China's Pulp Demand Growth to Stabilize9 December 2019
The decline in pulp demand seen in China in late 2018 and early 2019 seems more temporary than structural. Demand drivers point to moderate growth in demand from 2020 onwards, as printing and writing paper are more resilient in China than in other major economies and as tissue has room for sustained growth following rising urbanization. Despite announcements by Chinese mills for new domestic investments, the country is set to remain dependent on pulp imports to supply 60% of its demand going forward. Rabobank expects pulp demand to gradually bounce back in late 2019 and throughout 2020 in China
A Sudden Drop in Pulp Demand
Orders Dried up and Inventories Boomed
Global pulp markets were rattled in 2H 2018 when, after a long rally in prices (2016-2018), sentiment changed rapidly and customers’ orders dried up. Most market analysts called it a temporary blip in demand, and many (including us) expected a relatively rapid bounce back in purchasing during 1H 2019. However, this was more than just a short adjustment in inventories held by Chinese offtakers and caused a substantial build-up of stocks in the hands of producers, as orders were slow to materialize and buyers patiently waited for lower prices from Q3 2018 onwards while holding record low inventories themselves.
Meanwhile, supply remained robust through the end of 2018 and the first half of 2019, with no significant downtimes until Suzano’s planned downtime from May onwards. This was a significant difference from 2017 and 2018, when several large plants suffered temporary closures and we saw mainly positive weather in most producing regions. The result was ample supply in the past 12 months, as previously added capacity (2016-2018) was fully operational. Prices have subsequently fallen for more than twelve months and reached twoyear lows of USD 450/mt by Q3 2019 (BHK pulp in China).
However, the demand downturn in China did not come out of the blue. Offtakers, like paper mills for printing and writing (P&W) and tissue, had been struggling with high costs and low margins for some time, as pulp prices remained high up until Q3 2018 and the higher costs couldn’t be fully passed on. Between 30% and 50% of operational costs of Chinese producers come from pulp for most paper grades, which meant that high pulp prices pressured margins. Pulp offtakers thus moved aggressively to reduce their own inventories and cut production in China as a result of weakening consumer demand for paper and packaging grades and the effects of the trade war with the US. As global pulp supply steamed ahead at full strength in late 2018, the conditions for a correction matured, with demand drying up and supply building up strongly. Several pulp mills in China rapidly decreased their pulp holdings from an average of 90 days down to just 30 days from Q3 2018 onwards as they pulled back on orders. This caused inventories to shift hands from buyers to sellers, contributing to a rapid build-up of pulp volumes in Chinese and European ports.
Chinese Demand Drivers Signal Moderate Growth
Future Pulp Demand Drivers in China
The importance of China in the global pulp market has continued to increase in recent years, with strong demand growth taking China’s pulp consumption share from around 15% to around 30% (combined hardwood and softwood) over the past ten years. Price movements in other regions are now mainly driven by dynamics in China. Consequently, it is crucial for the rest of the global pulp market to understand what is happening in China. Rabobank estimates that 35% of Chinese pulp demand is generated by the P&W paper sector. Tissue production represents 28%, virgin boxboard around 15%, and speciality papers 12%. These four components account for the bulk of pulp demand in China (90%). Each of these sectors has different dynamics, and understanding them is key to understanding how overall pulp demand might perform.
Printing and Writing Paper: Growth in Consumption of 1%
In the past five years (2013-2018), due to the government’s stringent environmental regulations, slower economic growth, and weak demand (especially in 2018), many small P&W paper mills were forced to close in China. With limited new mills entering the market during this period, the overall supply side of the P&W paper market declined, and, looking ahead, there will be no significant capacity entering the market in either 2019 or 2020. This will make this market even more balanced in 2020, with little spare capacity – market sources indicate that capacity utilization reached 85% in 2018. By 2021, three companies plan to invest in new capacity of 1.1m metric tons in total. Sun Paper will add 450,000 metric tons, Bohui Paper 310,000 metric tons, and Gold Huasheng Paper 320,000 metric tons.
This capacity will partially substitute older capacity, but overall we expect total capacity of P&W paper to increase by 2% to 3% in 2021. On the other hand, demand for P&W paper achieved a moderate volume growth, with 0.69% CAGR from 2013 to 2018. We expect that demand for P&W paper from 2020 to 2022 will continue to grow moderately, mainly underpinned by the following factors:
1. Higher penetration rate of fundamental and higher education and further expansion of educational institutions. According to the Ministry of Education of China, the number of students from kindergarten to high school will reach 212m by 2020, up from 187m in 2018. Meanwhile, the increasing number of students will stimulate the higher education market, and the government has set up a goal for the gross enrollment rate of higher education to reach 50% by 2020 – up from 48.8% in 2018. As P&W paper is mainly used for textbooks and tutorial materials in China, the increasing number of students will drive demand growth.
2. The paper book market continues to grow. In recent years, the impact of the internet and ebooks on paper books has been moderate. Digitalization is rapidly changing how consumers shop and pay for goods and where they buy books but not necessarily how they read (paper as opposed to digital books). Book sales are growing at an annual pace of 10% in China, according to Beijing OpenBook research (a Chinese research firm), but the majority of books are still read in paper format. Most publishers in China are government owned, and private ones need to go through a government approval process before publishing. This, in part, encourages the use of printing paper for books, which, added to large printouts of political documents and speeches, makes the Chinese book sector more dependent on printing paper than its counterparts in many other countries. According to the National News Publication Bureau, in 2018, the number of books published and printed in China reached 9.5bn, an increase of 2.8% compared to 2017. The children’s book market accounted for 25% of the total and registered faster growth in recent years. According to local analysts, parents in China often prefer to buy paper books rather than digital versions, due to concerns about their children’s eye health.
3. Political materials. The party’s central committee has always attached great importance to political work and the education of party members. In addition, to celebrate the 70th anniversary of the People’s Republic of China's founding, large printouts of political books are requested regularly and released in the market. The increasing printouts of party and educational work will drive the demand for P&W paper in the coming years.
Tissue Paper: Demand to Continue Growing at 4%
Ongoing urbanization and rising hygiene awareness, in combination with the pursuit of safe and healthy products among local consumers in China, are likely to further promote product penetration and premiumization in the tissue market. Urban consumers are getting sophisticated and are seeking more functional tissue products. This promotes the segmentation of tissues, including shifting from toilet paper to boxed facial tissues and pocket handkerchiefs, starting to use paper towels, and forming the habit of using personal wipes out of home. Local research has shown that the per capita consumption of tissue and hygiene products in China has a significant linear relationship with per capita GDP. Slower economic growth forecast in China for 2019 and 2020 will therefore impact the growth of tissue consumption to some extent . We expect China’s tissue demand to remain healthy in 2019 and to continue growing at around 4% per year. Although 4% can be considered a very healthy growth rate, it is much less than the historic 6% growth level, so capacity will need to adjust to lower operating rates for some time. As significant capacity has been added in recent years (2.5m metric tons for 2019-2020), this will likely push high-cost mills out of business and will continue to pressure margins in the sector for some time.
China’s total boxboard demand fell by around 6% YOY in 2018, according to China Paper Association. This decline was entirely driven by the recycled boxboard segment, which was disrupted by China’s RCP import policies – similar to recycled containerboard (please see An Unsettled Future for China’s RCP Markets).
The demand for virgin boxboard continued to show uninterrupted growth of about 1% YOY from 2015 onwards. We expect that virgin boxboard demand will maintain this growth trend of 1% per year in both 2019 and 2020, driven by consumption trends for major offtakers of virgin boxboard, including pharmaceuticals, cosmetics, and electronics (65% combined market share), and food (8% market share).
Thanks to rising disposable income in China and rising health awareness, the demand for pharmaceutical, beauty, and personal care products grew steadily in recent years and will continue to gain momentum. Also, the launch of 5G smartphones is likely to shorten the replacement cycle of smartphones and, as consumers replace older 4G devices with 5G-enabled ones, stimulate sales of luxury packaging, which traditionally uses virgin boxboard. Meanwhile, following the sustainability trend, food companies are paying more attention to food packaging and substituting plastic packaging with paper packaging where possible. For example, coffee companies are replacing plastic straws with paper ones, and biscuit companies are shifting from plastic to folding carton trays.
Substitution of recycled boxboard with virgin grades will also contribute to a higher demand for virgin boxboard. Due to stringent government environmental policies introduced in recent years, some small and medium recycled-boxboard mills are being forced to shut down. The production of recycled boxboard subsequently declined by 13% YOY in 2018 (China Paper Association) – stronger than the 6% overall market decline. These policies will continue to drive the substitution of recycled boxboard with virgin grades until the market finds a new equilibrium. Also, food safety concerns related to the potential mineral-oil contamination risk of recycled fiber-based packaging with direct food contact stimulates this substitution trend.
All these factors indicate positive domestic developments for virgin boxboard in China and are encouraging Chinese boxboard producers to build new capacity. They are also looking for additional export opportunities to other Asian countries, but the limited domestic production makes it difficult to take advantage of that market opportunity. According to company reports, Asia Pulp & Paper and Bohui Paper will invest in new virgin boxboard projects with a capacity of 5.4m and 0.75m metric tons, respectively, during 2020.
Pulp Demand to Grow, Albeit at a Slower Pace
Light at the End of the Tunnel
Pulp demand is already showing the first signs of stabilizing in China. Demand in Q3 2019 picked up, as paper mills prepared for the busy end-of-year period. Various seasonal events, such as the Moon Festival in September and the festivities surrounding the October 1st commemorations of the 70th anniversary of the People’s Republic of China, helped accelerate purchases during a busy period. Shipments of pulp from Brazil to China picked up again in August and September, despite still high inventories at ports (see Figure 6). This pick-up in sales happened as Suzano reported a reduction of around 450,000 metric tons in inventories during Q3. This indicates that overall sales have picked up and inventories of pulp producers are gradually being reduced, not only due to the recovering shipments from Brazil to China.
The key to higher pulp prices is tied to a more significant decline in inventories at Chinese ports that would lead buyers to secure larger volumes. However, large producers have announced bulk negotiations to offload large volumes held in China, and this will gradually drive inventories lower as 2019 draws to a close. Despite the slowdown in demand during 1H 2019, overall shipments of Brazilian pulp to China are actually higher YTD in 2019, when compared to 2018 .
Accelerated Market Concentration Leading to More Negotiating Power
The competitive environment in the Chinese pulp and paper sector has become significantly stricter and more expensive for operators in recent years. The implementation of the ‘environmental protection tax’ and ‘pollution permit system’ have added significant operational costs to all players. In particular, small- and medium-sized paper mills have seen their margins contract faster. Industry earnings have also declined in recent years for Chinese players. However, the profitability of large companies is higher than that of small- and medium-sized firms, due to the advantage of integrated pulp and paper mills, power self-sufficiency, and procurement scale of inputs. Under dual pressure from lower profitability and rising regulations, small- and mediumsized paper mills are under pressure, and the closure of outdated production capacity is inevitable, which also promotes industry concentration. In 2018, the top four paper mills jointly accounted for 69% of the P&W paper market sales, while the virgin boxboard market is even more consolidated, with the top four players accounting for 92% of sales. The tissue paper market is still fragmented. However, the four largest players are gaining scale and have increased their share of total sales from 27% in 2012 to 34% in 2018.
Summarizing Our View for Pulp Demand in China
The downturn in Chinese pulp demand seen from late 2018 into mid-2019 resulted mainly from a long compression in the margins of offtakers that caused a sharp adjustment in owned inventories and, to a lesser extent, from weaker macroeconomic factors (slower economic growth and trade impacts from the dispute with the US). High pulp prices that lasted from 2016 to 2018 resulted in higher costs for paper mills in China (and elsewhere), and mills struggled to pass higher costs onto end-product prices, which deteriorated the financial state of many pulp offtakers. By mid-2018, pulp buyers were determined to slash orders, significantly reduce their pulp inventories, and even curtail production in order to obtain larger discounts from pulp sellers and reduce their costs. With pulp supply at full speed in 2018, the reduction in Chinese demand caused a rapid accumulation of inventories at Chinese and European ports, with buyers and sellers failing to find an equilibrium in prices until Q4 2019.
However, in Rabobank’s view, this reduction in Chinese demand is a short-term adjustment rather than a permanent shift in the pillars of demand. Looking ahead, Rabobank’s view is that structurally China will remain dependent on imported pulp. Integrated mills in the country are expensive and largely dependent on imported wood chips from Southeast Asia and other suppliers. This dependence on imported wood creates risks on the cost side, and there are sustainability concerns that might impact that specific supply chain in the future. Domestic pulp capacity will continue to increase in coming years, but China is set to remain dependent on imports for at least 60% of its demand needs in the medium term, when all grades are considered. It is true that overall economic growth will probably be slower in China going forward (closer to 5% of GDP), and, although the economy is much bigger now than say ten years ago when GDP growth was at double digits, it will be harder for demand to grow as rapidly as it used to.
The shift to increased urbanization is good news for future tissue paper demand, which will continue to be the most dynamic pulp offtaker. As discussed above, P&W paper demand tends to be more resilient in China than in other major economies, with fewer incentives to digitalize educational books and political materials. This is good news for pulp demand, as printing and writing still account for around a third of demand.
Overall, after finding a new balance, China’s pulp demand will likely start to improve in 2020 after declining in 2019, and prices will gradually move higher once inventories at Chinese ports start declining and return to normalized levels, which is likely to be from Q1 2020 onwards. However, underlying demand points to a slower recovery than in past downturns, in part due to an economy that will struggle to regain its past level of expansion and also due to the fact that some sectors are more mature and will grow more slowly.
It is worth mentioning that part of the growth in pulp demand in China that Rabobank expects in 2020 will be due to the replenishment of inventories by pulp mills and other buyers. Once stocks at ports are reduced and buyers see an advantage in securing lower prices for longer, their own holdings of pulp will rise from the historically-low level seen at present and contribute to a boost in demand.