Paper Outlook—Will Prices Continue to Drop?

First, what’s the trajectory for pricing through the rest of this year? Will prices drop further or is backlash in store?

Second, what are the consequences of the demand drop on the paper industry overall? The current price cuts can’t boost consumption back to levels the mills need for profitable operation. What other responses might the industry have?

Prices: Defying Economic Logic
It would be nice if we could apply classic economic theory to the impact of the recession on the paper market, but theory has been tossed out the window. The scale of the problem is so large that it’s hard to wrap a theory around it.

According to data tracked by forest-products-industry information provider RISI, apparent consumption of coated mechanical paper dropped 34 percent in the first quarter. Free sheet was down 26 percent. These declines come from the one-two punch of a recession and a general retreat from print as an ad vehicle. We can’t easily separate these two strands, but we must do some pondering, since an economic recovery will not bring back the losses that stem from a permanent migration from print.

Consumer magazine ad pages dropped 26 percent in the first quarter, as reported by Magazine Publishers of America’s Publishers Information Bureau data, and declined 29 percent in the business-to-business segment, according to American Business Media. Not surprisingly, paper demand went right along with it. Similar drops occurred in catalog and free-standing insert consumption—down was the only direction.

Price cuts can’t stimulate demand under current conditions. All they do is allow the mills to fight each other for the business that remains. And, so, price cuts do most of their cutting against the mills themselves, reducing profitability while generating a few more orders at the expense of a competitor.

We extrapolate, with caution, to sketch a price trend for the rest of the year. Since these cuts are only the sign of the mills clawing each others’ eyes out, they don’t solve any strategic problems. Mills are approaching transaction prices that match 2007 lows, and can’t go much lower without selling paper at an absolute loss.

Though we may not have reached the sheer bottom, we are near it. Of course, there’s no predicting how suicidal the competitive fervor will get. If 2007 is a reasonable guide to where the mills will cry “uncle,” we still have about $5 to shave off typical hundredweight prices. But bear in mind that mills will only dust off those prices to fight for particular orders. Any grade, weight or trim they consider marginal won’t be pushed that hard.

If Demand Increases …
There are reasons to believe that the 2009 holidays will be better commercially than 2008’s. Of course, one of the reasons is that there’s probably nowhere to go but up. Another is that the general psychology of this recession has people ready to believe that conditions will improve in 2010, even when there’s limited pure economic data to suggest it.

Even so, the most optimistic demand scenario would not be enough to justify a significant October price hike. As long as the mills keep dividing our tiny pie, they will have to use some price wars to get their share. The best a mill can do is let some specific, situational discounts evaporate, or try for a modest increase.

My prediction, boiled down, is this. There is nothing present or on the horizon that allows mills to raise prices. There is also reason to believe that little is gained by cutting them further. I’ll mention some wild-card forces in a moment, but I anticipate prices will stand still through the fourth quarter.

Tough Decisions Facing Many Mills
But looking beyond immediate price patterns, we can see the larger forces at work on the mills. Private equity ownership of many of the major mills means that today’s papermaker is measuring return on investment by very strict standards. It also means that ownership’s ultimate plan is to sell the mill at a nice multiple.

Well, good luck on that. To own a paper mill in the 21st century is not a forward-looking business play. I’m not sticking my neck out too far to say that paper consumption will remain on a downward slope for the next five years, no matter what type of economic recovery occurs, until there’s a new, natural balance of lowered supply and lowered demand.

Mills have already scheduled just about all the downtime they can. The next move is closing down a machine temporarily, but indefinitely. After that comes shutting down a machine permanently, then the permanent closure of an entire mill. The final play is exiting the business altogether.

If you’re running a mill for a private equity concern, you’re in the bluffing stage of a poker game. You are probably never going to be able to sell the business for what you hoped. The only question is how long you hang on to it. Stay in the game and collect a lift from whatever economic upswing we manage, then sell the business when one or more competitors have fallen out? Or sell it now, cutting your losses, since the danger of someone else beating you out and further lowering the value of the entire industry is so great?

Tough choice, but now I’ll be the gambler and bet that at least one major player will fold its cards this year. When that happens, we’ll have a not-so-gentle drop in capacity that could be as big an upheaval as the 2007 shutdowns. If we replay that history, prices will rise fast and furiously.

That’s still a possible scenario in 2009, depending on how much tonnage vanishes, but I don’t think we’ll relive the full price spike. If a price increase does follow such an industry contraction, it will be milder than 2007’s all-hands-on-deck drill. This time, there’s still too much inventory to buffer a supply crash, and too many magazine and catalog publishers cutting demand.

Now for another wild card. The Postal Service has obtained approval on a proposal to cut postage rates in a “Summer Sale”—offering a 30-percent rebate to eligible (large) mailers on Standard Mail letters and flats—in an effort to boost volume. It’s a novel approach. Large mailers will earn the rebate on mailings from July to September in excess of their volume for the same period in 2008. It bears watching to see whether catalogers and direct mailers find the incentive compelling enough to step on the gas.

How much demand the USPS can stimulate is anyone’s guess, but if they succeed, paper demand could rise more robustly than general market conditions suggest. The seeds of a paper price hike could germinate in such fertile soil, but I believe the volume increase would have to extend to even bigger increases in the fourth quarter before the mills could extract an increase.

Anticipating Supply Changes
Now, let’s turn to supply itself. If the USPS “Summer Sale” punches up demand and a major mill departs, paper supply will swing sharply. And paper buyers tend to play very conservatively when that happens, driving inventories up and protecting allocations tooth and nail.

If a price increase could take root in late 2009 and flourish on into 2010, it probably won’t be because supply contracted enough to permit it, but because there were sufficient fears that supply could tighten. Because we buy on the basis of predictions, careful buyers must follow their fears. They may not be right all the time, but the danger of being wrong even once can’t be ignored.

That’s a reminder that the paper market inherently operates on forecasts, not facts, and that the aggregate decisions of all paper buyers usually exaggerate real conditions. You can play the current market overpaying slightly with a contract to protect supply, certain in the knowledge that every mill out there is looking for a way to cut capacity. Or you can count on staying one step ahead of mills that grow weaker and weaker, and must discount to survive day to day.

Those two extremes define two equally appropriate strategies. The oversupply problem will either be solved by intelligence or panic, but the size of the marketplace must contract—so, stay vigilant. The mills have little leverage to raise prices and some pressure to keep cutting when particularly valuable business is at stake—so, keep negotiating.

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