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How Much of a Manufacturing Facility’s Wood Supply Should Be under Supply Agreement?

February 04, 2014
Author: Pete Stewart
Every year, 25 million tons of wood move under supply agreements indexed to Forest2Market’s data and pricing. It’s no wonder why we get barraged by questions about supply agreements. How long should they last, should it be based on delivered prices or stumpage prices, what pricing mechanism should I use, and, of course, how much volume should I place under agreement.

The answer to these questions is the proverbial, it depends! It depends on your goals and on who really needs the supply agreement.

Wood supply agreements are not new; they have been used effectively for years by the forest products industry. Broadly speaking, many agreements qualify as “supply agreements.” From the long-term harvest tenure system in Canada to traditional timberland leases to agreements between private owners that are guided by a strict legal contract – all are examples of supply agreements. Although used sparingly now, it was common in the 1950s to 1970s for pulp companies – that were long on sawtimber – to trade sawtimber from their own timberland in exchange for pulpwood. Today, sawmill chips are swapped among mills to save freight – another form of supply agreement.

What’s common today and more pertinent to the market is supply agreements between large landowners – usually commercial tree growers – and a traditional pulp mill or sawmill or a new pellet facility. Pulp mills and sawmills enter into supply agreements for a number of reasons. First and foremost, they allow procurement staff to extend their effectiveness and efficiency - allowing for an assured or known volume of fiber coming in at a predetermined or indexed price. There are different words for this volume: base-load, secured, controlled or guaranteed.

Despite the abundance of words used to describe this supply, none perfectly describe supply agreement volume other than it is “assured to be there within reason and within the limits of the contract and within the limits of what mother nature will allow.” And often these caveats can be very limiting.

Most wood buying facilities view “supply agreement wood” as just one of the many sources of wood fiber available. It should not be thought of as the only source. Other sources, including gatewood, direct purchase fiber and fee wood are just as important. A smart procurement operations uses supply agreements in a very strategic manner: to leverage other sources of wood to meet more favorable volume and price criteria.

An emerging use of supply agreements is as a tool to acquire bank financing by energy companies – usually pellet manufacturers, though few have been successful. In theory, reducing supply chain risks by putting most of their supply under agreement makes sense. However, the realities can cloud the theory, turning the theory into a fairy tale.

Many developers (and bankers too) falsely believe that if they can get 100% of their wood supply under long-term agreement with iron clad guarantees for price and volume, then the project is sure to be a success. F2M data would suggest this notion is far from the truth. In fact, such an agreement will likely render your project a failure.

Why? F2M’s data show that even the best, lowest cost procurement organizations rarely have more than 15% of their supply under a long-term agreement. The best procurement organizations rely on a mix of procurement sources that fits their local needs and provides flexibility in order to adapt to changing market conditions.

For the past 13 years, Forest2Market has collected and analyzed hundreds of millions of wood supply transactions. As part of this process, details such as price and volume, source and contract type are collected on every transaction. F2M statistical analysis of these data records suggests that the law of diminishing returns applies to the amount of wood under supply agreement.

The lowest cost wood fiber buying organizations do many things right, but one thing they have in common is that they have between 10-20% of their wood contracted under some sort of long-term agreement. Statistically speaking, there is no significant difference in cost between a manufacturer that has 10% of their supply under long-term agreement and that of one that has 20%.

However, as the percentage of wood under supply agreement goes up from there, so do costs. So, there is no advantage gained by having more than 20% of one’s supply under long-term, secured agreements. In fact, there is a disadvantage. This may seem counterintuitive, but not if one considers the practical realities of the forest resource.

  1.  It is often difficult to find enough suppliers within a logical freight haul willing to enter into long-term agreements to secure even a moderate percentage of a manufacturers' wood supply needs – let alone 100%.
  2. It is rare to find one landowner with such a large ownership in one area that would allow a manufacturer to contract for all its supply.
  3. From a risk mitigation perspective, many landowners are unwilling to commit all or most of their future harvests to one buyer, and as the volume demanded by one buyer increases, so does the landowner’s perceived risk and the price risk premium demanded.

Considering these practical supply chain issues and the fact that when long-term agreements make up more than 20% of a manufacturer’s total wood supply, the presence of that agreement ceases to be an advantage, supply agreements need to be thought of as part of the supply chain solution, but not the entire solution.

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