This is the first in a two-part series related to wood supply agreements and their relevance to analyzing timber markets.

In his 1989 book Liar’s Poker, Michael Lewis wrote, “Risk, I learned, was a commodity.  Risk could be canned and sold like tomatoes.”  This represented a prevailing view among the sophisticates of Wall Street prior to the mortgage bubble and collapse of AIG.  Though the view of risk “as a commodity” varies over time, it remains critically important to managers and investors exposed to timberlands and wood-using assets.  One tool employed to mitigate risk in timber-related industries is a wood supply agreement.

Forest industry managers and bioenergy project developers sometimes use wood supply agreements to manage the costs and flows of logs and other woody raw materials to manufacturing facilities and bioenergy plants.  Integrated forest products firms also used them to work through the operational impacts of timberland divestitures.  A typical agreement comprises a contractual obligation by a supplier to provide agreed-to volumes of wood to a buyer, who commits to purchase this raw material at the contract price.

Most agreements reflect a tradeoff between security and flexibility.  In guaranteeing volumes, the supply agreement secures supply for the mill and a market for the timberland manager.  The aspects subject to negotiation include product, volume, timing, and price.  Product specifies the species and “specs” of the product to be delivered.  Pine pulpwood or hardwood logs?  Volume specifies the amount of wood covered under the agreement, whether it is fixed or a range.  Timing specifies the timeframe covered, and the time periods for actually delivering the wood.  Price specifies the method and manner for pricing the wood delivered, and the process of updating and communicating this price.

The “pricing mechanisms” built into wood supply agreements are of central importance.  They have influenced many a bonus, ulcer and sleepless night.  How can fair prices be calculated over time that account for actual market activity while minimizing the “penalties” for being locked into a set marketing arrangement?  Existing supply agreements attempt to balance two competing aspects of pricing wood based on available data.  The first asks the question, “How does the market price this wood?”  The second asks, “What is the value of this wood in the market?”  The first is the question of the wood buyer, and the second is the question of the stumpage seller.

Common approaches include rolling averages, indexing, and blended indexing.  Rolling (moving) averages are used within the forest products industry, and in other heavy industry settings, to calculate transfer prices and for raw material supply agreements. One advantage of a moving average is that it reduces the peaks and valleys associated with changes in log prices.  One disadvantage is that, for any given month, the transfer price lags the actual market price, though this should balance over time.

Recent issues related to supply agreements have focused on reduced confidence in the data underlying a supply agreement and concerns about conflicts of interest associated with pricing mechanisms or indices provided by the same firm that collects and reports the underlying price data.  These issues become relevant when conducting due diligence on timber markets or wood baskets as they can affect the ranking and risk assessments associated with potential or existing wood procurement strategies.