Fuel Escalators: More Harm than Good in Supply Agreements?

Financial backers of new pellet mills often require the project developer have a percentage of the project’s feedstock under supply agreement. Long-term supply agreements describe the volume and type of feedstock (or mix) to be delivered to the buyer as well as the buyer’s product specifications. Some supply agreements have a contracted price that lasts the length of the index but, more commonly, supply agreements have language that peg the total delivered price of the feedstock to a credible market price.

Using such an index for supply agreements, provides assurance to both parties that future feedstock will be priced at market at the time of delivery and facilitates the longer-term supply agreements financiers favor. While the concept is reasonable and simple there are a few nuisances.

Wood feedstock delivered price consists of four primary cost components: stumpage, harvest costs, freight, and dealers’ commission. A fifth component, procurement expense allocation on a per ton basis may be included depending on the parties involved. It is prudent to understand which conditions can have an effect on the components of price before negotiations proceed.

Stumpage price is amazingly independent of energy price, inflation, or the market price of the products produced from wood raw material. As pure supply/demand markets, local average stumpage prices are affected by area competition among buyers, volume of supply and, in usually short cycles, the weather. Typical of markets with fragmented sources of supply, stumpage price power is for the most part with the buyer.

One would image that harvest and freight costs are highly correlated to diesel and CPI as both of these activities are labor and diesel intensive. When we took a close look at how these components changed relative to changes in diesel and CPI, we expected to see consistent response to changes over time. Instead, we found a flexible and resilient forest products supply chain.

Starting with Q1 2009 pine pulpwood market price for a region encompassing the southeast coastal areas of South Carolina, Georgia, and Florida, Forest2Market calculated a Q2 2009 price. We started with stumpage market price and calculated harvest and haul components using the percent change in diesel prices and CPI from the previous quarter. Our Q2 2009 calculated price was $1.09 above actual market price, our Q3 2009 calculated price was $1.72 over actual market price, and by Q1 2012 we overshot the market by $3.65. The calculated price stayed higher than market price for the entire study period (Q2 2009 – Q1 2012).

Maybe you are thinking our control (market price) is flawed, but be assured, it is not. You can read why by following these links: US South Wood Raw Material Benchmark  and Benchmark Methodology.

Instead of the consistent response to changes in diesel and CPI we expected to find, we found instead a flexible and smart supply chain. As diesel prices rose, haul distances shrank, and dealer commission decreased. The actual market price change over the period was $2.22: $29.97 (Q1 2012) compared to $27.75 (Q1 2009); $0.60 of the change is attributable to stumpage price variation.

How does this inform indexed supply agreement negotiations?  Supply agreements based on quarterly reports of market price during periods of even mildly increasing or decreasing diesel prices or inflation can seriously affect a buyer’s or seller’s cash flow. Suppliers need to ensure that they do not “own the delay” of inflation or diesel price increases being reflected in index market price. They may seek diesel adjustments as a way to manage their cash flow.  However, our analysis shows an adjusted agreement price will quickly diverge from a market price that reflects a smart wood supply chain.

In “normal” markets where diesel and inflation fluctuations are mild, using a 90-day rolling average price will reduce price volatility. This is favorable to both buyer and seller and helps to alleviate supplier cash flow concerns. However, neither quarterly nor 90-day rolling average price indexes will suffice in a long-term, hyper-inflationary or deflationary period or in a long lasting period of rising or falling diesel prices. The supply agreement should include specifics addressing what both parties’ rights are when the index can never “catch-up” to the economic trends.

Comments

Robert G. Chambers

02-14-2014

“Stumpage price is amazingly independent of energy price, inflation, or the market price of the products produced from wood raw material” what an amazingly insightful observation.

This has been a core belief of mine for years.  From a timber seller view point (stumpage) think of the ramifications:

1. Independent of energy prices – means we cannot predict the impact of higher energy price on delivered wood or stumpage prices.  This creates great uncertainty.

2. Independent of inflation –Does this mean that the billions of dollars of timberland held by Institutional investors is truly not protected against inflation.  With uncertainty it appears to be a crap shoot.

3. Independent of the market price of the products produced -  This is the big one.  So all the comments about an increase in housing starts with certainty will produce increased stumpage prices may not be true?  Not necessarily if true independence reigns.  Again we are uncertain of the outcome.

Uncertain response to energy prices, uncertain response to inflation, uncertain response to market price of wood products being produced.

Uncertainty = risk.

Maybe timber is not a low risk play – not a sure thing after all.

I have never understood “supply agreements” from an investment point of view.  Timber has always been touted as a low risk asset.  Just look at the low volatility of the NCREIF Timber Index for proof.  Supply agreements protect against risk, but almost always take away the opportunity to “store timber on the stump” during low price periods. So one buffers a low risk by giving up the right to not sell timber when prices are low.  No thanks, especially for an Institutional owners with limited need for current income.  Seems the ability to store-on-the-stump would be a more important benefit.  If the need for current income is critical they probably should not be invested in timber.

The Waycross, Georgia area may be a good case study.  Last year when at least one large supply agreement limited pulpwood price to the $12/ton range independent owners (supply agreement free), were selling significant volumes of pulpwood for $20 per ton or more.  The only looser here were owners selling stumpage under market price based supply agreements.

The real worry for stumpage price is the oversupply of wood in world markets.  Just today I read of a new 250,000 ton per year pellet mill in Estonia bringing the owner of that mill up to 1,000,000 tons per year.  The US south is not the biological wood basket of the world, the World is awash in wood.  Nor is the US South the “natural” supplier to Europe - Europe and parts of Asia are.

Finally, an article in the October/November 2012 Journal of Forestry leads one, by extension, to conclude that with a constant supply/drain scenario approximately 14 billion (yes that is billion) cubic meters of wood will be added to southeastern forest over the next decade.  Talk about unsustainable, but that is fodder for another day.