Stormy Forecast for Paper Buyers

THERE’S NO sugar-coating it: the paper market is bleak for buyers. The problems lie in both price and availability, and the forecast has almost no bright spots. Here’s a look at how we got here, what you can do today to cope, and what trends may affect paper purchasing this year and beyond.

First, it’s easy to be puzzled about how the paper market could change so abruptly and intensely. Paper buyers have seen the dark clouds massing over the mills for years but little has come of it. Why is it actually raining now?

In the last five years, we’ve seen several mill closures. Tembec and UPM closed mills, and other mills shut down individual machines. NewPage is taking out 25,000 tons of capacity during downtime this summer, and permanently closing machines at the Niagara mill. The net effect is a drop of more than 20 percent of North American coated paper capacity.

When the first of these closures occurred, paper tightened a bit, but there always seemed to be another ready source.Now the industry has finally carried its capacity reduction to a point that supply is constrained, here and in Europe. It moved in what looked like baby steps, but in the end a real distance was crossed: depending on the specific stock, demand is very close to, or in excess of, supply.

Let’s look from the paper industry’s perspective for a moment. If you’ve watched the market through several cycles, you’ve probably noticed that the mills seem to have forgotten a little section of the Economics 101 textbook: commodities prices can rise when demand exceeds supply. Why, you might wonder, haven’t mills limited capacity like this sooner?

We’ll leave out some of the variables, but there are two key reasons why shutting down machines hasn’t been a shortcut to profitability. First, the enormous capital costs of paper making mean mills become profitable only when capacity utilization is extremely high. Roughly speaking, a mill might start turning a profit when it’s producing about 95 percent or more of all the paper it could possibly make. Notice the limited upside, as well as the long, brutal road to profitability. The gap between losing money and making money is very narrow.

The second reason mills tend not to adjust capacity tightly to demand is that there are two levels of competition for the U.S. paper dollar. Domestic mills battle each other, and then they balance foreign paper sources, with all the extra complications of currency exchange.

External Safety Valve Defunct

For the last several decades, whenever demand edged sharply above U.S. capacity, European and Canadian mills were a handy safety valve. Asian and South American sources have also appeared in the mix. For much of this time, the dollar’s strength has made exporters keen to court the large market in this country.

We’ve all but lost this safety valve against supply/demand tension now that the exchange rate is so poor. A Finnish mill would very much prefer to sell paper to Germans, in euros, than to Americans.

Then again, what’s a “Finnish mill” these days? The paper industry is consolidating into international entities. But that doesn’t provide any relief under our current conditions. In fact, the consolidation is not merely a compression of sources, but a new style of ownership.

Five companies—NewPage, Verso, Catalyst, Pine Bluff and West Linn—are now owned by private equity concerns. Add up the volume these mills represent, and you’ll find that private equity controls about two-thirds of the coated groundwood market in North America, and nearly 60 percent of the coated freesheet.

These companies are playing by new management rules. They want a prompt return on investment and, presumably, they want to sell the underlying assets as soon as they’re sufficiently buffed up. Perhaps an industry that’s struggled for so long to scratch towards decent margins should be shaken up. But it’s fair to say that the new trends in management, which may spill over to publicly traded mills, are not designed to ease the buyer’s sufferings. If a price increase can be supported, a price increase will be made.

So that’s how we got here: reduced supply, falling dollar, private equity ownership. These conditions justified price increases, and mills have demanded them. Are they happy yet? Not really. Despite the 2007 round of price hikes, increases in the direct costs of paper making have munched up much of the revenue. Fuel oil, which affects both papermaking and shipping, is the main villain, but raw materials have also been increasing. In short, if the market can support further price increases, they’re on the way. Increases of $50 to $60 per ton have been announced for July. It will be tough for mills to get the full amount with demand weakening, but some of the price hikes may stick. Expect about a $30/ton uptick when the dust settles.

What’s The Buyer To Do?

The paper buyer is left without many tactics. In broad terms, the only force that can mitigate the current paper price increases is a drop in demand still greater than the so-so to negative growth we’ve been seeing in the magazine and catalog market. Of course, there’s a death wish wrapped inside any hope for falling consumption—printing impressions are down too.

Let’s crack out the emergency flotation devices, then. To fight the impact of price increases, you can reduce basis weight, trim size, paper grade, or, of course, pages. Cutting basis weight will work fine, provided your new weight is available. Because we’re struggling with both price increases and supply shortages, check the practicality of your new spec before celebrating. Plenty of mills have basis weight preferences.

A trim size cut is trauma for the design team, but roll size or sheet size adjustments can be implemented quickly. Sheetfed projects are elastic in both trim dimensions, but web cutoffs limit you to one. In all cases, beware of underutilizing equipment or scheduling inefficient plant loads to scrimp on paper.

Changing paper grade can save a great deal, as long as it doesn’t require throwing the baby out with the bath water by harming your end product. If you’re already on grade 5, the next train leaving the station is supercalendered stock. With the closure of the 180,000-ton Katahdin SC mill in Maine announced for July, downgrading will be difficult. In fact, with any grade change you may face supply problems when adjusting your allocation.

Despite the caveats, all three of these adjustments are smart techniques for controlling costs today. Make sure they suit your product and your audience, and get your paper supplier to help carry them to fruition.

The other key concern is guarding your ongoing paper supply. It’s safe to say that mills have taken on a make-my-day demeanor—if you fight too hard for better prices and terms, the mill doesn’t mind an excuse to cut your allocation. Tread cautiously.

As business practices become increasingly hard-nosed, it’s almost quaint to imagine that business relationships still matter. Private equity owners are ready to be just as cutthroat as you are, so good old relationships don’t count for as much as they used to. But with the magnitude of supply cuts now and in the immediate future, a good connection with a mill or broker is one of the few shelters in this storm.

The dollar is almost certainly going to continue its swoon, so don’t look for much help from Europe. Asia, however, appears to be another matter. The currency problem is just as nasty against the yuan, but China and Indonesia have shown a strong interest in cracking our mighty market.

Will shipping Chinese paper across an ocean and half a continent fix things? Not so fast. The price of pulp is higher in Asia, where fiber sources include imported pulp. Asian mills began introducing their wares at startlingly low prices, but have steadily edged upward. The currency exchange problem and the threat of a future tariff all suggest that Asian papers will not radically alter our paper landscape.

Our ace in the hole, sad to say, is a continued drop in demand that forces mills to choose between cutting still more capacity and selling at prices more favorable to buyers. Needless to say, a drop in demand comes along with a lot of other depressing baggage, including the sight of printers falling by the wayside. But those who remain strong may be able to reap benefits. In other words, the publishing market may experience its own shakeout, courtesy of rising paper prices—and let’s not forget the hike in distribution costs that completes the one-two punch.

The big question is not how much mills may raise prices, but how gradually. If private equity thinking leads the way, we may see a steep curve upward, sharp enough to kick buyers out of the market, or constrain growth. The resulting drop in demand could hurt the mills. If mills take it slowly, they might end up with both profits and customers.

Prepare for more increases this year, inventory your specifications to see if you can change what you buy, and pay attention to your supplier relationships to keep the paper flowing. These are challenging times, but smart paper buyers will survive them. IPG

Alex Brown is a consultant to magazine pulishers specializing in manufacturing and magazine management. She founded her consulting company, Printmark, in 1984, and is a frequent speaker at industry events.