Martin Glass
EMGE & Co., can be reached by phone at +44 1872 581000, or by email at post@emge.com. You can also visit the company’s Web site at www.emge.com.

World paper markets adjusting to a zero inflation psyche

In the 1970s and 1980s, the dislocation of oil supply generated sharp rises in energy prices; hence, inflation. In contrast, the recent Asian crisis has created a dislocation in demand, leading to a global oversupply in most commodities, deflation of producer prices, including industries such as pulp and paper. For the economy as a whole, in Europe and the U.S., we have now entered a period of almost zero inflation. The positive side of this is the economic benefit of low inflation, allowing continued expansion of the western economies. This is especially true in the U.S., where new technology growth, such as the Internet, is generating vibrant activity.

The global economic conditions are reflected in the paper industry. In 1998, demand in Asia fell significantly. However, in most other parts of the world, paper demand showed positive growth and global demand rose of 1.6% last year. World paper demand in 1999 is forecast to move sideways by 1%, while capacity increases continue unabated. For 1998 and 1999, we calculate annual world capacity growth at 4.2% and 2.7% respectively.

The implications are clear. The world paper markets have entered a period of structural global oversupply, and unless the world economies can sustain a coordinated period of growth then the prospects for general operating rates in the industry remain poor overall.

This picture is not unique to the pulp and paper industry. Of all commodity prices, oil is perhaps the most critical as it affects the direct cost of energy and hence the general cost of living and manufacturing.

Not so long ago, oil prices were consistently above $20/barrel. With a decline in oil consumption in Asia, and reducing demand in Japan, oil prices have taken a slide since the financial crisis in 1997. They recently fell below the $10/barrel watershed, although they have since rebounded to $16/barrel since OPEC decided to cut back production. All oil producing countries have seen their income slashed, but consumers and manufacturers around the world have benefited from the fall in the price of oil.

An analysis shows that more than 60% of the movement in pulp prices and possibly as much as 80% is accounted for by factors that affect other industries. So what we see in the paper industry is not unique at all.

Many industries worldwide have been affected in a similar fashion by the Asian crisis and price inflation has come steadily down since 1997. In developed countries, inflation is approaching zero with consumer prices rising by as little as 2% per annum. Since mid-1997 the producer price inflation has tended towards zero or even turned negative. In Europe, the Producer Price Index has come down from 10% in 1997 to almost zero today. With the psyche at zero inflation in the western world, there is little wonder that pulp and paper producers are finding it difficult to raise prices in a sustainable manner.

In the face of low prices and poor profitability, the industry has argued that consolidation is critical to success. Indeed, the world paper industry has made serious strides toward concentration in recent years. Compared to 1990, industry concentration levels have risen from 17% to 23% last year and 25% currently. However, I question how profitable this concentration has been for the industry. Compared to the market average, the industry has seen its share price decline by 62% since 1980. In just the last three years, relative shareholder value has fallen by over 50%.

The question now is that with global oversupply, low prices and poor profitability, producers are desperately seeking their chance to increase prices. In pulp, prices have already started to rise and paper suppliers are looking for their chance at increases. Unfortunately, the economy is only going to move forward if inflation stays low and the recent price increases in world commodities threaten that low inflation. As soon as inflationary pressures start to appear, the policy makers will raise interest rates, the growth in the money supply will stop, share prices will fall and economic activity will, in turn, come to a standstill. There are signs that this situation might be starting to develop in the U.S., which has so far been the mainstay of the world economy.

For these reasons we question how much faster the world economy can grow in the next one to two years. Should the U.S. momentum start to slow down, we suspect that the improving situation in other world regions will be hindered and world growth will falter. That is our scenario for the next 12 to 18 months.

The Asian contagion provides an important explanation for the current market situation. A critical issue now is the era of zero inflation. Industry prices, not just in pulp and paper but in other commodities too, have fallen so low that some price recovery is in order. Should producer price rises feed through to a wider economy, policy makers will be forced to slow down the economic momentum and this could be the key issue for western markets, preventing a renewed period of expansion.

This is excerpted from the World Graphic Paper Report presentation at the American Forest & Paper Assn. meeting in March in New York.