Pulp and Paper Canada

News
State of the Industry


April 1, 2008
By Pulp & Paper Canada

It is no longer relevant to discuss the light at the end of the tunnel. While perhaps a mere matter of semantics, it may be more appropriate to instead address the speed at which we are moving through…

It is no longer relevant to discuss the light at the end of the tunnel. While perhaps a mere matter of semantics, it may be more appropriate to instead address the speed at which we are moving through the proverbial passageway, and what Canada’s pulp, paper and forest market might look like when we emerge, weathered, worn and weary, yet hopefully transformed, educated and enlightened.

What characterizes this particular journey is the lack of knowledge about the destination. Once the cutbacks and setbacks, the mergers and consolidation give way to stabilization, where will Canada’s industry be? What will our sector’s role be in a market whose playing field was leveled by new challenges and competitors?

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“The industry in Canada is going through a period of tremendous transformation,” notes Craig Campbell, incorpo- rated partner in the advisory services practice of PricewaterhouseCoopers LLP. “We’re seeing product moving to emerging markets, downsizing, chal- lenges with rising costs, challenges associated with fibre pricing and supply security, as well as increasing fuel and transportation costs. We are in the midst of the biggest transformation this industry has ever gone through.”

These difficulties are compounded by lower-cost structures in competitor countries which enjoy the additional benefit of fast-growing fibre sources. Figures for 2007, when released, are expected to be, “a notch or two below those for 2006,” as Campbell notes.

In terms of investment, the numbers fare no better. While there is some movement anticipated in energy systems, the flow of capital to large upgrade projects remains but a trickle. “We aren’t seeing any investment in the sector in Canada,” Campbell confirms. “Most of it is in pellets, or bio-energy. There are small, focused projects in these areas, such as the one shared by Nexterra and Tolko, but there is simply no business case to invest right now.”

The hostile investment environment in Canada invites mills to direct restricted capital to repair and maintenance projects but does not support any kind of expansion: Unless, as Campbell notes, expansion projects are undertaken south of the border in areas with more favourable cost structures. “We should be looking into Brazil,” he notes. “There is a much different operating environment in that part of the world, and the only pulp, paper and forestry companies that are doing comparatively well at the moment are those and their shareholders, who have gone in.”

Of course, shuttering up Canadian assets and setting up shop in South or Latin America poses a host of challenges, not the least being shareholder resistance. While a somewhat utopian scenario for corporate bottom lines, Campbell acknowledges that such geographical shifts aren’t solely “as easy as redirecting capital.”

Investment vs. Depreciation

According to Statistics Canada, Canada’s forest industry invested a substantial $3.1 billion in 2007 -a heady figure by any account. However, such numbers must be considered in context of the depreciation of the sector’s assets, which continue a downward trajectory. In 2007, the industry’s assets depreciated in value by $4.3 billion, a marginally better ratio than that for 2006, where $3 billion was invested, and depreciation was $4.5 billion. See Fig. 1. This characterizes the constricting nature of the industry, as our inability to invest in the latest technology continues to exert downward pressure on the overall operating environment, and bolsters the comparative competitive advantage of offshore companies.

Instead of focusing on the need to effectively catch or keep up with our adversaries, it is, as Campbell highlights, a more constructive objective to stabilize the industry’s contraction: “We need to slow it down. There are too many advantages in other parts of the world, and so we need to adopt progressive government policy that will attract investment. We need to invest in our people.”

Unfortunately, the biggest obstacle to repositioning our industry competitively is one over which we have no control -the Canadian dollar. “It remains the biggest impact,” Campbell confirms. “Every cent the dollar appreciates knocks off $500 million in revenue.” What would be an ideal resting spot for the loonie? “Forty-five cents would be ideal,” Campbell says, tongue in cheek. “Realistically? Within the range of US$0.85. We need to remember that a ten-cent drop would imply an extra $5 billion worth of revenue.”

Canada’s Competitive Advantage

Irrespective of its challenges, Canada does have some strong advantages, which are not necessarily modest in nature. “Three words,” says Nancy Oleweiler, professor of economics and director of Public Policy program at Simon Fraser University in Vancouver: “Stable, secure government.

“While South and Latin America have fast-growing trees, they also have unstable governments, and environmental challenges,” continues Oleweiler. “While in some ways, they are the ‘Canada’ of 30 years ago, they’re on a roll and in 20 years they might be where we are now. In those 20 years, we in Canada can grow whole new forests. The smart investor will look to the future instead of the past. The smart investor will look at our investment environment and realize that it offers secure opportunities.”

Avrim Lazar, chief executive of the Forest Products Association of Canada, agrees. While he notes the comparative advantage of our competitors in certain areas such as fast-growing fibre sources and lower labour costs, the benefits of investing in countries such as Canada that are characterized by stability, such benefits cannot be negated. “Our competitors are indeed happy to see our difficulties, but there is no way they’ll be able to supply global demand.”

Further, as global food demand increases, forestry production in places such as Brazil, China and India will ultimately slow, as pressures to employ land for food-growing purposes increase. “People won’t simply want more food, they’ll want better food,” Lazar says. “Demand for protein sources will increase, which will impose land-use constraints. While we can’t compete solely by improving our productivity and we certainly can’t compete with fast-growing fibre, economics will dictate that land in other parts of the world is used for food production. It will make more sense to invest in areas where there is land available for the extensive growth of trees. As a result, we see the medium to long-term picture as being quite positive.”

PricewaterhouseCoopers’ Craig Campbell agrees that Canada does have a levy in certain areas, and our fibre source is indeed one of them. “There is demand for Northern Bleached Softwood Kraft, and on the lumber side, BC mills in the interior will be well positioned when that demand picks up.” In terms of niche markets, Campbell sees a role for Canada in bio-energy as well. British Columbia’s recent announcement of a carbon tax could create new opportunities for energy markets, and pulp and paper mills will have an incentive to produce it and sell the excess back to the grid.

Challenges and Solutions

No one could reasonably contest the extreme difficulties the industry is experiencing. How we arrived at our current condition is a matter of some debate, however.

Professor Oleweiler says many contributing factors played a role. “The private sector’s management planning for long-term sustainability has never been perfect, but government policy hasn’t always helped either.” She points to the multitude of Royal Commissions that have been established over the years to study the forestry industry; the inconsistent policies that resulted have not helped to position the industry favourably. Parallels can be drawn with the Canadian automotive sector. Not having access to larger capital markets, expertise and the latest technology, combined
with an industry push to streamline, has left Canada producing gas-guzzling cars that do not typically sell well on the market, and as a result, profits evaporate.

A similar scenario has played out in the pulp and paper industry, where many small and inefficient firms that had been isolated from an undervalued Canadian dollar, are now suffering the ramifications of a lack of investment in the latest technology, as well as management issues and a robust currency. “The exchange rate has hit the industry hard,” Oleweiler acknowledges. “Where we didn’t have to pay as much attention to cost margins in the past, now we absolutely do.”

The insatiable mountain pine beetle remains a challenge as well, particularly in the areas of BC and Alberta, a difficulty that fits neatly under the looming umbrella of global warming. “Every time I talk to people who don’t understand the issue of climate change, I tell them to look at a photograph of BC’s forests,” says Oleweiler. “The damage caused by the mountain pine beetle is testament enough.” As well, the effects of climate change in the form of ravaging forest fires, droughts and foreign species all take an extreme toll on our industry.

Adapting to climate change and working towards environmental sustainability is crucial for any company seeking to build corporate staying power. Research indicates that Canada’s pulp and paper industry recognizes this, and is acting. A recent report compiled by PricewaterhouseCoopers on paper, packaging and forestry CEO perspectives on the industry noted: “Many executives recognize that climate change will simultaneously enable the industry to leverage its existing assets and sustainable forest management skills more effectively.”

Another factor to be considered, notes Oleweiler, is the response of large markets to our product. The

U. S./Canada softwood-lumber dispute serves as a prime example of the operative constraints Canada must work within. While the mountain pine beetle was considered by some in the industry as a window of opportunity in light of the increased access to fibre it provided, our neighbours to the south once again started to rattle their sabers at the possibility that Canada could be sending fibre killed by the mountain pine beetle beyond our borders. What is a positive event for Canada, as Professor Oleweiler notes, “causes some markets to say: ‘Well hold on, now.’ It’s a constant threat to the industry.”

In order for the sector to reposition competitively, Oleweiler would argue for a big adjustment on behalf of the industry, in the form of either implementing wage cuts or layoffs. Despite the inherent difficulties attached to either of these scenarios, she argues for a collective approach to responsibility for the industry’s current state, and the solution: “The worst thing you can do in a bad time is retrench. We should be preparing for the future. We need to make investments as an industry so that when the market is ready, we’re ready. The groundwork has already been laid. The sunk costs in terms of large capital assets have already been made.”

With respect to shareholder resistance to capital investments when quarterly and annual losses reach continual new lows, Oleweiler offers a proactive solution: “Get your message out there. Get into the media. Start talking about your industry. Do people who hold assets panic when an industry takes a downturn? Yes. But we need to remember that the biggest shareholders are not Tom and Mary; they are large entities. So spend time talking to brokerage firms, spend time talking to your trade publications. Get them to know your industry and what you’re doing.”

It cannot be contested that Canada’s pulp, paper and forest industry is confined by a number of prohibitive factors. However, as Oleweiler argues, emphasis on our comparative advantages is what will propel us forward and upward.

“We have the infrastructure, an educated and qualified workforce. We have transportation to bring our product to market. We have the physical capacity. What we need is to look ahead. I think there’s a bit of an identity crisis in this country, at times. But we need to remember that all of the things that made Canada’s industry so good 30 years ago, they are, in large part, still here.”

PPC

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“Our competitors are indeed happy to see our difficulties, but there is no way they’ll be able to supply global demand.”

-Avrim Lazar

———Federal Budget 2008: What’s in it for us?

The Federal Budget was released at the end of February. While it fell short of many objectives the industry wants to pursue, it does seek to remedy some of the challenges plaguing the sector through tax incentives, investment in research, and a focus on clean energy.

• The Federal corporate income tax rate to be cut to 15% by 2012 from the current rate of 22.1%

• Extending the accelerated capital cost allowance (CCA) treatment for investment in machinery and equipment for three years

• $10 million over the next two years to Natural Resources Canada to promote Canada’s forestry sector in international markets as a model of environmental innovation and sustainability

• $10 million for research in bio-fuels

• Expanded tax incentives for clean-energy generation

• $66 million to help regulate industrial air contaminants

• Improvements made to the scientific research and experimental development tax incentive program

• Accelerated capital cost allowance (ACCA) and GST relief for renewable generation

• $21 million for more research chairs for science

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“The worst thing you can do in a bad time is retrench. We should be preparing for the future. We need to make investments …”

-Nancy Oleweiler

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Making a Case for Capital

Building a case for capital expenditure in Canada’s pulp, paper and forestry industry poses numerous challenges for companies looking to invest. Shareholder resistance, a low return on capital employed and a lack of funds make it extremely difficult for facilities to invest beyond small, necessary maintenance projects. The recent project announced by Catalyst Paper illustrates the complexities associated with moving even relatively low capital projects forward.

In February, Catalyst Paper confirmed plans for a $12-million capital upgrade and the restart by mid-year of PM4 at the Port Alberni facility. The undertaking represents a substantial portion of the budgeted $35 million the company will spend in 2008. The approval of the upgrade project came on the heels of months of discussions with community and union leaders on what was required to improve the mill’s competitive position.

As Lyn Brown, vice president corporate relations and social responsibility for Catalyst, noted: “What’s commendable is that three inter-related factors had to be addressed to reduce mill costs at Port Alberni. The two union locals reached agreements that put modern work practices into place, the municipality took action to begin reducing mill property tax rates and the company committed capital for thermo-mechanical pulp capacity. The result in this case, will return the mill to a two-machine operation with a significantly improved cost structure.”


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