Managing Financial Risk in Forestry, Part III: Pricing Options and Wood Supply Agreements

12 11 2012

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

Colonel Kurtz, in the movie “Apocalypse Now,” says “you must make a friend of risk.”  While I don’t like people telling me who I need to be friends with, I acknowledge the need to embrace inevitabilities.  This brings us to Mother Goose, who advised:

For every ailment under the sun
There is a remedy, or there is none;
If there be one, try to find it;
If there be none, never mind it.

Part I of Managing Financial Risk in Forestry (Real Options and a Practical Question) summarized efforts related to using financial derivatives in the forest products industry and timberland investing sector.  Part II, To Hedge or Not to Hedge, introduced the concept of hedging risk in forest and timberland management. This post, Part III, discusses the pricing of options and use of supply agreements to manage timber prices.

Wood procurement managers at sawmills, pulp mills and wood bioenergy projects seek stable or predictable wood flows at low or predictable prices. In that sense, wood procurement manages wood flows with cash flows. Tools or strategies that improve the control over these wood flows at no additional cost or reduce wood costs with minimal impact on wood flows are desirable. We can picture this both as a portfolio of activities and menu of alternatives.

In developing risk management strategies for forestry investments, I modeled the application of “options on forwards” for wood procurement systems and supply agreements.  These models build on the work of Black-Scholes (1973).  In 1976, Black extended applications to cover commodities, such as agricultural products.  In 1985, Thorpe developed a model to price options on forwards, which, by default, accounts for logistical issues associated with forestry operations.  Why were these developments important?  Because in forestry and timberland investing, we must wrangle imperfect data and irregular trees into standardized contracts.  “Options on forwards” represent relatively flexible contracts that actually account for the time required to drive a load of logs to a mill.

What did we learn?  First, “valuing” and “pricing” options on forward contracts for timber applications reflect two different exercises.  The fact remains that available timber price data and the irregularity and localized nature of timber values challenges the capability of standardized financial models.  In the end, pricing options in forestry, while guided by models, includes negotiation.  Second, valuing options in forestry supports efforts to price wood supply agreements and insurance-based strategies.  When, as Mother Goose implores, we “try to find” remedies, we generate new alternatives for managing risk that may include operational and other readily available approaches.  For example, option pricing helps us evaluate the costs and benefits of building or buying wood yards and the length of wood supply agreements.  Finally, option modeling provides a useful benchmarking tool.

Timberland-owning firms and investors may work with sufficiently long time horizons – typically 10 years or more – to mitigate log price exposure by adjusting harvest levels with log price levels.  However, these same firms may require short-term regular cash flows, and hedging can, in theory, reduce cash flow volatility.  This is especially true for wood procurement operations, where daily, weekly and monthly wood raw material needs drive the schedule.  Isolating transactions and exposures that may result in variable cash flows provides a basis for evaluating risk management and hedging alternatives.

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

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Managing Financial Risk in Forestry, Part II: To Hedge or Not to Hedge

2 11 2012

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

Part I of Managing Financial Risk in Forestry (Real Options and a Practical Question) introduced industrial views and academic efforts related to the use of financial derivatives to manage risk in the forest products industry and timberland investing sector.  Gaston, in the 1958 movie “Gigi”, captures the general forest industry sentiment when he said “if you like that sort of thing.” Regardless, derivative securities improve the liquidity of risk (if you like that sort of thing).

Let’s name our parts.  Derivative securities “derive” their value from the prices of other underlying assets, such as stocks, bonds, currencies or commodities (i.e. wheat, gold or lumber).  The most common of these financial instruments are forwards, futures and options. In theory, these derivative securities manage exposure to risks associated with the underlying assets.  They do this by locking in prices and volumes in advance, thereby reducing uncertainty.  For example, a lumber manufacturer can lock in prices for future lumber sales by buying lumber futures contracts traded on the Chicago Mercantile Exchange (www.cme.com).  If lumber prices go up, the gain in the lumber sales price is offset by the loss from the lumber futures contract.  If lumber prices fall, the loss in the lumber sales price is offset by the gain from the lumber futures contract.

When used correctly, futures and options act as a form of insurance against unexpected price movements.  This phenomenon, where risk associated with one asset is offset with a position in financial derivatives, is called hedging. Alternately, “speculators” trade futures and options simply to profit from price level changes.

How can hedging strategies apply to forest management and timberland investing activities?  I have conducted research and analysis on risk management in forestry and timber using derivatives related to weather (crazy, huh?), currency exchange rates, energy prices, fertilizers and stumpage prices.  For example, a significant price relationship exists between urea cash prices and urea futures prices.  (Urea is the most common nitrogen fertilizer used in forestry.)

Discussions with forest managers revealed that high, short-term urea prices can lead them to forgo planned forest management investments.  This decision to “underinvest” relies on short-term cost and cash flow considerations. Using estimated hedge ratios, we calculate net realized urea prices for the U.S. South cash market for nine fertilization seasons over five years.  [Mendell, B.C. 2006. Hedging urea for forestry applications in the US South, Southern Journal of Applied Forestry, 30(3): 142-146]

Does hedging add value to overall forestry investments? Answers to this vary.  For example, the diversification of timberland investment portfolios is an operational hedge that produces clear, unequivocal benefits to investors. Alternately, the use of derivative contracts for day-to-day forest management activities works better on paper than in practice because of issues associated with the relatively small scale of individual forestry activities and the relatively large scale of standardized financial contracts.

Part III discusses the pricing of options and use of supply agreements to manage timber prices.  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





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