Hancock Timberland Investor

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1 Hancock Timberland Investor Third Quarter 2006 Housing Starts, Lumber Prices, and Timberland Investment Performance What does the prospect of a slowdown in U.S. housing construction and an associated drop in lumber prices mean for the investment performance of timberland properties? We find that the effect of a change in housing demand on the performance of private timberland property performance seems to be muted by shifts in profit margins for lumber producers. A prolonged change in the economy in particular a prolonged slow down in housing demand brings questions from investors, as it should, regarding implications for their timberland investment. Quarterly housing starts fell from 2.12 million in the first quarter of the year, to 1.87 million for the second quarter, to 1.73 million starts during the third quarter. This reflects a decline of 8 percent from the same period last year and over 18 percent from the start of the year. Despite the recent rise in housing starts for the month of September, analysts point to a few of the fundamentals a drop in the number of new building permits issued and the high percentage of unsold homes remaining on the market as signs that the September increase is only temporary and starts will dip to below the long-run level supported by demographic trends of 1.8 million units per year in Given a fall in housing starts, the implications for timberland performance may initially be oversimplified. One can imagine a decline in the demand for housing means less lumber is needed to build houses. All else equal, if less lumber is demanded, lumber prices should fall. Lower demand for lumber also translates to a decrease in demand for timber. Again, all else equal, less demand for timber leads to falling timber prices. Less timber harvested equates to lower timber revenues, and less timber revenue puts downward pressure on timberland returns. The effect on timberland performance from a slowdown in housing construction may not be so simple. It is important to understand the extent to which a change in housing demand passes through to timber and timberland markets. Relationship between the demand for housing and lumber prices As housing is the largest end-use for softwood lumber, a change in housing starts translates fairly directly into a change in lumber usage. We tested this relationship, and found that over the past thirty years, 86 percent of the variation in the volume of lumber produced in the U.S. can be explained by changes in the demand for housing, as measured by single family housing starts (see Notes on page 6 for statistical results). Lumber moves readily around the country, and among countries, for that matter, and construction practices can be species-specific regardless of regional supply and demand balances. Therefore, comparing national statistics makes the most sense when trying to measure meaningful relationships between the demand for housing and the subsequent response in wood markets. Information regarding the demand for lumber, measured by national lumber production statistics is not as readily available to investors or as easily interpreted as lumber prices for tracking the primary end-use market for the timber harvested from an investment. A host of factors affect lumber prices, making it a bit more difficult to translate a change in housing starts into a change in lumber prices. For in the short run, a critical factor in determining lumber prices is the inventory in the system (mill stocks, lumber in transit, and lumber at wholesalers). In the longer run however, lumber supply is fairly elastic, so a change in housing starts is likely to result in a less-thanproportional change in lumber prices. To test this theory, we regressed the change in annual inflation-adjusted lumber prices (both Douglas-fir and southern pine lumber) against annual changes in U.S. housing starts. The regression coefficient indicates that a 1.0 percent change in U.S. housing starts translates to about a 0.60 percent change in lumber prices, a less than proportional change as conjectured (Continued on page 2)

2 Housing Starts, Lumber Prices, and Timberland Investment Performance (Continued from page 1) How do timber prices and timberland performance fit in? A change in housing demand is a weak correlate of timber market activity. The correlation between rates of change in inflation-adjusted timber prices and housing starts for the last 30 years has not been strong, at 0.13 for Douglas-fir sawlogs and 0.46 for southern pine stumpage (see Note 2 on page 6). When addressing the effect of housing demand on timberland and timberland markets, one must take into account the role that lumber markets play in conveying changes in housing demand to timber and timberland markets. The connection between lumber prices and timber prices is complex. The 2Q 2000 edition of the Hancock Timberland Investor examined the relationship in some detail. We concluded that timberland investors should indeed pay attention to conditions in lumber markets as our examination of the relationship between timber prices and lumber prices proved significant. We updated our look at this relationship by examining the last thirty years of data. Much as we concluded previously, movements in lumber prices do translate to movements in timber prices, with the transfer being less than one-to-one. We find that for every 1.0 percent change in annual real contemporaneous and lagged lumber prices, a subsequent 0.8 percent change in real timber prices has occurred. This makes economic sense. On average, lumber and timber must be priced to allow lumber producers to cover production costs timber plus labor, energy and capital and earn a profit. Interestingly, 40 percent of the effect of a change in the current period timber price was due to last period s lumber price. This lagged analysis suggests that market signals from lumber producers to timber and timberland markets take time. Yearto-date benchmark lumber prices have dropped over 20 percent from the same period last year. In contrast, timber prices to date have fallen by about 3 percent in the South and risen by 3 percent in the Pacific Northwest over the same period (see Figures on page 3). Drawing on data provided by RISI for average lumber producer costs in the U.S. South and Pacific Northwest, we constructed the cost structure for an average U.S. lumber producer to provide information on the resultant profit margins as lumber revenues fall (Chart 1 below). Historically, producer profits, or the difference between revenue (lumber plus chip revenue) and costs (timber stumpage, harvesting and manufacturing costs) have experienced large fluctuations from year to year. The standard deviation of the annual change in profits has been almost 70 percent over the past 23 years. Chart 1: Average Profit Margins for U.S. Lumber Producers Revenue and Costs (2005$ per MBF - lumber tally) $700 Source: HTRG Research, RISI In contrast, the volatility of changes in annual timber stumpage prices is considerably less, at just under 10 percent. As lumber prices rise or fall, margins for lumber producers expand or contract, buffering timber prices from large price swings. Currently, we see this in declining margins for lumber producers, shielding timber prices against the recent deep declines in lumber revenues. The final step in the chain reaction of events occurring from a slowdown in housing demand is the translation of changes in timber prices to the performance of timberland investments. Timber prices are among many factors that combine to influence timberland returns. Yet, as one would think, the value of the product your investment is producing timber should have a fairly substantial effect on the investment s return. Detailed analysis found that changes in southern pine timber prices have a 57 percent effect on changes in timberland returns (see the 4Q 1999 Hancock Timberland Investor for more detail) Stumpage Costs Harvest Costs Manufacturing Costs Profit Margin Lumber Revenue Lumber plus Chip Revenue $210 $180 $150 $120 $90 $60 $30 Profit Margin (2005$ per MBF- lumber tally) (Continued on page 6) 2

3 Quarterly Average Regional Composite Prices for Softwood Sawtimber Stumpage (U.S.$ per MBF) $1,000 U.S. Pacific Northwest Export U.S. Pacific Northwest Domestic $900 New Zealand Export U.S. South U.S. Northeast $800 $700 Sources: Log Lines, Timber Mart-South, New Zealand Ministry of Forestry and HTRG Analysis Figure 1. Softwood Sawtimber Stumpage Prices Prices for export logs continued trending upward third quarter. Pacific Rim demand for both U.S. Pacific Northwest Douglas-fir and New Zealand radiata pine logs held strong. New Zealand radiata prices rose by over $60 per MBF in US$ terms or 26 percent from last quarter, and up over 35 percent from the same period last year. Demand from Korea, China and India have been the market drivers for radiata. Renewed demand from Japan for more volume of Douglas-fir has buoyed price levels. Stumpage prices for domestic softwood in both the US Pacific Northwest and the US South have held, despite pressure from falling prices for manufactured products most specifically lumber and wood panels. Quarterly Average Prices for U.S. South Lumber and Sawlogs ($ per MBF lumber scale) Southern Pine Saw Logs Southern Pine (Westside), Kiln Dried, 2x4 #2, Random Length Lumber Southern Pine Chip-N-Saw Logs Figure 2. Lumber and Sawlog Prices in the U.S. South Southern pine lumber prices averaged $287 per MBF third quarter, a 18 percent drop from average price levels last quarter and a 36 percent drop from peak levels in the third quarter of In contrast, prices for southern pine delivered logs have moved down just two percent third quarter from both last quarter and from year-ago levels. Sources: Random Lengths and Timber Mart-South Quarterly Average Prices for U.S. Pacific Northwest Lumber and Sawlogs ($ per MBF - lumber scale) Douglas Fir, Green 2x4 Lumber Douglas-fir Sawlog Hem-Fir (Coast), Kiln Dried, 2x4 Lumber Whitewood Sawlog Figure 3. Lumber and Sawlog Prices in the U.S. Pacific Northwest Lumber price in the U.S. Pacific Northwest fell hard during the third quarter as well. Douglas-fir green 2x4 prices dropped 19 percent from last quarter to average $253 per MBF. Kiln dried hemlock 2x4 prices fell 16 percent from last quarter, averaging $277 per MBF. Delivered log prices in the Pacific Northwest held steady third quarter, with hemlock log prices flat and Douglas-fir log prices up $7 per MBF over last quarter. Sources: Random Lengths and Log Lines 3

4 Quarterly Average Regional Composite Prices Softwood Pulpwood Stumpage ($ per ton) $40 $35 $30 $25 $20 $15 $10 $5 U.S. Pacific Northwest U.S. Northeast U.S. South Figure 4. Softwood Pulpwood Stumpage Prices Pulpwood prices were flat-to-up in all regions of the U.S. third quarter. Prices for pulp logs in the Pacific Northwest showed the greatest percentage change increase over last quarter as demand continues to outpace the supply of pulp logs to the region. As lumber production slows, less sawmill residual chips have been available for pulp mills, increasing the demand for whole logs. In the South, pulpwood prices held at last quarter levels. -$5 Sources: Log Lines, Timber Mart-South and HTRG analysis -$10 Quarterly Average Prices for Market Pulp ($ per metric ton) and U.S. Pulp Logs ($ per 10 tons) $900 $800 $700 NBSK Market Price Figure 5. Market Pulp and U.S. Pulp Log Prices The price for NBSK market pulp rose to $711 per metric ton third quarter, the fourth consecutive quarterly increase. Both Douglas-fir and southern pine delivered pulp logs rose slightly. Douglas-fir Pulp Logs Southern Pine Pulp Logs Sources: FOEX Industries Ltd., Log Lines and Timber Mart-South Quarterly U.S. Timberland Values ($ per acre) $2,500 $2,000 $1,500 U.S. Pacific Northwest Figure 6. U.S. Timberland Values in Private Property Markets U.S. timberland values moved little from second to third quarter, with per acre values averaging $1,178 in the South and $2,386 in the Pacific Northwest. $1,000 U.S. South Source: NCREIF Q1 Q1 Q1 4

5 Quarterly EBITDDA Multiples for Privately Traded Timberland (trailing 4-quarter EBITDDA) U.S. South U.S. Pacific Northwest Figure 7. U.S. Timberland Valuation Multiples in Private Property Markets Third quarter timberland income in both the U.S. South and Pacific Northwest was not unlike third quarter levels over the past three years, at just under $10 per acre in the South and slightly over $40 per acre in the Pacific Northwest. Pricing multiples for the Pacific Northwest however, continued to climb as market values rose in the region. 5 Sources: NCREIF and HTRG Research Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Monthly Securitized Timberland Share Value (Indexed to 100 at start date) Rayonier Crown Pacific Timberwest The Timber Company Plum Creek Deltic U.S. Timberlands Index Figure 8. Hancock Securitized Timberland Index Share prices for the four companies included in the HSTI were mixed during the quarter. Yet, falling share prices for Plum Creek, the largest contributer to the Index based on market capitalization, depressed the Index by almost 4 percent. Declines in manufactured wood product markets particularly for lumber and panel products has weighed heavy on earnings. Stronger export log volumes and higher-and-better use sales where available, helped moderate declines. 40 Source: HTRG Research 0 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Quarterly U.S. South Timberland Values ($ per acre) $1,400 $1,200 $1,000 $800 Private Property Market Figure 9. U.S. South Timberland Values in Public Equity and Private Property Markets The gap between public and private timberland values widened further third quarter. Public market timberland in the U.S. South, at $1,012 per acre third quarter, was valued just under $160 per acre less than private timberland. Public Equity Market Sources: NCREIF and HTRG Research 5

6 Housing Starts, Lumber Prices, and Timberland Investment Performance (Continued from page 2) Summary and Conclusions The connection between timberland performance and a slowdown in housing demand is indirect. Observation of historical U.S. housing starts and private timberland property returns show no clear relationship. In fact, the historical correlation between these data since inception of the NCREIF Timberland Property Index is a negative 11 percent. Instead, we find that the effect of a change in housing demand on the performance of private timberland property performance seems to be muted by shifts in profit margins for lumber producers. There is a direct relationship between changes in lumber usage and changes in housing starts. Likewise, a change in the demand for housing translates directly to changes in lumber prices. Currently, both lumber usage and lumber prices have fallen similarly in both magnitude and speed as the demand for housing construction slows. However, statistical analysis shows it takes time for signals in lumber markets to transfer to timber and timberland markets. The small changes in current year-to-date timber prices further reflect this lag. Lumber price declines have instead contracted profits for lumber producers, buffering timber prices and timberland returns from current declines in housing demand. NOTES Cover 1. The relationship between housing starts and lumber consumption was estimated by the equation: Dt = α + β1(ht)+β2(ht-1)+ε, where: D = the annual change in the natural log of U.S. lumber consumption H = the annual change in the natural log of housing starts α,β = estimated coefficients ε = error term and the relationship between housing starts and lumber prices was estimated by the equation: Pt = α + β1(ht)+ε, where: P = the annual change in the natural log of either Douglas-fir or southern pine lumber prices, adjusted for inflation. H = the annual change in the natural log of housing starts α,β = estimated coefficients ε = error term and the relationship between lumber prices and timber prices was estimated by the equation: St = α + β1(tt)+β2(tt-1)+ε, where: S = the annual change in the natural log of either Douglas-fir log prices or southern pine stumpage prices P = the annual change in the natural log of either Douglas-fir or southern pine lumber prices, adjusted for inflation. α,β = estimated coefficients ε = error term Dependent Variable α β 1 β 2 R 2 Lumber Consumption Southern pine (Westside) kiln dried, 2x4 #2 std&btr, random length lumber price Douglas-fir, Green, 2x4 #2 std&btr random length lumber price Southern pine sawtimber stumpage prices Douglas-fir delivered sawlog prices Note: standard error in parenthesis (0.005) (0.021) (0.027) (0.019) (0.021) (0.039) (0.147) (0.193) (0.141) (0.122) (0.094) 2. The correlation between housing starts in the South and southern pine inflation-adjusted stumpage prices is The correlation between housing starts in the West and Douglas-fir inflation-adjusted sawlog prices is N/A 0.34 N/A (0.138) (0.123) Research Team Courtland L. Washburn, Ph.D Managing Director and Chief Investment Officer cwashburn@hnrg.com Robert W. Hagler Director of International Investment Strategies & Economic Research bhagler@hnrg.com Mary Ellen Aronow Senior Forest Economist maronow@hnrg.com Hancock Timber Resource Group is a division of Hancock Natural Resource Group, Inc., a registered investment advisor and wholly owned subsidiary of Manulife Financial Corporation. Figure 1. The composite price for southern sawtimber is based on quarterly average Timber Mart-South published prices for pine sawtimber and chip-n-saw stumpage. Pacific Northwest prices are derived from quarterly average Log Lines published prices for whitewoods and Douglas-fir with internal analysis of logging costs for stumpage calculations. New Zealand export prices are based on New Zealand Ministry of Forestry quarterly average published prices for radiata unpruned A, J, and K sort export logs with internal analysis of logging costs for stumpage calculations. Northeast sawtimber prices are calculated from internal analysis. Figure 2. Quarterly southern pine (Westside), kiln dried, 2x4 #2 lumber price published by Random Lengths. Timber Mart-South published southern pine sawlog and chip-n-saw log prices converted to lumber scale using RISI historical lumber recovery rates as published in their North American Lumber Forecast. Figure 3. Quarterly Douglas-fir, green 2x4 lumber (Portland rate) and Hem-Fir (coast), kiln dried, 2x4 lumber prices published by Random Lengths. Douglas-fir and whitewood sawlog prices derived from Log Lines published priced for #2 and #3 sawlogs in various regions in the Pacific Northwest converted to lumber scale using RISI historical lumber recovery rates as published in their North American Lumber Forecast. Figure 4. Pulpwood composite prices are derived from quarterly average Timber Mart-South published prices for southern pine pulpwood stumpage, Log Lines published whitewood and Douglas-fir pulp logs with internal analysis of logging costs for the Pacific Northwest, and HTRG analysis of spruce/fir pulpwood in the Northeast. Figure 5. Quarterly NBSK pulp priced derived from daily list prices reported by FOEX industries Ltd. Southern pine pulp log prices published by Timber Mart-South. Pacific Northwest Douglas-fir pulp log prices published by Log Lines. Pulp log prices expressed in multiples of 10 to accommodate market pulp pricing scale. Figure 6. Regional NCREIF timberland market value per acre is derived by dividing the total regional market value at quarter end by the number of acres reported in that region. Figure 7. EBITDDA multiples are calculated using NCREIF timberland value per acre at quarter end divided by trailing four-quarter average NCREIF net income per acre. Figure 8. The Hancock Securitized Timberland Index (HSTI) uses a base-weighted aggregate methodology (similar to that used to construct the S&P 500) to calculate a market capitalization-weighted value for seven publicly traded timber-intensive forest products companies. Base weights were adjusted for the emergence of new companies or at the beginning of each year. Dividends are not reinvested. The companies included in the HSTI have no investment relationship with Hancock Timber Resource Group. Figure 9. Public equity values are derived from our Timberland Enterprise Value per Southern Equivalent Acre (TEV/SEA) calculation for five timber-intensive publicly traded companies as compared to southern timberland values per acre calculated from the NCREIF database. TEV is a quarterly estimate based on total enterprise value (total market equity + book value debt) less estimated value of processing facilities, other non-timber assets and non-enterprise working capital. SEA uses regional NCREIF $/acre values to translate a company s timberland holdings in various regions to the area of southern timberland that would have an equivalent market value. Hancock Natural Resource Group, Inc. References to expected investment performance in this newsletter are based on historical information and on management s projections. Potential for profit as well as for loss exists. 6