Managing a risky business

The challenge of introducing financial risk management to a skeptical paper industry is proving to be a tough nut to crack. But things may be changing…

by Jim Kenny

In a none too flattering overview of the paper industry, the analysts at Credit Lyonnais Securities Europe recently labeled paper industry managers 'arrogant', 'naïve' and, putting it as bluntly as they could, 'stupid'. But what was the cause for such a blast from Henry Poole and Christian Georges? The basic point was that pulp and paper companies had been too greedy in the good times and were now set to pay the price as demand weakened.

The report did in fact recognize that companies had made some progress, for example, buying rather than building, consolidating and managing their capacity better. But Poole and Georges apparently felt that the sector had not done enough to escape a rerun of the mistakes made in 1995 when prices went through the roof, only to collapse within the space of a few months. As they see it, that same scenario is being played out once more as the current cycle unfolds and there is little prospect for any significant improvement for many months to come.

Scathing stuff, but there were some bright spots in the report too. One of the few companies to escape the wrath of the Credit Lyonnais analysts was Norske Skog, which was held up as a model of good capital management. And here in fact is the key point. Whether or not you actually believe the industry is managed quite as badly as Poole and Georges describe it, there is much to be said for their emphasis on good capital management. Because whatever way you look at it, in the paper industry, as in many other commodity businesses, use of capital is one of the main factors that will differentiate the companies that survive from the companies that will go under. With just two main paper machine suppliers, technology is simply not going to offer enough of a competitive edge and despite all protestations to the contrary, paper pricing indicates that this is definitely a commodity industry.

In short, in a capital intensive industry, it would seem self-evident that capital management is going to be a key success factor.

Exchanging times

Fortunately, there are many ways available for pulp and paper companies to improve their capital performance, but certainly one of the most interesting has appeared with the advent of financial exchanges such as Pulpex and the burgeoning interest of major players such as Enron Industrial Markets.

Some time ago, Enron used to be a fairly basic US utilities group. But over the last decade it has evolved into one of the world's most dynamic financial powerhouses and the group's interest in pulp and paper has pumped some much-needed life back into efforts to create a futures market in the forest products sector. While the likes of FOEX, Pulpex and the dimly remembered Livedex can hardly be described as incredible success stories so far, the involvement of Enron with its massive financial muscle brings a real prospect that a fully-fledged futures exchange is set to become reality.

Enron has set itself up as the sole market maker for the Pulpex exchange, but it also has fairly good relations with the FOEX team too. An outsider would probably note that the group is less interested in the players than the end result. Enron's main goal at present is to help create a functioning risk management market for forest products. The key element that Enron provides is the same thing that has proved such a problem for Pulpex and FOEX in the past - liquidity. Without the necessary commodity volumes and financial turnover, a derivatives market cannot function effectively. But with Enron now committed to help deliver that missing element, there is a real chance that things will change.

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The numbers underline the seriousness of the intent. Enron now has almost 200 people worldwide involved in developing structured finance packages for the sector and has committed over $1 billion to the cause. That kind of clout has also helped attract the interest of other financial players such as JP Morgan Chase, Deutsche Bank, Tradition Financial Services, Nordea Bank, Merrill Lynch and the National Bank of Canada. As a result, a whole host of new financial options are emerging for pulp and paper companies.

Not only that, but Enron has even bought assets in the North American sector, snapping up Garden State Paper, Papiers Stadacona and Papiers Masson. As Enron Industrial Markets director, Martin Holmes, explains, "Our initial concentration was focused on building a liquid book and in the beginning we had some major challenges to overcome. We had a fairly good idea about the pulp and newsprint markets, for example, but in order to really get to the next level it was essential to get price discovery and that was why we bought the newsprint assets that we did. We needed to know exactly what the price was at any given time. Price discovery is the key to our business in terms of making swaps and options as competitive and imaginative as possible. We could probably have done it without actually buying the assets, but with our position now, it allows us to be much more creative."

Although Holmes admits his company is a "reluctant owner" of the paper companies it holds, the move has allowed the group to gain a valuable insight into the various pulp and paper markets and their price mechanisms. But what Enron envisages for the future is a long way from current practice. According to Tom Bruce-Jones, director at Enron Industrial Markets, "It is important that we can offer a lot of different pricing mechanisms to the market. For example, we can currently offer cash-traded deals, we can offer term prices where we undertake to buy a set volume each month for a particular price, or we can offer conventional derivatives. But what we certainly want to get right away from is the current system of list prices and discounts."

It is this last point that has prompted a very cautious response from the industry to date. While there are obviously benefits for pulp and paper companies that use the financial mechanisms on offer, the fundamental change to the structure and execution of the buy/sell relationship has left many industry managers extremely wary about getting involved.

That is not to say that there is no interest at all though. Indeed, Södra has made some fairly substantial deals recently and Stora Enso has even gone so far as to set up its own risk management unit. But given the potential, the volumes being traded are still relatively small and there are still a fair number of companies that are showing absolutely no interest in any form of futures trading - something that the team at Enron must find frustrating.

The big question many paper companies are asking is 'what is in it for us?' And this is where the likes of Enron and Pulpex have a job on their hands. It is not so much that there are no benefits. Indeed, if the process is managed well, pulp and paper companies could strengthen their balance sheets enormously and customers could really tie down their long term raw materials supply costs. The problem for companies in the forest products sector is that there is a significant learning curve involved in first understanding the risks involved, then creating systems of checks and balances needed to exploit the opportunities available without leaving the company vulnerable to significant financial risk.

Big bets

According to Enron, the signs are that companies are gradually coming round to the benefits and getting more comfortable with the potential risks involved. But to help matters along, Enron has also started flagging up 'special' deals to boost interest among the main players. Just recently, the group offered a price of $472/tonne cif for NBSK (northern bleached softwood kraft) pulp for delivery in October 2002. "That move created a great deal of interest from a lot of people in the industry," according to Bruce-Jones. "People really want to know how we can do it. Generally speaking, we're having a pretty good dialog with a lot of CEOs, CFOs and company treasurers and these types of deals help get people interested. We've seen a lot of activity, but I think a lot of companies are still assessing who takes responsibility for these types of deals and who deals with the day-to-day running of the operations."

As Enron is keen to stress, if Pulpex is successful or not it is highly unlikely that any pulp and/or paper trader - either now or in the future - is going to beat the market over the long run. As Bruce-Jones says, "You can't beat the market and we're not encouraging people to look at it that way."

But the financial risk management packages on offer do have the potential to add some much-needed long term visibility and security to corporate balance sheets and in the final analysis that can help companies perform better.

Some of the Financial Packages on offer from Enron

Prepayments - term transactions whereby the company agrees to prepay for future pulp or paper production to be delivered over a set time period Inventory Management - the group takes title of a particular inventory while offering the company the opportunity to repurchase at a predetermined future date. In this way, the company can free up working capital and help bolster the balance sheet Asset Monetization Swaps, Options and Hybrids Physical Trading - physical off-take agreements to buy or sell assets at a fixed or floating price Structured Finance

Looking ahead, it is still uncertain whether or not the type of exchange that Enron and Pulpex have in mind will eventually be an unqualified success. But the signs are certainly looking more positive than at any time in the past and neither effort nor commitment are among the qualities lacking on the part of those involved.

The question hinges on the willingness of pulp and paper companies to get involved and for the moment at least, they look like they could be inching toward acceptance. If that does happen, then pricing mechanisms and the relationship between pulp and paper buyer and seller could be transformed for good.