The China OCC Question – Marginal Upside for Wood Based Producers
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
November 10th, 2014
The China OCC Question – Marginal Upside for Wood Based Producers
- Companies utilizing wood as containerboard furnish will see marginal upside as OCC prices rise in the coming years. This will benefit forest-rich North America, which as a region uses proportionally less OCC in the production of containerboard than the rest of the world, and specifically PKG, which uses proportionally less OCC than the North American average – based on our prior, broader work, we view the company as a best in breed containerboard play, and believe the market is still relatively undervaluing PKG’s simplicity, flexibility and industry leading margins, as well as the extent of the continued operational synergies deriving from the Boise acquisition.
- Since OCC prices reached a near term peak in 2011, supplies of recovered fiber have been more than sufficient to meet the still growing Chinese demand – prices have dropped as demand has increased, suggesting efficiency gains in fiber recovery operations have outpaced Chinese demand growth, with recycled providers in the developed economies of the US and the EU (which together account for 73% of China’s OCC imports) gearing up to meet demand that is expected to increase for years to come. The AF&PA reported OCC recovery rates have increased to above 90% from 67% in 2011. This leaves little room for further supply increases.
- China continues to absorb heavy volumes of recycled fiber (or OCC, old corrugated containers) however. The Journal of Commerce’s list of largest exporters by quantity of trans-Pacific containers included in its top four: the sister companies of two Chinese paper makers, International Paper, and Koch Industries (parent company of Georgia-Pacific, the #3 containerboard producer in North America). That said, the “Green Fence” initiative indicates China is no longer content to be the world’s dumping ground – OCC imports actually declined in 2013 as China rejected shipments that failed to meet quality standards.
- Though most of the new North American containerboard capacity is indeed recycled-fiber based, it is Chinese demand that will ultimately be responsible for driving prices if the global OCC shortage is to occur. For perspective, in what was a disappointing year of Chinese OCC demand in 2013, every quarter the country was importing nearly two times the amount of recycled fiber required annually by the 2013 North American capacity additions that were a cause of much concern.
Source: International Corrugated Case Association, RSA Inc.
Even with the recent recycled-fiber based capacity additions, North American consumption of recovered fiber has continued a decade-long downward trend. Note that the terminology used here, “recovered fiber” includes not only the OCC feedstock for recycled containerboard mills, but also ONP (old newspapers), OMG (old magazines) and mixed paper. Within these subcategories, OCC consumption saw the biggest year over year gain in 2013, up 3.7% vs. ONP/OMG down 12.4% and mixed paper down 4.9%. Consumption of OCC has increased in the short term as recycled containerboard capacity has been added – additionally, flat Chinese demand has freed up supplies, which have been further bolstered by increases in the recovery rate.
Source: Numera Analytics
OCC demand from China, while actually flat to down over the past year, remains at elevated levels (first exhibit below), and recovered paper is expected to constitute an increasing share of the Chinese containerboard feedstock mix (second exhibit below). The 21% compound annual growth rate seen from 2000 (off a very low base) is probably not a realistic expectation moving forward, but neither is the 5% year over year decline in 2013. If we think about the drivers of box demand, a large percentage is tied to consumer non-durable goods, and simply stated, it stands to reason that a still developing country of over a billion people with a growing middle class and a focus on moving toward a consumer driven economy will increasingly require the boxes needed to package and transport consumer goods. As China’s box making capacity is almost entirely recycled-fiber based, we can perhaps more reasonably expect OCC demand from the country to grow at roughly the rate of GDP, so likely around 7%. RISI notes that China’s OCC recovery rate is already very high, so domestic sources are unlikely to provide further marginal supply increases and any additional containerboard production will require additional OCC imports.
Contributing to the decline in Chinese OCC imports in 2013, beyond a level of growth that seemed to be a notch below expectations, was the Chinese government’s “Green Fence” initiative. Long a key outlet for much of the world’s waste, China is no longer content to serve as a global dumping ground, and to this end has begun rejecting recovered paper shipments that are not of a minimum quality standard.
While volumes may have flattened recently, China continues to absorb heavy volumes of recycled fiber. The Journal of Commerce’s list of largest exporters by quantity of trans-Pacific containers included in its top four: the sister companies of two Chinese paper makers, International Paper, and Koch Industries (parent company of Georgia-Pacific, the #3 containerboard producer in North America). Also in the top 10 were two Californian scrap paper exporters and Weyerhaeuser. Europe is experiencing a similar dynamic, with large Chinese paper companies coming to the region to procure OCC supplies.
Source: Chinese Customs, Numera Analytics
Source: ICCA/WCO Global Summit May 2013, Pöyry
OCC Pricing Down
With flat Chinese demand freeing up OCC supplies, pricing has fallen over the course of 2014. Pricing has been depressed for the past several years, as efficiency gains have led to increases in the recovery rate of recycled papers. The recovery rate, which stood at 67% in 2011, is now over 90% (the AF&PA has it at 94%). Price declines indicate supplies have outpaced the combined effects of Chinese demand and new domestic recycled fiber containerboard demand, but high recovery rates leave little room for further supply increases. Now it is just a matter of when demand from China will pick up, and how long it will take to absorb the increased supplies and drive OCC prices higher.
Source: IP Investor Presentation
We continue to favor PKG as a long term pure play on this dynamic (larger competitors RKT and IP should also benefit, though these companies are more diversified and utilize a greater proportion of OCC relative to virgin fiber in their production.) The positive price reaction during PKG’s Q3 earnings call shows there are multiple ways to win in the stock – while the company had not been mentioned in the initial report that suggested virgin containerboard mills could be structured as MLPs, we noted in our prior work on PKG that the company would on the surface be a disproportionate beneficiary in this scenario, as its capacity slants more toward virgin sources than any of its peers. This also forms the basis of our favorable view on the company in the context of a rising OCC price environment, as the cost advantage already enjoyed by virgin producers will be markedly enhanced (exhibit below), with a major impact seen in the export market in particular – every containerboard producer in the world will be inputting higher cost OCC and PKG will have all the lower cost softwood trees they can handle, readily available right here in the US.
Source: IP Investor Presentation
A long term OCC price of $200 per ton is not unreasonable, as the 2011 highs approached such a level, and it was widely anticipated at the time that prices would continue higher – though this obviously did not play out for the reasons detailed above, notably an increase in recovery rates (supply up) and a flattening of Chinese imports (demand down). With recovery rates leaving little room for further marginal supply increases, if you expect the Chinese economy to continue to expand, you should expect OCC prices to climb higher. The time frame is less clear cut. Anecdotal evidence is suggesting year to date cutbacks in Chinese volumes of OCC imports from the flat to down levels seen in 2013. As credit tightens in the country, inefficient Chinese mills are folding. The broader thesis is supported by a growing consumerist Chinese middle class, but industry consolidation and capacity rationalization within the country are likely to be necessary precursors to a sustained pickup in OCC demand from the region.
Capacity Additions (Domestic & European) a Potential Catalyst, but China the Long Term Driver
The recent wave of North American containerboard capacity additions using recycled OCC feedstock have not yet had an impact on pricing, which has been flat to down in 2014. Further additions could be on the way however – the Spanish company SAICA is reportedly looking to build a recycled containerboard mill in the US, and the Canadian producer Kruger is evaluating the conversion of a newsprint machine. Conversion has recently been a popular topic in Europe as well, where declining paper markets have led producers to consider alternate uses for their assets. At a certain point, with high recovery rates leaving little room for further supply increases, incremental demand increases from new capacity in the developed European and North American markets could nudge prices higher. To put things in perspective however – take the total tons of capacity added in North America in 2013 (nearly a million). Given it takes roughly 1.18 tons of OCC to produce a ton of recycled containerboard, that equates to about 1.18 million tons of annual OCC demand. In the “down” year of 2013, China was importing nearly 2 million tons per quarter from North America alone (the US accounts for 43% of Chinese OCC imports). The impetus for a significant move higher into the “wood advantaged” shade of the breakeven chart in Exhibit 6 is therefore expected to come from the Far East.
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