By John Richardson
WHEN traders acquired big volumes of polypropylene (PP) cargoes to export to China at the end of last year for arrival in Q1, they were confident that the country’s domestic market would easily absorb just about every single pellet in every single container.
Their confidence was based on the recovery in China’s economic growth in 2016 and the expectation that growth would continue to accelerate throughout 2017.
Adding to the logic of exporting big quantities of PP to China was the widespread expectation that oil prices would increase. When oil prices are rising plastic converters in every country are of course compelled to buy ahead of their immediate raw-material needs in order to hedge against future polymer prices rises (oil prices drive polymers pricing).
But it hasn’t turned out like this, and what has gone wrong in China’s PP market might have many parallels in other chemicals and polymers markets during the rest of this year:
- The 36% rise n Q1 2017 PP imports, on a year-on-year basis, to 1.4m tonnes has occurred as downstream demand has weakened on slower Chinese credit growth and greater weakness and volatility in oil prices. This has led to high inventory levels and a wider discount for domestic PP over imported material.
- China’s net PP trade (imports minus exports was) was up by 42% because China’s PP exports have fallen. In Q1 last year, exports totalled 58,000 tonnes but this year they have been at just 18,500 tonnes. This is because the weakness in China’s PP markets has spread across the rest of Asia. China has been largely unable to re-export unwanted imports to the rest of Asia during Q1.
- A further problem is a rise in domestic production. Local output in Q1 rose to 4.7m tonnes from 4.2m tonnes – a 12% increase when you look at the exact numbers (note that this doesn’t include powder PP production, only granules).
- If you then calculate the growth in apparent demand in Q1 (net trade plus domestic production), this gives you a year-on-year increase of 18%. This is three times the 6% real consumption growth that ICIS Consulting expects for the full-year 2016 over 2017. Real consumption in demand growth adjusted for inventory distortions.
- This all adds to up to the potential for a prolonged period destocking in China, and so downward pressure on pricing.
What Has Gone Wrong With Demand
It is all about the availability of credit, as I discussed on Wednesday. I’ve been warning about a potential slowdown in lending, and its implications for the Chinese economy, for two months. Only now, though, is consensus thinking catching up with my views.
Don’t get me wrong – I don’t expect the economy will see anything like a collapse. But even a slight moderation in growth will still have significant negative implications for chemicals markets. The evidence so far this year of a significant slowdown in lending has become compelling.
First came the fall in total social financing (a measure of all new credit in China, from state-owned and private lenders) in January-February 2017 on a year-on-year basis.
Next came the fall in state-owned lending in March but a rise in risky private, or shadow, lending.
Since March, we have seen several new regulations that are restricting the availability of shadow financing. Further underlying the determination of Beijing to deal with the credit bubble now rather than later is the investigation of several senior government officials and financial speculators for corruption, who appear to have tried to sidestep the new regulations.
The effect on the manufacturing sector, including of course the plastic converters, is more expensive credit, as well as less availability of lending. As the UK’s Daily Telegraph wrote yesterday: Three-month [China] Shibor lending rates have almost doubled to 4.35% since November. Caixin magazine reports that Chinese companies cancelled $20bn of bonds and short-term debt issues in April because of tightening market liquidity.
And in analysis that once again underlines the importance of being ahead of the curve in monitoring credit cycles in China, the newspaper adds that last year’s re-inflation of the lending bubble led to: A drastic decline in real interest rates from asphyxiating levels of 10% to the other extreme of minus 3%. This is now reversing. Real rates have spiked back up to 3.4%.
This is underlined by anecdotal reports from our ICIS pricing team of tighter and more expensive credit across many chemicals markets in China.
GDP growth is therefore likely to have reached its 2017 of 6.9% in, and will now moderate for the rest of this year.
Then there is the issue of oil prices. It is too early to make a firm call that prices will soon start to head back to what I believe is the level that reflects real supply and demand fundamentals – below $30/bbl.
But consider this: The recovery in oil prices that we saw in late 2016 and into this year was largely driven by the re-inflation of the China credit bubble. The same applied to other commodities prices. As China’s economy slows down on a dip in the availability lending, so too will the growth in its crude imports.
A fall in Chinese crude import growth might combine with ever-rising US shale-oil production. Saudi Arabia could also eventually decide “enough is enough” in its attempt to stabilise the oil market through taking the lion’s share of the OPEC production cutbacks.
Sentiment in oil markets has of late become more negative on all the above possibilities. At forefront of many plastic converters’ minds must therefore be the risk of a significant fall in crude prices. Why would they buy polymer resins today when tomorrow polymers might be cheaper?
An Alternative Argument
Forecasting markets is, of course, a very perilous business. History is littered with many, many people who have fallen flat on their faces. Events are notoriously difficult to predict. So I could obviously be wrong.
China might once again relax lending conditions and some unforeseen set of circumstances – perhaps geopolitical could once again send oil prices soaring. A return to very easy lending and expensive might crude might also combine with a lower domestic production of PP for these two reasons:
- Thermal coal prices have risen in in China on the back of a large-scale closure of coal mines in China for environmental reasons (thermal, rather than metallurgical or coking coal, is used in the coal-to-olefins-to-PP process). If thermal coal remains expensive for the rest of this year, this could squeeze the margins of China’s coal-to-PP producers and thus lower their operating rates.
- Late last year, teams of environmental inspectors began to tour China and these inspections are continuing today. Environmental regulations are being more strictly enforced as the Chinese government tries to fulfil its promise to make great improvements in water and air quality. This might lead to the cancellation of environmental permits for new coal-based PP plant that had been due to come on-stream this year. And we might even see the closure of existing plants that are in breach of environmental regulations.
Why This Alternative Argument Could Be Wrong
President Xi Jinping of China is aware that he is running out of time. The longer that the debt bubble continues, the more difficult it will be to deflate without a major financial crisis. China also has the cushion of very strong GDP growth in 2017 of 6.9% – above its official target of 6.5% – to continue to gradually cool the economy down. In other words, Beijing isn’t starting from a position of weak growth, and so doesn’t have to panic if GDP growth slips ever-so slightly from now onwards.
On oil prices, well, who really knows in the short term? But, as discussed on Monday, the reflation of the global economy has been driven by China – and the major symptom of this reflation has been higher commodity prices.
But now global commodities are retreating, largely because of China. Why should oil be the exception – especially when you also factor in ever-low shale oil production costs and the possibility that Saudi Arabia will return to a market share strategy?
And what if thermal coal prices now start moderating on the overall fall in commodities prices? This would improve the economics of China’s coal-to-PP plants. On Tuesday, we saw early signs of this when thermal coal contracts on the Zhengzhou Commodity Exchange dropped 2.6% to Rmb513/tonne.
The environmental issue is also more complex than it at first might seem (also see my blog post next Wednesday – 10 May – on this subject).
The Chinese government is deadly serious about improving air and water quality. It has been a firm political commitment to the Chinese people to deal with what is very probably the world’s worst-ever pollution crisis.
But the environmental crisis seems to be mainly affecting China’s bigger cities. Take Beijing as an example. China’s Ministry of Environmental Protection released data this month showing that the concentration of small particulates in the city’s atmosphere, known as PM2.5, rose by nearly 27% in Q1 of this year versus the first quarter of 2016.
Coal-to-PP capacity is located in inland, and so less populated, regions of China, whereas most of the end-users of PP – e.g. the plastic converters and the auto and washing-machine plants etc. – or located in, or near to, the big cities.
Perhaps we might therefore see more downstream consumers of PP shut down than coal-based PP plants. So the net effect could be that the loss of demand is greater than the reduction in supply. Also see my 1 May blog post for further complications.
You have to look at the wider economic and environmental picture when considering what might happen to production at China’s coal-based PP and polyethylene plants.
You Have To Start By Asking The Right Questions
We are living in an ever-more complex and ever-more uncertain world, and so the above analysis only scratches the surface of all these complexities and uncertainties.
But what I have attempted to show in this post is this: Only if you ask the right questions can you have any hope of getting the right answers.