Kirk J. Finchem is technical editor of Pulp & Paper magazine.

WHAT'S AHEAD

Surveys information systems managers at both the corporate and mill levels about their use of such applications as enterprise resource planning, supply chain management, business information management, and maintenance analysis systems.

TISSUE
MANUFACTURING REPORT

A special "Markets & Manufacturing Report" details
the worldwide tissue and toweling market, including major world players, as well as discussing innovative technologies being used to manufacture this important grade.

ENVIRONMENTAL TECHNOLOGIES

Several articles examine the probable effects of the
recently released Cluster Rule regulations and how some paper companies are working to meet those regulations or even go beyond compliance.

From the EDITORS

A future for derivatives?

Last year was important for financial derivatives-contracts that use forwards, futures, options, and swaps to manage explicitly and systematically the financial risks that firms face. For example, the Black-Scholes model for pricing options contracts won a Nobel prize. And the fledgling pulp- and paper-based derivatives markets-both organized and "over the counter"-moved from almost no activity to having nearly 1 million tons under contract.

These financial "risk management" instruments could prove as important to the industry as was the commercialization of chlorine dioxide as a pulp bleaching agent. In financial terms, derivatives can be just as dangerous, "puffing" in the faces of inattentive or unwary managers and leaving the financial landscape strewn with twisted balance sheets and ruined careers. But, for those that master the arcane techniques of financial engineering, the result can be improved value creation performance -- a holy grail many forest product firms claim to be seeking.

A RIPE MARKET. This issue of Pulp & Paper explains the basics of derivatives: how they work and how they might change the way producers and consumers do their business. Several seemingly inherent features of the forest products industry make derivative-based risk management plausible.

First, pulp and paper markets are famous for their price volatility. Small changes in supply or demand exert incredible leverage on price, and with it, the earnings of both producers and consumers. While commodity-based derivatives in other markets have not demonstrated the ability to reduce spot market price volatility, they have helped firms "smooth their earnings" and create more value for shareholders.

Second, the industry typically finances its incremental capital investment with operating cash flow. Volatile cash flow results in both higher financing costs and uneven capital investment, which in turn causes further market volatility. Properly designed and managed derivatives can both increase cash flow and reduce its volatility.

Third, both producers and consumers
currently sign long-term sales and purchasing agreements to reduce their exposure to price risk. But this "hedge" breaks down when either side successfully "renegotiates" (i.e., refusing to ship or take delivery within the terms of the contract) to exploit spot market prices that have turned in their favor. Derivative contracts virtually eliminate such renegotiation.

Finally, producers -- and their customers -- are competing globally, and the competition is intensifying. Even those that do not export products are subject to import competition. Low-cost producers like Indonesian's Riaupulp Mill (owned by Asia Pacific Resources International Holdings, Ltd.), with an announced cash production cost of $188/metric ton of tropical hardwood market pulp during the third quarter of 1997, can exert pressure on domestic markets that is disproportionate to their market share. Derivatives can, in part, insulate firms from this pressure, even when it is brought on by changes in currency exchange rates, a significant factor in Riaupulp's current low cost.

MILES TO GO. Of course, there are several challenges to overcome before these tools can become mainstream management strategies, and making it into the mainstream is critically important to building efficient, highly liquid markets. Aside from purely mechanical issues such as revising corporate bylaws and negotiating master trading agreements, the first big challenge is widespread education-getting executives to understand how reduced risk can help them create value.

The next is credibility. Given their checkered (and sensational) recent history, derivatives are viewed very skeptically by many managers and executives. Credibility is something that market makers and organized exchanges have to build for themselves, collectively and individually.

Finally, and perhaps the greatest challenge, market participants need to learn to design risk management strategies that meet the individual needs of their companies. The treasury departments of most large firms understand derivatives and how they work. They have the resources to quantify their risk exposure and attitudes, develop sophisticated market forecasting models, and manage portfolios of forwards, futures, options, and swaps.

But it is the small and medium-sized firms, with proportionally smaller resources, that might benefit most from these tools. It is these firms that tend to be more vulnerable to market volatility and more dependent on predictable operating cash flow. Just how these firms will enter the market and manage their positions-individually, through trader/ brokers, or with the guidance of freelance portfolio consultants-remains unclear. But this fast-developing market tool seems sure to generate a solution. This year could be an important one, too.