OUTLOOK 1998

Pulp and paper markets are expected to weather financial turmoil in Southeast Asia

Outlook 1998 was prepared by Pulp & Paper editors Noel DeKing, Joyce Routson, Diane Keaton, Carolyn Marshall, Greg Rudder, Debbie Garcia, Philip Goldsmith, and Jim McLaren. Special assistance with charts, tables, and graphs was provided by Tarita Whittingham and Darwin Yang.

U.S. Paper Industry Will Continue Gradual Price Recovery in 1998

Following a lengthy period of inventory destocking, the U.S. paper industry enters 1998 with good underlying demand for its products. Strong U.S. consumer spending and industrial output growth will lead to increased consumption of paper and paperboard. This will support efficient mill operations and ultimately higher product prices, according to industry analysts and paper company executives.

The industry has finally emerged from the most volatile business cycle in history. After a record year in 1995, the inventory destocking process that followed in 1996-97 resulted in a sharp reduction in worldwide prices for paper products and the shutdown of high-cost pulp and paper production facilities. As a result, paper industry profits fell dramatically and many capital expansion projects were canceled.

Over the past six months, however, strong growth in the U.S. economy has pushed paper consumption and shipments upward. Going into 1998, paper demand in North America remains well ahead of the levels seen a year ago, which is raising production at U.S. and Canadian mills and pulling up market prices. U.S. production of paper and paperboard increased an estimated 4.6% in 1997, reaching a new record of 94.5 million tons.

Production is forecast to increase about 2% in 1998, raising industry production to 96.2 million tons. And while production is growing in both the paper and paperboard segments, new capacity additions will fall below historical trends in every grade segment. This will improve the paper industry supply/demand balance and allow for higher prices across the board.

"We anticipate a more traditional price recovery in 1998," said Mark X. Diverio of UBS Securities in New York. "The aggressive price increases that took place in 1994 and 1995 proved to be unsustainable and led to the price collapse in 1996-97."

The good news in the U.S. will be complicated by market developments overseas, particularly in Asia. North America's paper and forest products exports to Asia have already weakened due to reduced consumption and much weaker local currencies vs the U.S. dollar. This combination will slow overall imports into the region and make more paper available from new, low-cost paper mills located in Indonesia, Korea, and Thailand. Some segments of the U.S. paper industry will be negatively affected by the market turmoil in Asia-mostly market pulp and white papers-but the impact should be short-lived and will not stop the overall recovery in pulp and paper markets in 1998, commented Chip Dillon of Salomon Smith Barney.

The North American pulp and paper industry will be in a more globally competitive position this year following a large number of mergers and acquisitions during 1996-97. With increased industry consolidation, decisions regarding capital investments and additional production capacity will be more controlled and concentrated among fewer companies. Most observers see this as a positive development, given the industry's past record of managing cash flow generated during cyclical upturns. The focus this year will be on improving ongoing business operations and generating shareholder value from existing assets. Capital spending plans will not be overly aggressive and some expansion plans will probably be scaled back. Capacity additions for most pulp and paper grades will be in line with demand growth.

MARKET PULP

First-quarter market pulp prices may be weak but, in the long term, positive

Pulp prices are usually on their way up or on their way down. But with the exception of a few dollars in each direction, there has been little change in pricing for more than a year, and at the end of 1997, even a small mid-year price gain was under threat. The market's slow recovery from its 1996 collapse left 1997 prices too low for comfort for some North American and Nordic producers struggling to meet costs. Though demand was steady in 1997, buyers kept the upper hand because of a world oversupply of pulp-even though some mills were out of production for labor and other reasons.

After plunging from nearly $1,000/metric ton in late 1995 to $520/metric ton by April 1996, the price of benchmark northern bleached softwood kraft (NBSK) reached $580/metric ton in the U.S. and about $560/metric ton in northern Europe by September 1996. And there it stayed until February 1997, when excess supplies-reflected in North American/Nordic (Norscan) inventories that shot up to 2.1 million metric tons-weakened pricing by $20/metric ton or more.

By May, Norscan producers had reduced inventories enough-to 1.6 million metric tons-to firm prices back up to the $580/metric ton level in the U.S. and $540-$560/metric ton in northern Europe, and to reach the new list of $610/metric ton in July in the U.S.; northern Europe and Japan/Korea continued to lag, at about $580/metric ton. Producers tried unsuccessfully to raise prices another $40/metric ton in October 1997, but the U.S. stayed at $610/metric ton, while Europe, where the U.S. dollar was strong, showed a $580-$610/metric ton range. By November, European futures market prices were eroding, and the financial crises in Asia, along with reduced Chinese buying after earlier stockpiling, had weakened pricing in Japan/Korea to about $550/metric ton. In December, even the U.S. market was showing the strain, with the spot market for NBSK as low as $580/metric ton, and the price was also dropping in Europe. Despite reduced pulp producer operating rates, there was still too much pulp on the world market and, taking in the other factors, first-quarter 1998 appeared to be shaping up weaker than expected.

Nevertheless, the longer-term outlook is good. Analysts generally expect the pulp market to strengthen in 1998 and 1999 because of strong demand and-in contrast to recent years-limited new capacity additions worldwide.

FIGURE 2 Bleached kraft market pulp consumption is expected to grow at a rate of 3.6% annually from 1996 to 2001, reaching 35.6 million metric tons (consumption grew at a rate of 4.4% annually from 1991 to 1996, to 30.6 million metric tons). Explaining the reduced growth rate, Canfor Corp. director of Marketing Analysis and Development Fraser Evans said that with more consolidations expected in Europe, market pulp used today will be integrated in the future; increased use of deinked pulp (particularly by Europeans) is another factor. He added that the Asian financial turmoil will haunt the industry for a while, but he said 1999 and 2000 should be banner years.

Speaking at the November 1997 Paper/Forest Products Global Outlook Conference, Evans noted that world paper-grade market pulp shipments, driven by graphic papers and Asian markets, grew by more than 4% annually from 1991 to 1996. From 1991 to 1996, the annual growth of world graphic paper production increased from 71.1 million metric tons in 1991 to 86.4 million metric tons in 1996-an annual growth rate of 3.8%-while production should jump to 109.9 million metric tons in 2001, a five-year 4.9% annual growth rate. That figure especially reflects the growth in Europe, which is the destination of more than 40% of the pulp market and which has recovered from its first half-decade weakness-especially in coated paper consumption.

Evans noted that despite short-term extremes, pulp supply and demand are not that out of balance in the long-term-just 12,000 metric tons of extra capacity on a monthly average from January 1991 to August 1997. He added that lower-cost short fibers will show the biggest growth but that costlier higher-strength northern softwoods will be especially essential to withstand increasingly faster machine speeds. Given such uncontrollable variables as world currencies and the uncertain impact of pulp futures, he said the industry should focus on building economic value through an effective use of capital dollars.

NEWSPRINT

Newsprint price recovery to continue into 1998, although at a slower pace

Newsprint prices and demand rebounded in 1997 in North America, and were expected to continue upward into 1998, although on a flatter growth curve than last year. A sampling of five analysts on Wall Street and Bay Street resulted in a forecast of one or two price increases in 1998, and an estimate of the average East Coast transaction price of 30-lb standard newsprint of $615/metric ton in 1998 (up just 10.8% from an estimated average of $555/metric ton for 1997). On the demand side, the robust U.S. GDP growth that helped foment advertising spending last year was expected to drop off. Annual GDP average growth was estimated at 2.9% in 1998 compared with 3.7% in 1997.

Bustling demand from U.S. daily newspapers (demand increased 7.3% for the year through October 1997, or an estimated 650,000 metric tons over 1996) and a strike at two newsprint mills in British Columbia that eliminated about 60,000 metric tons a month from the market helped producers gain a fourth-quarter $35-$40/metric ton price increase. It was the second one for the year following a $75/metric ton hike in March; over the year the transaction price rose from a rock-bottom $500/metric ton in February to about $600/metric ton by December.

Impacts. Heading into 1998, the newsprint market supply/demand scene in the U.S. and Canada was-and will continue to be-impacted by consolidation among producers that should result in greater control over inventory and pricing. Three other short-term issues could impact the market: the strike in B.C. that entered its fifth month at year end, labor contracts that expire at 25 North American newsprint mills, and an economic slowdown in Asia that could reduce the region's need for imported newsprint from North America.

On the central issue of pricing at home, buyers and sellers tried special deals last year to iron out extremes. The deals included setting a range or one amount that the price to the buyer cannot exceed regardless of market conditions over a given time. Several companies acknowledged the new arrangements for some of their tonnage. Enron Capital & Trade Resources Corp. and Citibank offered various price hedging deals, but buyers and sellers were cautious.

The bottom line, according to Abitibi-Consolidated Inc. executive John Weaver, calls for consolidation and production efficiencies that should protect producers in any market. "The North American market is likely to promote more mergers and acquisitions-historically that's how growth goes up and costs go down in mature markets," said Weaver, president of newsprint operations and sales. "In North America, it's the low-cost, high-value providers that will thrive."

Abitibi-Consolidated of Montreal was created from the largest amalgamation ever in newsprint history. The C$4 billion merging of Abitibi-Price Inc. and Stone-Consolidated Corp. was finalized in May 1997. The new company is the largest newsprint producer in the world and the largest uncoated groundwood maker in North America. On a smaller scale, Alliance Forest Products Inc. expanded with the $602.7 million purchase of the Kimberly-Clark Corp. newsprint mill in Coosa Pines, Ala., and nearby timberlands.

North America's seventh-largest newsprint producer, Champion International Corp. of Stamford, Conn., put up for sale its two newsprint mills in Texas with capacity of 700,000 mtpy. Noranda Forest Inc.'s newsprint mill in Masson Angers, Que., run by James Maclaren Industries Inc., went on the block, and Tembec Inc. was interested in buying the Pine Falls Paper Co. Ltd. newsprint mill in Manitoba. The largest producer on the West Coast, Fletcher Challenge Canada Ltd., intended to grow by acquisition after selling two properties for about C$1 billion in 1996-97.

Another key wild card that will continue to influence North American supply/demand was the export, or offshore, market. By October, North American producers were en route to a record year for offshore exports of an estimated 3.6 million metric tons or 23% of estimated total production. The offshore exports balance output for many North American producers and help prop up the domestic market. The majority of offshore tonnage went to Asia, particularly China.

Weaver of Abitibi-Consolidated said overseas markets such as Asia hold great potential, despite the economic problems in the region last year. "Overseas markets aren't short-term, problem-solving markets. They're long-term, growth markets full of opportunity," he said. "It's time to revamp our thinking."

On uncoated groundwood grades that often track newsprint, prices increased for the first time in two years in November. Demand was expected to remain good in 1998 and some buyers of higher-cost lightweight coated (LWC) paper were considering switching to the lower-cost supercalendered (SC) paper. Stora Port Hawkesbury Ltd. was on schedule for starting a 385,000 tpy SC-A+ machine in April at its mill in Nova Scotia, with the intent to convert some publishers to SC.FIGURE 3

UNCOATED FREE-SHEET

Long-term demand growth slowing, but short-term market looks positive

The uncoated free-sheet market ended 1997 in a firmer position than at the beginning of year. Indications are that steady economic growth should bode well for the market this year, with demand projected to grow about 2.5% in the U.S., slightly outpacing capacity growth of 2.1%.

While uncoated free-sheet demand growth is no longer outpacing the GDP by several percentage points, within the segment there are significant areas of growth-and others where the "paperless office" is making inroads. "The uncoated free-sheet business is in the midst of a major upheaval," said L. Scott Barnard, executive vice president with Champion International Corp.

One of those growth areas is cut-size papers. Thanks to the rise of digital printing technologies, cut-size volume has grown an average of about 5% between 1993-96. With sales of ink-jet and laser printers still trending upward, cut-size demand is expected to grow two to three times faster than overall uncoated free-sheet demand through 2002. To capture rising demand for cut-size, a number of North American producers have installed or will install additional sheeters during 1996-98, including Georgia-Pacific Corp., Domtar Inc., Champion International Corp., and Weyerhaeuser Co. Meanwhile, offset growth has flattened out and some offset rolls are now being used in high-speed digital printing. Forms bond volume has declined, caused by customers switching to electronic transactions or to cut-size. In other converting grades, tablet continues flat and envelopes are showing some growth due to demand from direct mail.

Capacity. The startup of Boise Cascade Corp.'s 330,000 tpy machine in April 1997 had little effect on the market, due to robust economic conditions and conversions to coated papers at other mills. In addition, Boise earlier shut down its 105,000 tpy production line in Vancouver, Wash., and Domtar shut two small machines at its Cornwall, Ont., mill.

This spring, Willamette Industries Inc.'s 300,000 tpy machine will come online at the Hawesville, Ky., mill and a rebuild at Avenor Inc.'s Dryden, Ont., mill is expected to be completed, adding about 50,000 tpy. But with demand growing faster than capacity, and mill inventories at a reasonable level, the domestic market has the potential to remain tight or at least in balance through the year.

One wild card is the availability of paper from overseas due to excess capacity, especially in Asia. Japan and Indonesia dominate the region in cut-size production, but while most Japanese production is consumed within its borders, most Indonesian cut-size is exported. Asia Pulp & Paper and Asia Pacific Resources International Ltd. are both building world-class machines in Indonesia with 1998 startup dates which together will have the capacity to produce more than 1 million metric tons. In addition, significant expansions are planned over the next several years by companies in China. Brazil already has a sizable cut-size production; Brazilians can be lower cost producers because of lower fiber and labor costs.

Under typical conditions, this growth could be absorbed into the world market without disruption. But growing economic and financial problems in Southeast Asia could put a dent in demand for uncoated free-sheet, as for coated papers. "This is likely to leave Asian producers looking for overseas customers," according to Pulp & Paper Forecaster. "The incentive to export outside the region will be especially strong in Indonesia where the value of the rupiah has fallen by more than 30% against the U.S. dollar since mid-1997-a huge cost advantage for producers who decide to export to the West."FIGURE 4

COATED PAPERS

Solid year predicted for coated papers, although Asia capacity a wild card factor

With U.S. coated paper demand tied in large part to the economy, 1998 should be a good year for manufacturers. Overall, both consumer spending and advertising are expected to remain healthy, with catalogers, magazine publishers, and retailers expected to have another solid year. The U.S. Postal Service rate increase for third-class mail is not expected to have much effect on paper demand, which has historically on average outpaced the GDP plus 1.6% since 1970.

Forecasts for North American coated paper purchases for 1998 average about 3% growth. Coated paper shipments were estimated to hit 9.9 million tons (U.S. and Canada) for 1997. "The outlook for coated paper markets is good," said Neil Falco, president of Repap Marketing. "Solid economic growth continues, lower prices have stimulated demand, and inventories are becoming normal. Price recovery will continue to follow volume recovery and global demand growth will exceed capacity growth. Industry consolidation will minimize future downturns."

That said, the outlook for the two markets, coated groundwood and coated free-sheet, differ somewhat, based on the factors of capacity, consolidation, and competition. While the coated groundwood market is expected to remain tight with a previously announced price increase this month and perhaps one mid-year, an excess of coated free-sheet capacity worldwide could impact that sector. However, consolidation among producers could ameliorate some of that, with better-planned incremental increases evening out new supply. Competition comes into play with some potential grade switching from groundwood to free-sheet, or from coated to newer supercalendered grades which could also affect growth rates.

Coated groundwood. The rebound in demand for coated groundwood in 1997 was remarkable, with U.S. shipments up 23.2% through September (and a projected gain by year-end of 17.2%; final year-end totals were not available by press time). A lessening of inventories (and a positive U.S. economy) contributed to a tight market situation for the second half of the year, driving prices up about 5%. An across-the-board price increase was announced in July, and a selective increase on spot prices was applied in October. Some producers called the increases "discount reductions" off list prices, which haven't paid since 1995. By November, discounts were 15% to 19% off list, about half of what they were going into 1997.

Paper prices are likely to continue to rise in 1998, as the inventory destocking from 1997 is largely complete, and any inventory building at the customer level this year should keep pace with demand growth and new capacity additions should fall below the trendline.

North American capacity continued to creep upward in 1997, an estimated gain of about 2.5%, most attributed to the conversion of MacMillan Bloedel Ltd.'s Port Alberni, B.C., machine that began the previous year. For 1998, the only North American capacity increase will be at the Blandin Paper Co. mill in Grand Rapids, Minn., an upgrade that is expected to put an additional 42,000 tons on the market.

While markets will remain tight, the startup of Stora North America's SC-A+ machine in Nova Scotia could impact coated groundwood sales. The 385,000 tpy machine is expected to produce 170,000-200,000 tons in 1998 which the papermaker is promoting as an alternative to LWC. Advances in SC technology in Scandinavia have prompted some U.S. publishers to switch to the cheaper, uncoated paper. Less of a factor in terms of capacity is coated groundwood expansion globally. While UPM-Kymmene Corp.'s 400,000 mtpy Rauma, Finland, machine will be producing paper this year, consumption is expected to remain mostly in Europe.

Consolidation among paper producers could also play a role in keeping shipments and inventories in check. In the last 12 months, more than 3 million tons of coated paper capacity has changed hands in North American and Europe-Sappi Ltd.'s purchase of KNP Leykam, Consolidated Papers Inc.'s acquisition of Repap Enterprises' Wisconsin mill, UPM-Kymmene's purchase of the Blandin Paper Co. mill, and Boise Cascade Corp.'s sale of the Rumford, Maine, mill to Mead Corp. Typically, buyers try to wring out cost savings from operating synergies which may include reconfiguring machine production or eliminating inventory.

Coated free-sheet. The rebound in coated free-sheet shipments and pricing during 1997 was not as dramatic as coated groundwood but like that sector, strong consumer spending was a major force driving it. For the first nine months of 1997, shipments were up 11.4%, according to the American Forest & Paper Assn. Mill inventories were down almost 18%. By November, pricing for the popular No. 3, 60-lb grade had gained about 15% from the previous year.

Continued moderate demand growth coupled with some inventory building at the customer level will likely bode well for papermakers. But a large capacity overhang worldwide (and some significant U.S. conversions that added capacity last year) are likely to impact the rate of price recovery for 1998.FIGURE 5

In North America, about 400,000 tons of new capacity was added from conversions from uncoated free-sheet and startups of idled mills. International Paper Corp. added 200,000 tpy at its Jay, Maine, mill and Appleton Papers Inc. 190,000 at Combined Locks, Wis. In addition, the former 180,000 tpy Simpson Paper Co. mill in West Linn, Ore., restarted. The AF&PA projects capacity will increase by 3.1% in 1998, mostly from delayed effects of the Appleton project which started up in the second half of last year.

More worrisome is that global overcapacity in coated free-sheet could weaken the North American market. Several huge new machines in Europe (Finland and Austria) and Asia (Indonesia and Japan) will add millions of tons between now and the year 2000; there are estimates that coated free-sheet capacity could grow by 7% to 8% in 1998. While most of the product is designated for domestic markets overseas, the recent currency crisis in Southeast Asia has prompted renewed concern about the world-class machines being built there. "A slowdown in growth of Asian demand would cut imports to the region and force Asian producers to look for customers overseas," reports Pulp & Paper Forecaster. "The recent currency devaluations across Southeast Asia-especially in Indonesia-will make it easier for these producers to market their paper outside the region." Whether or not the paper finds it way to U.S. shores, the effect on trade could be felt in North America.

CONTAINERBOARD

Recovery of 1997 will continue into 1998

The U.S. containerboard market started a slow but promising recovery in 1997 and, by all accounts, sustained and steady growth should continue throughout 1998. Although no one can rule out the possibility of short-term glitches-triggered by a post-holiday slump or delayed reactions to recent economic turmoil in Asia-analysts generally agree that linerboard, corrugating medium, and box producers will reap higher prices as the containerboard business eases into a period of improved supply/demand balance.

Needless to say, the containerboard market in late 1997 had nowhere to go but up. The year began with good orders, decent box shipments, and strong exports-conditions that should have helped solidify moderate price improvements initiated in late 1996-but the U.S. market remained stifled by a lingering capacity overhang that kept inventory supplies high. Prices slowly eroded and continued to slip, even as the second quarter kicked in, which could have been foreseen given operating rates of 95% to 98%. East Coast prices bottomed in the spring when semichemical medium tumbled to around $200/ton and below, and kraft linerboard fell to roughly $300/ton and below.

Although containerboard inventories at box plants and mills actually started to fall in the last half of 1996, producers got carried away after the holidays. Stocks slowly ballooned and stagnated near the 3 million ton level through the first quarter of 1997. The worst of it hit in February when close to 3.1 million tons, or 5.6 weeks of supply, blanketed mills and box plants. Not known for reacting quickly, containerboard producers gave lip-service to the need for curtailments, until it became painfully obvious that they needed to shut down. An inventory correction began in earnest during the second quarter and between February and October 1997, producers reportedly removed roughly 1.4 million tons of linerboard and corrugating medium from the U.S. market. By year end, rollstocks had been hammered to roughly 2.4 million tons.TABLE 3

With curtailments underway and export demand strong, conditions were finally ripe for a mid-year stab at a price hike. Producers eased into the effort starting with corrugating medium which somehow had fallen far below linerboard, leaving an unprecedented $100-$110/ton gap between the grades. A successful June 1 medium increase of $40/ton nudged the market into motion. During the last half of 1997, the market embraced two additional price increases for corrugating medium, two price hikes for kraft linerboard, and an 8% to 9% price increase on boxes (buyers appeared to be headed for a second 10% to 12% box increase in late December or early January). As the holidays approached, transaction prices for corrugating medium in the East topped $330-$350/ton, while kraft linerboard hit $380-$400/ton.

Demand growth. Analysts predict the U.S. corrugated box market will grow 3% to 3.5% in 1998, with shipments at 399 billion ft2, up from 1997 shipments of an estimated 388 billion ft2. Domestic containerboard production will slow in 1998, although both linerboard and medium production still should register a 2% to 2.5% increase over 1997 production levels. Exports have been on a remarkable upswing since late 1995 and overseas demand has been credited with keeping the domestic market afloat in 1996 and early 1997. Exports will slow in 1998, although growth still is expected: Export production will hit 4.55 million tons, a 1.5% increase over 1997's stellar showing of an estimated 4.48 million tons.

Modest price recovery should continue in 1998, although no one expects the spectacular returns seen in 1995. In general, analysts and major producers believe containerboard will-at the very least-support one more price increase of $50/ton in the first quarter, with an increasing number of market observers hinting that a second hike is possible. Conservative estimates forecast average transaction prices for kraft linerboard in 1998 in the range of $420-$430/ton, while 1998 transaction prices for semichemical medium should hover at an average of $360-$370/ton.

BOXBOARD

Folding boxboard outlook promising, but below historical growth trends

The U.S. folding carton and boxboard industry is a mature market, showing volume growth of less than 1% in 1997. The domestic folding carton industry has been experiencing some tough times recently, although most carton manufacturers are expecting a better year in 1998. Through the first nine months of 1997, the cumulative dollar value of folding carton shipments was down 2.2% from the same period in 1996, according to the Paperboard Packaging Council.

The decline was due to lower overall pricing levels for cartons and paperboard raw materials, increased market competition with flexible packaging, micro-flute and corrugated containers, and more aggressive purchasing trends from the country's largest packaged goods and food distribution companies. Finding new markets to maintain steady growth is an urgent goal of the industry.

Much of the recent growth in the folding carton and boxboard industry has come from exports. During 1997, exports of solid bleached sulfate (SBS) packaging board increased by approximately 15% and exports of coated unbleached kraft (CUK) board increased about 30%. Exports accounted for less than 1% of recycled boxboard production.

"Many of our major customers are producing goods overseas," said F. Scott Macfarlane, vice president of Jefferson Smurfit Corp. "There is already more global competition in our business because more of our customers-big consumer products manufacturers, particularly-are buying packaging materials worldwide."

The primary export markets for bleached board are liquid packaging for milk and juice products, and folding cartons for consumer goods, cigarettes, and food products. Exports of coated kraft board for folding cartons and beverage carriers have grown faster than bleached board over the past decade, and this trend should continue in 1988.

Another major factor facing the industry in 1998 is volatility in raw material pricing. Market pricing is driven both by fiber costs and paper mill capacity and production trends. Recycled fiber costs and wood pulp prices both headed downward during first-half 1997. As a result, recycled board producers lowered their prices significantly and SBS producers dropped their prices on many commodity bleached board grades.

Prices gradually recovered during the second half of the year as wastepaper and pulp prices edged up. Folding boxboard prices were about $40-$60/ton higher at the end of 1997 than at the start of the year. Prices are forecast to continue rising gradually during 1998-99 but no sudden "price shocks" are expected. No new paper machines are planned in the boxboard industry, so there is no short-term threat of surplus capacity. Combined with steady production trends, this should keep boxboard mills operating close to 95% of available capacity, according to analysts.

WASTEPAPER

Wastepaper markets to strengthen in 1998 despite continued lull in offshore exports

The recovered paper market will continue its slow but relatively steady improvement this year, following many of the same patterns as seen in 1997. Prices should rise, but not significantly-except for short-lived spurts in old corrugated containers (OCC)-but the increases might pick up in second-half 1998. U.S demand should improve, but this will be somewhat offset by an anticipated lackluster export market to Asia.FIGURE 6

The currency crisis in Asia will reduce U.S. exports of recovered paper for
at least the first half
of 1998, as Asian economies strive to
revive their businesses. The currency fluctuations there late last year have made it more costly to import into Asia; thus, these countries are expected to step up local recovery efforts and be even more frugal with their purchases
of offshore fiber, according to David Clapp, economist, Resource Information Systems Inc.

The increase in U.S. demand for recovered paper should benefit all scrap paper grades, although specific factors will effect the various grades differently.

In OCC, demand will rise in spite of the decline in recovered-paper based containerboard expansions and weaker overall demand from existing recycled containerboard mills. That is because this anticipated decrease will be more than offset by incremental increases in the use of OCC in "virgin" paperboard and other paper grades, according to Clapp.

Some OCC volatility ahead. OCC prices are projected to remain volatile for a number of reasons. In addition to the projected increase in demand that will tighten the market, the proliferation of just-in-time inventory practices in recent years has caused the sudden spurts in demand regionally that tend to drive up OCC prices and then bring them rapidly back down after the spurt is over, according to Bill Moore, president, Moore & Associates.

Demand for old newspapers (ONP) and mixed paper should also be firm in 1998. ONP prices could top $100/ton, depending on both supply and demand factors, according to industry analysts. ONP demand from newsprint mills should remain robust, particularly if various states continue to press on with higher recycled-content requirements for newsprint.

Sue Andersen, a consultant with Thompson Avant International Inc. (TAII), also noted that ONP markets are firming because recovery efforts are diminishing as the collectors are dropping programs that are not economically feasible.

The current weakness in the pulp market should continue to have a dampening effect on pulp substitutes prices though until about mid-year, when pulp prices should begin to rebound and take pulp substitute prices with them.

Still sorting out SOP. Demand for sorted office papers (SOP) is expected to be somewhat better in 1998 following the improvement in the pulp market. This should boost deinking pulp production, which will result in higher consumption of SOP and related grades such as white ledger and computer printout. In addition, tissue mills-which are also big users of SOP and other deinking grades-are expected to continue to operate well in 1998.

Mary Cesar, vice president of recycled paper for Jaakko Pöyry Consulting Inc., also expected that there will be more emphasis on various sub-grades of SOP this year, with communication down the line to the generator playing a bigger part in enabling the mills to get the paperstock qualities they require. Contamination problems will continue to be addressed and progress made at all levels, particularly with stickies caused by certain adhesives.

TISSUE

More mergers could be ahead; pricing stable in mature industry

A second mega-merger in as many years further redefined the $8 billion U.S. tissue industry in 1997, and ensures that it remains in a healthy condition both in terms of pricing and production. The $5.8 billion merger of Fort Howard Corp. and James River Corp. created the largest North American tissue producer, controlling an estimated 29% of total capacity in the region and pushing Kimberly-Clark Corp. into second place. Fort James Corp. becomes the largest away-from-home tissue producer with an estimated 34% market share, and the second-largest consumer tissue producer with 21% of the market after Procter & Gamble Co.'s 27% share.

Some observers believe that the Fort James merger will not be the last major consolidation in the region. In particular, Georgia-Pacific Corp., the fourth-largest U.S. producer, is thought to be interested in acquiring additional tissue capacity in North America. Chesapeake, the No. 5 producer, has been mentioned as a possible target. Such continuing consolidation, together with retailers' preference for higher-margin, strong brands, is expected to create stiffer competition for smaller regionally branded and private label tissue producers.

Tissue prices in 1997 were relatively stable, and that situation is expected to continue for much of the year. The last round of increases was on commercial products in early 1997, and with little upward movement in pulp prices expected in the near future, major price changes in early 1998 do not look likely. In late 1998, however, increases in both consumer and commercial prices could occur as pulp and packaging prices increase, according to Michael Burandt, vice president of packaged products at Georgia-Pacific.

With continuing strong demand and removal of higher-cost production facilities, as illustrated by K-C's recent decision to cut 7% of its worldwide tissue capacity, industry operating rates are expected to remain comfortably above 93% for the next few years, according to AF&PA estimates. This is despite the addition of over 200,000 tons of tissue capacity through rebuilds, startups, and restarts during 1997, and a further 440,000 tons of capacity planned during the next three years.

P&G will start up a 65,000 tpy machine at its Albany, Ga., mill this year, and it plans to have the first of two new lines running at its Cape Girardeau, Mo., mill in the year 2000. Other major expansions this year include a 60,000 ton machine due to start up this year at Georgia Pacific's Crossett, Ark., mill. In 1999, both Fort James and Marcal Paper Mills plan to start up 65,000 ton machines, and Perkins Papers will add a total of 52,000 tons of capacity with a new machine at Rockingham, N.C., and rebuilds at a number of sites in Canada.

North American tissue capacity in 1997 was estimated at 7.57 million tons, up 2% from 7.42 million tons in 1996. The top five producers account for around 71% of total capacity. In the U.S., capacity in 1997 was an estimated 6.78 million tons, and production was 6.35 million tons, giving an average utilization rate of 93.4%. The AF&PA estimates that utilization will remain at a healthy level, rising to 94.4% in 1998, but rates could dip slightly in 1999 and 2000, according to some industry estimates, as the effects of capacity additions filter through.

ENVIRONMENTAL REGULATIONS

International treaties and regulations may become the norm as businesses go global

It may well be that, in decades to come, pulp and paper companies will relish the days devoted to domestic regulatory battles embodied in the 1997 finalization of the Cluster Rule, a long, drawn-out industry struggle marred by debates, delays, divisions, and renegotiated terms that still will cost pulp and paper companies billions of dollars in capital outlay and millions in annual upkeep. But in the end, fancy footwork and political finesse by pulp and paper lobbyists led to the U.S. Environmental Protection Agency's endorsement of an industry-backed proposal to "virtually eliminate" dioxin discharges in waterways and slash hazardous air emissions from mills using elemental chlorine-free (ECF) technology rather than the more rigid and expensive requirement for oxygen delignification, as originally proposed in December 1993. Expect to hear about Cluster for the next five years or so as the EPA shapes additional phases of the rule and companies rush to comply.

In the meantime, expect to see more and more regulatory debates at the international level as the global economy collides with worldwide concern for environmental protection. Witness the urgent world meeting last month in Kyoto, Japan, where an international array of corporations and environmental groups stood at the sidelines while leaders from every key developing and developed nation gathered to negotiate a global warming climate treaty that will establish mandatory cutbacks in the release of carbon dioxide, methane, nitrous oxide, and other gases linked to global warming. Pulp and paper mills, like most industries, contribute to global warming through carbon dioxide (CO2) and other emissions, but the industry may have an easier time with treaty compliance than some of its chemical or oil and gas corporate counterparts. Paper industry experts argue that the forest industry actually contributes to a cleaner atmosphere through trees, which absorb and store carbon while releasing oxygen. One technical source said the "cradle to grave" life-cycle of the industry is "roughly in balance." The industry also argues that its fuel burning should be recognized as a zero gas emission because companies rely on cogeneration, rather than burning or heating sources such as coal, gas, or oil.

Which brings us back to regulations on the domestic front, where one of the hot environmental issues in 1998 promises to be utility and energy deregulation. Roughly 46 states are looking at legislation to improve competition in the electric power industry, an area that the American Forest & Paper Assn. aggressively supports. "The U.S. pulp and paper industry purchases $6.3 billion of electricity each year. When choice for all consumers becomes a reality, we stand to save 10% to 30% a year in power costs. That's $300 million to $2 billion annually," AF&PA's Josephine Cooper, the group's vice president of regulatory affairs, told participants at the 4th International Market Pulp Conference last June.

The U.S. Congress also will likely tackle energy deregulation issues in 1998, along with some of the same issues that swept over Capitol Hill in 1997. Only the Endangered Species Act and Superfund law received significant congressional attention in 1997, and neither law jumped through the necessary hoops to merit final action, suggesting the issues may surface again this year. Regulatory reform of key air, water, and right-to-know laws received short shrift in 1997 and there has been little word on whether they'll surface again in 1998. Certain to make the A-list are forestry and logging issues. Some say the U.S. Senate may again introduce industry-supported forestry legislation designed to reform logging policies in national forests. Forestry bills introduced in both 1996 and 1997 made little progress, but regulatory reform of the nation's forest management remains a key target on AF&PA's legislative agenda. Logging issues, of course, seem perpetual. In 1996 and again in 1997, an array of controversial logging riders surfaced as tag-ons to a key appropriations bill, a tactic increasingly used to push controversial legislation forward. The riders in question in 1997 included a Republican-backed measure to fund the $250 million purchase of the old-growth Headwaters Forest in California, along with other logging initiatives that addressed road building and export rules. President Clinton's advisers urged him to veto the bill, but he signed the measure at year end.

WOODFIBER

Woodchip output less in 1997; conditions expected to look up in 1998

Relative slack pulpwood demand and widespread pulp and paper mill downtime in key markets characterized the early part of 1997, but North American woodfiber conditions are expected to be tighter in early 1998 due to improved pulp and paper markets and a downturn in the solid wood industry. A slowing of U.S. housing starts, a weak Japanese lumber market, and sawmill overproduction plagued North American lumber markets in mid-1997, leading to widespread sawmill curtailments in the Pacific Northwest, reducing residual woodchip output.

Random Length's composite price for framing lumber stood at about $380/thousand bd ft (tbf) in late November, down 25% from peak prices of about $470/tbf a year earlier. Resulting sawmill downtime was reported widespread in British Columbia in the fourth quarter, although pulp mill downtime and labor strikes continued to suppress chip demand. In the U.S. Northwest, pulp mills were ramping up in-woods chip operations for an anticipated shortfall in residual chip output and greater competition for pulpwood.

U.S. Southern pulpwood consumers were already scrambling for wood in certain regions late in the year, with pine shortages reported in the competitive Georgia-Florida market and notably in Mississippi in October, according to International Woodfiber Report (IWR).

Average, delivered softwood chip prices in North America generally narrowed to a $28-$38/ton range across most regional markets in the fourth quarter, although southern prices were at peaks and Pacific Northwest and eastern Canadian prices were near bottom levels. South Central pine chip prices were up about 23% to average $38/ton in the fourth quarter compared with a year earlier.

Largely stable markets prevailed in U.S. Northeast and Great Lakes regions,which are mostly hardwood roundwood consumers. The South increased its share of U.S. total fiber consumption to 74% as eight of the top nine consuming states and 37 of the largest 40 pulp mills are located in the South. U.S. pulpwood production in 1996 totaled 240 million green tons, a 5% decrease from 1995. About 250 million tons of U.S. pulpwood production was forecast for 1997, according to IWR.

Timberland investments. Renewed interest in timberland resources in the 1990s, either as a component of fiber supply or as an undervalued asset with long-term investment potential, has led to a series of major timberland transactions across the U.S. and Canada. While most buyers and sellers remain forest products companies, a growing amount of acreage is coming under the control of Timberland Investment Management Organizations, or TIMOs. In a review of 32 timberland sales in the 1995-1997 period, TIMOs have been the primary buyer in nine cases, IWR reported. Among the largest is Hancock Timber Resource Group, a business of John Hancock Mutual Life Insurance.

Increasingly, pulp and paper companies depend on owned or controlled timberlands for woodfiber and pulplog supplies. About 30% of 1996 pulpwood furnish came from company owned lands, up 1% from 1995, while gatewood loggers delivered 28%, down a significant 10% from the previous year.

Canada - Qualified Optimism for 1998

Although there was gradual improvement in 1997, market conditions overall last year were generally a disappointment for the Canadian pulp and paper industry. For its two dominant products, newsprint and market pulp, transaction prices were close to rock bottom at the beginning of the year, but as the year progressed, they bounced back and returned to more acceptable levels by year-end. Other product lines, particularly packaging grades, also suffered in varying degrees from an imbalance of supply and demand. As a result of these trends, the profitability of the industry suffered and with the exception of a few low-cost producers, such as Donohue Corp. and West Fraser Timber Co., most of the Canadian companies were lucky to break even in 1997. A contributing factor to these disappointing results was a decline in transaction prices for various wood products, such as lumber, plywood and oriented strandboard.

Mergers and acquisitions (M & A) played
a major role in the industry's performance in 1997. The most notable was the merger of Abitibi-Price and Stone-Consolidated to form Abitibi-Consolidated Inc., now the world's largest producer and marketer of newsprint and uncoated groundwood specialties.

Towards the end of the year there were a number of other significant transactions pending. Domtar Inc. and Cascades Inc. were in negotiations to merge the packaging assets of both companies to form Canada's largest paper packaging company, and Stone Container Corp. announced plans to sell a good proportion of its Canadian assets including its 25% interest in Abitibi-Consolidated. Harmac Pacific Inc. was the target of an unsolicited offer by Pope & Talbot Inc. Harmac postponed a plan
to buy two Kimberly-Clark Corp. pulp mills. Canadian producers also made acquisitive forays outside of the country. The most significant were Alliance Forest Products Inc.'s purchase of Kimberly-Clark's Coosa Pines, Ala., mill complex and St.Laurent Paperboard Inc.'s purchase of Chesapeake Corp.'s West Point, Va., mill and related converting facilities.

Repap downsizes. Not only was consolidation the order of the day, but the selling of assets, not always voluntary, was a feature of the
M & A landscape for Canadian producers in 1997. Unable to find a "white knight," Repap Enterprises Inc., burdened by an excessive amount of debt, was compelled to sell two of its mills: its Le Pas, Man. kraft paper mill and its Kimberly, Wis., coated papers mill. Having handed the keys of a third mill in Prince Rupert, B.C., to its creditor banks, Repap Enterprises was left with one mill, its coated papers complex in New Brunswick. In addition, Fletcher Challenge Canada Ltd. sold, for "strategic reasons," its coated publication papers mill in Grand Rapids, Minn., to Finland's UPM-Kymmene Corp. At year-end, there was a variety of other deals on the table which involved the sale of Canada-based primary assets.

It is likely that M & A activity and other big dollar deals will once again play a significant role in the Canadian industry in 1998. Speculation is rampant on a number of fronts, two of which are the most prominent. Having appointed a new chief executive in 1997, MacMillan Bloedel Ltd. will no doubt see, in 1998, a shift in its corporate focus which will probably lead to a reshuffling of primary assets. And Fletcher Challenge Canada, sitting with some $C1 billion generated from asset sales, will certainly be in the headlines sometime in 1998, either because of a major acquisition or, as a distant possibility, because its New Zealand-based parent decides to take its subsidiary private.

Labor spotlight. Labor relations will once again be in the spotlight in the Canadian industry in 1998. A significant event of 1997 was the extended strike at Fletcher Challenge Canada's three pulp and paper mills in British Columbia. While money and contract length were important negotiable items, the main stumbling block was job flexibility and the number of mill operating days. The strike started July 14th and was continuing at the time Pulp & Paper went to press. Eastern Canada will be the focus of labor negotiations in 1998 with most of the mills finishing up five-year contracts on Apr. 30. Wages, pensions and length of the new agreement are likely to be the key issues in these negotiations. A target company with which to establish a pattern settlement will be likely chosen in the early spring.

Asia concerns. Improving market conditions and healthier profitability will be the backdrop for these negotiations in eastern Canada. Most of the pundits expect that slow but steady improvement in transaction prices will be the order of the day, although some of Canada's leading forest products analysts have some reservations about the short-term strength of this improvement. They cite the concerns over the impact of the currency turmoil and stock market gyrations in Southeast Asia and the impact these events might have on this region's economic growth and the demand for pulp and paper products. While concerned about the events in Asia, Brian Topp of Deacon Capital, Toronto, remains "very optimistic longer term about the industry's prospects." He is particularly bullish on the prospects for newsprint. Hamish Kerr of Goepel Shields,Vancouver, feels that there could be delays next year in implementing price increases for newsprint and market pulp,
but still has "high hopes" in 1998 for value-added grades such as coated groundwood and coated free-sheet. Both analysts had concerns about the demand and pricing for wood products in 1998.

Overall, most market watchers remain at least somewhat nervous about the fallout of the recent events in Southeast Asia and the spill-over into other regional markets such as South America. If there is a casualty in this unpredictable environment, it will more than likely be market pulp, the grade most sensitive to currency fluctuations and economic instability. Being the world's largest producer of market pulp, the Canadian industry would suffer considerably if market pulp transaction prices declined from current levels.

Certainly, investors were, as 1997 progressed, concerned about the sustainability of the improvement in market conditions. Share prices for most of the publicly owned Canadian pulp and paper companies peaked at mid-year, drifted sideways until the onset of the "Asian flu" and then proceeded to sink to lower levels towards the end of the year. Until the dust settles and some semblance of stability returns to Asian markets, investors in Canadian forest company equities will probably take a "wait and see" attitude before committing investment dollars once again to Canada's largest industry.

While some improvement in corporate
bottom lines is expected in 1998, the magnitude of the improvement remains the big question mark. It almost comes down to the extent to which improved profitability from pulp and paper production will be undermined by poorer financial results from the manufacture
of wood products.

-By Jim Rowland