Elie Rosenberg is a value investor based out of Dallas, Texas. He is the founder and editor of Value Slant
Paper pulp stocks have tanked in the last few months. With the pricing of their commodity products falling some of the stocks are off more than 50%. Although they are probably not out of the woods yet (pardon the pun), it might be worthwhile to take a look at the industry. I hope to provide a brief market overview in this post and then take a look at two pure play pulp stocks- Mercer International (MERC) and Canfor Pulp Products (CFX on the TSE, and CFPUF on the pink sheets)- that make NBSK (northern bleached softwood kraft pulp).
Here is a nice overview of the paper supply chain:
Market pulp makes up a relatively small portion of the material used in paper production, with most pulp coming from recycled products or in house in the case of vertically integrated paper producers. The two major types of market pulps are BHKP (bleached hardwood kraft pulp) and BSKP (bleached softwood kraft pulp). NBSK is the premium grade of BSKP and is produced mainly in Canada and Scandinavia.
In analyzing demand there are two issues to look at. One is the growth in the production of paper end products (printing and writing paper, tissue products, etc.) and the other is the mix of pulp types used. The overall picture is one of moderate demand growth. In developed countries, the production of writing and printing papers is slowing while tissue and specialty paper production is growing steadily. And in the emerging markets, especially China, paper production of all types is growing quickly with the rise in standard of living. As China has limited domestic forest resources (per capita forest stock volume is one sixth of the world average), it relies on imported pulp for a majority of its paper production. In 2011 China will account for 23% of world market pulp usage, up from 15% in 2005. Tissue and specialty paper production in China is expected to grow at a more than 10% rate for the foreseeable future.
BSKP is a stronger material than BHKP and generally commands a higher price. Paper producers prefer to use hardwood where they can to save on production costs, but there is a limit to how much they can substitute for softwood before degrading product quality and losing production efficiency. As paper machine technology and production speeds advance, fiber strength becomes more crucial to prevent tears and maintain machine uptime. Additionally, the strength of BSKP is needed as paper industry growth is skewed to lower basis weight products. Over the past 15 years producers have found ways to use an increasingly larger percentage of hardwood, but the substitution cycle is slowing. One possible indicator of this is the widening price spread between hardwood and softwood pulp (based on RISI data, chart from recent MERC presentation):
This forecast has market pulp demand for BKSP going from 22 million metric tons in 2010 to 26 million mt by 2014:
Supply is expected to be essentially flat for the next few years, as only one BSKP new build has been announced. This is in contrast to BHKP, where several million tons of new capacity is being added in the next few years (chart based on Terrachoice data, from MERC investor presentation):
There are several reasons for the divergence of BHKP and BSKP supply. One is that demand for BHKP is expected to grow faster than BSKP given the lower pricing on BHKP. The other is that the global stock of hardwood is double that of softwood, with softwood being concentrated in North America and Scandinavia. There is plenty of hardwood stock in Latin America and Southeast Asia where very low cost hardwood pulp plants are being built.
5.3 million mt of high cost NBSK capacity was shut from 06 to 09. Even with 1.9 million tons of capacity being restarted in the back half of 2009 and 2010, that leaves over 3 million tons that appears to be permanently shuttered. And by definition the restarted capacity is that of marginal players who will not be competitive as NBSK prices drop.
While the supply/demand fundamentals for NBSK appear decent, the short term picture is not as strong. The pulp markets are very sensitive to short term swings in the macro economy. Interestingly, pulp is the second most volatile commodity after oil as measured by standard deviation of market pricing. Oliver Landsdell, one of the leading industry consultants, has said macroeconomic issues cause two thirds of the swings in pulp market pricing, with specific industry supply/demand issues only causing one third of the pricing changes.
As you can see from the chart, NBSK pricing has been a roller coaster the past few years. Pricing collapsed in the second half of 2008. Producer inventories plummeted due to capacity shutdowns and production slowdowns. This led to extreme supply tightness when the economy started picking up in the second half of 2009. And the February 2010 earthquake in Chile further exacerbated the supply issues. Pricing hit a record this summer at over $1,000/mt for the benchmark European NBSK index, in part due to the dissolving pulp craze which diverted some NBSK supply, as well as a significant ramp up in new Asian paper capacity.
In the last three months the party has ended, with Europe NBSK dropping to $870/mt. The culprits appear to be the general jitters on the part of buyers due to the European debt scare and the Chinese government credit contraction in their attempt to control inflation. Producer supply is up to 34 days, well above the 30 day balanced level. Chinese buyers appear to have built inventory and are waiting for lower prices. Pulp producers will need to reduce inventories in the fourth quarter and they are selling into a weak demand environment. China pricing has fallen to $700/mt, or a 17% decline in just two months.
So, where does pricing go from here? Of course nobody knows, as even the industry experts are not very good at predicting pricing in such a volatile market. If the global economy crashes then so will NBSK, although there appears to be a floor around the $600/mt ton area as higher cost producers will just shut their plants down. And we know that the historical peak is around $1,000/mt. That doesn’t help much, but gives us a range to think about. The pulp markets are so volatile that there isn’t really a “normalized” price, but those bullish on the fundamental supply/demand dynamics will argue it is closer to $1,000 than $600. It will be interesting to see how long and how deep the current NBSK downturn will be. Barring a macro meltdown things might tick up as early as the spring as producers reduce their inventories. I think there might be an interesting opportunity to go long pulp in the near future and to that end will take a look at Mercer International (MERC) and Canfor Pulp Products (CFX) in the coming days.