The Extinct Society
Once the rage in small-log processing and efficient stud production, Quebec sawmillers now make headlines only when they are closing another mill or three. What happened, and can it be fixed?
If it ain’t broke, don’t fix it. Fair enough, but what if it has been broke for some time? Shouldn’t somebody think about fixing it? That’s about the state of the solid wood products sector in Quebec, and the need for a fix has been obvious to just about anyone in the industry for a couple of years now – anyone, it seems, except those with the power to do something about it, from industry to government.
The problem is real, and undeniable. Markets are collapsing, and costs are high, from energy to wood.
Start with the log supply, which is shrinking in every way. Given the rate at which mills are closing these days, the much-bemoaned 20% reduction in AAC announced two years back now hardly seems an issue. Still, any forest planner will tell you that adding constraints only drives costs up, and now fibre is coming from greater distances every season, with log transport a growing and unpredictable cost.
There is room for efficiency gains in every system, but it would be unwise to look to reduced logging costs for Quebec’s salvation. Given typical log sizes in Quebec, the province’s logging crews are already among the most efficient in Canada, itself home to some highly efficient logging crews. Recent market numbers from global forest equipment supplier John Deere speak volumes – Canada’s almost 100% mechanized logging sector harvests some 33% of the volume harvested in North America, but annually buys only 16% of all forest machinery sold on the continent to do so. In contrast, the US requires the remaining 84% to cut the other 67%, or five times the machinery to harvest twice the volume. On the whole, production and equipment utilization rates in Quebec, like the rest of Canada, are increasingly hard to improve upon, and most of the low-hanging fruit is long gone.
There are other cost factors that the industry can do even less about. What industry leaders like to call the high Canadian dollar seems here to stay for a while, although thankfully talk of parity has disappeared with more reasonable oil prices. Energy prices, while down at press time, seem set to stay at historically high levels.
Then there are markets. We all know where US housing starts have gone, and given the growing inventory of unsold houses, don’t look to another building boom anytime soon. Ditto remodeling and renovation, as falling housing prices (and thus equity) do not encourage adding an extra room or two to the shrinking nest egg.
Challenging markets will remain at least until late 2007, despite what enthusiastic real estate agents may tell you. Despite many predictions, 2005 was a great year for housing (and lumber demand), but that’s part of the problem. According to National Bank Financial, interest-only, deferred-interest, and no-money-down mortgages have artificially boosted housing demand south of the border for the past five years. Starting at close to 0% in 2000, this crack-cocaine of the lending world accounted for over 40% of US mortgages in 2005. Consider that these same marginal owners also bought their houses at the peak of the last boom, paying top dollar for a home they could scarcely afford, only to see the value of new homes drop well over 10% in recent months alone (the fastest such drop in 36 years). The US still boasts a growing population that is the envy of the western world, so housing will eventually get back on track, but it will be a while until this mess is sorted out.
To low prices and high costs add a 15% export tax courtesy of Stephen Harper and friends. Toss some very competitive BC Interior mills into the mix with an unlimited short-term fibre supply, and voila, Quebec mills have a big problem. In facing these issues Quebec is not at all a distinct society, as mills in other areas like Manitoba, Ontario and Alberta are also hurting. The Saskatchewan lumber industry is almost gone, with just a few mills remaining in operation. Still, given the scale of the Quebec industry, responsible for 25% of Canada’s lumber output as recently as 2003, the problem is significant. Just look at the closures to date, both temporary and indefinite from all the major players, like Abitibi (five mills); Domtar (four or more mills); GDS (all 10 mills as the company restructures); Kruger (its North Shore mills); LP (one sawmill, one OSB mill), and Tembec (five mills). Others are quietly taking downtime or scaling back, and some in the hardwood sector have simply shut down most or all of their mills without any fanfare.
Given the competitive position of the industry just a decade ago as small-log leaders, and the amount of leadingedge technology and suppliers the province still boasts, the sorry state of its solid wood sector should be surprising. What happened, and what can be done to fix it?
Perfect Storm
This term has been in circulation for two years now, but it may not yet be accurate – If it was already the perfect storm two years ago, should it keep getting worse? CWP spoke with a number of long-term industry analysts to get a range of perspectives on these issues, and to see if there is any consensus on what is required to clear up this mess. These industry experts include Russ Taylor, president and founder of Wood Markets in Vancouver, BC; Bill Mitchell of the Beck Group in Portland, OR; Libarid Guluzian, a partner and tax expert with PricewaterhouseCoopers (PwC) in Montreal, QC; and Paul Jannke, vice-president, industry analysis and forecasting with RISI in Boston, MA.
While the focus may be on Quebec’s industry, and some problems are unique to that province, solid wood manufacturers across Canada will recognize many of these issues. We’ve listed them in order of importance according to the Quebec industry’s potential to deal with them. For example, currency and housing starts may be the two biggest hurdles, but other than a little hedging, they are out of our hands. Also, major competitors across Canada, and even Europe are struggling with both issues.
Wood Costs: Quebec Forest Industry Council (QFIC) president Guy Chevrette says his members face the world’s highest delivered wood costs (see box on page 8), and none of our analysts would likely argue.
“Even as far back as 2003, we had seen major concerns regarding fibre supply – both availability and cost – and we were seeing some of the highest delivered wood costs out there,” says Bill Mitchell of the Beck Group, which specializes in solid wood products benchmarking. “Add to that a 22% increase in the cost structure from currency between 2002 and 2004 alone, and that’s becoming some expensive wood. From the outside looking in, it’s no surprise to me to see all these closures,” he adds. “Unless something changes, the party is over in eastern Canada.”
US Commerce Department ignorance aside, wood costs in Quebec include far more than stumpage. Factors driving costs up in recent years compared to other regions include a cumbersome regulatory environment, increasing environmental restrictions and costs despite the industry’s massive certification efforts, and increased roadbuilding and forest protection costs borne by industry.
Wood Cuts: Wood supply is also an issue, after a decade or more of over harvesting done by Quebec’s industry, with the complicity of the provincial government. With the Coulombe Report’s tallying of this at exactly 20% too much, the industry’s fate was sealed. RISI’s Paul Jannke says the report’s findings echo some of their own research into harvest levels in Quebec during the past 15 years of excellent markets, adding that it means that even under the best-case scenario, Quebec’s industry can only expect to rebound to 80% of its previous scale in terms of input and possible employment, and perhaps 85 to 90% of its production volume assuming it invests in technology to increase recovery and yield.
“In many ways, Quebec’s sawmilling industry has had it easy over the past 20 years. You had the spotted owl in the Pacific Northwest, then BC had its issues with the Forest Practices Code and other restrictions, and all the while Quebec could take advantage of those supply constraints elsewhere and the good markets, plus the currency. You could say that with those regions sorted out and their costs brought in line, it’s Quebec’s turn, but the difference is the over-cutting issue.”
Conversion Costs: Few would deny that Quebec has lost considerable ground over the past decade to such major competitors as the BC Interior (or even the Maritimes when that region’s duty exemption is factored in) when it comes to sawmill efficiencies. Some point to a lack of investment as the culprit in this, and indeed the re-investment ratio across the entire Quebec forest industry sector has not been impressive of late. Still, several of our analysts insist it’s far more than irresponsible or shortsighted leadership on industry’s part.
A major hurdle to investment in Quebec’s sawmilling sector is the way Crown timber is allocated. Unlike BC, the wood supply under a CAAF (Quebec’s forest management agreements) is directly tied to specific mills. Close the mill; lose the wood, an equation that makes the creation of BC-style mega-mills impossible.
“Our clients tell us over and over, they don’t have the volume to compete, and to warrant the investment in high-technology equipment,” explains PwC’s Guluzian. “They can’t reach that volume of production without the fibre, and the way the CAAF’s are organized, it simply can’t be done. Everybody sees consolidation and a move to larger mills as a big part of the solution, but fibre allocation policy stays the same. The government absolutely has to address this issue for the industry to move to a sustainable level. Otherwise, whatever they do will be just a series of band-aid solutions.”
From his vantage point on the doorstep of the BC powerhouse mills, Wood Markets’ Russ Taylor agrees. “Government meddling in timber supply and policy is one of the factors that has brought industry to this position. BC went through all of this in the mid ’90s, and now Quebec has to move to the megamill model itself, rather than the large number of small mills now running.”
How big is big enough? Lloyd Pederson, a sawmill design and feasibility consultant from Kelowna, BC, has done his share of new mill or upgrade studies, and says the magic number is much bigger than the typical Quebec mill.
“We’ve crunched the numbers, and no matter how you look at it, you need at least 130 to 150 million bdft. Otherwise the margin is not there, and your fixed costs just kill you.”
What’s black & white and red all over?: As in red ink, and it’s the newsprint sector, a market held together only by continual capacity restrictions. Jannke sees this as one of the great unknowns facing Quebec’s lumber sector, as the two are so inextricably linked. “Circulation is down, papers are smaller, and the trend continues, so where does this leave Quebec’s mills? The long-term viability of this sector is in question, and even now it is a factor for sawmills. Quebec sawmills recover 1/3 of their costs through pulp chip sales, but as demand drops with pulp mill curtailments, so too does price, and we’ve already seen a drop from $145 a metric tonne to $136. It’s another straw.” Death & Taxes: Or both at the same time if you are a Quebec mill. Guluzian notes that taxation laws on both capital and R&D are another structural hurdle to investment in Quebec.
“This is an area that is very damaging, as when companies are losing money, they don’t pay any income tax, but in Quebec they still have to pay capital tax regardless. This compares to BC, where it has been eliminated. R&D tax credits are a similar disadvantage, albeit a national one. At the Federal level, these are not refundable save for Canadian controlled private companies with less than $15 million in capital, despite the fact that companies obviously continue R&D projects through money-losing cycles. Quebec offers a bit of a break in that the labour component is a refundable credit, but overall this is an area governments need to look to create a better environment for investment.”
Overall, Guluzian has seen internal PwC studies for other international clients that show Canada’s forest sector as the highest taxed among competitive nations, from capital investment to forest management investments. “I can’t publish the details, but I can tell you Canada does not compete well on this front.”
Now add a new federal tax, otherwise known as the softwood lumber agreement (SLA), and things get very ugly. The Conservatives’ deal never looked all that good to CWP, but was sold in part on the assumption that the sliding duty structure would mean that mills would very seldom pay any duty, let alone the full 15%. Even before the deal was inked, Random Lengths, whose numbers would be used to decide when to launch the tax, were saying that even during the booming markets of the past decade, a tax would have been paid almost 50% of the time. Now, of course, mills are paying the full 15%, while neighbours to both the south and the east (the US and Atlantic Canada) are not. Given predictions in the US housing and remodeling markets, it seems likely that 15% will be a cost of business at least into 2008, with quotas another complexity.
New Competition: Whether it’s European lumber from new super mills designed for the US market, or cheap (but quality) Chinese furniture ruining our MDF, hardwood lumber and hardwood plywood markets, or South American pulp, there are new players in the game. Some are operating in lower-cost environments, where fibre and people are cheaper, and regulations a shadow of what they are in Canada.
Internally, the biggest threat facing the Quebec solid wood sector for the next five to 10 years is BC and its beetle wood. According to stats from the QFIC, output in BC climbed from 32.6 million m3 of lumber in 2001 to over 41 million m3 in 2005, a staggering 26% increase in five years. In contrast, Quebec saw its share of Canadian output fall from 25% in 2002 to 22% in 2005, and its volumes from 19.2 million m3 to 17.6, a drop of over 8%. Several analysts have suggested that the industry’s response to new competition has been slow and painful to watch.
Energy Costs: This new reality affects all forest operations, but it hits many Quebec operators hardest. First of all, the remote nature of an increasing amount of Quebec’s logging operations means the fuel-intensive hauling component of delivered wood is larger here than almost anywhere else in North America. Distance to market is also becoming more of a factor as fuel prices stay on the high side, notes Mitchell of the Beck Group.
“Even in the OSB sector, you have to start wondering about these mills in Quebec that are shipping product over 1,000 km, past more and more new OSB plants built right on the market’s doorstep in the US southeast.”
When you start off with a mill 1,000 km from the market, and process logs being hauled 200 to 400 km from the forest to your mill, the cost of diesel is no small matter. Predicting fuel prices is a fool’s errand, but some energy industry insiders like Peter Tertzakian predict greater price volatility and even $100 barrels at times over the next decade at least.
Currency costs: This is the biggest single hit to the industry, and as PwC’s Guluzian says, it’s a major revenue hit that, like the price of fuel, we should get used to.
“I’m not an expert in the energy sector, but it seems demand for Canadian energy will remain high, and with it we can expect our currency to remain high as well. The move we’ve seen from a 65-cent dollar to an 89-cent dollar is a 27% hit to top-line revenues, which is no small thing, and it seems there to stay for a while. Still, it is out of our control.”
Add all of these factors together with collapsed lumber prices, and you get an ugly mess. As one of RISI’s Quebec clients put it to Jannke, “We may as well be stacking $100 bills into every package of lumber we ship right now.”
Solutions Possible
A grim situation indeed, and even grimmer if you agree with analysts who say the SLA makes it impossible for the Quebec government to improve the situation for the average sawmill. Yet almost all of the analysts agreed that government would have to come to the table with whatever solutions they can, and as PwC’s Guluzian explains, it needn’t offend our neighbours to the south at all.
“If you look at some of the key areas that government can improve, it has more to do with creating a level playing field, and has nothing to do with the softwood agreement in any way. Taxes on capital and R&D, CAAF flexibility – None of this involves subsidies in any form, but they would all be steps in the right direction to put the industry on a more competitive footing. There are big changes that can be made, and will go a long way towards the $10/m3 savings the industry says it needs. Both levels of government need to grasp the role they can, and should play regarding this industry’s long-term sustainability. Looking at it from the outside, I am at a loss to explain why governments continue to do nothing other than provide band-aid solutions.”
In short, many of the short- and mid-term solutions can be found among the root causes listed above. Government needs to move the taxation burden closer to other jurisdictions, allow much more flexibility in fibre supply allocation, eliminate unproductive and redundant regulatory costs, and help cushion the blow for those most vulnerable to these changes – workers and communities in forest-dependent towns. Still, not all analysts let industry itself off the hook that easily. Yes, government will have to play a role, Taylor admits, but industry has some work to do as well.
“Right now there is no doubt that Quebec is in the worst shape of the major regions. It is probably the highest cost region, on average, in North America. Government will have to do something, but industry needs to take a hard look too. They’ve watched European competitors move into their core markets without any game plan. They need to re-focus their marketing efforts and move a lot quicker when opportunities arise – For example, the European market has been red hot since May, and where has the Quebec industry been in this?”
In other words, aggressive and imaginative leadership is needed on all fronts, from government to industry. So far, especially among large integrated companies, it has been lacking.
Still, Jannke makes his living by using past market behaviour to predict future behaviour, and he says it’s not all doom and gloom. RISI predicts the bottom of the US housing freefall will be hit in the third quarter of 2007, a year where they are predicting 1.56 million housing starts. RISI expects that to climb to 1.71 million in 2008, not stellar, but nonetheless a year where we can expect to start seeing general improvements. Even in the area of oil prices, where “break point” alarmists are a dime a dozen, RISI’s five-year forecast is more optimistic.
“We’re calling for a balance in the demand/supply equation, as both suppliers and consumers react to the recent high prices, and it’s already starting. We’re forecasting prices in the low $50s for a barrel.” Welcome news to Quebec loggers indeed. “There will be retrenchment in the Quebec industry,” Jannke concludes.
“There will be fewer mills, but they will be more efficient – They have to be. The demand/supply relationship will come back into balance, and a smaller, different industry will survive.”
Or as they say in Quebec – “Panique pas!”
Scott Jamieson, Editor
sjamieson@forestcommunications.com
1-888-457-3155 ext 24
