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Change comes slowly to the pulp and paper industry, where seemingly intractable boom-and-bust cycles have made it difficult for companies to establish a consistent pattern of profitability. Now, at the start a new century, real change is finally at hand, with promising implications for producers and consumers alike.
Three factors are driving the industry’s transformation: the increasing use of forward-market pricing to justify capital project decisions, the growing use of financial derivatives to manage price risk and improve customer service, and improved information flow that is leading to greater price transparency.
RETHINKING CAPITAL PROJECT DECISIONS. A widely accepted tenet of the pulp and paper industry is that the boom-and-bust cycles of the past were the inevitable result of overbuilding during market peaks. While some industry observers argue that the industry has become too disciplined to allow this to happen again, they are only partly right. The industry has become more disciplined, but only as a result of factors external to paper companies.
Chief among those factors is the development of a forward market allowing buyers and sellers to lock in future prices. In the past, lenders evaluating the potential of new projects relied on consultants’ forecasts that too often hinged on impossibly high price expectations. Today, lenders can look instead to the forward market, where fixed prices can be locked in with certainty for a substantial portion of the project’s life. It is a far more exacting methodology, and the result is that fewer unnecessary projects are getting built. In fact, the industry has already shelved a reasonably long list of projects because investors realized that forward-market participants were willing to sell product long-term at prices lower than those necessary to justify construction of a new mill.
To be sure, this rationalization of the project development process will not by itself eliminate volatility from the pulp and paper markets. Given the time required to build new plants and the speed with which the economy can change course, prices will still fluctuate around an average that approximately equals the full capital recovery cost of the cheapest incremental project. When prices shoot above this level, consumers will support new projects by locking into long-term fixed-price deals. When prices fall below this level, new projects will be shelved. Still, with better forecasting tools at the industry’s disposal, producers can expect to achieve volatile but higher-than-current returns on equity, while consumers can expect more opportunities to lock in long-term price certainty.
There is one caveat. If producers begin to eliminate the mills with the highest marginal cost of production, market volatility could be increased. Although it sounds counterintuitive, these mills allow the industry to effectively tweak supply to better match demand because they can be shut down with minimal loss of operating profit when prices are low. By contrast, low-cost mills can earn money even when spot prices are depressed, making owners reluctant to shut them down until prices firm. A world with only low-cost mills is a world without price-sensitive supply flexibility. This is a lesson already learned by the energy industry, which uses high-margin facilities to meet periods of peak demand and simply shuts them down at other times of the year.
FINANCIAL DERIVATIVES AS RISK MANAGEMENT TOOLS. A second major factor contributing to the rationalization of the pulp and paper industry is the use of financial derivatives as risk management tools, both among producers and consumers (Figure 1). Companies that could not easily withstand price volatility were among the earliest to embrace these tools over the past several years; stronger companies continued to absorb price movements within their earnings statements.
Now, though, even the stronger companies are embracing financial risk management tools as the advantages of hedging against price volatility and better managing their revenue stream become obvious. Helpful illustrations have included a recent spate of earnings failures that could have been prevented by hedging. The most prominent example was provided by Procter & Gamble, which announced that it would not meet earnings expectations due in part to a failure to control commodity costs. That P&G probably buys commodities cheaper than its competition (the goal of yesteryear) was not important to the stock market, which slashed P&G’s equity valuation by $36 billion in one day.
Producers are also learning that derivatives can be used to better service their customers and so drive sales. In the past, producers who didn’t wish to sell on a fixed-price basis would often turn away customers who insisted on fixed terms. With derivatives, those same producers can sell at a fixed price, then convert their revenue stream to a floating market rate by purchasing an offsetting derivative. It’s a win-win situation in which the buyer accommodates the seller without assuming the risk of a fixed-price contract and captures a sale that might otherwise have been lost.
FIGURE 1: Pulp and paper derivatives have grown in popularity as a means to control price volatility.
Consumers also gain flexibility by using derivatives. A buyer seeking a fixed price contract, for example, can now compare the fixed-price offers available from producers with structured offers that combine market pricing plus a derivatives hedge, and choose the solution that results in the lowest net cost.
These preceding examples are just a small sampling of how financial derivatives can be used to enhance a company’s business activities. The variety of price structures that can be created by combining physical spot sales with derivatives is virtually limitless, giving companies tremendous flexibility in managing their business and hedging their risks.
PRICE TRANSPARENCY AND THE INTERNET. A third and final driver of the pulp and paper industry’s current transformation is price transparency, which is currently improving. In the future, price transparency will improve rapidly as the industry leverages the power of the Internet through online trading exchanges and other information-disseminating networks that diminish the value of the list price system.
An archaic mechanism, the list price system was created to cloud the difference between the transaction prices of larger and smaller buyers. It worked—but only at the cost of completely blinding management to the performance of the sales and purchasing staffs.
In a better world, companies would report their actual transaction prices to third parties, thereby creating reliable parameters against which they could evaluate their selling and purchasing activities. Unfortunately, efforts by various data-producing entities to produce indices that reflect actual transaction prices have met with little cooperation from producers reluctant to share information. This was a mistake; providing price information on a confidential basis to third parties does not create competitive disadvantages for providers, and the pulp and paper industry would be wise to rethink its support of such ideas. (The purchasing and sales teams may tell management that this would be a disaster. The question, of course, is for whom?)
Until producers begin to cooperate with third-party pricing services, the surest route to greater price transparency lies with the Internet, which has the capacity to transform the industry by hosting highly efficient business-to-business (B2B) trading exchanges. While managers at many paper companies are feeling pressure to develop viable B2B Internet solutions, some caution is in order. Many of the current offerings simply don’t hold out much promise. Sites that promote themselves as exchanges are often just bulletin boards or auctions with substantial brokerage fees—glorified garage sales that do extremely little volume on mostly off-spec product. (One leading site stated in a filing with the SEC that it has traded only 6,000 tons of product in almost two years of business.)
With the opportunity for a misstep so abundant, companies must focus on what they want the Internet to do for them and create solutions around that ideal. Legitimate B2B strategies can have several goals, including lowering transaction costs, increasing liquidity and information flow, and achieving equity gains (or, to put it more bluntly, capturing some of the equity capital that investors have been throwing at Internet business ventures).
Achieving equity gains is tempting when one considers the huge valuations the stock market has placed on leading B2B companies in the past. Paper buyers and sellers alike are well positioned to use their trading volumes to demand a piece of the action. Because only one or two sites are likely to be successful over the long term, though, potential investors should participate either in a number of sites simultaneously or in the one site they deem most likely to succeed. Buying into a third-rate idea on the cheap is likely to prove a waste of money and opportunity.
Choosing a site carefully is especially important given the shift in market sentiment that occurred this spring, when investors began to withdraw money from many B2B stocks. Pulp and paper companies seeking entrée to the B2B market should look for an Internet site that has a strong capital base, support from a broad cross-section of the industry, and a leadership team that understands not only electronic commerce but the unique characteristics of the pulp and paper business.
Apart from hosting full-blown trading exchanges, the Internet can also be used by pulp and paper companies on a smaller scale to automate ordering, production, and shipping processes—essentially creating an online catalogue. This can be a valuable tool for reducing administrative costs and brokerage fees, but it isn’t likely to generate equity gains and can also limit a company’s access to market information.
For many companies, a sensible Internet strategy will focus on participating in a high-quality B2B site that improves product liquidity and access to information. With real-time price data at their fingertips, managers at last will be able to track the market with precision and so make better business decisions. As a bonus to companies that invest in it, any site that provides this opportunity is likely to achieve a high equity valuation by virtue of attracting high visibility and substantial product flow.
BRIGHTER DAYS AHEAD. As should be clear by now, technology is dramatically changing the pulp and paper industry, though not in ways that affect the production and consumption of physical products. Instead, it is creating improved price transparency and greater flexibility to tailor transactions using financial derivatives. Together, these changes will allow buyers and sellers alike to make better business decisions, manage their risks more prudently, and better service their customers. Forward markets, financial derivatives, and the Internet are the powerful tools that are driving these changes. A competitive advantage will flow to those who learn to use them most effectively.
Robert Crane is a senior paper trader for Enron North America.
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