Economics of Forest Management Decision Making in Today’s World

1. Economics of Forest Management Decision Making in Today’s World Cheryl Talbert Director of Forestry Weyerhaeuser Company Western Timberlands

2. Economics of Forest Management Decision Making in Today’s World • Wood products and timber are increasingly global commodities – puts a ceiling on long-term log values and quality premiums. • Advances in technology have reduced the value premium for large logs, older logs and higher-end quality. • Timber producers now are competing with pension and real estate investors for investment results – returns must be higher to compete. • Costs are high and payback-period long compared to other tree growing regions and other investments -and the gap is growing as other regions more aggressively implement yield-improving and cost-reducing technologies. • We enjoy some unique advantages with our species and relative proximity to major North American and Asian markets... ….but those advantages will not be enough to maintain our species’ competitiveness – and investment dollars for forest management - unless we can grow high-value stands faster, and at a lower cost. ….this does NOT mean ‘lowest cost forestry’. Within bounds, intensive management generates higher returns than low-intensity management.

3. Economics of Forest Management Decision Making in a Global Context Foresters can no longer afford to focus just on full stocking, dead weeds and high yields… Nor can we just focus on cost cutting….  We must be effective Investment Portfolio Managers!!

4. Economics of Forest Management Decision Making in Today’s World • You must make decisions every day. • “Investment thinking” means making those decisions based on the expected timing and financial benefits, compared to the timing and magnitude of costs and expected risks. • This talk highlights some key concepts, methods and considerations to help you integrate investment thinking into your tree-growing decisions.

5. Economics of Forest Management Decision Making in Today’s World Portfolio: Low-elevation, dry site Ponderosa pine sites Mid-elevation, N/E slope Larch/ white pine sites High elevation lodgepole pine sites Investment Options: Planting stock Vegetation control (spot, broadcast) Burning, scarification Thinning Fertilization Harvest age Available cash

6. Economics of Forest Management Decision Making“First Principles” for Forest Management Investments • Money costs money (“cost of capital”). • There is an opportunity cost to invest money in a plantation, defined by what your owners-shareholders-investors could make if they put that money into the best alternative investment of the same risk level. In effect you are ‘borrowing’ money from an investor for a defined period of time, and they want to make a competitive ‘interest’ on their money. Compound interest formula = $$ x (1 + i )t

7. The longer your organization must wait for ‘payback’ from an investment, the greater the ‘interest cost’ and the final benefit required to generate an attractive rate of return.  Early-rotation investments must have much greater impact than later investments to provide an attractive return.

8. Another way of looking at this is the ‘discounting’ of future values: those values are worth less to you today the further out in time that you expect to realize them. Discounted Future Value = $$ / (1 + i )t • Prescriptions that save you money early or generate earnings sooner will have higher investment returns.

9. Economics of Forest Management Decision Making“First Principles” for Forest Management Investments • Investment options need to be compared integrating the relative size and timing of costs and payback, including cost of capital. Would you rather have… • $100 today or $1500 in 25 years? • If your cost of capital (alternative rate of return) is 11% or less, you’d be better off waiting for the $1500 than saving the $100 and putting it into the alternative investment – as long as that alternative investment has the same or lower risk

10. Economics of Forest Management Decision Making“First Principles” for Forest Management Investments • Investment options need to be compared integrating the relative size and timing of costs and payback, including cost of capital. Would you rather have… • $100 out-of-pocket today for $1000 earnings in 10 years, or $500 out of pocket today for $20,000 earnings in 40 years? • If your alternative rate of return (cost of capital) is 8% or less you’d rather invest the $500 to make $20,000 • If your alternative rate of return is 10% or more, you’d rather pocket the $400 difference and put it in the alternative investment • as long as that alternative investment has the same or lower risk

11. Economics of Forest Management Decision Making“First Principles” for Forest Management Investments Tools for comparing investment options with variable timing of costs and payback: • Financial Life Cycle • “Discounted Cash Flow Analysis: • Return on Investment (ROI) • Net Present Value (NPV) • Wood growing cost per ccf

14. Economics of Forest Management Decision Making“First Principles” for Forest Management Investments “Discounted Cash Flow Analysis: Net Present Value: The difference between all positive and negative cash flows (costs and revenues) for a particular investment option, discounted back to the current year using your defined alternative rate of return. • Represents the $$ you could put into a 40 year CD today with your defined alternative return, and break even with the forestry investment. • If negative, you don’t expect to make your alternative rate of return • Can compare NPV for multiple options ROI: The percent return on investment that results from the string of positive and negative cash flows for a particular investment option. • Compare against your organization’s target rate of return • Compare ROI for multiple options

15. Economics of Forest Management Decision MakingNPV and ROI - Examples 100 / (1.06)15 = 42 Sum of discounted cash flows Can do these with NPV and IRR functions in EXCEL – requires a table with every year of cash flow listed. =NPV(C1:C40,6%) =IRR(C1:C40,X%)

16. Economics of Forest Management Decision MakingNPV and ROI - Examples Higher returns in this stand if you spend a little more up front, wait and commercially thin to bring in mid-rotation cash rather than thin-to-waste, even if the final harvest volume and earnings are reduced.

17. Economics of Forest Management Decision MakingNPV and ROI - Examples Thinning decisions also should consider the expected impact on harvest volume and earnings compared to an unthinned case. Some species will show drastic negative impacts on harvest value and yield if left unthinned, while in other species thinning can reduce harvest volume.

18. Economics of Forest Management Decision MakingNPV and ROI - Examples Even better if you can get the stand off to a fast start and thin early, enabling an earlier clearcut. Note that you can accept much lower final harvest earnings if you can get your earnings much sooner. These are just examples – every stand will be different!

19. Economics of Forest Management Decision MakingNPV and ROI - Examples In practice you will likely wait to a reasonable thinning age and compare your options given the better estimate of future price and volume at that time, rather than at year zero. In this case, you expect a reduction in final harvest earnings due to the thinning but would be financially better off taking it anyway (NPV is higher) because of the earlier positive cash flows.

20. Economics of Forest Management Decision MakingNPV and ROI - Examples • Another approach is a ‘marginal cash flow’ analysis, where you calculate the NPV and ROI on the CHANGE in cash flow you would experience with a new treatment. • This approach allows you to easily adjust the discount rate for higher risk or uncertainty. (More on this later)

21. Economics of ForestManagement Decision Making“First Principles” for Forest Management Investments • Wood growing cost in dollars per CCF is a useful metric to describe the financial competitiveness of the stands you’re managing in a ‘commodity’ marketplace. • “Commodity”: not much differentiation in price based on quality Wood growing cost = Total compounded cost through the rotation / Total merch volume produced

23. $400/ac initial land cost

26. Economics of ForestManagement Decision Making“First Principles” for Forest Management Investments • Well-chosen incremental treatment investments can improve wood growing costs per unit of harvest volume. • This results when you choose treatments that increase yields more than they increase total costs (including cost of capital).

27. Economics of ForestManagement Decision Making “First Principles” for Forest Management Investments 4. The higher the risk or uncertainty in your final payout, the higher the return that an investor will expect for their money. Risk and uncertainty: Probability (predictable or not) that results will be different from expectations Factors increasing risk or uncertainty: • Longer time from investment to payout • Size of assumed market premium • Higher assumed volume benefit, or breadth of sites you assume it will apply to • Site stress level, exposure to damage • Strength of data and past experience

28. Economics of ForestManagement Decision Making “First Principles” for Forest Management Investments 5. Attractive returns are not an assured proposition for every treatment on every site. • Treatments must be targeted carefully to sites where they can be expected to provide good returns. • particularly critical for stand establishment treatments because of their long holding period. Examples: • More expensive planting stock • Scarification • Intensive vegetation control • Fertilization

29. Economics of ForestManagement Decision Making “First Principles” for Forest Management Investments 6. The worst investment of all is the one that does not achieve the desired result – rework and delays cost money!! GOOD EXECUTION is the #1 investment priority. • Plan well • Adjust your treatments to the conditions • Calibrate your equipment ahead of time • Pick a good contractor, and INSPECT! • Measure what you’re getting, including variability

30. Economics of Forest Management Decision Making “First Principles” for Forest Management Investments • It can be considerably worse to spend too little than to spend too much!….IF the result is: • Significant land out of production or a significant yield falldown • A delay in the payout from your investment in the stand (increases your cost of capital) • Spending more money to correct a problem • A much higher risk that the stand value will be lost The margin for error is much narrower the more stressful that the site is.

31. Economics of Forest Management Decision Making “First Principles” for Forest Management Investments It ALWAYS pays to GET IT RIGHT THE FIRST TIME.

32. Economics of Forest Management Decision Making “First Principles” for Forest Management Investments Cost of Non-Stocked ‘Holes’ CV = “Coefficient of Variation” (standard error / mean) You could afford to spend up to $100 per acre up front to avoid these yield losses (not counting value degrade from the open-grown trees around the holes).

33. Economics of Forest Management Decision Making “First Principles” for Forest Management Investments Foresters must be effective investment portfolio managers! This requires: • Working knowledge of financial concepts, tools and methods • A model or other method to forecast growth and yield • Up to date price and market forecasts (e.g. RISI) • Data on treatment response that relates to your site types • Detailed forester knowledge of sites and conditions: • Productive and value potential • Stress level and survival risk • Soil and slash hindrances, vegetation communities Do your homework – it’s a matter of competitive survival!

34. Questions?