The Leather Pipeline - 30.06.15
30/06/2015
The situation in Greece has been dominating the headlines for a long time now. Considering the strained conditions between Russia and the West in relation to the Ukraine crisis, the refugee problem the EU has and the military conflict in various places in the Middle East, the importance of the government of a nation with the 8 million people spending more money than it makes for decades is beginning to feel a little bit exaggerated. However, this week, once again, the financial news is dominated by negotiations or non-negotiations between the related parties. At the date of writing the Greek government has tried to gain time with the announcement of a referendum on July 5 to see if Greek citizens will accept the conditions of the EU for repaying loans. Well, it doesn’t seem that this is of any importance any more and will hardly avoid the failure of the nation.
However, one should be aware that the Greek issue is more a political than an economic one, because the West cannot allow its presence in south-east Europe threatened at the same time as the conflict in Ukraine. If Greece should leave the euro the government in Athens would need to get money from somewhere and the options are pretty obvious.
Stock markets in Europe have declined moderately, but it is striking how low the volatility of the financial markets has been in this final lap of negotiations between the EU and the Greek government.
At the same time the Chinese stock market bubble seems to have burst. Stock values were rapidly declining last week extending losses over the last two weeks to about 20%. The government is trying to stem the trend and has again lowered interest rates. However, if the decline in the stock markets there continues it could harm the economy in China and that would not be good news for the global economy either.
Market Intelligence
We are right in the middle of a classical downward trend. Besides falling prices due to the imbalance between supply and demand we have all the negative side-effects that are usually to be expected in such a market situation. This is what everybody was so afraid of and what suppliers were trying to avoid for as long as they could. When supply exceeds demand or vice versa you have to bite the bullet one day and the market has to find a new balance. This is becoming increasingly difficult today with the exceptionally long lead-times and complex supply chains that make turnaround very slow and when a market has been driven to such an extent from the supply side it might even take a little longer, because all the congestion of material has to be absorbed and cleaned up.
We all need to understand that we have only one stream in the leather pipeline that seems to be flowing at normal speed and for which supply and demand are in balance: European premium automotive leather production is still backed by adequate orders from the premium automotive producers in Europe. Whether this will continue for the rest of the year is something we cannot judge before the end of September. For the time being premium tanners in Europe have projections and budgets for the coming months that may make it necessary to build up some inventory as a buffer for the holiday period in August. During the summer the automotive industry traditionally changes models and rolling out new models always boosts production for a certain period of time until all the showrooms and preorders have been satisfied.
However, everyone in this business and those familiar with the automotive industry are beginning to raise concerns. With all the problems we are facing around the globe can we really assume that premium car sales will not be hit eventually? So far there is no evidence that the premium automotive manufacturers are in a process of wrong planning, but it is also true that it would not be the first time that budgets and plans are suddenly and quickly revised. For the moment order books are full and tanners need to keep their supply pipeline of premium raw material well filled.
The exact opposite is the case for the rest of the car industry. Most productions in Asia are being cut and tanneries cannot adjust their capacities and inventories quickly enough to mirror the reduced sales of cars and orders from the automotive industry. Apart from the decline in sales of cars the market is also changing in some other aspects. It is no secret anymore that the automotive industry is no longer just focusing on genuine leather to impress consumers with the appearance of the interior. If the look of leather is still important, artificial substitutes are playing an increasing role. Artificial products are close to the real material, in particular when it comes to embossed and heavily corrected types. Material and manufacturing cost are so dominant today that the image of leather can only be justified and paid for the superior types. This explains also why the premium hides suitable for the premium leathers are barely changing in price (when others are). The leverage in price in relation to the cost of the car makes the raw material cost far less vulnerable and the real premium leathers (and only those) need still a certain hide quality to make them. Nobody should forget that even from the so called premium hides still only a certain percentage really qualify because a large proportion of the raw material is not good enough.
If we just look at the market and the leather pipeline in general at the end of the first half of 2015 we have to realise that we are in a difficult situation. A number of people are comparing the situation already with 2008 and 2009. This might seem reasonable just looking at the price declines we are facing since about three months ago, but the general conditions are completely different. Nobody can complain that the present situation has come as a surprise. It might be useful to read some of our reports from spring 2014 to realise what the differences between 2008 and 2015 are and that, in the present case, it has very little to do with any accidents in the financial markets. What we see now is a result of the situation in the leather pipeline itself, beginning with the beef industry and ending with the consumer. Financial issues play a role too, but they are just the consequence of what has happened in the industry itself and not the reason.
Our regular readers know that we had massive concerns about the pricing of raw material and the consequences this would have in the long term on leather prices and leather use. This is definitely the core problem which has led to the reduction of leather demand.
In particular the Chinese situation is having a serious influence on the market. China has grown in the past 10 to 15 years to become the largest producer of leather and manufacturer of leathergoods in the world. We have seen dominant countries with a large influence before in the history of the industry, for example Italy, Korea and Taiwan. None of these countries had, however, the influence and share in global leather production that China has today. Such a dominant geographical concentration causes problems of its own.
In many commodities, the rise of China as a producer and consumer has led to conditions in which the prices of certain commodities are determined by the consumption and behaviour of Chinese importers. The leather industry is no exception and it is important not just to look at the global demand and supply situation, but also at the particular influences in China. At one stage the anti-pollution campaign of the Chinese government played a very important role. We saw it very quickly in April and May 2014 when almost from one day to the next the entire fellmongering capacity in Hebei province was shut down, possibly more than 50% of the total global capacity in this segment. This should have been taken far more seriously than many people (in particular the global beef industry) did at the time.
Environmental problems are also the main reason why tanners in China have decreased split leather production so much. Of course the quality-price ratio has been a factor too, but many manufacturers of split leather and their customers have been seriously hit by governmental controls and regulations. The bovine sector has also had its problems and here too pollution controls and government regulations have hit production, in particular in the north of China. However, this segment is in a position to shift production to other countries and would do if there were enough demand for leather.
In the bovine sector another situation that plays an important role is that hides and skins have always been influenced by speculation. Trading companies in the US and western Europe influenced the markets in the last century by taking positions, long or short, as the basis of their business concept. While this era came to an end in the 1980s and 1990s, a new generation grew up in China with the rise of the industry and consumption in the mainland.
While those companies outside China were mainly focusing on offering finance, traders in China focused on importing, manufacturing, wholesaling and speculating. With longer lead times for raw material supplies to China, these traders aimed for a firm market and this was willingly and happily supported by the big beef companies around the globe. What all of them missed was the fact that leather demand was declining and this began to congest the pipeline nine or even 12 months ago. We believe that the last nail in the coffin was the strike at the West Coast ports in the US earlier this year, which for quite some time, interrupted regular product flow and reduced the control and influence of traditional players on the physical numbers of hides in the pipeline. On one side people had to substitute and on the other side suppliers were suddenly facing sales that could not be shipped. When the strike was over, additional volume streamed into the supply chain and could not be absorbed, financed or controlled any more.
This has put a lot of people into deep trouble and made the imbalance between supply and demand clearly visible. With the size of the Chinese market and the inflated inventories traders and tanners were running, a controlled correction of the raw material market was barely possible. The congestion is there, the financial consequences too and this makes it difficult to predict when and how the market can return to balance.
Now, at the end of the first half of 2015, we are in pretty dangerous territory because one can see that a lot of market players in China still need to sort out their own inventories and financial problems before they can return to anything approaching normal market behaviour.
We have very little to report from the split market: only some market niches are still displaying normal and regular business. Several large producers of standard quality splits still report that their long-term industrial customers continue to take material and shipments. For the vast majority and in particular again in China the business for splits has come to a standstill. We must admit that we haven’t seen a similar situation ever in history. There are no prices for lime splits any more and normally you would think this would tempt some with courage to take as much product from the market as they can store because finance does not play a role when the product itself is almost free. To own cheap raw material has never been a wrong decision before, even though there is low confidence in the future of split leather at the moment.
In the skins market we are heading into a similar situation. A lot of skins, sheep or goat, are accumulating around the globe and many of the prices quoted are, from our point of view, pretty theoretical. There are no buyers for many skins and this is not improved by the fact that the regular and quality suppliers still find some accommodation with their customers. There is still a massive surplus of skins around and they are as cheap as many splits today. Apart from the reduced demand for leather, the entity pollution campaign in China is playing a very important role in this sector. Alternative capacities that could be used for skins in countries such as India or Pakistan are simply not available or not attracting clients.
The next four-to-eight weeks could be difficult. We have already seen a lot of price corrections and we are sure that, with the present raw material price levels, tanneries with a decent order book can make money again instead of incurring losses as they have done for a long time. However, we are presently in classical situation of a falling market. The demand for leather is down and we have a market situation that is reflected by having too much and too expensive inventory and consequently just focuses on liquidating and raising cash. At the same time, we are missing leather orders and missing the courage to step into the raw material market without those orders in hand.
This is a pretty bad scenario for the end of June because the slow summer season is still in front of us and very few believe that it is the right time to step into the raw material market. From our point of view it is always advisable to buy carefully in such a serious market correction, but it is also true that there are still a lot of hides available. For the moment it doesn’t seem that there is enough money around to absorb and support the market.
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