functionality even today.
The Chinese government’s anti-corruption campaign has also had an effect on the leather business. Real big brands were able to compensate in other markets but those that appear more to be about the label were far more influenced. Quick and easy spending in the medium- and high-end sections faded to a greater extent than in the real high-end luxury sector. Logically this segment is consuming more leather then the very high end. This can also be seen in the raw material market price trends. While the very top-end raw materials (such as French calfskins) have suffered relatively limited price reductions so far, those next in line (such as Dutch calfskins) came under serious pressure and lost a fair amount of their value. For those who are pretty close to this business this was not a surprise because their values were basically supported and created by the ‘me too’ factor of labels trying to benefit from the luxury trend. However they never quite made it into the premier league of prices and image.
From our perspective, the biggest mistakes have been made by those suppliers who thought they were untouchable. Being tightly linked to certain supply chains, they were never going to lose volume or position. However, the valuation of raw material and the general demand for leather has been added to by changes in the currency market and this has led to massive price and value imbalances within the various raw material options. In the end, demand for overvalued leathers that cannot be sold at competitive prices due to the raw material cost has to shrink eventually.
When we look at price developments since September it can be seen what we mean. Automotive tanning and some of the industrial shoe tanning operations stuck quite tightly to their raw material sources. This is quite sizeable business but it is not enough to absorb all the raw material produced. If we consider that 70% to 80% of leather production can only change with big time-lags or not at all, there is still 20% to 30% of the same production that has to find a customer-base outside ‘the club’. Those buyers are however far more flexible and will readily look to substitute materials to find cheaper alternatives.
Even a lower kill in some of the supply origins did not take enough raw material out of the market to sustain prices and there was enough cheaper alternative raw material to substitute. Having said this, of course, the strength of the US dollar has to be mentioned too, because this made other origins in the last quarter more competitive by 10% to 15%.
We mentioned in previous reports that the wide price gap between medium- and high-end and lower-end articles and origins has to be closed. Flexible demand has shifted to the cheaper market segment, which can be seen in the strong demand for cows, for example, which were so attractive in price that they were able to substitute a lot of heifer and steer business, in spite of concerns about lower quality and any technical problems they might bring along. For the moment we can see the demand for this product was good enough to stabilise the price trends, but it does not seem that there can be much hope that these prices will go up again in the near future and the logic is that the prices for more expensive raw materials have to come, and they are indeed coming down.
These are the market fundamentals as we end the year 2014. The major forecasts on supply of bovine raw material remain pretty negative. However, we are already late in the high season of leather production. Many are saying, and we would agree, that tanneries are not running high inventories. Hand to mouth commands most of the purchasing decisions at the moment. More raw material purchases can only be expected if leather orders pick up or if the industry feels that it has reached the bottom and is willing to expand inventories again. Nothing has changed; expansion and contraction are driven by demand and price.
Asia is still the major driving force in the leather pipeline but the slow opening of letters of credits does not give the impression that tanners there feel they are short of raw material. However we are not in an easy time to judge because of the holidays in Europe and the upcoming holidays in Asia. In any case, one has to be a very strong optimist to believe that for the current season there is still much potential for a major improvement.
This is also determined by split credits, one of the issues that worries us much more than anything else. If price is such a driving factor, cheaper options should be in good demand and used in a larger percentage of total production. However, split prices remain under pressure and no matter how bad it may be, with several people exaggerating, it is definitely fair to say that split prices are under pressure rather than gaining in value. This does nothing to suggest there will be any short-term improvement in leather demand.
The skins market remains steady with just a bit of light at the end of the tunnel because of some speculators buying up large winter wool-on skins in Europe. The main supplying countries are the UK and Ireland, but there are some other European countries that can offer large skins with good wool for fellmongering have been able to gain some value and with the rising US dollar revenues for shippers have increased by 10% to 20% from the very low levels we reached in October and November. Some of the stocks that had been piling up for more than six months in Europe have been reduced, but there are still quite a number of old and questionable-quality skins around.
Into 2015 we believe it is going to be a slow start. In Europe most tanners have purchased what they need for January, while for Asia most suppliers are more concerned about securing letters of credit for material already sold than about new sales at this stage. We have seen what can happen to commodity markets, and this time the oil market has given another good example. It is not so long ago that almost everyone had a long list of arguments to explain why prices would never become cheaper again. The story of constantly rising demand due to rising wealth and growing emerging markets had been told to justify price levels again and again.
Just as the prices for oil and for hides and skins did not keep moving higher this time, they will not fall for ever either. You can never predict when markets are going to adjust, because too many factors such as future markets, supply issues, speculation, supply chain management and technology play a role too. Many will remember that we had been discussing the overvaluation of leather and of raw materials for a long time. We base our market assessments on real values, options of substitution and retail demand trends. From these factors the prices we had seen until the third quarter of 2014 had never been justified, with the exception of niche products in the luxury segment.
Markets tend to overreact and we haven’t seen this so far in the controlled readjustment of raw material prices. We must say that we are quite impressed by the slow and orderly readjustment. We don’t think that prices are back yet to what we would call a fair balance in the valuations. However, we have already come a good way and we just have to see now if the final adjustment will be made in the same orderly way as has happened so far or if we will see a quick and emotional over reaction in the first quarter 2015. By the end of January we might have a better view on the situation.
It’s now time to wave goodbye to the year 2014 and to wish all our readers a very merry Christmas and a happy and prosperous year in 2015. We hope we have been able to serve you with information and to give you some valuable input to help you think and to make your own decisions for whatever you have to decide for your business. We are not an oracle; we don’t have a crystal ball and we don’t pretend always to be right, but we try to deliver every fortnight some constructive reasons not just to follow the mainstream and to find your own way through the leather pipeline. We hope to have some more good ideas in 2015.
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