Uncoated FreeSheet: Can Domtar and IP Control The Market?

Implications: The Uncoated FreeSheet market in North America is declining with the Internet and electronic devices being blamed for much of it. Is this really the case?  In spite of this decline selling prices have increased with few objections from  major buyers.  Is there any threat that lower cost overseas producers may try to enter the N.A. market?  Domtar and IP now control 60% of the market. Is this sufficient to maintain the proper supply/demand balance for prices to continue to increase? Several major moves have already been made in closing some mills, shutting down paper machines and transferring UFS grades to other mills. But what about those older, less efficient mills with their outdated pulp mills and lower production levels – are they candidates? Is this the next step if demand continues to decline?

Analysis:  

In 2000 the North American Uncoated FreeSheet market demand amounted to 15 million tons. In 2005 and 2006 it declined by an additional 856,000 tons and will likely decrease by another 500,000 tons in 2007 to a level of 11.5 million tons. With demand declining how much more capacity must be shut down to keep supply and demand in balance? Will capacity reductions be sufficient to raise prices on all the individual paper grades: Cut-size copybond, Offset (commercial printing plus books), envelope paper, tablet, carbonless, thermal imaging, and, Text & Cover?   Domtar inherited a number of  mills from Weyerhaeuser, which when added to their own mills brought the total to 16 facilities. With all this papermaking capacity at the various mills Domtar now is faced with the daunting task of improving efficiencies in order to realize their original projected cost savings.  How will this be done (besides closing older/smaller mills)?  Three strategic moves will undoubtedly be made over the next 12-18 months. (1) Combining paper grades on the most productive machines to achieve longer runs thus reducing the number of grade changes, (2)improving deckle utilization by moving those grades with fixed roll sizes to those machines where full utilization can be made of the machine width and (3) to reduce freight costs by moving grades to those mills closest to their markets (i.e. major printers or envelope producers).
Accomplishing these three strategic moves will certainly improve both productivity and profitability with the result that several more paper machines can be shut down.

International Paper has already discontinued UFS at Pensacola, FL and has announced plans to stop UFS production at their Bastrop, LA mill. Domtar has done their part by shutting down two small mills (Port Huron,MI and Port Edwards, WI) and shutting  the paper machine at Baileyville, ME.  Georgia Pacific has shut down three small machines in Oregon and, in addition, transferred the UFS grades at Wauna to another mill to free up that machine for tissue & towelling grades.   Boise Cascade has announced any closures but, in truth, they aren't a major factor in the general market since 85% of their UFS production goes to Office Max (675,000 tons/year).
 

What about the older, smaller mills with their outdated pulp mills that Domtar inherited from Weyerhaeuser- are they possible candidates for further contraction?  If the market continues to decline and the already mentioned strategic moves result in over capacity, who are the next likely candidates?  Two mills come to mind - the old small mill at Kingsport, TN and the mill at Rothschild, WI.  Both have pulp mills using outdated technology.....both mills do not have the production levels required for "economy of scale" and both mills, because of their age, carry a high maintenance liability.  But, of critical importance, is the fact that both mills must purchase outside pulp in order to supply their paper machines.  With NBSK at $870/admt it will be difficult to make money on UFS even with some of those grades selling for as much as $1000/st (i.e. copybond).

With rising prices on UFS does this now present an attractive market for lower cost countries like China, Indonesia and Brazil to begin shipping their own UFS grades to North America?   We believe this is unlikely for two reasons: (1) high sea and land transportation costs brought about by the fact that North American customers insist on delivered prices - where the seller must pay the inland trucking/rail costs.  In other countries pulp and paper must only be delivered to the Port where the customer then must pay to have the product transported to their mill. But, and this could be the overriding reason, these low cost countries all are experiencing rapidly increasing domestic demand.  The demand for copybond, textbook paper, envelope paper and all the others is growing at such a rate that little or no paper is left over for export.  China is an excellent example.  In 2002 their per capital consumption of paper was 22 kpp, in 2006 it had grown to 50 kpp and by 2010 the Government predicts it will be at 70 kpp.  The PRC has said that their country's total fiber demand by 2010 will be 81-84 million mt (all kinds of recovered paper plus market pulp).  With a pressing demand from their domestic market how could paper producers ever think about exporting?

The future looks bright for the major North American UFS producers in spite of the fact that demand is declining.  There are no low-cost rogue competitors likely to undercut the market and, even more importantly, Domtar and IP have enough options at their disposal to maximize profitability while maintaining the proper supply/demand balance.