Chinese TiO2: mixed signals amid a flight to overcapacity

Titanium dioxide (TiO₂) production can be seen as a mirror of the GDP of any country, and an expression of its economic activity.

But for China, the relationship has taken on a deeper meaning.

Capacity and production, locally held paragons of economic health, are growing faster than their economic value-add, and the same is happening in TiO₂, where huge inventory additions have masked weaknesses in real demand while capacity building continues at an astonishing rate.

China celebrated the year of the dragon in 2012, and as economic activity market wavered throughout that period, perhaps it began to resemble the shape of the mythical creature?

The first quarter enjoyed expanded volumes and higher prices, a strong continuation of the rebound from the de-stocking in the latter half of 2011. Imports grew to nearly 40,000 tonnes and many thought that, despite a slowing property market, the industry was set for yet another bumper 12 months. But by April, the market began to turn. Orders dropped and rutile and anatase prices fell continually during the remainder of the year as volumes tailed off.

China produced approximately 1.7m tonnes of TiO₂ pigment in 2012. Production grew at just below 6%, and was the smallest positive expansion since TZMI’s records begin in the early 1990s. The only other years that growth was lower was (in negative territory) in years of external shock - 1997 when the Asian financial crisis froze regional economic activity and production was cut back by 2,000 tonnes (which, in those days was a noticeable drop); and in 2008, when production fell by 10%.

Demand and supply grew further apart during the course of 2012, reflected by a significant build-up of inventories both by pigment producers, which, despite slowing production in the second half of the year, overproduced more than 100,000 tonnes, and by their distributors, which collectively held the equivalent of a medium line’s production for an entire year. TiO₂ plants ended the year sitting on close to 12 weeks’ inventory.

When inventory changes are factored in at the supplier and distributor level, it becomes apparent that demand shrank in 2012, albeit by a small amount. The evidence for a weak 2012 is strengthen by offer pricing, which has fallen by a quarter since its peak seen in March that year. Even with such steep discounts, anecdotally, many major pigment sellers were transacting below their stated offer prices.

However, feedstock pricing has not followed suit. Ilmenite remains above $340/tonne, which has had implications for profitability. At the end of 2012, many of the major pigment plants were hovering at the break-even mark and several were in the red. The third quarter saw the acquisition of a struggling plant by Henan Billions and the idling of a number of mid-tier producers.

Despite these conditions, capacity building has continued unabated. It is estimated that there are more than 2m tonnes in the pipeline, with up to 500,000 due in the next couple of years on top of 2.5m tonnes of existing nameplate. While it should be noted that capacity estimates in China are unreliable - TZMI plant audits have shown that factors such as maintenance, circuit alignment and feedstock variance typically mean that capacity is overstated by a quarter - this continuing increase of capacity is confounding. It begs the question why, in this weaker market cycle, are the Chinese still so bullish?

The answer lies in the unique interplay between China’s five-year industrial policies, the specific signals from economic planners and the consequences of having a plant that is either too small or not part of the industrial system that the state is trying to create.

Addressing the signalling specific to TiO₂ provides some indication of what it means for the market. To put it into context, a brief look at the anatomy of China’s growth engine is necessary.

China Inc.’s macroeconomic framework

Increases in wealth in China can be traced to one of three sources: investment, exports or consumption. The economy relies substantially on investment as a source of growth and during the past decade fixed asset investment (FAI) has grown by a compounded average of 24%, compared with 10% real GDP. In 1994, one dollar of FAI was equal to more than five dollars of GDP. But this had shrunk to 1:1.4 by 2012, implying a substantial drop in investment productivity.

This growth engine relies on two major ingredients. Firstly, a high savings rate, which it is afforded due to a dearth in alternative asset classes (a symptom of this is seen in China’s ever-expanding real estate market). And secondly, the ability to mobilise and control the majority of capital flows in the country. This is enabled by state ownership of, and control over, most of China’s industrial economy and its financial system.

It has been a very effective growth engine. China has enjoyed a decade of uninterrupted growth, which has seen the emergence of world-class infrastructure, globally competitive corporations, public healthcare coverage and heightened influence on the global stage. But as the vector of the chart shows, this growth model is unsustainable. Sometime in 2019, investment will start producing negative returns.

China’s leadership has taken measures to address this imbalance. The most visible manifestation of this was attempts to cool investment in the property sector. During the course of 2012, many public works projects were also slowed or suspended. This was partially induced by the cooling measures, but was also a function of China’s leadership change during which many cadres, unsure of the position they would get in the new administration, erred to caution and froze projects.

The burst of growth between October 2012 and the time of writing was driven by the resumption of public works projects once the leadership change went through and shows that the government can turn the taps on and off very quickly these days. Crucially, though, it has become a signalling mechanism to Chinese industry. With all this road, rail and air capacity being added, those building more TiO₂ capacity have taken this as a green light.

Mixed signals?

The specific investment projects are shaped by China’s 12th Five-Year Plan, a blueprint for the country’s industrial policy that outlines the objectives for the economy as a whole and guidelines on how specific industries are expected to contribute.

With respect to titanium dioxide, the 12th Five-Year Plan is encouraging investment in domestic production capabilities. Implicitly, China’s economic planners want to wean it off foreign dependence and put it in a position where Chinese pigment is competitive in emerging markets such as South East Asia.

The plan consists of several development objectives. The major one, in terms of investment scale and the way it frames the industry, is the formation of industry hubs in Sichuan, Yunnan and Hebei, where titanium-bearing mineral deposits are most abundant. The plan calls for consolidated mining and pigment processing in each hub, stating that production of TiO₂ pigment should collectively account for more than 1m tonnes or 50% of total target domestic production by the end of the 12th Five-Year Plan in 2015.

The areas presently account for an estimated one-third production, although there is no production in Hebei. At the same time, pigment plants in Sichuan and Yunnan are constructing close to 450,000 tonnes of additional capacity to be commissioned on or before 2015. This will bring capacity from its current 750,000 tonnes to almost 1.12m tonnes. A further 600,000 tonnes has been announced, of which approximately 150,000 tonnes is likely to go ahead.

Herein lies the problem. By the implications of this plan, the rest of China is currently overproducing. Its 2015 production target is 1m tonnes, but by the end of 2012 it was producing nearly 1.2m tonnes. And the non-hub regions are planning to add capacity. Taking the most conservative estimates (local government documents) another 250,000 tonnes is currently being added, ostensibly in contravention of high-level state directive.

Could it be that pigment companies are receiving mixed signals? And if so, what are the implications for an industry that ends up far exceeding the targets of China’s planners?

Restrictions, shut downs and the chloride question

Despite calls for further TiO₂ development, sulphate-processed TiO₂ belongs to the restricted category of industries, meaning it is tolerated, but not encouraged. The government is calling on plants below 50,000 tonnes to be shuttered and has forbidden the allocation of land for more greenfield sulphate plant construction. This is part of a general move to clean out small and environmentally unsound producers from the industry. But is has lit a fire under some TiO₂ producers who were hoping that a flight to overcapacity will save them.

The plans are also stipulating a higher-quality titanium-rich feedstock production process, signalling that slag is being favoured over ilmenite. Open-top slag furnaces are going to be closed and power consumption limitations (sulphuric slag must be less than 2,300 kWh/tonne of product; chloride slag less than 2,800) are being imposed.

Besides capacity building, the plans, investment and restrictions are guiding Chinese TiO₂ producers to higher points in the value chain, particularly chloride-processed TiO₂. A question that is often asked is how close the Chinese are to commercialising the chloride process? This could well be turned into an article in its own right if the issue was not so secretive. But the two companies thought to be closest, Henan Billions and Yunnan Xinli, are not showing their cards.

What we know is that Henan Billions and PPG have signed a $1.8m chloride licensing contract and that Billions is paying nearly $100m for a transfer of fluidised bed technology.

Yunnan Xinli claims to be nearing completion of its chloride line. Other plants may be in various stages of development, but are choosing not to go public, perhaps due to intellectual property sensitivities. To rehash a well-known saying by business people in this part of the world, believe it when you see it.

It also remains to be seen how much chloride capacity is added in China. The country’s own mineral deposits, with high magnesium and calcium content, are more suited to sulphate processing. But technologically, chloride is a tougher nut to crack. With sulphate processing you can usually still get some pigment if the technology is not quite right, but with chloride everything needs to be perfect.

Looking ahead

At the time of writing, two important signals have been sent from the central government. The first is that GDP is targeted at 7.5% - a modest aim given the trillions in the public works pipelines and will most likely be surpassed. The second is FAI, which is targeted to grow at 18%. The signals from the National Development and Reform Commission (NDRC) are clear: an acceleration in investment is needed to keep the economy growing and government officials in counties and provinces will be measured against how much investment their locality is generating for the GDP target.

There is also the threat of closure if a plant’s capacity is too low, a need to get on with building sulphate plants while land can still be allocated, and the relentless pricing competition that has eroded profits for much of the industry. In all these respects, we can expect capacity building to continue at full steam in the pigment industry and announcements of further capacity expansion to continue.

But there is another signal coming from the NDRC in the form of industry zoning in the 12th Five-Year Plan. The plans imply that plants in parts of the rest of the country will somehow be surplus to the central government’s vision.

If this is the case, then arguably there are two types of capacity emerging. One type will be inside the system, that is, the plants that are within the zones and major plants outside the zone that have some degree of state investment and long-term relationships with customers that are also participants inside the system. The other type will be the capacity that is outside the system. These plants will be targeted for shutdowns and will see their domestic market squeezed or taken away from them. Many will turn to the export market and, during the next few years, world markets will see a steady increase of cheap (but not necessarily low-quality) Chinese TiO₂.

Within China, the capacity over-expansion could lead to regional protectionism. Local level officials who have invested political (and possibly financial) capital in pigment plants and are evaluated by their contribution to local GDP and employment, will not stand back while more successful plants threaten to encroach on their turf. Perhaps the merger activity that has been gathering momentum is an attempt by far-sighted companies such as Henan Billions and GPRO to establish a benchmark. The different locations of acquirer and target suggest that this is the case.

How these predictions will be borne out depends on how China’s growth model is handled during the next few years. China’s GDP growth is largely fuelled by FAI from public sector debt. The government can turn the capital flow up or down as it deems necessary in response to macroeconomic conditions, guiding the economy along a middle path of between 5% and 7% per year.

If FAI is turned too high, debt levels rise, inflation rises and loan productivity falls. The state owns or controls a disproportionate amount of the economy and the well-documented effects of public sector inefficiencies, plus the compression of the majority outside the system, contribute to a drop in consumption, giving China a hard landing at the end of the decade.

At the other end of the scale, the China growth model is dismantled, pro-market reforms are implemented and the state takes a back seat again. State-owned enterprises are allowed to go bankrupt and massive write downs of local government debt are forced on lenders, with losses tempered by deflation. Under such as scenario, unemployment rises to above 20% for a long time.

The goldilocks path, which is the one we are being steered on to, allows for a mixture of investment and pro-market reforms. Growth in China will decelerate through to 2020, as consumption slowly compensates for falling investment productivity. Excess liquidity will create a series of inter-industry bubbles, some of which will cause shutdowns and cuts in capacity. It will affect some markets more than others.

There is a temptation to view China as a cohesive whole. It is not. China is made up of many different mechanisms running on different speeds and the TiO₂ sector is no different. Like everyone else, participants inhabit a world of changing information, where they respond to the signals of the government and other market participants.

These signals will create and sustain the success of a set of participants within the system, while the risks mount for those on the outside. These are interesting times for the industry.