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Eliminating the impossible in China’s polyethylene market

Financial Events
By Paul Hodges on 12-Aug-2014

China PE Aug14Very large amounts of copper, iron and other commodities are in long-term storage in China as part of the ‘collateral trade’.  More recently, it seems large amounts of polyethylene (PE), ethylene glycol (MEG) and probably other chemicals have also started to be used for the trade.

None of this used to matter when the Chinese economy was booming.  Why ask too many questions, when the profits are rising?  But now China’s economy is slowing fast under the new leadership.

So now people are asking questions about why, for example, polyethylene imports appear to have risen 20% in H1 versus 2013, as the chart above shows, based on Global Trade Information Services data:

  • Could total demand in a large, nature market like China’s really have grown 12% in H1?
  • It was already nearly 20 million tonnes in 2013, and now it seems to have grown another 1.2MT in 6 months
  • We can certainly believe that production has grown 6% as China continues to support its job market
  • But can import demand really have grown 20% over the period to 5MT?

The blog, like many others, is left scratching its head about what is happening.

The likely answer comes from the insight of the famous fictional detective, Sherlock Holmes:

When you have eliminated the impossible, whatever remains, however improbable, must be the truth?”

If we apply this rule, then we must eliminate as impossible the idea that China’s demand could have grown 12%.  Instead we must accept that the imports have been used for some other purpose, however improbable this may seem.

Luckily, however, there is good support for this conclusion when we look at what has been happening in other commodity markets such as copper and iron.  Vast amounts of these commodities have been stored in warehouses as part of the ‘collateral trade’, as the blog described in its recent China Compass research note.

Fellow-blogger John Richardson has described recently how ethylene glycol also appears to be involved.  And in a “must read” post yesterday, he describes how polypropylene also appears to have been used – via the establishment of full-scale BOPP lines – for the same purpose.

The logical conclusion from the import data is that PE has become part of this trade, which appears to work as follows:

  • A company buys PE from an overseas supplier on 180 days payment terms
  • They immediately sell the volume on the Dalian futures exchange
  • Now they have money to invest in the property market at rates of up to 60%
  • They can then ‘roll over’ the purchase after 180 days by selling to a Hong Kong-based company
  • This company opens a letter of credit and can use the proceeds to ‘roll over’ the previous trade

The risks of a disorderly unwinding of China’s “collateral trade” are now rising day by day, as the leadership tackles the housing bubble.  As the Wall Street Journal reports, 17 cities now have inventories of unsold housing that will take at least 5 years to clear at current sales rates.

PE producers and consumers need to urgently develop a strategy to deal with this possibility.  Waiting until it happens will be too late.