Managing Financial Risk in Forestry, Part I: Real Options and a Practical Question

28 10 2012

This is the first in a three-part series related to managing financial risk associated with timberland investments, wood procurement and forest management activities.

In his 1989 book Liar’s Poker, which provides a behind-the-scenes look at Wall Street, Michael Lewis writes, “Risk, I learned, was a commodity.  Risk could be canned and sold like tomatoes.”  While this might be true for traders and insurance brokers, it has not been the prevailing view or practice in the forest industry or timberland investing sector.  Ten years ago, I attended a Global Forest Products conference in New York and listened to a panel of forest products Chairmen and CEOs express little interest and much skepticism regarding the potential role of derivative securities – such as options and futures contracts – for managing risk at their firms.

Rather, timberland investors and researchers – such as Chris Zinkhan in 1995 and David Newman in 2002 – often view forest management as valuing and choosing between a series of real options.  In part, this focused on the traditional forest management problem of identifying the optimal forest rotation.  Real option theory addresses limits of net present value (NPV) analysis, which screams “YES, INVEST!” in all investments where the present value of incoming cash flows (benefits) exceeds the present value of outgoing cash flows (costs). Simply, NPV analysis takes a view of decisions as fixed, while real options analysis assumes a dynamic view of the future and considers issues such as flexibility, volatility and contingency.

However, the leap to real options thinking and research in forestry bypasses applications regarding the use of financial options and related contracts in managing forest businesses.  Efforts to better understand the potential for financial derivative contracts included projects on hedging lumber with lumber futures contracts (Deneckere et al 1986), calculating the option value of converting timberlands to alternate uses (Zinkhan 1991), using option valuation to confirm estimates of optimal forest rotations (Plantinga 1998), and valuing forest assets using option pricing models (Hughes 2000).  And in 2002, I initiated research into risk management specific to forestry investments and forest business management by studying opportunities for using widely accepted financial contract structures and strategies for optimizing the financial performance of timberland and forest industry assets.

Ten years ago, I asked “Given developments in the broader field of applied finance, how might forestry professionals and timber-dependent firms enhance their financial risk management associated with forest management and timberland investments?”  Today, after a market crash and recession, the question remains relevant, though with a shorter leash and narrower focus. Ultimately, we wish, more than ever, to better understand how to think about risk management – the identification, assessment, and management of a firm’s exposure to selected forms of risk through the use of insurance, financial derivatives, and operating strategies – and financial risk – those risks that a firm is not in the business of bearing – in the forest products industry.

Part II discusses hedging strategies and their potential relevance to the forest industry.  Since 2003, Dr. Brooks Mendell has delivered keynotes and workshops throughout North and South America, in English and in Spanish, related to risk management in forestry and timberland investment markets. To schedule Dr. Mendell for your event, please contact Heather Clark at 770.725.8447 or hclark@forisk.com





“Getting Smart” in Forest Finance

17 10 2012

What opportunities exist for “getting smart” in forest finance?  I field versions of this question regularly from students seeking work in the timberland investment sector and from forestry professionals looking to broaden their skills and offerings to current clients.  To me, the opportunity is to be and remain knowledgeable and strong in at least one of the following areas in addition to forestry.

  1. Understand taxes.  You can make a lot of money and lose a lot of money based on what you know or don’t know about timber taxes.  Taxes matter.  For example, tax laws encourage ownership changes.  Issues associated with tax efficiency facilitated the movement of timberlands to institutional investors, Real Estate Investment Trusts (REITs) or subchapter S Corporations.
  2. Understand financial statements.  They are the language of investors and executives.  At the end of the day, the results of managerial business and capital allocation decisions get translated through audited financial statements which, like haikus and box scores, require interpretation and translation.
  3. Understand ownership structures.  At a minimum, be able to explain a C-corporation vs. a REIT vs. the range of other single-tax entities (LLC, S-corporation…)
  4. Understand true risks (and accounting for them).  Timberland investment and forestry novices ask first about fire, bugs, disease and hurricanes. Forest investment professionals can help them put these into perspective and understand more about markets. Part of getting comfortable with timberland risk results from being familiar with available information on physical, operational, financial, and regulatory risks.  The long investment horizons associated with forestry investments increase the interest in understanding the frequency and severity of potential risks.  Forest analysts should be prepared to think about and answer “how should we think about timberland risks?”
  5. Understand markets and forestry data.  Know current prices and industry trends.  Wood prices provide a key signal in understanding the economics of a given wood basket today and historically in an easily communicated form.  Be familiar with indices and data sources such as NCREIF, the FTR Index, and the US Forest Service.  Remember, all forestry data is a sample…..
  6. Understand how to communicate with a range of individuals.  In person and in writing.  I wrote a book – Loving Trees is Not Enough – and speak on this topic because my mentors, starting with my parents, have long emphasized its central importance to success.  Forestry and investment analysts communicate with a broad range of groups and individuals, including researchers, clients, private consultants, executives, our bosses and colleagues. Our analysis has little value if it cannot be easily communicated, either by us or by others, as part of a presentation or in writing. We owe it to them to be able to explain our findings, our assumptions, how we came to these conclusions, and how they could help or affect them.

Click here to learn about and register for “Applied Forest Finance” on February 7th in Atlanta, Georgia.





Timber REITs: Trees Outgrow the Market Long-Term and Year-to-Date

10 10 2012

In forestry and timberland investing, sometimes our job is to get out of our own way.  In other words, let the forestry asset do what it’s going to do for us given it’s inherent exposures to housing and pro-cyclical financial performance.   Year-to-date and over the past ten years, publicly-traded timberland-owning firms (timber REITs) outpaced the S&P 500, while private timberland investments led even timber REITs for the ten year investment period (figure).

Reflecting on alternate timberland investment vehicles in an improving post-recessionary environment, we can reaffirm key advantages delivered by the asset class.  Positive cash flows.  Portfolio diversification.  Optionality.   Meanwhile, the risk profile for the sector has changed.  New investors face limited downside in their portfolios to the physical risks of insects, disease, fire and weather events, but struggle to quantify the risks associated with shifting forest certification and regulatory expectations.

For FTR calculation methodology, please visit www.forisk.com and click on “Equity Research.”  To subscribe to the free FTR Weekly Summary, or for information regarding Forisk Equity Research, please contact Brooks Mendell, bmendell@forisk.com.