Investing in wood-using mills and timberlands requires having a strategy about how to “feed” the mill or how to “market” the trees. These efforts raise questions about the relative value of vertical integration, where one firm owns mills and forests, versus alternatives such as wood supply agreements or joint ventures or outsourcing. This post includes key findings from our work over the years related to the benefits and disadvantages, from the view of a manufacturer, of owning timberlands or securing wood supply agreements.

Timberland Ownership

Over the past several decades, most public, vertically integrated forest industry firms in the U.S. divested their timberlands. This includes household names such as International Paper (IP) and (now private) Georgia-Pacific, and firms that split manufacturing from timberlands, such as Rayonier (RYN) the REIT and Rayonier Advanced Materials (RYAM). Remaining public integrated firms include, for example, the timber REITs Weyerhaeuser (WY) and PotlatchDeltic (PCH), which own mills in taxable subsidiaries.

In the 1980s, the motivation to divest started when firms accumulated high levels of debt during a period of forest industry consolidation. In addition, tax disadvantages associated with C-corporate structures (which faced double-taxation issues), along with opportunities to develop land, encouraged alternative timberland ownership models. In sum, divesting timberlands provided a ready means to generate cash, pay down debt, and “unlock” shareholder value.[1]

The strategic question for wood-using firms was “are timberlands simply an owned source of raw material or do they represent a competitive advantage?” Previous research suggests clear benefits to owning timberland, but few are realized within a vertically integrated firm for wood procurement purposes. The primary economic benefits of timberlands ownership – from inflation hedging to diversification to wealth preservation – are best realized within an investment portfolio. Operationally, timber markets had become more liquid, allowing mills to meet most needs without “fee” ownership.

That said, timber markets are uniquely local; each situation differs. Forest ownership offers wood procurement managers opportunities to diversify and optimize a procurement strategy. The primary operating issue is the tradeoff between minimizing the cost of delivered raw material and maximizing control over the volume of supplies needed. For investors and executives, the question becomes “who is better positioned to optimally manage timberlands with respect to costs and returns?”

One thing is clear on this: taxes matter. The tax efficient structures of timber REITs and many TIMO clients provide advantages to certain forms over others. Financially, one can argue that timberlands should be owned in single-layer tax structures, without exception.

Wood Supply Agreements

A wood supply agreement is a contractual obligation by a supplier to provide agreed-to-volumes of wood to a buyer, who commits to buying this raw material at the contract price. Forest industry managers use supply agreements to (1) help manage the costs and volumes of wood raw materials needed at their plants and (2) to mitigate potential impacts on forestry and procurement operations from timberland ownership changes.

While wood supply agreements reduce uncertainty for buyers and sellers of logs and trees, our experience has been that they can be viewed at times as an inconvenience to timberland buyers and wood sellers. These supply agreements rarely lead to expected reductions in headcount, as both buyers and sellers retain forestry staff to supervise and confirm proper execution of existing agreements.

In supporting price mechanisms and arbitration proceedings in the past, we found that the following three criteria include the proper principles for wood or fiber supply agreements while maintaining the necessary operability for participants:

• Reflects market prices: wood prices flowing through any agreement should approximate “arms-length”, market-based prices. While the contract price may deviate from the market price at any given time, the prices paid by the buyer over time should minimize the perceived and actual missed opportunities of the seller bypassing other customers and markets.
• Easy to implement and to use: the approach should be easy to understand, easy to explain, and easy to use. Complex pricing mechanisms do not create value for business owners or investors.
• Retains flexibility: at times, the two parties may feel the pricing from the supply agreement requires an adjustment. Rather than disregard the model, an agreement should allow and encourage the parties to sit down and work things out through a “reset” or negotiated adjustment.

Conclusion

In theory, the most direct way to answer the timberland ownership question for a manufacturer is to measure the per-unit cost of growing timber, and then benchmark it against the price of open-market purchases of wood. The “cost” of growing timber would include cash expenses and the opportunity cost of the committed capital. In practice, this approach works better on the blackboard or in Excel.

In the current era, estimating the cost of acquiring timberland plus growing multiple forest products (pulpwood and grade) as compared to procuring (or selling) these products in the open market reflects a multi-dimensional, highly speculative, and head-splitting exercise. For a manufacturer, the priorities are sustainable, low delivered cost raw materials. As such, this often elevates the “cost-versus-control” question of focusing on approaches that secure volumes – whether through supply agreements or hiring more foresters or owning trucks or other components of the supply chain – rather than committing the type of capital required to acquire timberlands.

This post includes themes covered in the (virtual) “Timber Market Analysis” course on October 11^th and 12^th, whichwalks through a process to track and analyze the price, demand, supply, and competitive dynamics of local timber markets and wood baskets. Early registration ends September 27^th! For more information, click here.

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[1] Ironically, these divestitures resulted, at times, in a nostalgic view of former industrial owners from environmental and conservation groups, who expressed appreciation for the relative stability and their understanding of timberland stewardship.