Forestry: Pulp friction

The forestry industry is in rough shape. The high Canadian dollar, tight government regulation, increased competition from international producers and falling demand have all conspired to make profits difficult. And don't forget about the mountain pine beetle, currently wreaking havoc on millions of hectares of British Columbia forest and already spreading in Alberta.

Given the challenges, why would anyone sink money into forestry? Because all is not lost, especially for those producing lumber and construction materials. “The outlook for lumber is actually very strong over the next decade,” says Mark Bishop of RBC Capital Markets in Vancouver. Jim Pattison's large stake in Canfor (TSX: CFP) is a positive sign, as is the presence of New York investment firm Third Avenue Management, which owns large chunks of Canfor, Catalyst Paper Corp. (TSX: CTL) and Abitibi Consolidated (TSX: A).

Cory O'Krainetz with Odlum Brown in Vancouver is bearish on forestry short term but says there are long-term opportunities. O'Krainetz likes Norbord Inc. (TSX: NBD) and West Fraser Timber Co. Ltd. (TSX: WFT) for keeping production costs down. “They're the best-run lumber producers out there,” he says.

A U.S. housing slowdown is a problem for Norbord and West Fraser, however, and it could take until the end of 2008 for housing starts to pick up. The companies also have to contend with an excess supply of dead wood resulting from the beetle infestation. Infected trees can still be turned into usable products, but that's proving costly, given the wood is drier and prone to cracking. There is enough beetle-killed wood to last up to 10 years, but that time frame may shorten if processing becomes too expensive and producers switch to another species, such as fir.

Once U.S. housing starts increase and beetle-killed wood is exhausted, timber supply will be tight, as demand for construction materials grows in both North America and Asia. That will push prices higher. As well, Russia slapped an export tax on raw logs in January to boost its domestic industry. China and Japan are importers of logs from Russia, and may nowseek other suppliers, including Canada.

O'Krainetz also sees Canfor as a long-term play as a result of new management, which is expected to be more aggressive in cutting costs and making acquisitions. He calculates the company has close to $100 million in cash it can use to purchase U.S. assets to hedge against the loonie.

For pulp and paper companies like Abitibi, it's a different story. Recent mill closures have cut pulp supply and pushed prices above US$800 a tonne, but pulp is soon expected to drop as low as US$600 due to oversupply. That will make it tough for older mills to compete, says John Desjardins, national director for KPMG's forest industry practice in Vancouver.

There's also been a shift in pulp production to South America, where the trees grow faster and transportation and labour costs are cheaper. “The quality isn't quite as good as our pulp, but it's getting better,” Desjardins says. “And there are more newmills coming on stream.” Brazil's Votorantim Celulose e Papel (NYSE: VCP) plans to triple capacity over the next four years, and Aracruz Celulose (NYSE: ARA), already the world's largest and lowest-cost pulp producer, is also adding capacity. “We expect the new supply will squeeze out high-cost pulp producers in Canada and Europe,” Stephen Atkinson of BMO Capital Markets noted in a recent report.

Canadian producers also face decreasing demand for newsprint. One option is to diversify into specialty paper, as Domtar (TSX: UFS) has done with uncoated free sheets (used in printers and photocopiers), which are likely to grow in demand. Sticking with newsprint could be risky. “Long term, where does the decline of newsprint stop? Does it stop at all?” Desjardins asks. That is a question investors may not want to hang around long enough to have answered.