In This Issue

• Clarky's Comment
• Big Challenges Getting East Coast Logs to Market
• International Emissions Reduction Target Setting - Post CP1 Kyoto
• Can an Understanding of the Global Commodity Market and International Trends Assist us in Timing our Harvesting Better?
• PF Olsen Nursery Wins Innovation Award
• Log Market
• Recent Large Sale of AAUs

Clarky's Comment

Plantation Forests and the Environmental Benefits They Provide Should Not be Treated as a Public Good to be Nationalised

The NZ Government has been grappling with a fine balancing act. How do we portray New Zealand as a responsible global citizen, but also protect jobs, trade-exposed industries and agriculture from the full impact of the international price of greenhouse gas emissions, at least for a period until we get a level playing field with other nations?

While a temporary cap on the price industry must pay for its emissions above a particular base allocation may be appropriate, attempts to restrict the sale or cap the price that forest owners will receive for forestry credits is not. These two ideas need to be de-coupled now. The reason is simple but compelling. It is all about trust in government.

Forestry investment is a long-term game, and because of that has plenty of risks attached to it. Investors can live with, and to some extent manage, the biological, fire, wind and technical risk. What they cannot manage is governments treating plantation forests and the environmental benefits they provide as a public good to be nationalised.

There is evidence of this behaviour in New Zealand already with the allocation of nitrogen pollution rights around Lake Taupo and the Rotorua lakes. In effect the unequal treatment of land uses is like the Resource Management Act polluter-pays-principle working in reverse. The environmental good guys get to pay (through reduced land value) so that the polluters can continue to pollute! The deforestation carbon liability in the Emissions Trading Scheme, without full compensation for loss of land value, is another example.

Talk of a "temporary" price cap or any restriction on export of NZUs (by further restricting the conversion to AAUs - see Recent Large Sale of AAUs) leaves forestry investors very nervous about how much we can trust this, or future governments, not to interfere with plantation forestry harvesting in the future - or what "temporary" really means if the going gets tough for NZ Inc.

Forest investors need to be able to trust governments not to behave in this way. Investment will flow to where the trust is greatest.

New Zealand needs new forests, and lots of them, to help meet even modest national net emissions targets. We can get these forests either by the taxpayer funding the planting and maintenance, or by setting up the right investment environment for private sector investment. In my view the latter will result in lower total costs to the taxpayer and better risk management in the long-term.

The government has every right to phase-in the impact of climate change policy at a rate that minimises overall damage to the economy. However any shielding of "at risk" sectors must be underwritten by the total taxpayer base, not by the forest industry.

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Big Challenges Getting East Coast Logs to Market

The East Coast region of the north island has large areas of forest resource nearing harvesting age.

Wood availability forecasts by the Ministry of Agriculture and Forestry show harvesting levels increasing from the present 1.2 million m³ per annum to in excess of 3.0 million m³ per annum over the next decade.

A sustainable harvesting programme of approximately 3.4 million m³ per annum for a period of 15 years from 2020 has been modelled as one possible scenario.

The wood is here, and represents a great opportunity for forest owners and the region.

BUT

To maximise the benefits of the region's forest resource a number of important issues must be addressed now!

These include:

• Developing adequate port and log storage facilities.
• Investment in roading infrastructure.
• Investment in domestic processing.
• Commitment from local government to support and promote the forest industry.
• Improving export returns.

Eastland Port Ltd

Eastland Port has recently enjoyed a number of record months with log exports exceeding 80,000 tonnes per month. While this is excellent for the port and district, port facilities as they stand are inadequate for the expected ramp up in harvesting volume.

This isn't to say there hasn't been work done already. Recent port investment includes:

• The new Hirini Street bypass diverts traffic away from port operations, adding log storage and improving safety.
• Upgrade of the port dredge.
• Purchase of bookends to improve log storage by allowing higher stacking.
• Installation of debarking plant and anti-sap-stain facility.
• Increasing the log storage area by removing buildings and Caltex tanks.
• New weighbridge and gantry facilities.

These investments by Eastland Port have been beneficial to the industry but further investment is imperative to meet future requirement of the industry for both log exports and processed wood.

Other initiatives the port has planned over the medium to longer term include -

Medium Term Investment

• Development of lower log yard to yield 8,000m³ storage.
• Development of upper log yard to yield 15,000m³ storage.
• Ongoing sealing of log yards enabling higher stacking of logs.
• Development of three hectares of off-port log storage.
• New log scaling station with three scaling bays.
• New port entry and exit to improve internal traffic flows.
• Channel dredging to 10.5 metres to allow full vessel loading.

Longer Term Investment

• Development of two log ship berths.
• Increased tug power.
• Potential four hectare reclamation.

One issue for Eastland Port is the volatile nature of the log export trade. They are reluctant to invest in new facilities if they might sit idle for long periods. On the other hand, these are not quick-fix solutions and you can't wait to the last minute to implement them. One of PF Olsen's roles is to ensure effective lobbying for sufficient investment to allow efficient export operations to be carried out.

The forest industry believes that reclamation will be required to handle the increased volumes. Off-port log storage is expensive costing $7.50 more per tonne than storing logs directly at port. The cost/benefit of enhancing off-port storage versus reclamation needs to be re-examined, as does the ridiculously high cost associated with consents for reclamation.

Roading Infrastructure

The Regional Roading Fund from central government has been a tremendous boost for the district. Many of the key harvesting routes have been upgraded to allow safe transporting of logs to markets and Gisborne port. There are still a number of road projects and bridge upgrades to complete with the remaining funding expected to cover most of the required work. Ongoing maintenance of these roads is important and is the responsibility of local government. This was one of the requirements for the regional road funding to be granted.

Investment in Domestic Processing and Local Government Support

As PF Olsen frequently advocates, a stronger domestic log processing sector for the Gisborne/East Coast region (and NZ generally) is very desirable. Prime Sawmills has significantly reduced its operation in Gisborne largely due to the strong NZ dollar reducing export returns along with weak market demand for product. Hikurangi Forest Farms is still progressing with their large mill facility to be commissioned in 2011. This mill will take 900,000 tonnes annual log input when fully developed which is a significant proportion of the district's harvest.

As the wood flows increase from the region, there will be greater opportunities for new investment in processing. The ramp up in wood flow comes mainly from smaller forest owners.

Wood flows from Juken Nissho, Hikurangi Forest Farms and Ernslaw One are relatively static. Significant increased harvest from PF Olsen clients, forest investment companies and syndicates including Forest Enterprises Ltd and Roger Dickie will occur over the next decade.

This wood will be available to supply and attract new processing. Local government and Eastland Infrastructure Ltd must ensure that infrastructure such as power and industrial zoned land is available for potential investors.

Long-term council plans should continue to recognise the importance of forestry for the region and implement planning to welcome and assist new investment. PF Olsen continues to work with potential processors looking to establish new mills in New Zealand. In addition to viable projects, would-be NZ-based processors are also looking for receptive communities in which to invest. PF Olsen will continue to promote the East Coast as an area of huge potential given the rapidly increasing wood resource.

Improving Export Returns

Gisborne forest owners are very reliant on export markets. The East Coast region currently has limited domestic log processing; much less than its neighbouring Central North Island region. Hikurangi Forest Farms is building a large scale facility and Juken NZ has an established and well-run mill producing plywood, laminated veneer and sawn products. As mentioned above Prime Sawmills is struggling. All these operators do, or will, largely use their own resource to supply logs to their mills so the increased wood flows will still require exporting should further domestic processing not occur.

Log export prices are highly sensitive to the NZ$ exchange rate and ocean freight costs. There are no easy solutions to these price drivers. PF Olsen's strategy is to choose reliable and efficient export sales channels that can minimise the negative impact of adverse movements in currency and ocean freight rates, and to have an unrelenting focus on developing more efficient supply chains from forest to market. Lobbying for better forestry servicing infrastructure is a critical aspect of this role.

The argument is advanced that a volatile currency is a product of a small and open economy and cannot be subject to any controls. However, the reality is that the volatility in the currency is not caused by trade, but driven by speculative and short term movements of capital from off-shore investors and hedge funds. These forces were not at play at the time the NZ economy was opened up.

If you accept that a less volatile currency is in the interests of the NZ economy then the issue for the government is how to achieve this. If this can be achieved the export sector will have a much sounder basis for investment and growth. If not, and we continue to be subject to a wildly fluctuating currency, then the inevitable outcome for forestry will be continued wide swings in activity levels and required harvesting infrastructure (road, port facilities and logging and log transport contractors) and the high associated individual and societal cost. It also means that the quality and availability of harvesting infrastructure will be severely constrained when the wood flows need to increase.

Ocean freight rates have also fluctuated widely based on supply/demand balances. Very high freight rates last year were caused by unprecedented demand for shipping from China, a lack of new ship builds and an ageing fleet. Freight rates plummeted in early 2009, a result of the global recession and to a lesser degree some new ships entering the market. However, at the same time, export log prices in Asia plummeted, muting NZ at-wharf-gate price rises. In recent times ocean freight rates started increasing and they remain volatile.

Cooperation with shipping amongst NZ exporters can help manage costs but in addition, NZ Radiata pine needs to be aggressively marketed in Asia and its features of affordability, ability to treat, machine-ability and high strength-to-weight ratio aggressively marketed. There is a unique opportunity to grow significant market share for Radiata pine as the traditional log supply areas (Russia, SE Asian, N America) become less competitive.

Summary

The East Coast region provides a great opportunity for the forest industry and community. There is a great deal of work to do to ensure that these opportunities are maximised. The Eastland Wood Council and individual forest companies are addressing industry issues but require the continued support of local and central government.

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International Emissions Reduction Target Setting - Post CP1 Kyoto

Delays in outcomes from the current review of the NZ Emission Trading Scheme are related to the process of setting internationally-recognised new emissions reductions targets (post CP1 Kyoto). Review outcomes are now not expected until late August.

In early July world leaders at the G8 meeting in Italy agreed that green house gas emissions should be cut by 80% by mid century and the rise in global temperature should be kept below 2 degrees Celsius. However, when the world's 17 biggest emitters met after the G8 meeting, they were still unable to agree on specific targets, time-lines and burden sharing.

The burden sharing issue is both amongst developed countries and between developed and developing countries.

On one hand some of NZ's largest business and industry lobbies are calling for NZ to set a low level of emissions cuts to be achieved by 2020. On the other hand, NGOs such as Oxfam and Greenpeace are calling for much larger cuts. Scientists at the UN Intergovernmental Panel on Climate Change have said that developed countries must cut their total emissions by 25-40% below 1990 levels by 2020 if the world is to meet a target of limiting global warming to 2 degrees Celsius. Recently the NZ government announced an emissions reduction target of 10-20% below 1990 emissions by 2020.

So far, 27 European nations have set an emissions cut target of 30% below 1990 levels by 2020 if UN negotiations lead to a strong, global climate treaty. Australia has promised to cut emissions by 25% below 2000 levels if UN talks are successful, but reduce this to only 5% if post a CP1 Kyoto Protocol fails to produce significant reduction targets from others.

Within this context, New Zealand is presently over 20% above 1990 emissions when the CP1 target is to be equal to 1990 emissions by the end of 2012.

So its easy to see (although not necessarily acceptable) that NZ domestic policy and legislation is being further delayed by the international context. Therefore the period of uncertainty is prolonged, and in most instances, people will have to sit on their hands and await developments.

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Can an Understanding of the Global Commodity Market and International Trends Assist us in Timing our Harvesting Better?

From time to time, when clients are searching for the elusive answer to what is the best time to harvest, we get into some pretty detailed discussions about global trade, commodities and economic cycles. For those of you interested in such matters, we are going to venture (briefly) into this esoteric world and see what wisdom we glean to make us better decision-makers.

Let's look at how closely timber prices (represented by US D fir log exports) are correlated to the price of another widely traded global commodity - metals. The first thing we note is a lack of correlation between metal prices and D fir log export prices - see chart below.

1. From July 1988 to July 2000, there are predominantly strong negative correlations.
2. From August 2000 to August 2005, there are predominantly positive correlations.
3. Very mixed correlations from August 2005 to July 2009, and high volatility.

The negative correlations shown above are also exhibited in the value of timberland. Timberland assets are sometimes sought after as part of a balanced portfolio because they exhibit this negative correlation to the market (and lower volatility). They can increase the returns on a portfolio without increasing its risk (beta). Whilst this can be observed empirically, explaining this phenomenon is more difficult.

However, causal factors are believed to include:

• The biological growth of forests means that the opportunity cost of holding forests during periods of weaker prices is lower than holding (dead) assets such as metals.
• The period of time from inventory to market is (usually) relatively short (mature standing forests, compared to delineated mineral resources - "pounds in the ground").
• Market segment affect: a significant amount of logs and log residues are used in pulp and paper manufacture. Pulp and paper up-cycles can drive higher harvesting levels, increasing supply of saw logs (weakening saw log prices) but overall returns from harvesting are balanced by the higher pulp log and residue prices. The reverse happens during economic downturns.
• At higher prices, timber is highly prone to substitution from metals (principally steel and aluminium), concrete and plastics/synthetics. This limits price elasticity.

Having said that, log prices in New Zealand, exhibit much more volatility. This is due to:

• Strong (and increasing) reliance on the export log market - see chart below.
• High volatility in NZD:USD exchange rate.
• High volatility in Ocean Freight rates.

The chart below shows why the export log market is important and why it will increase in importance. The only option for the increased harvest will be to export the logs.

Note: At present there is little evidence that the even modest forecast of increased domestic consumption assumed in this chart will eventuate.

The increase in log availability is much more pronounced in some regions (see chart below reproduced from the article above). Northland, Gisborne and the Southern North Island, for example, will experience significant increases in log availability in relatively short time-frames. There regions also have particularly challenging harvesting contractor availability and log handling and log storage constraints even with present harvesting volumes.

Wood Availability Forecast from Ministry of Agriculture and Forestry for Period 2007 to 2049 - East Coast Region.

The chart below, courtesy of Agrifax, demonstrates the volatility in price of an industrial export log (KI grade). Due to the above factors, this volatility is typical of all NZ export log prices.

New Zealand also hits capacity constraints quickly in a market upturn. During the infamous price spike of 1993 (seen above in the D fir chart, and experienced in an even more pronounced way in New Zealand), harvest volumes increased relatively little, despite prices soaring. The main capacity constraints are:

• Availability of Harvest-Ready forests - lead times to harvest are increasing as we are moving into more remote hilly country.
• Availability of harvesting contractors.
• Availability of trucks and drivers.
• Availability of port infrastructure, especially low-cost log storage.

Summary and Conclusion

• Studying global trends in commodities is interesting but forecasts based on past performance are unreliable. The international log and timberland market is often negatively correlated to other commodities and economic cycles.
• International experiences and trends do not necessarily apply to New Zealand forestry and harvesting and marketing.
• New Zealand has some unique features such as higher log market volatility and production capacity constraints.
• Whether large or small, forests that are Harvest-Ready will be in a stronger position to maximise returns:
  • If large, at least start harvesting during an uptrend; engage capable and experienced harvesting contractors (a big determinant of returns) and have the option of suspending harvesting if a pronounced downturn occurs.
  • If small, start and perhaps complete harvesting during an uptrend with a capable and experienced harvesting contractor.
  • Near-mature forests on PF Olsen's books enables us to get ahead with critical harvest planning and better provide infrastructure such as contractors and log handling facilities at ports. It also assists us in developing markets for the logs.

Being Harvest-Ready is a means of increasing the liquidity of your forest asset and making the decision to harvest concurrent with the ability to harvest. If you would like to find out more about getting your forest Harvest-Ready please contact your local PF Olsen representative, or call us on FREEPHONE 0508 PFOLSEN (736 5736) or email us at info@pfolsen.com or visit our website www.pfolsen.com.

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PF Olsen Nursery Wins Innovation Award

PF Olsen picked up the Innovation of the Year Award at the recent Nursery and Growers Association Annual conference in Palmerston North. The award was for the design, construction and application of a new machine to top containerised Radiata pine tree-stocks growing in our nursery at Waiuku.

The master-mind behind the innovation is Kevin Haine, PF Olsen Nursery Manager, and it's a great acknowledgement of the good old NZ #8 wire mentality. Kevin utilised equipment and materials that were readily at hand which meant he didn't need to invest large amounts of capital to get a great result.

"This approach is tending to be lost with the new generation as kids become less hands-on and physical, and more into the virtual and digital worlds of mobile phones, laptops and computer games. It is this sort of capability which is an important part of being a Kiwi", points out Kevin, "It sets us apart and gives us a real competitive advantage."

The innovation is an over-grown lawn mower that is suspended above the rows of tree-stocks on a 12 meter beam. Its wide cutting swathe means it can top many rows of tree-stocks in a single pass along the rails on which it travels.

This new machine has reduced the time it takes to top the tree-stocks from 50 hours to less than one hour, meaning topping can occur more often, resulting in higher crop yields, lower disease levels and higher quality tree-stocks. On top of all that, it is expected that costs will be lowered by around $50,000 per year.

Kevin comes from a do-it-yourself family and credits his dad for encouraging him to create, fix and modify things. Congratulations Kevin, we are sure your dad would be proud of what you have achieved, and PF Olsen is certainly appreciative of your application of simple, but highly effective innovation.

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Log Market

Domestic Market

The announced closure of Prime Sawmills in Gisborne was another blow for domestic processing and particularly serious for the East Coast region which has limited processing capacity as it is. Within a week, however, there was a further announcement that the operation would continue, albeit, at a much lower level of activity.

Otherwise, the domestic market has been stable with prices remaining largely unchanged overall. High export demand for logs and wet winter conditions is keeping the volume of domestic logs subdued but generally balanced with demand.

The Crows Lumber and Panel Price Indices crept up over the past month in conjunction with the improved outlook for the US economy, but are still 17% and 12% (respectively) off their values this time last year. The Radiata market in the US is described as "firm at low levels". Radiata Mldg&Btr 5/4 inch random width flitch is selling at USD1,000/mbft. Radiata Mldg&Btr has traditionally been an important market for NZ sawn Radiata clear timber.

Export Market and Ocean Freight

Despite shipping indices for the large bulk carriers continuing to fall for the month, the price of out-bound NZ log bulkers (Handysize vessels) continued to rise with spot rates exceeding USD40/JAS m³. The divergence is due to reduced incoming tonnages (e.g. coal and fertiliser), high demand for vessels and reduced supply of vessels due to a major vessel supplier seeking court protection.

However, continued increases in log price in China has offset not only these increases in ocean freight rates, but also continued appreciation of the NZ$, resulting in at-wharf-gate prices moving up $3-$5/JAS m³ in August.

In addition to China continuing to take large volumes of NZ logs, Korea is also starting to show strength again, and prices have increased sharply in that market in the past two weeks.

The consensus view is that export log prices will stay firm with modest increases expected through to the end of the year.

The Agrifax Combined Log Price Index, which indicates returns from the whole forest, increased $2/tonne in the South Island (to $71/tonne) and remained unchanged in the North Island at $73/tonne.

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Recent Large Sale of AAUs

What does it mean for Post-1989 Forest Owners?

A European buyer has purchased approximately 520,000 forestry generated AAUs from Ernslaw One, a large NZ forestry company. (AAUs are assigned amount units - these are the units allocated to governments as part of the Kyoto Protocol) The process involved obtaining NZUs (NZ units) under the NZ Emissions Trading Scheme for carbon sequestration in post-1989 forests during 2008. The NZUs were then converted to AAUs and sold. Whilst the price has not been disclosed, it is understood to be around 10 Euros per unit.

This is by far the most substantial trade of forestry units so far, but the lack of disclosure makes interpretation difficult. On the positive side it does indicate an international market for NZ forestry units but the depth and liquidity of the market is still unclear.

Based on this announcement we have received the following question from a number of clients:

Have I missed out on an opportunity?

Firstly, 2008 NZUs can still be claimed. The next opportunity is during the period 1 January to 31 March 2010. You will have until 31 March 2013 to claim 2008 NZUs.

The sale was possible for Ernslaw One as they are a large forest owner with multiple age-classes, allowing them to mitigate the carbon price risk associated with harvesting (one, or few, age-class forest owners are highly exposed to a high carbon price at harvest time when they have to buy back the carbon credits). They also offered a large parcel which is much more sought after for an international sale. Finally, they invested heavily in development work (including mapping and carbon assessment) with an uncertain outcome. Few other forest owners would have wanted to take on this level of risk.

The above situation does not match that of most NZ forest owners.

Whilst it is unlikely this sale would suit, or could have been emulated, by most NZ forest owners, such a sale also potentially forgoes other opportunities. With the ETS under review, there could be significant changes announced later this year. Some attractive possible new options may include:

• The government may bring in a scheme whereby a forest owner can claim a lesser amount of NZUs but doesn't have a carbon liability if they replant. This could suit single/few age class forests very well.
• New schemes (such as carbon pools) and financial instruments may become available that allow forest owners to hedge carbon price risk.
• Inclusion of emitters into the ETS should encourage the development of a domestic market for NZUs. Currently the domestic NZU market is virtually non-existent as emitters await outcomes from the ETS review.

Concern has been expressed about the cap on conversion of forestry NZUs to AAUs. Under the Kyoto Protocol New Zealand must retain a minimum of 90% of its allocated AAUs in its registry in CP1 (2008 to 2012) - called the Commitment Period Reserve. This cap will allow approximately 39 million NZUs to be converted to AAUs (less the 520,000 already converted by Ernslaw One and some minor transactions). This is more than all of 2008 and 2009 carbon credits for all the post-1989 forests across all of New Zealand! So you don't have to feel as though you are going to miss out on this count; depending on how many opt into the ETS, the cap may never be reached at all in CP1.

It is possible, however, that the government could otherwise put restrictions on how many carbon credits go offshore to try to increase domestic supply for emitters. This would, however, be foolish policy as it would effectively result in the forest owners subsidising the emitters. If there is to be any subsidy, it should be from the tax payers generally, rather than one disadvantaged sector (see also Clarky's Comment).

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