China Containerboard:Trip takeaways,A bubble is brewing but it may not burst yet

Takeaways from Dongguan and Shenzhen paper trip on 5-6 July.

    We met with the environmental bureau and paper mill and boxboard/boxmakers. We believe the recent paper price hikes have been mostly speculativein nature, starting with 1) a reduced supply due to production halts by leadingpaper mills, 2) abnormal restocking by downstream users anticipating a peak4Q, and 3) higher OCC pricing due to reduced import quotas and aggressiveChinese bidding. Across the vertical chain, paper inventories are high at 4months (normally 1-1.5 months) with most box makers over-stocked. Due toweak demand, small mills have begun cutting prices by RMB200-300/t whilelarge mills have begun cutting purchase prices for domestic OCC by RMB150/t.

    gSales strategy changes since 4Q16 to hoard inventory and keep pricing high.

    Since 4Q16, leading paper mills have altered their sales strategy by holdingback production (NDP selling c.5.7-5.8mt for CY1H17 vs. a target of 6.2-6.5mt)and cancelling fixed price contracts with downstream. As a result, smaller millshave gained market share and are operating at higher utilization rates. Anartificially tight supply environment has led to higher prices and speculativebuying by box makers, with some renting extra storage space to hoard paper.

    Since purchases of paper are placed on credit, a sudden drop in the paperprice could hurt the cash flow of box makers and lead to a price free fall. Fornow, paper mills and distributors have low inventories, so the price bubblemay continue in 2H. After the recent round of hikes in June, CCTV reported onexcessive paper prices on three separate occasions during 2-6 July. In 4Q16,NDRC had raided the premises of large mills to investigate price collusion.

    Boxboard/box makers barely surviving but caught in dilemma over paper prices.

    Boxboard and box makers can no longer fully pass through the 14% hike inpaper prices since Jun-17, considering that their net margins were only 2-3%.

    However, box makers don’t mind the higher paper pricing as it gives them anexcuse to raise box pricing to their customers; they are also stocking up onpaper inventories (1-3 months), having learnt their lesson from 4Q16. Boxmakers with higher exposure to the electronics segment were able to passthrough paper price hikes due to the higher price points of end-products,unlike those in the lower-margin FMCG/toy/textile sectors, which have resistedprice hikes. In order to survive, boxboard makers are in the process ofupgrading their machines to newer, more efficient ones to reduce overheads,or choosing to simply turn away business outright.

    Structurally higher OCC costs on lower import quotas & stricter quality control.

    Old corrugated containers (OCC) costs are set to stay high in 2H17, withbuoyant seasonal demand both in the US and China, higher freight cost now2x, tighter bank loans and stricter environmental regulations. Since April, Chinahas stepped up the inspection of imported waste paper with the governmentturning back shipments of US#3 paper (RCP mixed with garbage). Thealternative is US#6, which is essentially a pre-sorted version of US#3 but witha higher cost. For 7M17, import quotas for RCP are also cut 22% yoy andquotas are now granted on a quarterly instead of yearly basis. This hasincreased demand for domestic OCC and the pricing power of domesticrecyclers, in turn boosting prices. Over the last three months, domestic OCCprices were +40% vs. imported OCC prices at +14%.