GLG News by Robert Weinberger

Implications: The article very dramatically portrays the plight of the wood products industry and its workers in British Columbia and raises the question: " When will homebuilding pick up to the point where all the shut sawmills will be able to restart? But, more importantly, will all these shut mills still be able to start up?"

Analysis: Most of the current indicators point to a major recovery of the US homebuilding industry no sooner than late 2009 or early 2010.

For many North American wood products operations, especially those in Canada, that recovery alone will not be enough to allow them to restart.

Some operations, such as the Harmac paper mill featured in the article, are simply too inefficient in todays highly competitive environment to make a decent profit in any but the very best market conditions. The high capital costs to build a new paper mill or even retrofit an old one, combined with very high transport costs to evolving paper markets make any significant replacement (let alone expansion) of paper making capacity in North America unlikely - though some expansion in market pulp capacity is still a possibility.

For many Canadian sawmills, the relative strength of the Loony relative to the US dollar is as much a problem as the overall downturn in the demand for lumber in the US.  Even with a rise in lumber demand in the US, Canadian mills will have difficulty capturing that demand without a change in the relative values of the two currencies that keeps their lumber competitive.  The most efficient operations will still recover unless the currency factor is too extreme. There is also the possibility that overall world markets for lumber may be good enough to overcome the loss of much of the US market.  However, transportation costs significantly dampen the prospects of that being a likely factor.

In the US, while there has been significant shuttering of wood products operations and curtailing of production as a result of the current downturn, it has not been nearly as drastic as has happened in Canada.  Considerable attrition and consolidation in US wood products operations had already occurred in the US in the decade immediately before the current downturn,   While some of the more inefficient operations and those without a reliable supply of timber will likely not be able to start back up on a recovery of the market, most will, and some of the many that simply went to reduced output will likely increase their output. The loss of experienced workers may in some areas somewhat retard the speed with which they can ramp back up. And though most of the large timber companies have sold off their timberlands, in almost every case where that occurred, the seller retained long term supply agreements from the buyer.

So overall in the US, while the market downturn is likely to cause considerable attrition and consolidation of operations, when the market recovery does come, total production of the industry will likely be very close to what it was pre-downturn.

Implications: The article states that Weyerhauser has put off conversion to a REIT this year, largely in response to passage of the TREE act (Timber Revitalization and Economic Enhancement Act ) by Congress. This closely fits the prediction I made in my analysis in early January this year (see:" Further Evidence That Weyerhaeuser Is Planning To Change Structure" 01/02/08).

Analysis: Though passage of the TREE act will give them about $50 million in tax benefits, it doesn't equal the tax benefits that they could eventually reap by converting to a REIT (or similar structure).  Additionally as the lumber market continues to struggle (likely well into 2009 and perhaps beyond), they well have additional pressure to trim additional manufacturing facilities. I predict that that plus the pressures from investors wanting the additional returns that REITs provide will force them to convert to a REIT no later than the end of 2009.

Implications: The article does an excellent job of explaining why North American pure timber companies ( e.g. Rayonier, Plum Creek, and Potlatch) are  doing so well, while their customers (wood products and paper companies) are doing so poorly. More importantly it spells out why, when paper and woods products companies finally recover, pure timber companies are poised to do even better and are in good position for explosive growth.  Most of the reasons for this phenomena are best gained by reading the article rather than my repeating them here.

Analysis: Although the article makes a good case for why pure timber plays are superior to wood products or paper right now, it misses two very important issues that make the likelihood and magnitude of a breakout for timber values and returns on any recovery for wood products even more impressive:

1. By concentrating their harvest on thinning and removal of low value trees now, the timber companies are increasing both the growth rate on and value of their remaining trees. These increases in both volume and value of higher value trees will continue until the company chooses to harvest them under good market conditions.

2. Although, opportunities to market biomass are currently somewhat limited, this is an extremely fast evolving market. The development of commercially viable processes for making cellulosic ethanol, for instance, are proceeding at a pace that should see wide spread deployment of these technologies at about the same time frame as the recovery of the wood products market.  This and other growing and/or evolving technologies for converting wood to energy, will both create a market for what was previously waste (limbs, bark, tops, defective logs, etc.) -  and thus a disposal cost or fire liability item, it will also create an additional market/demand for clean wood chips which are needed by the paper mills - thus keeping the price up and further squeezing paper margins.

Implications: For more than a year there has been strong conjecture that Weyerhaeuser, the last of the wood products giants still standing as a vertically integrated company, would soon follow Plum Creek, Potlatch, Rayonier & others and restructure itself as a Timber REIT.  The naming of Daniel Fulton, VP of their Real Estate Division, to be President certainly seems to add credence to that  position.

Analysis: Weyerhaeuser has long prided itself on its vertical integration and near full self sufficiency for raw material, and that pride is deeply embedded in the company's culture. They truly consider themselves "The tree growing company". 
However, the tax inefficiencies for a timberland owning vertically integrated C corporation relative to a REIT or TIMO structure, and the pressures of the investment community have been pushing them relentlessly (and reluctantly) towards a change in structure.  If they are successful in their lobbying efforts to gain tax treatment for their timberlands on a par with REITs etc., they will likely remain a vertically integrated company.  However, success in those efforts seems quite unlikely.
In order to qualify for conversion to a REIT a company must (among other things) receive at least 75% of its income from REIT qualifying operations (e.g. Real Estate, timberl & timberlands) and place the non-qualifying operations (e.g. lumber and paper mills) in a subsidiary company.  Over the last year or so WY has been divesting itself of non-REIT qualifying operations at an unprecedented pace. However, a couple of months ago when I asked a company VP " At your current rate of striping non-REIT qualifying  operations, how long will it be before you could convert to a REIT?", the question was somewhat deflected by the VP statiing that the company was always looking out for their shareholders' interest by evaluating and disposing of assets that were under performing their goals. 
While the current rate of divestiture or indefinite shuttering of building supply yards and lumber, plywood, and other solid wood products mills, can be explained by the extreme downturn in home construction, the same is not true for their closing or sale of paper products operations (e.g. Dotmar transaction).
Thus at this point the naming of the VP of their Real Estate Division to President would seem to be almost akin to their overtly announcing their intention to convert to a REIT or other tax efficient structure.

Implications: Sierra Pacific is auctioning off ~5000 acres of timberlands that they have identified as having higher values for uses other than growing timber.  This is typical of the trend occurring on most large timberland holdings that have been traditionally owned and managed for timber production. Though this type of sale usually represents a tiny fraction of the owner's overall holdings ( e.g. Sierra Pacific selling 5000 ac. out of a total ownership of 1,700,000 ac.) such sales can have impact on the company's operations far out of proportion to their relative size.

Analysis: The sale by a timber company of HBU (Higher and Better Use) lands can bring an immediate hefty boost to the company's bottom line, since such lands can sell for prices that are an order of magnitude more (or at least several multiples of) their value for growing trees.  Of course not all forest lands have HBU values, and when the supply is all sold the company's bottom line can drop precipitiously. 
Of equal or greater significance is the fact that the sale of some HBU lands can negatively impact the viability and profitability of the remaining lands at levels that exceed the profits from selling the HBU lands.

Ongoing timber management practices often can create vistas that are not aesthetically pleasing (at least short term), can creat considerable noise and dust, often involve the use of herbicides, often result in periodic heavy traffic of very large trucks on what are typically narrow winding roads, and in general are the antithesis of the environment that the typical buyer of "a place in the forest" sought in buying his HBU parcel.  The remaining timberland can become more expensive to manage or even be forced to no longer be managed for timber production just as those who move next to an airport or under the flight path can eventually cause the airport (that was there first)  to either adopt expensive operating procedures or shut down.  Thus timberland owners must be very thorough in analyzing the possible overall impacts of any HBU parcel they plan to sell.

Implications: While the BC Logging and sawmill strike is likely to have a negative impact on coastal BC pulp and paper mills as they run out of wood chips, it is likely to benefit US Pacific Northwest operators.  Also many BC sawmills were losing money during the currently poor lumber market, so welcome the opportunity to shut down.

Analysis: The longer a BC timber workers strike lasts, the more likely it is to further impact the already tight supply of pulp and wood chips on the Pacific Coast.  This will drive up prices for pulpwood, wood chips, and market pulp, especially in the US Pacific Northwest.
While BC companies such as Catalyst Papers, Howe Sound Pulp, and the Canadian operations of Pope and Talbot will suffer, US PNW  timberland owners such as Pope Resources, Hampton Resources, Longview Fibre, Plum Creek, etc. will benefit greatly from the higher prices they receive for some of the output from their timberlands. Secondarily the reduced output of lumber caused by the strike will help narrow the current supply demand imbalance in that sector.

Implications: Timberland has been an excellent investment over the last 30 years – both for the return it has provided,  and as a diversification vehicle. Wells with their experience in other forms of REITs is expanding their product mix by launching a Timberland REIT.  However, in some important  timber regions of the country, much of the investment grade timberland is either already in publicly traded REITSs or controlled by Timber Investment Management Organizations (TIMOs ) either as non traded REITs or limited partnerships.

Analysis: In several important US timber regions (most notably the Pacific Northwest and the Northeast) virtually all the large blocks of investment grade timberland was owned by large vertically integrated forest products companies.  With a few notable exceptions (e.g.Temple-Inland NYSE:TIN  and Weyerhaeuser NYSE:WY) these lands are now in publicly traded REITs (e.g. Potlatch NYSE:PCH and Rayonier NYSE:RYN) or controlled  by TIMO’s such as John Hancock Timber Resources Group, Forest Capital Partners, and The Campbell Group, among others who manage them as nontraded REITs or limited partnerships.

Though some work can be contracted out to consultants, a local forestry staff is required order to properly manage timberland for a group of investors. It takes on the order of > 10,000 – 30, 000 acres (depending on the region) within commuting distance of a local company forestry office to economically justify this staff. Also, large contiguous blocks of ownership are much less costly (on a per acre basis) and easier and less costly to manage than small scattered blocks. Since in several regions the  availability of investment grade timberland in economically efficient sized blocks that would be available at a cost that will provide an acceptable return on investment is extremely limited, it is problematic whether Wells will be able to meet their goal of geographical and timber type diversity anytime soon.

The increased competition for investment grade timberland that the entry of a large player like Wells into the TIMO arena brings and the higher timberland prices for such land that will likely ensue should be a boon for companies such as TIN that have large timberland holdings that could be available for sale. That could also apply to WY in the unlikely event that they sell their timberlands, but they’re more likely to convert to a REIT.

Implications:  "A severe log shortage made worse by nine months of extreme weather conditions on the B.C. coast is pushing up log prices and pitting log exporters against local sawmillers who say they need the wood to keep operating. "  Meanwhile a deep slump in the US housing market has caused many US mills to cut back on their log demand with a subsequent impact on timber prices to land owners. 

Analysis: The pinch in log supply for western BC mills could be a boon for timber owners in western Washington at a time when the prices for their logs locally are somewhat depresssed.  However, they will need to be fairly nimble to take advantage of the situation as it will probably only last a few months - until BC loggers have a long enough period of good weather to help make up the log shortfall. Meanwhile those who are in a position to do so should reap considerable benefit both in selling logs to BC mills and from the improved export market.

Implications:  New York City has pledged to plant 1 Million new trees by 2017 to reduce pollution and cool temperatures in the city. The target article which was analyzed ( http://abcnews.go.com/US/wireStory?id=3064822 ) also mentions that NYC has a goal of reducing CO2 emissions by 30 % over the next two decades, but (quite properly) does not link this to the tree planting.

Analysis: Trees can play a great role in improving the livibility of a city. Benefits include reduction of peak summer temperatures (as much as 3.5deg. F at street level), filtering and absorption of pollutants such as ozone and NOX, acting as noise "filters", softening the harsh angular impact of city views, andsequestering (for a relatively short period) CO2.
Planting of trees, especially in a large city, for the primary purpose of long term storage of CO2 is for the most part simply a "feel good" action. Yes, trees take up CO2 and give off O2 (though the process is reversed at night) , and yes they convert CO2 to O2 - storing the Carbon in biomass, for a net short term reduction of CO2 emissions.  However, much of the carbon storage is in the leaves which simply release that carbon back to the atmosphere each year when they are burned or rot down. Additionally, urban trees have an average life of only a few decades, and the carbon stored in the trees themselves is likewise returned to the atmosphere when they are burned or rot down.  Thus, unless NYC is willing to utilize a very large percentage of its precious landfill space to deeply bury its tree residue, urban trees are not a long term solution to reducing its net CO2 emissions.

Although long term sequestration of carbon is not a good justification for planting urban trees, the other benefits of trees in the city make planting and maintaining them a good idea.

Implications:
Weyerhaeuser(NYS:WY) and Chevron(NYS:CVX) have announced that they will pool their efforts to assess the feasibility of commercially producing ethanol (for fuel) from cellulose.  Ethanol is relatively readily produced from cellulose, but much work remains to be done to develop and perfect economically efficient and commercially feasible processes.

Analysis: This joint effort is virtually a "no brainier":

Weyerhaeuser is continually searching for ways to more completely and efficiently utilize the wood fiber (mostly cellulose) they produce from their operations.  A significant portion of the cellulose they produce has little or no current economic value. Though some of this material has some value (material left on the land to rot provides some soil tilth and nutrients, and some low value mill residuals can be burned in a boiler to provide process heat and/or power) much of it represents a cost to treat or dispose of.  Any additional economic outlets to utilize this marginal/waste material would help Weyerhaeuser's bottom line.

Chevron has expertise in manufacturing and marketing liquid fuels, and in molecular conversion technologies. They are certainly interested in maintaining or expanding their fuel market share if/when ethanol becomes a significant portion of the supply.

Unlike corn, soy beans, sugar cane, or other biofuel crops that require cultivation,  fairly large energy inputs to grow, and create demand that puts price pressures on their use for food; cellulose, in the form of wood waste, requires little or no additional cultivation, low energy inputs to grow, and places little or no price pressures on existing other uses of cellulose. 

Implications: The article describes the strong trend over the last ten years for wood products companies to sell off their timberlands - primarily to Timberland Investment Management Organizations (TIMO's).  The strong financial drivers of this trend are described - among which is the lower volatility of timberland values and returns relative to those of wood products manufacturing companies. 

Analysis: The greater stability of timberland values over wood products manufacturing is valid. However, the article (nor any other article I have seen on the TIMO phenomenon) does not mention a very real risk to timberland values.

Timberland investment value derives primarily from two sources:

1. The cash flow that can be obtained from selling the the timber growing on the land to wood products manufacturers.

2. Selling land that is suitable for development or other higher and better use (HBU lands).

HBU lands rarely make up a very high percentage of large timber holdings that were held for timber production - timber production lands are often located in rugged terrain, in remote locations & without needed infrastructure for development. 

The bulk of the value is in the land's ability to provide trees to harvest and sell to wood products facilities, and the majority of that value is in trees already on the land that are large enough for harvest.
 
It is not a given that wood products facilities will continue to be present within economic haul distance of the timberlands owned. Several areas of the country have lost so many of their wood products manufacturing facilities that there is no longer a viable market for the trees that grow there, Thus, unless there is a strong enough market for recreational land in those areas, the timberland values there are much reduced.

Implications: The original article points out that the sudden decline in demand for structural panels has lead to an oversupply situation - even with just existing capacity -  that has lead to price reductions and cutbacks in expansion plans.  Some OSB producers are instead looking at merger and acquisition as the way to grow.  Mr. Kolstad, in his analysis of the original article, sees this situation as only a temporary setback for OSB, and implies that in the long run OSB will benefit due to taking over a larger part of the structural panel market.

Analysis: I agree with Mr. Kolstad that, due to its lower production cost, OSB will continue to gain market share of the structural panel market, and as he points out this trend seems to be somewhat accelerated during times of structural panel oversupply. However, most (or at least much) of this substitution of OSB for plywood - for those applications where OSB is an adequate substitute for plywood - has already occurred.  OSB is not a suitable substitute for plywood where strength is the primary requirement or for such applications as concrete forming. Thus, while I believe that in the long run OSB will continue to gain a larger share of the structural panel market (while plywood capacity will continue to decline), that gain in market share will be at a significantly reduced rate than has occurred previously, and it is unlikely that the gain could absorb (anytime in the near future) the OSB production that had been planned prior to the recent market downturn.

Implications: In a move that runs counter to the usual practice in the timber industry of retrenching and shedding assets during a down market, West Fraser Timber Co. LTD. is buying 13 IP lumber mills in the US South for $325 mil.. This acquisition, along with their current two mills in Arkansas and Louisiana, will make them a major presence in the US South.

This acquisition will likely have some negative effect on their profitability in the near term, but the long term impact could likely be another matter altogether.

Analysis:

While some might question the advisability of buying more milling capacity in the face of a major slump in the US housing market, I view it as an extremely wise strategic move.

Timber industry companies have often been their own worst enemies when it comes to making good long term economic decisions.  It has been all too common for them to acquire assets when times are good (and acquisition costs are high) only to sell them when times are tough (and prices are low).  e.g.  in terms of price, IP probably couldn't have picked a worse time to sell these assets.

West Fraser has gone against this trend by acquiring these mills at the beginning of what is expected to be one of the worst housing slumps in US history - a slump that will probably last 2-3 years. 

I believe that this is an extremely wise strategic move for the following reasons:

* They are getting the mills for an attractive price.

* The outlook for raw material supply for these mills is quite positive (as opposed to mills in several other parts of the country).

* They will not need to take on debt to acquire the mills - much of the money for the transaction will come from their share of the reimbursement of money withheld in the recently settled US/Canadian lumber dispute.

* Although the near term outlook for lumber markets is quite grim, the long term outlook is very good.

* The output of these mills will fit in quite nicely with their overall product mix.