The Leather Pipeline - 14.05.19
14/05/2019
One cannot complain about a lack of excitement and news from politics and the financial markets in the past two weeks. In normal times, we might have talked here about further Brexit news, election results from Spain and the UK, the progress in Venezuela, missiles fired on Israel, or further missile tests by North Korea. This would be important enough news, but it is President Trump who has once again dominated the headlines in the past two weeks.
Two major subjects caught the attention of the public and made the headlines in the news. The escalating conflict with Iran has seen the President implement further sanctions, and the relationship between the two countries has become a lot tougher recently. The US has sent aircraft carriers to the Persian Gulf and the risk of a military conflict is reaching new levels.
However, the trade war with China seems to be more attractive and important for the global media. President Trump again carried out politics by Twitter, sending a tweet to announce that he would trigger the second level of tariffs on Chinese imports. He said the Chinese has gone back on agreements previously made in the trade negotiations. The tariffs came into force on Thursday, although the back door was left open because goods that had already left Chinese ports were not affected. Considering the normal transit time is 2-4 weeks, there is still time for the two big players to come to an agreement.
The financial markets, which have been almost completely unaffected by political subjects in recent times, reacted this time. Stock markets fell and investors were said to have substantially increased their cash positions.
One can easily see that both sides understand the importance of the situation. Despite the raised tariffs, President Trump still displays hope for and willingness to make an agreement and is praising the Chinese president for beautiful letters and the great opportunity of direct phone conversations.
The US has given China another month to sign a trade deal before raising taxes on all Chinese imports. Both sides have been busy reassuring the public that discussions are still positive. However, to an outsider it seems like it is just about how to save face for either side. This is not an easy task as both presidents have to meet the expectations of their people. There is a large distance to bridge, which will require some creative wording if both sides are going to get a satisfactory conclusion.
The conflict in the Persian Gulf would normally have sent oil prices rocketing, but the trade conflict between the US and China has been a dampening factor. Oil prices have retreated from the peak of a few weeks ago and now trade at $60-70 per barrel, depending on quality.
The currency markets didn’t react much. The US dollar continues to trade within very narrow ranges. A few ‘safe-haven’ currencies like the Swiss franc and the yen saw more interest from investors.
The movement of precious metals was minimal; so far, investors have not decided to dramatically pull out of specific investments in favour of others.
Market Intelligence
The leather pipeline remains in misery. Prices for raw material all over the globe continue to slide. This is the consequence of the unresolved and massive surplus of raw materials. This doesn’t even include the stocks that have already been accumulated by tanneries and traders across the globe.
The main problem is actually China. The great dominance the country has exerted over leather production in the past 20 years has resulted in plenty of overcapacity. As a result, we are dealing not just with the decline in global leather demand, which is bad enough, but also with the erasure of leather production capacity that was never actually needed in the first place. This is a massive hit to the markets.
Nobody was prepared; the question is whether there was any real opportunity to prepare for what has happened. The decline in leather demand due to the substitution of the material is certainly something that hide and skins producers should have realised was coming. Were there strategies that could have softened the situation or even avoided it? We tend to believe that the majority would say there was no solution or alternative.
The decline in leather demand, which began some time in 2016, has been amplified by the stricter environmental controls from the Chinese government and by the massive change in retail business from offline to online. This accelerated the speed of stock turn, triggered much better inventory management and became a massive threat to the long supply chain between production and retail in China.
To make things worse, the global economy lost steam for various reasons. Finally, the automotive industry, one of the last safe havens for volume in the market, has struggled. Add to that the rising supply of raw material, and you arrive at the current situation.
In the meantime, many activities have been started to support the acceptance of leather and to stimulate demand. Plenty of initiatives are on their way and more are expected to come. The problem is that none are very convincing; despite all the good intentions, it is hard to believe any of them can really trigger a turnaround.
As we have mentioned in previous publications, it is still just a matter of business and profits. Those who are successfully marketing products made from leather will certainly be enjoying substantial rises in their margins. Finished product prices have not fallen since the collapse of the raw material market and so the margins of leather producers, and even more so of finished product manufacturers, have improved.
The frightening thing is that even better margins have not been enough to stimulate demand for leather products and for leather as a material. The demand for leather is stagnant as it is not the leather that is offering the higher margin. For standard products, the margins have only just come close to the ones leading manufacturers can generate from alternative products. Although this is not stimulating demand for leather, it is definitely preventing an additional sharp reduction in demand.
The biggest headache we are now facing now is the stocks that have built up along the leather pipeline in recent months and even years. It is frightening to think what might happen to the huge inventories of wet blue and crust that are sitting stranded in so many placed around the globe. Current production and demand might be in a better balance than before, even if the market does not really reflect this, but the valuation losses in an unclear future are paralysing great parts of the industry.
Much of what is already tanned has a predefined use. Taxes and tariffs have made plenty of material unmarketable; if one does not see any light at the end of the tunnel for the stocks one owns, how can we expect these people to plan for the future and make decisions for a new start.
Material concerns
It is useless to complain so let us check if there are any positives around. There appears to be some redirection of production, which is declining in China. Many we speak to feel there has been a slight recovery of demand and production of shoe leather in India. Africa is also beginning to become not just a production place, but also a market with rising potential for finished products. The Middle East and Russia still have potential, but they suffer from the political environment. They could help if unleashed.
In the developed market, it is all about making leather more attractive again. It is a fact that global consumption has a far bigger potential than the entire raw material base could ever offer. We could never satisfy the demand if everyone wanted something made from leather.
Let’s get back to basics. Leather will likely not win the price battle in the near future. Material decisions for the next season or seasons have already been made, the automotive industry is consuming less leather, and the global economy is not stable. Political tensions are rising and the commodity section of the leather pipeline is congested, which means we would need an extra boost just to clear up the stocks.
We know that many intelligent people are already working on the subject and all in the leather industry are looking for a magic key, which is unlikely to exist. Most of the efforts and activities are focused on defending leather and trying to explain why consumers should favour it. We think the problem lies with the words ‘defend’ and ‘explain’. In today’s world, anything that has to be defended and explained does not have much market chance. Easy, quick, nice, happy, performing, pleasing, image creating are the terms which could create a market for the material again.
We still have a large base for leather consumption, with its use by luxury brands remaining high and still rising. The automotive sector is sending positive signs for the future; even if the forecasts for the coming year prove to be too positive, leather demand will not collapse. Models and interiors are fixed and the industry has already adjusted its inventories over the past six months. This leads us to believe that declines exceeding seasonal adjustments are no longer needed.
We see a similar scenario for shoes and handbags. The adjustments in material use have been made and we don’t expect many more. Leather prices are down, leather has become more competitive and leather buyers play hardball because they know about the falling raw material prices, the overcapacity and the stiff competition between tanneries. However, all of this is not enough to digest the total supply of raw material produced, nor is it consuming any of the accumulated volumes.
We have to find solutions for this excess material. Considering the issue of hides with grain problems, we have to think about the following:
1. Fashion and function need to be in the limelight because leather will struggle to win the price and cost of production battle.
2. More than 80% of active global leather production meets acceptable environmental standards. We think we can easily prove that leather, which is almost the perfect example of a circular economy, has a better environmental footprint than any plastic. If we choose to target the environmental concern of consumers, we have to force them to opt for the longer product life cycles that leather offers.
3. To achieve the above, the leather industry has to shift strategy. Recent decades have put the focus on price and yield, trying to win the price battle. This has destroyed the image, function and value of leather. The trend towards standardisation and the attempts to make a natural product look more like an artificial one has come to an end.
4. The lower raw material prices offer a chance to review the types of leather that are attractive to manufacturers and consumers. Instead of closing the gap to plastic, we should make leather distinguishable so that it is a conscious decision to buy it. The historical tanning centres around the globe still have the know-how to do this.
5. The supply base of raw hides begins to shrink. Prices for raw hides are so low that collection and processing of hides and skins is not profitable. Across the world, collectors and processors, slaughterhouses and rending plants are at the end of the road when it comes to hoping for better prices. They stop collecting and processing and so the supply begins to shrink. This will continue until the market returns to balance, although nobody knows when this is going to be.
Splits and skins
The split market remains the same, with the exception of the lie split section in Europe. Lower soaks have created a bottleneck in supply and the large manufacturers have realised that offers are unlikely to rise in the near future. Presently, we have two groups. One is the collagen and gelatine industry, which is watching the problems in the leather industry and the changes in pork supply. They are failing to find new supplies in the tannery industry and are having to look for other options.
The beef and hide industry is looking for solutions for the hides that are currently in surplus. This is not too easy because the calculations are hard, but to check for the potential it requires joint action with everyone being asked to deliver information about cost and yield. This is coming too late; what should have been done in normal time now need to be rushed. However, a lot of projects are triggered and some are already running. It might still be a while until final conclusions can be made.
The hide market might be fragmented, but the skin market is even more so. Nappa and standard leathers do not show any improvements, but specialties remain untouched by all the problems around leather. Hides in general are a commodity product, while skins are split across so many different segments and offer many options. This is why the fragmentation of the sector comes as no surprise. The new season has started in Europe and, as usual, there are a lot of enquiries and ambitious asking prices.
Problems to solve
We are heading further into spring and summer. Leather production is slowly beginning to reach the lower seasonal levels and holidays are around the corner in the Northern hemisphere. In Europe, lower kill levels will bring the better quality hides more into balance. We also expect a certain pick-up in demand for quality automotive leathers. The ramp-up in production of the new models coming to the market in September will normalise hide demand, in combination with lower kills. Just as a remark; butchers should not make the mistake of believing that it is already time for higher prices. Also, these hides contain a lot of lower grades, which drag the average return down.
The shoe and upholstery sectors swing into their low season and the general problems around leather also remain unsolved. Supply begins to ease in many parts of the world, while many sellers still need to place their existing stocks. This absorbs the effect of lower hide and skin recovery.
This leads us to the opinion that the price trend will continue to be a negative one. Better quality hides from the various origins need to find their correct valuations. This means some may have a chance for more stability, while others still have decent potential for price correction to find adequate values.
In the commodity section, demand does not meet supply and there is no price question. We need to increase leather demand; until this happens, the price will depend on the seller’s desperation to sell.
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