FINANCIAL ANALYSTS: Black Liquor Credit - Will It Continue?

By Drew Miller, Senior News Editor, PPI Pulp & Paper Week, RISI

NEW YORK, Oct. 16, 2009 (Viewpoint) - Depending on the timing and magnitude of credits related to a) potential for paper and forest companies to realize a $1.01 per gallon cellulosic biofuel credit, and b) potential to collect a $22.50/green ton subsidy under the Biomass Crop Assistance Program (BCAP), these programs have the potential to trigger a broad-based rally in shares of paper and forest product stocks, in our view. However, we have more questions than answers at this point, and as biofuel, cellulosic ethanol, and potentially carbon cap and trade markets evolve, the one asset most likely to benefit, in our view, is timber. Although we remain highly skeptical of burning trees to generate power, there is some logic, in our view, to use trees to create cellulosic ethanol (and other products), and it is our strong opinion that trees offer one of the single most cost effective ways of absorbing carbon from the atmosphere. We remain bullish on every timber-rich company in our universe (WY, RYN, and PCL all rated 1-OW) but to the extent the industry enjoys a broad-based rally, we remain cautious on downstream paper and paperboard producers. Thus, we continue to favor the capital efficient, upstream timber owners, over the downstream converters.

This week we learned of 2 interesting developments regarding the paper and forest industry's black liquor alternative fuel credits. First, the October issue of International Woodfiber Report ("Federal biomass price support program may spell trouble...", October 2009) highlights details of the Farm Service Agency's (FSA) Biomass Crop Assistance Program (BCAP), aimed at providing a $22.50/green ton subsidy for wood used as "boiler fuel". To put this in context, this subsidy is roughly 100% of the current delivered cost of wood. Second, an IRS memo reportedly released on October 9 ("Tax Changes for Businesses", October 9) raises the possibility for companies to realize a $1.01/gallon cellulosic biofuel producer credit.

Currently, companies such as International Paper are benefiting from a $0.50 per gallon alternative fuel credit (resulting in nearly a $2 billion credit during 2009 for IP alone). While the $0.50 per gallon alternative fuel credit expires at the end of 2009, the cellulosic biofuel credit extends for another 3 years through the end of 2012. The credit requires companies to be in a cash tax-paying position with unused credits carried forward against future cash tax bills.

Several questions come to mind. Does black liquor qualify for the cellulosic biofuel credit? The IRS memo implies the answer may be yes, but this is far from certain, in our view. Does the black liquor need to be used as a fuel such as cellulosic ethanol? This is not clear either. What are the specific details of the credit, and when will these be known? Who will pay for the credit - taxpayers? Will the subsidy trigger a trade dispute with Canada and other key paper and forest product trading partners with the U.S.? Unfortunately, we have more questions than answers at this point.

In terms of FSA's BCAP subsidy, the International Woodfiber Report article discusses potential for a $1 billion to $4 billion credit being paid out in 2010, up from just $25 million in 2009. And the article highlights the potential for a doubling of wood biomass prices. The program requires resource providers (timber companies and intermediate converters of wood) to deliver wood to qualified facilities to receive the $22.50/green ton subsidy. But this subsidy would only apply to the portion of delivered wood used by the converter to power up a boiler. In our view, the incentive here appears to be to jumpstart the emerging biomass energy sector.

If not for the industry's surprising ability to capture billions of dollars in alternative fuel credits during 2009, we would be highly skeptical of the latest round of subsidies - both from the Biomass Crop Assistance Program and the cellulosic biofuel producer credit. Given the sheer size of the figures in question - we believe it is at least theoretically possible that companies could collect enough cellulosic biofuel credits to eliminate the need to pay cash taxes for decades - we are watching these developments very closely.

At this point, we are not willing to invest in paper and forest product companies on the basis of speculation about what may or may not happen with regards to the BCAP program and the cellulosic credits. However, we continue to believe that if there is a long-term beneficiary of recent developments, it belongs to the timber owners, not the converters. After all, it is the upstream timber owners who own the resource which has the potential to be used in a) biomass boilers, and b) cellulosic ethanol plants. And as trees naturally regenerate themselves, they sustainably sequester carbon.

Peter Ruschmeier, Barclays Capital