Contract Problems

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Timber Contract Problems
In 1983, the Pacific Northwest lumber                 Forest Service contracts
industry moved out of the depths of reces-            In keeping with the general pattern through-
sion and into recovery. This year, due to the         out the West, lumber manufacturers in west-
strength expected in homebuilding and                 ern Oregon and Washington rely heavily on
other lumber markets, lumber production               publicly owned lands for their timber sup-
and prices may show further moderate                  ply. In 1976, the latest date forwhich official
improvement. Nevertheless, scores of firms            data are available, about 22 percent olthe
could face financial pressures arising from           total sawtimber harvested on commercial
the cost of raw materials not only in 1984 but        forestlands in that region came from Nation-
in the remainder of this decade. Those pres-          al Forests managed by the U.S. Forest Ser-
sures result from the high-cost public timber         vice. Another 20 percent came from public-
under contract that is unprofitable to harvest        Iyowned lands managed by the      u.s. Bureau
at current and foreseeable lumber prices.             of Land Management and state agencies.
                                                      The remaining 58 percent came from lands
                                                      owned by the forest products industry and
To date, the affected companies have re-              other private landowners. In contrast, out-
ceived extensions of contract expiration              side the West, public lands account for only
dates, but they are pressing for federal legis-       10 percent of the total annual harvest. Near-
lation that would dissolve some of their              ly all lumber firms operating in western
contracts. They argue that the federal gov-           Oregon and Washington rely on public
ernment shares responsibility for their diffi-         lands to some degree for their raw material,
culties because it affects housing markets            but dependence is especially great for small,
and controls both the amount of their raw
                                                      non-i ntegrated producers.
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
This Letter will describe the contracts and
                                                      bidding process. The contracts then call for
lumber market conditions that contributed
                                                      the winning bidder to harvest the tract with-
to the present problem. It will show that
                                                      in the Iife of the contract, usually of several
whi Ie the "forward" contract method of seIl-
                                                      years duration to allow for road construction
ing public timber provides some benefits to
                                                      and logging. The purchaser pays a small
purchasers, it also subjects them to great
                                                      initial cash outlay but is not required to
uncertainty about the profitability of the
                                                      make full payment until the timber is cut. For
timber under contract. To prevent a possible
                                                      contracts awarded in western Oregon and
recurrence of the current problem, public
                                                      Washington before August 1, 1983, pur-
timber management agencies should con-
                                                      chasers are to pay the original bid price at
sider reforming the sales system to derive the
                                                      time of harvest. As such, the contracts are
price paid for timber more directly from the
                                                      forward contracts. Even with subsequent re-
prevailing price for lumber. The discussion
                                                      forms, the contracts require companies to
will focus on National Forests in the western
                                                      formulate their bid prices by forecasting the
half of Oregon and Washington. The heavy
                                                      production costs and selling prices for
preponderance of the key homebuilding
                                                      lumber and other wood products they ex-
Douglas-fir species in that region, along
                                                      pect to prevail when the timber will be
with the absence of a mechanism to adjust
prices downward in contracts awarded be-
fore August 1983, have made the problem of            These forward contracts afford purchasers
uneconomic timber the most serious there.             certain benefits. They permit firms to secure

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 a contract with a small outlay of capital                                       meet the requirements of the post-World
 "upfront", And they allow the purchaser to                                      War II baby boom. Meanwhile, increasing
 pay only for the actual volume of useable,                                      amounts of commercial forestland were set
 non-defective raw material found as the                                         aside for wilderness purposes.
 trees designated for harvest are removed and
 measured, But the contracts also render the                                     Expecting that strong product demand and
 purchaser vulnerable to changes in lumber                                       tight raw.material supplies would continue
 prices. If lumber prices should rise more                                       to push lumber prices upward throughout
 than the firms expected when they formu-                                        the 1980s, mills bid frantically for public
 lated their initial bid, they may receive a                                     timber during the late 1970s. On National
 larger profit than they expected. On the                                        Forests in western Oregon and Washington,
 other hand, if purchasers expect lumber                                         the average winning bid price for Douglas-
 prices to rise but they fall instead, firms may                                 fir timber nearly doubled between 1977 and
 receive less profit than they had anticipated                                   1980 (see chart).
 or they may even suffer losses.
                                                                                 But, instead of conti nu ing upward as expect-
 Origins of the problem                                                          ed, prices for softwood lumber dropped be-
 Long contracts, requiring little initial capital                                tween 1979 and 1982. For example, the
 and no specific interim payments, encour-                                       price of Douglas-fir fell by 31 percent. This
 age purchasers to secure and hold large                                         occurred as housing starts plunged down-
 volumes of timber when they expect pros-                                        ward to only 1.0 million units by 1982 and
 pective demand and prices for lumber to rise                                    lumber consumption also fell in other mar-
 sharply. Federal contracts in use in the late                                   kets. When housing starts recovered to 1.7
 1970s were particularly conducive to such                                       million units in 1983, lumber prices rose
 behavior. Most contracts ran from three to as                                   sharply on an annual basis but failed to re-
 much as seven years in duration. Besides the                                    gain their 1979 peaks. Prices continue to lag
 nominal deposit with bid, the winning bid-                                      behind 1979 levels because they showed
 der posted only a performance bond when                                         renewed weakness in the latter half of 1983
 the contract was signed and no interim pay-                                     before rising during the first quarter of 1984.
 ments were required until the purchaser cut                                     The end-result is that many firms currently
 the timber, often in the last year of the con-                                  hold sizeable volumes of unprofitable
 tract. Unlike Forest Service contracts else-                                    timber under contracts awarded during the
 where in the West, they contained no                                            late 1970s.
 stumpage rate adjustment clause to adjust
 original bid prices upvyard or downward in                                      Magnitude of the problem
 response to changes in lumber prices.                                           At present, firms hold about 9.5 billion
                                                                                 board feet of uncut timber on National
 Lumber market conditions in the late 1970s                                      Forests in western Oregon and Washington
 encouraged bidder optimism. Between                                             in contracts awarded before January 1, 1982.
 1977 and 1979, producer prices for                                              (Contracts awarded thereafter are not a
 Douglas-fir lumber rose at an average                                           problem because bid prices fell dramatical-
 annual rate of 16 percent (see chart). Home-                                    ly.) The average bid price on the timber
 building-by far lumber's largest market-                                        awarded before 1982 is $316 per thousand
 was booming. During those years, the                                            board feet. Forest Service and market data
 number of new homes built annually aver-                                        show that it currently would cost an average
 aged 1.8 million units, with a near-record                                      operator about $482/thousand board feet to
 high of 2.0 million units being reached in                                      harvest and deliverthattimber in log form to
 1978. Demographic factors suggested that at                                     the mill (including stumpage), while such
 least 2 million housing starts per year would                                   logs would bring an average market price of
 be needed during the decade of the 1980s to                                     only $281 /thousand board feet. At current

  Ratio Scale
$ per Thousand                         Rallo Scale
  Board Feet                           1970=100


       'WolternOregonondWashlngton                                                         - ' - ;_ _

finished lumber prices, such contract                    award and certain payments mid-way
holders therefore would incur an average                 through the life of the contract. The agency
loss of about $201 /thousand board feet on               also shortened the term of new contracts.
timber contracts awarded before 1982.
                                                         The Forest Service introduced perhaps its
This analysis does not mean that all of the              most important reform on August 1, 1983
9.5 billion board feet sold prior to January             when it added a stumpage rate adjustment
1982 is currently uneconomic to harvest                  clause to new contracts in western Oregon
since the $316/thousand board foot price is              and Washington. The clause permits the bid
an average. But it does suggest that lumber              price to be increased or decreased, within
prices would have to rise sharply in the                 stated limits, in accordance with changes in
future to make much of this timber worth                 lumber prices. The procedure, already in
harvesting.                                              use on Ndtional Forests elsewhere in the
                                                         West, ad justs bid prices to reflect 50 percent
Government. reponse                                      of any upward change in the lumber price
To give fi rms more ti me to meet thei r obi iga-        index and 100 percent of any decl ine in
tions, the Forest Service, in May 1980 and               lumber prices below a base level. Its pur-
October 1981, extended contracts by one                  pose is to transfer some of the profits and
and two years in programs known as Soft I                losses that would otherwise accrue to pur-
and Soft II. Then, on July 28,1983, the Secre-           chasers during periods of rising and falling
tary of Agriculture announced that all feder-            lumber prices to the federal government,
al timber sales contracts awarded before                 thereby reducing the variability in the lum-
1981 cou Id be extended for another five                 ber companies' profits. However, because
years without payment of interest on the bid             the adjustment mechanism is skewed more
value of the uncut timber that would have                to protect buyers from the risk of downside
been due. Holders ofthose contracts still                loss than to remove profits in a rising market,
argue that th is proposed" Five-Year Mu Iti-             it will impart an upward bias on bid prices
Sale Extension Plan" is unworkable because               and will not completely eliminate earnings
domestic lumber prices are not likely to rise            variabi Iity.
sharply enough over the 1984-90 period to
permit them to harvest that timber profitably,           To eliminate uncertainty about the profita-
nor is demand likely to be great enough to               bility of public timber, the Forest Service
combine that volume with new Forest Ser-                 would have to sell timber at spot prices
vice offerings. In February, over one hun-               derived directly from contemporaneous fin-
dred contract holders won a court injunc-                ished lumber prices. Such a system exists in
tion temporarily prohibiting the Forest                  British Columbia. There, the government
Service from enforcing those contracts or the            allocates the supply of public timber avail-
February 15, 1984 deadline for submission                able for sale to forest product firms under
of harvest schedu les for the five-year exten-           long-term contracts. The price it charges for
sion plan.                                               timber cut in any given year is a residual
                                                         value based on the current price of lumber
Beyond extending contracts, the Forest Ser-              minus costs of conversion and a reasonable
vice on April 15, 1982, introduced a number              margin of profit. Its objective is to provide
of new provisions for future contracts de-               forest products firms with secure timber sup-
signed to reduce the upward pressure on bid              plies at a profitable price, and thereby pro-
prices. Those measures, in effect, make it               mote the growth of the industry.
more expensive for purchasers to hold tim-
ber under contract. They include, for exam-                                               Yvonne levy
ple, requiring a 5 percent cash deposit on
the total value of the bid within 30 days after

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(Dollar amounts in millions)
Selected Assets and Liabilities                Amount            Change                Change from 12/28/83
Large Commercial Banks                        Outstanding         from                              Percent
                                                4/25/84         4/18/84                 Dollar    Annualized
Loans, Leases and Investments' 2                178,572          -  244                   2,547             4.4
     Loans and Leases' 6                        158,.827         -   65                   3,472             6.8
          Commercial and Industrial              47,372             130                   1,409             9.3
          Real estate                            59,612          - 30                       713             3.7
          Loans to Individuals                   27,926             123                   1,275            14.6
          Leases                                  4,994               0            -         69      -      4.1
     U.S. Treasury and Agency Securities2        12,074          - 154             -        433      -     10.5
     Other Securities2                            7,670          -   26            -        493      -     18.4
Total Deposits                                  184,539          -3,535            -      6,458      -     10.3
     Demand Deposits                             43,133          -2,445            -      6,104      -     37.9
          Demand Deposits Adjusted3              28,844          -1,152            -      2,487      -     24.2
     Other Transaction Balances4                 12,124          - 834             -        651      -     15.5
     Total Non-Transaction Balances6            129,281          -  257                     296             0.7
          Money Market Deposit
               Accounts ~Total                   39,617          -    477                    20             0.1
          Time Deposits in Amounts of
               $100,000 or more                  38,004                202         -        161      - 1.2
Other Liabilities for Borrowed MoneyS            21,183              2,167         -      1,824      - 24.2
Weekly Averages                                Weekended             Weekended
of Daily Figures                                 4/23/84               4/9/84
Reserve Position, All Reporting Banks
  Excess Reserves (+ )/Deficiency (-)                 68                     273
  Borrowings                                         174                      53
  Net free reserves (+)/Net borrowed( - )            106                     220
    1   Includes loss reserves, unearned income, excludes interbank loans
    2 Excludes trading account securities
    3 Excludes U.s. government and depository institution deposits and cash items
    4 ATS, NOW, Super NOW and savings accounts with telephone transfers
    S Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
    6 Includes items not shown separately
    Editorial comments may be addressed to the editor (Gregory Tong) orto the author. , , •Free copies of
    Federal Reserve publications can be obtained from the Public Information Section, Federal Reserve
    Bank of San Francisco, P.Q. Box 7702, San Francisco 94120. Phone (415) 974.2246.

Description: Contract Problems document sample