In the balance

09 May 2005 00:01  [Source: ACN]

China’s polyester industry faces a bleak future owing to over-enthusiastic investment. But, as Malini Hariharan observes, restructuring and much less investment could help the sector recover its balance

CHINA’s polyester industry is a victim of its own success. The industry was long a favourite with companies that had extra money on hand. In the early part of this decade, healthy profits, strong demand growth, and dreams of China’s dominance of the global textile world post-2005 prompted a spurt in investments.

Today, many of the producers are struggling to survive as overcapacity has pushed profitability to unseen depths. The immediate future is bleak. And a change in fortunes in the medium term is likely only if hopes of restructuring in the industry materialise.

In many ways, the polyester story showcases the problems typical of most manufacturing sectors in China.

The late 1990s and the early part of this decade were the boom period that triggered the famous herd mentality. No doubt the smell of profits was hard to ignore, but it has led to a major problem as it attracted not just a few investors, but hundreds.

Then, there was also easy availability of money and technology. Banks had, in the past, done little to discourage investors in the polyester sector, and few Chinese companies had problems getting banks to fund their reckless expansions. The government also remained quiet with no policies to guide investments. The end result was a massive overcapacity that is unlikely to disappear very soon.

But in the midst of all this chaos, and even as profits decline steadily, at least Chinese polyester demand growth continues to be robust.

According to the PCI Consulting Group, Chinese mill consumption of polyester staple fibre (PSF) is set to increase to 5.9m tonne/year in 2005 from 4.7m tonne/year in 2004. Consumption of polyester filament yarn (PFY) is set to grow to around 8.2m tonne/year from 7m tonne/year. This represents a demand growth rate of 16% for PSF and 17% for PFY.

The demand growth is probably the only bright spot in the polyester picture, but it is not sufficiently bright to mask the problems created by overcapacity.

Speaking at the recent World Petrochemical Conference, PC Huang of CMAI pointed out that the scenario for the polyester industry was generally grim and likely to remain so for the medium term. Although the demand growth for polyester fibre and polyethylene terephthalate (PET) bottle chips had been extremely promising, margins had not been attractive for quite some time, he said.

Almost all the polyester products showed negative margins in 2004. Polyester chip producers have been the worst hit as this sector has seen negative margins in four of the last five years. Today, most of the companies are fighting for survival, often operating at as low as 60%.

The pain

The pain is evident in even a brief chat with any Chinese polyester producer. ‘I am very pessimistic about the future,’ said one, while a second producer believed that it was difficult to say when things will improve.

‘No one knows which way the Chinese textile industry will go; we are all confused,’ said a third producer.

The confusion stems partly from developments in the downstream sectors. China’s bid to dominate the global textile world has run into trouble, with both the US and the EU threatening to place restrictions on Chinese exports.

Bowing to pressure from US industry, which is said to have seen 14 plant closures since the beginning of this year, the Bush administration said in early April that the US would bring trade cases against China to determine whether quotas should be re-imposed in three clothing categories: cotton knit shirts and blouses; cotton trousers; and underwear made of cotton and man-made fibres.

US data show that shipments of knit shirts from China increased by 1258% in the first three months of this year, compared with Q1 last year, while shipments of cotton trousers were up by 1521%.

If Chinese exports are thought to be disrupting the US market, the government has the power to re-introduce quotas and restrict growth to just 7.5%/year.

In the case of the EU, trade chief Peter Mandelson has already recommended a probe into nine categories of Chinese exports of textiles and clothing, ranging from T-shirts to trousers, as they had allegedly risen by 534% since the end of the quota system on 31 December 2004. Chinese exports in 11 other categories are said to be approaching the alert level.

Worry about the likely impact on the local industry has prompted France to lodge a formal request to expedite the EU process that would lead to restrictions on Chinese exports.

China has protested against the proposed EU investigation, saying it runs counter to the spirit of free trade and places Sino-European relations at risk. But the government is well aware that Chinese producers face a serious threat of being pushed back to a quota regime, at least for some product categories in some countries. To avoid this scenario, it introduced an export tax earlier this year to curb growth, but there are few signs to suggest that the tax is working.

In the long run, there are other factors that could derail China’s ambition of becoming a global power. These include rising labour costs and a shortage of workers in key export zones.

One industry player estimated that monthly wages of workers in the garment industry in the coastal provinces had risen from US$100 to US$400 in the past few months. If this continues, the industry will have to move inland, but it would then face higher logistics costs. The other option would be to move overseas to countries such as Sri Lanka, Bangladesh, Cambodia, and Vietnam.

The impact of such shift on the global polyester industry would not be much, as it would merely represent a shift in demand from one country to another. And the industry source believes that even the Chinese polyester producers would be able to survive, as Sri Lanka or Bangladesh do not have local polyester production.

He says: ‘The point here is that countries such as Bangladesh and Sri Lanka do not have polymerisation, dyeing, and finishing capacities, and so exports will continue from China, even if China becomes uncompetitive and/or safeguard measures are imposed on the country to slow the growth of its finished-product exports.’

This is probably true for the short term, but if history is anything to go by, it is quite possible that these countries will gradually promote local production, which would then place the Chinese producers in the same position as their counterparts in South Korea or Taiwan – one of declining domestic demand, rising costs, and an inability to compete in the export market.

Capacity woes

A more immediate concern for the Chinese producers is the almost unending addition to capacity that has pushed competition to unprecedented levels. A Japanese trader estimated that China added about 3.5m tonne to its polyester capacity last year. And, on a nameplate basis, this year will see a further addition of 5m tonne.

CMAI’s Huang estimated that, while polyester demand grew by 3m tonne last year, expansions were almost twice this level. In 2005, capacity additions are likely to be about 9m tonne, almost three times the expected global demand growth.

A second industry source said China’s 17m tonne/year of polymerisation capacity in 2004 represented 5m tonne of oversupply. And his forecast is that a further 7m tonne/year of capacity will be commissioned this year and 3m tonne/year in 2006.

PCI expects the combined production of PSF and PFY in China to grow by 18% this year from last year. China’s production of PSF and PFY increased by 22% each in 2004 from 2003, to 4.3m tonne and 7m tonne, respectively. This factors in the 70% capacity utilisation of most plants last year.

With production growing faster than demand, China is gradually emerging as an important player in the export market, threatening many of the older players.

China’s PSF exports are likely to exceed imports for the first time in 2007. By 2009, export volumes are likely to be more than twice that of imports.

China exported 144 000 tonne of PSF in 2004; this is likely to rise to 288 000 tonne in 2005 and 521 000 tonne in 2007, according to CMAI. Imports amounted to 503 000 tonne in 2004, and this is likely to decline in the coming years.

The country has run into problems even in polyester exports. In March, the EU imposed antidumping duties (ADD), ranging from 18.6% to 85.3%, on Chinese PSF. Producers are now scouting for new markets to target their surpluses, while the country’s Ministry of Commerce is deciding whether or not to lodge a complaint with the World Trade Organization against the duties. China is expected to argue that the EU should not have used the US as a surrogate country to assess the normal value of Chinese PSF.

Finding a solution

Returning to the overcapacity crisis in China, an early solution is possible only if industry-wide restructuring takes place in the form of mergers and/or closures. And, although there is no history to suggest that Chinese companies would be willing to bite the bullet, most industry players believe that some companies may have no choice.

‘I have heard that two companies shut down permanently in Zhejiang province in October last year, and two more ceased operating in March,’ says the third producer.

However, this being China, it should perhaps not be surprising to know that many other producers have not heard of the closures. But, with banks gradually tightening credit to the sector, there is a consensus that the number of Chinese companies facing bankruptcy will only increase in the coming one to two years.

‘The bankers have a greater understanding of the polyester market now; they are tracking market developments regularly. They now visit us regularly to check how we are operating,’ says the third producer.

He also believes that companies in which the government has a stake have a better chance of survival, as they are likely to find it easier to obtain support from the banks.

Others are not so sure, as they think the private companies will be faster to restructure to adapt to the changing business environment. And they also believe that the government is unlikely to support loss-making companies for a long time.

What is clear, though, is that those with little integration and poor technology are likely to be the first ones to exit. And polyester investment is likely to taper off because of stricter government criteria for approvals, likely further hikes in interest rates, and stricter lending practices.

Polyester project proponents in the eastern provinces have to deposit 50% of the cost of their projects with banks before loans are issued, up from the previous single-digit percentage. Even the cost of doing business has gone up, with banks now asking for higher deposits for opening letters of credit.

It is easy to be optimistic that the banks and the government will play a major role in improving the fortunes of the polyester industry. But it should also be remembered that, by acting tough, banks run the risk of adding more bad loans at a time when there is pressure to bring them down.

The government, too, might not be keen on large-scale closures, as this would add to unemployment and contribute to social unrest.

Let us assume, though, that some restructuring will take place and the energy to invest further in this sector will wane. The industry would then need another two to three years to recover its balance, says the first source, while the Japanese trader’s forecast is more gloomy at five years.

CMAI’s Huang thinks the financial damage of 2004 and 2005 will require time to heal. He expects the overcapacity situation to remain into 2008.

‘The market may recover gradually from 2009 onwards, provided the Chinese producers reduce the rate of expansion.’

In the meantime, a number of Chinese producers are working seriously to change their product mix.

This time, the trend is to shift to speciality grades as they offer better profitability. However, the fear is that there will once again be a spate of investments in this area resulting in companies successfully killing the goose that lays the golden egg.

Impact on PTA and MEG

AN INEVITABLE question arising from the doom and gloom surrounding the Chinese polyester industry is what impact the Chinese polyester overcapacity will have on purified terephthalic acid (PTA) and monethylene glycol (MEG) demand.

The overcapacity has dragged down polyester operating rates, at times to as low as as 60-70%. The average operating rate was 65% in March and about 60% in April.

The industry operated at about 70% in 2004, and many companies expect the operating rate to drop in 2005 and 2006. A recovery is likely from 2007 if expansions slow down and restructuring takes place.

For the past 12 months, polyester producers have been caught between high feedstock costs and falling end-product prices. The uncertainty in the downstream markets has also not helped matters.

‘Usually, April and May are strong months for the textile industry. But this year there has been a steady decline in orders and prices,’ complains one polyester producer.

The current market situation may not be a good basis for forecasting the future for PTA and MEG, but concerns are already being expressed in some quarters that polyester feedstocks will also be squeezed in the near future.

A Japanese trader in aromatics through to MEG warns: ‘I am pessimistic. The peak [for MEG] has arrived and pricing is on the way down.’

A second trader points out that a great deal of polyester from new production in China is being placed into inventory. Eventually, plants will have to shut down, polyester operating rates might go even lower, and the decline in production will work its way up to paraxylene (PX)

‘I am talking to my sales people every day and they are getting more pessimistic,’ says a PTA producer. And, although he is hopeful the market will recover, he admits he does not know why the downturn has arrived earlier than expected this year, ahead of the May Day holidays in China.

Some other producers are more optimistic. ‘All the talk about declining operating rates is harmful and creates a negative sentiment in the market; it is also misleading,’ stresses an MEG producer.

‘If you talk about polyester operating rates being at 60% this year, down, say, from 70% last year, then you are talking about 60% from a much higher base, as capacity is rising dramatically. You also have to bear in mind that, as new capacity is brought onstream, it won’t immediately run at 100%. What you need to look at is production growth, which was 10% last year,’ he adds.

He believes Chinese MEG demand growth is running at 10%/year, with demand at 4.4m tonne last year, of which 1m tonne was met through imports. The market is sufficiently big to absorb volumes from BASF YPC’s 300 000 tonne/year plant that will soon be starting up in Nanjing, China.

MEG producers all over the world have enjoyed high operating rates and record profits for the last couple of years as demand growth outpaced additions to capacity. But five new plants, with a total capacity of 2.39m tonne/year, will be commissioned next year – Shell’s 300 000 tonne/year plant in China, Jubail United’s 650 000 tonne/year unit in Saudi Arabia, 440 000 tonne/year by National Petrochemical Co in Iran, Thai Olefin Co’s 300 000 tonne/year plant in Thailand, and Nan Ya Plastics’ 700 000 tonne/year unit in Taiwan.

As the large-scale additions are unlikely to be offset by major capacity closures, is the global MEG market likely to be oversupplied in 2006?

In a recent presentation in China, Doug Rightler of PCI Consulting Group pointed out that, even with the new capacity, MEG would be sold out in 2005 and 2006. The global picture showed the development of a manageable surplus of about 200 000 tonne in 2007, up from around 100 000 tonne in 2006. Demand is projected to hit 18.352m in 2007, as against 17.416m tonne in 2006. The average global operating rate is expected to slightly decline from 93.2% in 2006 to 91.71% in 2007.

However, the record profits from 2003 to 2006 will stimulate more capacity additions beyond 2007, especially mega plants in the Middle East. Going by announced plans, the industry faces a 2m-3m tonne annual surplus in 2008-09. Prices are likely to plunge once again, forcing a fresh wave of rationalisation among those suffering from high feedstock costs.

Turning to PTA, PC Huang of CMAI said at the World Petrochemical Conference that, despite the bad news about polyester, PTA producers had somehow managed to survive the storm. PTA margins have been reasonably healthy over the past five years.?But the start of new plants in China is expected to start affecting the market from 2007. China imported 5.7m tonne of PTA in 2004, and those imports will rise to 6.7m tonne this year, but fall to 1m-2m tonne/year from 2007 onwards, according to one industry source.

China’s increasing self-sufficiency will also put pressure on the major Asian exporting countries such as South Korea (a surplus of about 2m tonne/year), Taiwan (2m tonne/year), and Japan (1m tonne/year), he adds.

Huang thinks the start-up of new PTA plants next year will not ease the tightness in supply. Operating rates are, therefore, likely to hover about 90% until 2006, with Asia experiencing the tightest supply in 2005 and in the first half of 2006.

But he warns that, even if operating rates remain high, producers may not be able to squeeze the almost non-existent margins in textiles. They are also likely to be forced to share a major portion of the margins with PX producers. Despite this, PTA margins this year are likely to be an improvement over 2004, but are expected to slip slightly in 2006.

Beyond 2007, the PTA market runs the risk of being oversupplied as a number of large Chinese polyester producers have been inspired to back-integrate to PTA. Based on projects that have been approved by the government, the country is expected to add 9.6m tonne of new capacity during the 2007-09 period.

If the other projects currently awaiting approval are also realised, the PTA market may not recover from oversupply before the end of this decade, says Huang.

More interestingly, the Chinese industry would be repeating the mistakes of the polyester sector.

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