Annual Economic Review and Outlook for the Canadian Forest Sector: 2005-2006

December 20, 2005

Executive Summary

Introduction

This report provides an overview of recent developments in Canada’s major markets for forest products and the state of Canada’s forest industry. We also describe some of the major factors that will affect the state of the forest industry going forward and provide a qualitative assessment of the outlook for the industry’s performance over the remainder of 2005 and into 2006. The remainder of this section provides a brief synopsis of the major conclusions of our report.

Economic Outlook for Major Markets

North America

The United States economy accelerated in 2004, showing even stronger growth than it did in 2003 when it began to recover from recession. The Canadian economy also picked up steam after a weak performance the previous year. While the US Federal Reserve began a series of interest rate increases in mid-2004 with the Bank of Canada following suit later in the year, interest rates in both countries remain at historically low levels in both countries. The low cost of borrowing combined with rising income levels has resulted in a North American housing boom. Investment in new and existing housing increased, reflected by near-record housing starts in 2004 along with rising repair and renovation expenditures.

Strong overall economic conditions in North America contributed to a continued rise in demand for pulp and paper products, pushing prices for many products higher in 2004. The hot housing market also contributed to further increases in demand for wood products, pushing prices to near-record levels by mid-year. However, the continued appreciation of the Canadian dollar versus the US dollar offset some of the gains to Canadian producers of higher prices in US markets. In 2004, the Canadian dollar averaged 77 cents US, up a further 7.5 percent from 2003 levels. Furthermore, the Canadian dollar continued to rise in value as the year progressed breaking the 80-cent mark late in October.

Economic growth is expected to continue in 2005 and 2006, though the pace of growth is expected to slow as economies approach full capacity and monetary authorities raise interest rates to curb any inflationary pressures that arise. This should aid further increases in prices for pulp and paper products. However, rising interest rates will cool housing markets leading to declining wood prices from the extremely high levels seen in 2004. The Canadian dollar also looks to remain strong in the near-term given the likely persistence of the US current account deficit and strong commodity prices.

Japan

Japan, which is Canada’s most important offshore export market for forest products, experienced an economic recovery in 2004. This was accompanied by a moderate increase in housing starts in the country, raising demand for both wood products and pulp and paper. However, the long-term prospects for demand growth in forest products are poor due to a number of structural factors. Most important of these are the large and growing public debt and a rapidly aging population. These will hamper Japan’s macroeconomic performance and reduce housing construction activity over the next decade and beyond.

China

China’s economy continued its rapid expansion in 2004 fuelled by strong investment and, to a lesser extent, growth in consumer demand. The country has increased in importance as a market for Canadian pulp, and now ranks third behind the US and Japan in terms of its total imports of forest products from Canada. This trend is expected to continue, as the economy continues to industrialize, though there are concerns that the economy could be overheating. The Chinese government has implemented a macroeconomic control strategy to curb investment growth to engineer a soft landing for the economy.

Western Europe

The major economies of Western Europe have traditionally been large export markets for Canadian forest products. In 2004, the economic picture in the region was mixed, with some countries performing well, notably the United Kingdom, while others continue to do poorly, such as Germany and France, which are the region’s two largest economies. Economic growth will continue to be slow in the near-term due to weak consumer demand in Germany and France, along with a strong Euro and British pound, which will put a drag on growth in the export sector.

Developments in Forest Product Markets

Softwood lumber

US consumption of softwood lumber continued to grow rapidly in 2004, breaking record consumption levels seen in 2003 by a considerable margin. Strong demand was fuelled by the current boom in North American housing markets, which has been supported by low interest rates and rising income levels. As a result of this demand, lumber prices reached near-record levels in mid-2004 before moderating late in the year. Both Canadian and US increased production in response to high prices, though they did not keep pace with the demand levels resulting in a large increase in offshore imports to the US market. As a result, offshore producers increased their market share to 5.2% in 2004, compared to only 3.2% in 2003, while Canada’s share declined slightly to 33.5%, down from 34.2%. Despite the small loss in market share, Canadian producers benefited greatly from high prices and increased volumes, which drove exports C$3.4 billion (40%) higher for the year.

Wood-based Panels

As with lumber, North American structural panel markets have also benefited from strong demand created by the housing boom. North American consumption of both oriented strandboard (OSB) and plywood increased in 2004, driving up prices by 21% over already high 2003 levels. OSB producers in both countries and plywood producers in Canada increased their production to meet strong demand, though offshore imports also surged led by softwood plywood from Brazil. In 2004, offshore producers made up 38% of total US panel imports (all types), up from 31% in 2003. Despite this increase in competition, Canadian producers continued to increase the value of panel exports, which rose by close to 30% from 2003 levels due to a moderate increase in volume (+6.7%) and the large increase in prices.

Wood pulp

Demand and prices for wood pulp continued to rebound in 2004, with the price of Northern Bleached Softwood Kraft (NBSK), Canada’s most important grade of market pulp, rising by 16.8% from 2003 levels. However, despite increased demand, the volume of Canadian pulp exports was virtually unchanged in 2004, as declines in exports to the US and European Union offset gains in volumes to China. The value of Canadian exports increased by 5.1% in 2004 as a result of higher prices, which more than offset the negative impact of the continued appreciation of the Canadian dollar.

Newsprint

Despite strong economic conditions in the US, newsprint consumption fell in 2004, continuing a long-term secular decline. North American production also fell, with most of the decrease occurring among Canadian producers. Despite falling consumption levels, newsprint prices increased in 2004, rising by 8.8% from 2003 levels. The volume of Canadian newsprint exports fell, due to a large drop in shipments to the US, which more than offset modest gains to other markets. The value of Canadian exports also dropped, as newsprint price gains were not sufficient to offset the declining volume of exports and the higher Canadian dollar.

Graphic Paper

Prices for many grades of graphic paper rose modestly in 2004, though remain well below cyclical peaks seen in 2000 and 2001. The volume of Canadian exports of graphic papers expanded substantially in 2004 (+16%), though the value of exports rose more modestly (11%), as exchange rate movements offset some of the impact of rising volumes and prices.

Forest Sector Employment

In this year’s edition of the Annual Economic Review and Outlook, we examined employment developments in a few specific sectors of the forest industry: (1) sawmills and wood preservation, (2) panel and engineered wood product manufacturing, and (3) pulp and paper mills. In 2004, employment in the sawmill industry increased modestly from 2003 levels, with increases in BC and Quebec, but a fall in employment in Ontario. This was a reversal of the last few years which has seen a decline in employment in this industry, with the largest declines (relative to employment) occurring in BC and Ontario. Employment in the production of panels and engineered wood products increased strongly in 2004, with increases concentrated in Quebec and Ontario. This is the continuation of a longer-term trend of increasing employment in this industry, which has grown by 3.7% per year since 1991. In contrast, employment in pulp and paper mills has been declining in Canada over the long-term (-3.2%/year since 1991), though average employment was down only modestly in 2004 compared to 2003. However, when compared to 2001, average employment has fallen substantially (13.4%) with substantial loses in all regions.

Financial Performance

Operating profits for Canada’s forest industry rebounded strongly in 2004 following three consecutive years of decline. The return on capital employed (ROCE) also increased in 2004 to 7.6%, though it still remains below the 10% target used an a benchmark by many industry observers. Both increased revenues and lower expenses contributed to improved financial performance. Rising wood product and paper prices contributed to improvements in revenues, though these were partially offset by the continued appreciation of the Canadian dollar vis-à-vis the US dollar. Rationalization in the industry and consolidation brought about through mergers and acquisitions in the last couple of years is cited as a possible factor reducing overall industry expenses although rising wood fibre and energy prices have impacted the industry bottom line on the cost side. In the near-term, wood product prices are expected to decline; pulp and paper prices will continue a gradual rise, while the Canadian dollar will remain strong. Overall, this is expected to have a negative impact on financial performance.

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