Prolonged Downturn Demonstrates Cyclical Nature of Business:
Not Hospitable to New Entrants

The solid wood industry is a full year into a viscous downturn. All solid wood products, save plywood, have retreated back to 1990 pricing levels, while saw timber prices have only marginally softened, putting manufacturers in quite a squeeze. Red ink is bleeding everywhere.

Canadian companies, seeking refuge from the difficulties at home, invested heavily in US South-based assets over the past couple of years. Canfor purchased three sawmills in the Carolinas from New South and recently purchased a fourth in South Carolina. West Fraser, already established in Louisiana, purchased 13 additional mills from International Paper. Koch Industries—a US-based private company—purchased Georgia Pacific and their 47 solid wood facilities (US South). It is interesting to note that at least 66 solid wood facilities or approximately 30% of the total production is under new ownership in the US South.

How these companies respond to the downturn could determine how deep the downturn will be and how long it will last. If the new owners choose to run hard to lower unit costs in the face of an already oversupplied market, prices will be pushed lower. If however, they choose to curtail, the trough will be dampened.

According SFPA, 2007 production year to date is down 12% compared to 2006. This is roughly one-third of the drop in housing starts.

There have been additional casualties of the poor market, most importantly OSB producers. Louisiana Pacific announced the permanent closure of its OSB mill in Silsbee, Texas. Ainsworth idled two mills in Minnesota. Grant Forest Products’ ambitious plans are all but dashed. Its first mill in South Carolina is running at 30% of capacity. Construction on its sister mill 90 miles away has stalled. Finally, Roy O. Martin’s new OSB mill is operating below capacity due to “engineering issues”, but likely these are market induced engineering issues. F2M expects the so called second generation OSB facilities (circa 1988-1996) to continue to curtail or drop out over the next 18 months. The production will be made up by the mega mills, such at Louisiana Pacific at Thomasville, Norbord at Cordele, Roy O. Martin and eventually Grant.

If you are a Southern producer, there is one bright note. The Canadian OSB producers are wrestling with more problems than you are. True, they are selling into the same dismal market, but their currency is on equal footing with the US dollar—evaporating the currency margin. Not to mention the freight disadvantage that has long plagued the Canadian producer. As long as fuel costs remain elevated, the northern Ontario and Quebec OSB facilities will remain the highest cost facilities in North America and are likely to be the first to shut down.

The poor commodity pricing, high fuel costs and currency parity are a deadly combination for the Canadian producer. The Ontario Ministry of Forestry recently suggested that Ontario’s forest products output will be 60% of last year’s—truly devastating for eastern Canada.

Still, despite the dismal market conditions, F2M knows of a number of Canadian companies actively seeking assets in the US South. Recently, even some Pacific Northwest based companies—s eeking market diversity—have entered the acquisition fray.

In addition, F2M expects European companies will take a more active ownership role in the US South for the same reasons—cheap assets, weak currency and global diversification.

Each downturn has its own unique characteristics. Contrary to this downturn, the downturn of 2001-2 was supply driven. Domestic overcapacity, coupled with Canada’s unfettered access to the US market led to lumber supplies in excess of demand.

The current downturn, however, is demand driven. Housing starts are the prinicipal culprit. This type of downturn is much more dangerous. Supply driven downturns can be managed by legislative initiatives (softwood lumber agreement), political initiatives, or by limiting production. Demand driven downturns are much more insidious however. Recovery is dependent on the resuscitation of demand—in this case—housing, which is dependent on any number of national and international factors, exchange and interest rates. All of these factors are highly variable and out of the industry's or individual producers' control.

In the wake of a demand driven recession, producers are forced to cut back production and lower costs, both of which stem losses, but rarely produce profitable businesses until demand pops.

These factors mean that timberland owners, too, are feeling the pinch. Sawtimber prices have moved down by 5-7% across the South year-over-year. To give some perspective, this drop is roughly half of the drop in lumber production, but only a fraction of the drop in lumber prices. The only conclusion one can draw is that log prices have nowhere to go but down.