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May1 1 ,1 984 Timber Contract Problems Forest Service contracts In 1 983, the Pacific Northwest lumber industry moved out of the depths of recession and into recovery. This year, due to the strength expected in homebuilding and other lumber markets, lumber production and prices may show further moderate improvement. Nevertheless, scores of firms could face financial pressures arising from the cost of raw materials not only in 1984 but in the remainder of this decade. Those pressures result from the high-cost public timber under contract that is unprofitable to harvest at current and foreseeable lumber prices. In keeping with the general pattern throughout the West, lumber manufacturers in western Oregon and Washington rely heavily on publicly owned lands for their timber supply. In 1 976, the latest date forwhich official data are available, about 22 percent olthe total sawtimber harvested on commercial forestlands in that region came from National Forests managed by the U.S. Forest Service. Another 20 percent came from publicIyowned lands managed by the Bureau of Land Management and state agencies. The remaining 58 percent came from lands owned by the forest products industry and other private landowners. In contrast, outside the West, public lands account for only 1 0 percent of the total annual harvest. Nearly all lumber firms operating in western Oregon and Washington rely on public lands to some degree for their raw material, but dependence is especially great for small, non-i ntegrated producers. u.s. To date, the affected companies have received extensions of contract expiration dates, but they are pressing for federal legislation that would dissolve some of their contracts. They argue that the federal government shares responsibility for their difficulties because it affects housing markets and controls both the amount of their raw material supply and the methods by which public timber is sold. The Forest Service sells the rights to harvest given tracts of standing timber (stumpage) on National Forests through a competitive bidding process. The contracts then call for the winning bidder to harvest the tract within the I ife of the contract, usually of several years duration to allow for road construction and logging. The purchaser pays a small initial cash outlay but is not required to make full payment until the timber is cut. For contracts awarded in western Oregon and Washington before August 1, 1 983, purchasers are to pay the original bid price at time of harvest. As such, the contracts are forward contracts. Even with subsequent reforms, the contracts require companies to formulate their bid prices by forecasting the production costs and selling prices for lumber and other wood products they expect to prevail when the timber will be harvested. This Letter will describe the contracts and lumber market conditions that contributed to the present problem. It will show that whi Ie the "forward" contract method of seIling public timber provides some benefits to purchasers, it also subjects them to great uncertainty about the profitability of the timber under contract. To prevent a possible recurrence of the current problem, public timber management agencies should consider reforming the sales system to derive the price paid for timber more directly from the prevailing price for lumber. The discussion will focus on National Forests in the western half of Oregon and Washington. The heavy preponderance of the key homebuilding Douglas-fir species in that region, along with the absence of a mechanism to adjust prices downward in contracts awarded before August 1983, have made the problem of uneconomic timber the most serious there. These forward contracts afford purchasers certain benefits. They permit firms to secure 1 § \,y,"LJ :.''''!;\. WJ .., 1(;;"\ ,(:]" L ,.,"'\, L, .I., Lj, .'.\,¢,,".J 'Co'" ',,,,Y (JplniOi1S expn's<,ed in thIS m'\vslelter do not necessarilv reflect the views 01 the rnanagement ot the Federal Reserve Bank of San Francisco, or of the Board of C;overnor', of tfw Federal Reserve Svstem, meet the requirements of the post-World War II baby boom. Meanwhile, increasing amounts of commercial forestland were set aside for wilderness purposes. a contract with a small outlay of capital "upfront", And they allow the purchaser to pay only for the actual volume of useable, non-defective raw material found as the trees designated for harvest are removed and measured, But the contracts also render the purchaser vulnerable to changes in lumber prices. If lumber prices should rise more than the firms expected when they formulated their initial bid, they may receive a larger profit than they expected. On the other hand, if purchasers expect lumber prices to rise but they fall instead, firms may receive less profit than they had anticipated or they may even suffer losses. Expecting that strong product demand and tight raw.material supplies would continue to push lumber prices upward throughout the 1980s, mills bid frantically for public timber during the late 1970s. On National Forests in western Oregon and Washington, the average winning bid price for Douglasfir timber nearly doubled between 1977 and 1 980 (see chart). But, instead of conti nu i ng upward asexpected, prices for softwood lumber dropped between 1979 and 1982. For example, the price of Douglas-fir fell by 31 percent. This occurred as housing starts plunged downward to only 1.0 million units by 1982 and lumber consumption also fell in other markets. When housing starts recovered to 1.7 million units in 1983, lumber prices rose sharply on an annual basis but failed to regain their 1979 peaks. Prices continue to lag behind 1979 levels because they showed renewed weakness in the latter half of 1983 before rising during the first quarter of 1984. The end-result is that many firms currently hold sizeable volumes of unprofitable timber under contracts awarded during the late 1970s. Origins of the problem Long contracts, requiring little initial capital and no specific interim payments, encourage purchasers to secure and hold large volumes of timber when they expect prospective demand and prices for lumber to rise sharply. Federal contracts in use in the late 1970s were particularly conducive to such behavior. Most contracts ran from three to as much asseven years in duration. Besides the nominal deposit with bid, the winning bidder posted only a performance bond when the contract was signed and no interim payments were required until the purchaser cut the timber, often in the last year of the contract. Unlike Forest Service contracts elsewhere in the West, they contained no stumpage rate adjustment clause to adjust original bid prices upvyard or downward in responseto changes in lumber prices. Magnitude of the problem At present, firms hold about 9.5 billion board feet of uncut timber on National Forests in western Oregon and Washington in contracts awarded before January 1, 1982. (Contracts awarded thereafter are not a problem because bid prices fell dramatically.) The average bid price on the timber awarded before 1982 is $316 per thousand board feet. Forest Service and market data show that it currently would cost an average operator about $482/thousand board feet to harvest and deliverthattimber in log form to the mill (including stumpage), while such logs would bring an average market price of only $281 /thousand board feet. At current Lumber market conditions in the late 1970s encouraged bidder optimism. Between 1977 and 1979, producer prices for Douglas-fir lumber rose at an average annual rate of 16 percent (see chart). Homebuilding-by far lumber's largest marketwas booming. During those years, the number of new homes built annually averaged 1.8 million units, with a near-record high of 2.0 million units being reached in 1978. Demographic factors suggestedthat at least 2 million housing starts per year would be needed during the decade of the 1980s to 2 Ratio Scale $ per Thousand Board Feet Rallo Scale 1970=100 500 'WolternOregonondWashlngton -'-; _ _ award and certain payments mid-way through the life of the contract. The agency also shortened the term of new contracts. finished lumber prices, such contract holders therefore would incur an average loss of about $201 /thousand board feet on timber contracts awarded before 1982. The Forest Service introduced perhaps its most important reform on August 1, 1983 when it added a stumpage rate adjustment clause to new contracts in western Oregon and Washington. The clause permits the bid price to be increased or decreased, within stated limits, in accordance with changes in lumber prices. The procedure, already in use on Ndtional Forests elsewhere in the West, ad justs bid prices to reflect 50 percent of any upward change in the lumber price index and 1 00 percent of any decl i ne in lumber prices below a base level. Its purpose is to transfer some of the profits and losses that would otherwise accrue to purchasers during periods of rising and falling lumber prices to the federal government, thereby reducing the variability in the lumber companies' profits. However, because the adjustment mechanism is skewed more to protect buyers from the risk of downside loss than to remove profits in a rising market, it will impart an upward bias on bid prices and will not completely eliminate earnings variabi I ity. This analysis does not mean that all of the 9.5 billion board feet sold prior to January 1982 is currently uneconomic to harvest since the $31 6/thousand board foot price is an average. But it does suggest that lumber prices would have to rise sharply in the future to make much of this timber worth harvesting. Government. reponse To give fi rms more ti me to meet thei r obi igations, the Forest Service, in May 1 980 and October 1981, extended contracts by one and two years in programs known as Soft I and Soft II. Then, on July 28,1 983, the Secretary of Agriculture announced that all federal timber sales contracts awarded before 1981 cou Id be extended for another five yearswithout payment of interest on the bid value of the uncut timber that would have been due. Holders ofthose contracts still argue that th is proposed" Five- Year Mu ItiSale Extension Plan" is unworkable because domestic lumber prices are not likely to rise sharply enough over the 1 984-90 period to permit them to harvest that timber profitably, nor is demand likely to be great enough to combine that volume with new Forest Service offerings. In February, over one hundred contract holders won a court injunction temporarily prohibiting the Forest Service from enforcing those contracts or the February 15, 1984 deadline for submission of harvest schedu les for the five-year extension plan. To eliminate uncertainty about the profitability of public timber, the Forest Service would have to sell timber at spot prices derived directly from contemporaneous finished lumber prices. Such a system exists in British Columbia. There, the government allocates the supply of public timber available for sale to forest product firms under long-term contracts. The price it charges for timber cut in any given year is a residual value based on the current price of lumber minus costs of conversion and a reasonable margin of profit. Its objective is to provide forest products firms with secure timber supplies at a profitable price, and thereby promote the growth of the industry. Beyond extending contracts, the Forest Service on April 15, 1982, introduced a number of new provisions for future contracts designed to reduce the upward pressure on bid prices. Those measures, in effect, make it more expensive for purchasers to hold timber under contract. They include, for example, requiring a 5 percent cash deposit on the total value of the bid within 30 days after Yvonne levy 3 SS",: > .lSl::Il:I • YPln • uollaJO • ppPAaN• 0YPPI PIUJOJIJP::>'. puozuV liPMPH (G) '1!1l?:J 'o:>sPUl?J:! Ul?S i':SL 'ON lIWll:ld OIVd :J9V1 S0d 's'n llVW ssvn 1sm:! mUI OS: JMd B AN KI N G D ATA-TWE L F TH FEDERAL RESERVEDI STRI CT ( Dollar amounts in millions) Selected Assetsand Liabilities Large Commercial Banks Loans, Leases and Investments' 2 Loans and Leases' 6 Commercial and Industrial Real estate Loans to Individuals Leases U.S. Treasury and Agency Securities2 Other Securities 2 Total Deposits Demand Deposits Demand Deposits Adjusted3 Other Transaction Balances4 Total Non-Transaction Balances6 Money Market Deposit Accounts Total Time Deposits in Amounts of $100,000 or more Other Liabilities for Borrowed MoneyS Weekly Averages of Daily Figures ReservePosition, All Reporting Banks Excess Reserves ( + )/Deficiency (-) Borrowings Net free reserves (+)/Net borrowed( - ) 1 2 3 4 S 6 Amount Outstanding 4/25/84 - 178,572 158,.827 47,372 59,612 27,926 4,994 12,074 7,670 184,539 43,133 28,844 12,124 129,281 244 65 130 - 30 123 0 - 154 26 -3,535 -2,445 -1,152 - 834 257 39,617 - 477 38,004 21,183 202 2,167 Weekended 4/23/84 68 174 106 Change from 12/28/83 Percent Dollar Annualized Change from 4/18/84 - - - - 2,547 3,472 1,409 713 1,275 69 433 493 6,458 6,104 2,487 651 296 4.4 6.8 9.3 3.7 14.6 - 4.1 - 10.5 - 18.4 - 10.3 - 37.9 - 24.2 - 15.5 0.7 20 0.1 161 1,824 - 1.2 - 24.2 Weekended 4/9/84 273 53 220 Includes loss reserves, unearned income, excludes interbank loans Excludes trading account securities Excludes U.s. government and depository institution deposits and cash items ATS, N OW, Super N O W and savings accounts with telephone transfers Includes borrowing via FRB, TI&L notes, Fed Funds, RPsand other sources Includes items not shown separately Editorial commentsmay beaddressedto the editor (GregoryTong)orto the author. , , • Freecopiesof Federal Reservepublications can be obtained from the Public Information Section,FederalReserve Bank of San Francisco,P.Q. Box 7702, SanFrancisco94120. Phone(415) 974.2246.
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