This post includes themes and topics that will be addressed in the (virtual) Applied Forest Finance course on March 14^th, 2024.

In graduate school, I conducted research on managing risk in forestry, which included the use of financial contracts, operational hedges, and “options” for timberland investors and forest owners.

Options? Yes, some view forest management as valuing and choosing between a series of real options. Research by leading forest investment professionals and economists Chris Zinkhan (1995), Andrew Plantinga (1998), and David Newman (2002) addressed versions of this theme, which focused on the traditional forest management problem of identifying the optimal forest rotation, and applied real options theory.^[1] Real option theory addresses limitations with net present value (NPV), which does not account for flexibility, volatility, and contingency with potential forestry investments.

Flexibility. Volatility. Contingency. What do these mean in the context of forestry? Flexibility refers to the manager’s ability to defer, abandon, expand or reduce an investment due to new information or investment opportunities.  Volatility references changing market conditions – particularly changing timber prices – or new technologies that can alter the attractiveness of potential investments. Contingency refers to situations where future investments depend on investments made today. Presumably, these options provide value and should be accounted for, or at least considered.

In practice, not all investors have the same levels of flexibility, exposure to volatility, or concerns about contingency. In many cases, NPV analysis, which views decisions as fixed, is sufficient for making decisions. This makes real options analysis a whiteboard discussion for comparing and discussing a dynamic view of future choices for strategic planning.

Stand and forest level analysis centers on determining optimal silvicultural treatments and timber rotations, while accounting for product price risk and other uncertainties. Faustmann, through his work in 1849, established that forestry has perspectives on financial risk and opportunity cost.

Conclusion

At a certain level, forestry managers and timberland investors manage risk instinctively. This occurs through the normal calculus of assessing the risks and rewards associated with silvicultural treatments and timber sales. Forest resource and industry professionals identify, assess, and manage the risk and uncertainty encountered by their operational activities in business environments subject to financial risks emanating from outside of the forestry sector.

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[1] Zinkhan, F.C. 1995. The management of options and values. Journal of Forestry. January 1995: 25-29; Plantinga, A.J. 1998. The optimal timber rotation: an option value approach. Forest Science 44(2): 192-202; Newman, David H. 2002. Forestry’s golden rule and the development of the optimal forest rotation literature, Journal of Forest Economics 8(1): 5-27.