China Containerboard:Imported OCC contaminants cap cut to 0.
While the OCC contaminants threshold has yet to be determined, we knowthat imported OCC will need to be of a higher quality going forward, becausethe import of “unsorted waste paper” will also be banned, starting January 1,2018. Based on Chinese standards, the benchmark US#11 OCC contains 1%contaminants and, according to DB's US paper analyst, many US recyclers aregetting away with a 1.5% contaminant level for waste paper being shipped toChina currently. In order to comply with the new standard of 0.5%, considerablesums will need to be invested so that assets can be upgraded accordingly. If the0.5% contaminant level sticks, Chinese paper mills will be forced to import themore expensive US#12 waste paper, which fits the 0.5% standard and which isUSD15-40/t more expensive. Even excluding the contaminant factor, we estimate8mt, or 28% of imported OCC, will have to be upgraded or rearranged basedon 2017 numbers, including 6.1mt of unsorted waste paper and 1.9mt sorted bypaper mills with capacity of less than 300k.
According to our spread analysis, the NP/t of China's large paper producers, NDPand LMP, decreased by 3%/8% wow to RMB107/t and HKD440/t this week. Atthis level, smaller paper companies are just breaking even or are already lossmaking. Most paper mills want to increase paper price but it is proving verydifficult because of sluggish demand. With imported OCC entering China at ahigher price but falling paper price, we expect paper mills' margins to stay low orsqueeze further in the future. We reiterate Sell rating on NDP with target price ofHKD10.98/sh and Hold rating on LMP with target price of HKD8.30/sh.
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%.
In 2H17, large paper mills in China enjoyed an unprecedented advantage, giventhe surprise import ban since May 2017 and the subsequent crash in US OCC.
On January 11, 2018the Ministry of Environment Protection (MEP) releasedthe "Environmental protection control standard for imported solid wastes asraw materials—Waste and scrap of paper or paperboard (GB16487.4- 2017)",effective from March 1this year. Ignoring protests by WTO, China has fixedthe OCC contaminant cap at an extremely strict level of 0.5% versus 1.5%in the previous regulation, published in 2005(GB16487.4- 2005). This meansthe impurities included in the OCC (i.e. waste wood chips, glass, plastics,rubber, metals, paints) cannot exceed 0.5%. The final contaminant requirementis unchanged from the version submitted by China government to WTO onNovember 16, 2017, which attracted many protests from global recyclingcommunities as they have to invest considerable sums to upgrade their collectionand sorting facilities. Accordingly, we expect recycling/sorting costs to riseworldwide with US recyclers most affected since they are the largest supplierto China, accounting for 46% of waste paper shipped into China in 2016. Basedon the current standard, US#11waste paper shipped into China has a 1.0%contaminant standard, which would force China to buy more expensive US#12or US#13OCC, not to mention the lack of supply globally. The most immediateoutcomes are as follows. 1) OCC #11prices will plummet, benefiting global millswhile Chinese mills will suffer from higher OCC prices through grade upgrading.2) Margins will be squeezed for China mills since imports of finished paper willcontinue to flood China, with the global cost curve being lowered as they canuse cheaper US#11OCC. China still has the highest paper prices in the world, soraising domestic paper prices to pass through higher OCC costs will be difficult.3) Large players' advantage to import cheap waste paper overseas will dissipate,putting them on equal footing with small mills, which primarily use domesticpaper. This new rule clearly benefits box makers as opposed to paper mills.
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.
While a cost push normally suggests higher domestic paper prices, China alreadyboasts the most expensive paper prices globally, so further prices hikes shouldnot be expected. On the contrary, this creates an opportunity for more finishedpaper imports into China in 2018.
Paper mills' margins to stay low or be squeezed further in future
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%.
According to the Bureau of International Recycling (BIR), on November 15, Chinanotified the WTO that it intends to control the percentage of contaminants inimported OCC to 0.5% with new rules due to be published on December 31,2017 and implementation on March 1, 2018. (See "Environmental ProtectionControl Standard for Imported Solid Wastes as Raw Materials - Waste and Scrapof Paper or Paperboard (GB 16487.4 - 2017".) The contaminants percentage forimported OCC is currently 1.5%, based on Chinese regulations published in 2005,but was revised to 0.3% in the initial draft released in August 2017; however,such stringent requirements generated many protests globally. The protests ledto speculation that China would revise the percentage to 1%, but this appears tohave indeed just been speculation. If there are no further changes to the 0.5%standard, which differs a lot from what is currently followed by global recyclingcommunities, this could lead to a significant cost push to Chinese paper producerssince they will be forced to use more expensive higher imported OCC grades.
On January 12, the MEP released the #3batch of 2018OCC import quota of 466ktto seven large paper mills, including Shenyang/Hebei/Quanzhou plants of NDPand Jiangxi plant of LMP. Including the 2.3mt in #1batch and 344kt in #2batch,China's government has approved 3.1mt of import quota, accounting for 11% oftotal recycled paper usage in 2016or 13% excluding unsorted waste paper. On anapples-to-apples basis, the approved import quota implied a decline of 82% yoyfrom the first batch last year and would last for two months of production. Theincreased frequency of quota release has prevented speculation of waste paperprice. At present, US#11OCC is still RMB968, or 37% cheaper than domesticGrade A OCC, which means upcoming cheaper OCC overseas may lead domesticOCC prices falling further.
Takeaways from Dongguan and Shenzhen paper trip on 5-6 July.
Imported OCC prices structurally higher for Chinese mills.
#3batch import quota released
Boxboard/box makers barely surviving but caught in dilemma over paper prices.
Paper mills' margins to be squeezed further next year.
Imported OCC contaminant threshold fixed at strict levels of 0.5%
gSales strategy changes since 4Q16 to hoard inventory and keep pricing high.
China intends to revise OCC contaminant threshold to 0.5%.
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.
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.
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.
Structurally higher OCC costs on lower import quotas & stricter quality control.