pulp global price.pdf

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This report has been prepared by UBS Securities LLC. ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 19. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Global Research 25 June 2015

Global Paper & Forest Products Can Global Pulp Pricing Remain Immune to the Accelerating Pace of Supply Growth?

We expect industry's ability to absorb supply to become severely challenged Over the next few years pulp capacity growth is set to accelerate from an already high level potentially 2.5x faster than historic trend. We expect this to exert pressure on global pulp pricing later in 2015-through 2017. We expect hardwood prices to fall about 25% from current levels and softwood to decline about 12.5%. We estimate about 80% of planned capacity growth is hardwood, though there is some softwood coming on, particularly over the next year or so. Near-term we expect softwood to show relatively better trends than hardwood as markets make adjustments to the very narrow softwood premium. Over the long-term we expect hardwood/softwood to trade on their own supply/demand dynamics and the softwood premium to widen.

Shift from nonwood pulp in China was a big help absorbing recent supply While we would not characterize markets as strong, we acknowledge that pulp markets have held up better than we had expected over the past year or so. We attribute this to a steep contraction in nonwood pulp consumption in China-off 40%+ (~5.5mm tonnes) since 2010. We also believe some Chinese wood pulp producers have opted to purchase pulp in lieu of own production (price of purchased pulp less than their own production costs). We caution against extrapolating 2014/early 2015 experience to the future. The rate of pending supply growth is even greater than recent past. And we do not believe these factors in China will prove as helpful with the coming wave of new supply. We do not expect Chinese nonwood pulp demand to fall to zero (rate of decline slowed in 2014). Some of this demand could be price sensitive; some Chinese pulp lines could restart in the event of sufficient pulp price recovery.

Underlying demand not likely too supportivesome risks to our forecast Global paper demand growth has slowed, impacting pulp consumption. While tissue remains a relative bright spot, tissue demand growth has not been enough to offset the decline in printing and writing demand. Key risks to our negative forecast include pulp expansion projects being delayed/cancelled, offsetting capacity closures, a surge in demand growth from emerging markets such as India, a sharp decline in the US dollar.

Select global producers: Fibria (Sell), CMPC (Neutral), Klabin (Buy), Domtar (NR), International Paper (Buy), Weyerhaeuser (Sell), UPM (Sell), Stora Enso (Sell)

Equities

Global

Paper Products

Global Paper Team 212-713-3486

Gail S. Glazerman, CFA Analyst

[email protected] +1-212-713 3486

Andreas Bokkenheuser Analyst


David Hallden Analyst


Nishal Ramloutan, CFA Analyst


Edwin Chen Analyst

[email protected] +852-2971 8007

Global Paper & Forest Products 25 June 2015

2

While not strong, pulp markets have held up better than we had expected the past 1-2 years given material new supply that has entered the market. We caution against extrapolating that success to the market's ability to absorb the brewing virtual tsunami of new supply that appears to be poised to hit in 2016-18.

Our medium term outlook for global pulp remains cautious, predominantly based on the sheer magnitude of planned capacity growth. We estimate close to 80% of expected incremental supply is hardwood. That said, over the next year or so there is a reasonable amount of softwood capacity coming on line as well.

Nearer term, we expect softwood trends to improve modestly, somewhat at the expense of hardwood. We believe some of the relative weakness in softwood in 2015 reflects a delayed response to the outsized price premium which had built in mid 2014. With the softwood/hardwood gap in China having narrowed to a very thin level we expect some paper mills to increase softwood consumption and lower hardwood usage. Even in lieu of lost demand to softwood - CMPC's new 1.3 million tonne line started in May and will likely exert pressure on the hardwood market in the second half.

In this report we outline our new global pulp price forecasts, try to explain why the markets have been able to absorb recent capacity additions, and outline the pending flow of new supply and expected impacts.

We expect hardwood pulp prices to fall about 25% by 2017. We forecast a more moderate 12.5% erosion in softwood prices over this period. This would restore about a $100 per tonne softwood premium. Longer term, given divergent supply dynamics we expect the hardwood/softwood markets to decouple, favoring softwood given much lower planned supply growth.

Our primary concern is the outlook for pulp capacity growth into 2018 (and potentially beyond). We expect annual pulp capacity growth to accelerate through that period with average annual growth of about 3.7 million tonnes, more than 2.5x the historic growth rate.

We believe this rate of supply growth is well in excess of demand growth (closer to 1.2 million tonnes per year). While global tissue demand is growing, the tissue market is relatively small and this growth has not been enough to offset declines in the much larger printing and writing paper markets. Barring material capacity closures or project delays/cancellations we expect pulp operating rates to fall to low levels-in the mid 80s.

It appears consumption changes in China have been a big help for paper grade wood pulp the past few years. But we believe future benefits from this trend may be more muted. Since 2010 Chinese production/consumption of nonwood pulp has declined 5.4 million tonnes, or 42%. Over the same period, Chinese consumption of wood pulp has grown 6.8 million tonnes (36.5%). This likely absorbed much of the new global wood pulp capacity that was added 2013-14. According to the local trade association the rate of decline in Chinese nonwood pulp demand moderated sharply in 2014. We do not expect nonwood pulp production in China to completely disappear so we see this opportunity as finite. The rate of growth in Chinese paper/board consumption has slowed over time (the trade association actually estimates a moderate decline in 2014). Additionally, there is risk that some of that swing from nonwood to wood pulp was opportunistic with buyers taking advantage of low cost purchased pulp in lieu of their own production. If so, this could reverse in


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a higher pulp price environment with Chinese mills returning to own-production.

The strong US dollar has not been supportive of market pulp recently. Even as US dollar denominated prices have declined, realizations for producers in Russia and Brazil are attractive/high in local currency terms.

We have elected to base our forecast on published prices into China. We note that list into China approximates spot transaction pricing in North America. In contrast the gap between spot and list pricing in North America is distended, sitting near record highs. We do not believe list is reflective of economics in the North American pulp markets.

Key risks to our forecast include continued substitution of purchased pulp for own production in China, substantial closures of capacity (both integrated/nonintegrated) in other parts of the world and a surge in paper demand, especially from countries like India.

Forecast update We are launching new pulp price forecasts. Our forecast is based on NBSK and eucalyptus pulp delivered to China. Previously we forecasted pulp prices delivered to North America. But, as we will discuss later, we believe North American list pricing has become too far removed from economic reality. We believe Chinese prices are a closer approximation of mill nets.

We are quite cautious on market pulp, predominantly based on our supply outlook with announced projects looking to keep the pulp capacity growth rate at a multiple of historic trend well into 2018.

We expect pressure to mount, particularly on hardwood pulp, in the second half of this year and accelerate through late 2017.

We expect NBSK prices to fall 9.3% in 2015, 3.3% in 2016 and nearly 9% in 2017. We expect eucalyptus prices to rise 5.5% in 2015, fall 8.5% next year and fall nearly 15% in 2017. While we expect average hardwood prices to rise in 2015 we believe hardwood prices are near peak and expect them to come off moving through the second half.

The softwood pulp premium has narrowed to only about $15 in China. By 2017 we expect this to return closer to $100 per tonne.


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Figure 1: NBSK pulp price, delivered China, US$/t Figure 2: Eucalyptus pulp price, delivered China, US$/t

Source: RISI and UBS estimates Source: RISI and UBS estimates

Figure 3: Pulp price ($/t) delivered to China

NBSK BEK

1Q14 757 637

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2Q16E 650 590

3Q16E 635 570

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2017E 585 495 Source: Source: RISI and UBS estimates

Figure 4: Global paper grade chemical pulp supply & demand, 000 tonnes

Figure 5: Global paper grade chemical pulp op rate

Source: RISI, PPPC, industry sources and UBS estimates Source: RISI, PPPC, industry sources and UBS estimates

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Pricing a bit weaker than appears on surface - look to China or spot to understand pricing dynamics Over the past few years published pulp list prices have become more and more detached from actual mill nets as discounts off list have swelled. This situation is most acute in North America, but exists to a lesser degree in other regions as well. This dynamic is more evident in softwood than hardwood.

In China we believe reported prices are more reflective of the actual market and represent the best barometer of market trends.

As can be seen in the charts below, published US NBSK list prices are $355 or 57% higher than reported spot. These are about double the 10-year averages. And these averages are driven up sharply by recent extremes. The current gap represents a record level. We believe a large portion of this disconnect reflects rising contractual discounts. That said, at least some of the gap is attributable to market dynamics/balance. Historically, spot/list pricing converge in tight markets.

Since March 2014 peak US list prices have declined $50 (5%) while spot prices have contracted $165 per tonne, a 21% decline.

Current US spot prices are 8.5% below the 10-year average while current list is still 13% higher than the long-term trend.

Buyers appear to be taking advantage of this disconnect. There have been trade reports of contractual buyers limiting purchases to the bare minimum, substituting spot for contractual tonnage. This should exacerbate the challenge since pulp mills will end up with fewer sales of contractual tonnes and be forced to sell more pulp on the spot market.

We believe some buyers reduced contractual commitments to allow flexibility to take advantage of cheaper spot pricing. But buyers will need to make sure they meet whatever commitments they have in place which may force them to reduce spot purchases in favor of contractual orders at some point later in the year.

Figure 6: US NBSK list and spot price, US$/tonne Figure 7: US NBSK List-Spot pricing, $/t

Source: RISI Source: RISI

Interestingly, US spot pricing has been tracking quite closely with reported Chinese 'list' prices, supporting our view that Chinese transaction prices are more reflective of economic reality.

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The recent, albeit slight, pickup in Chinese NBSK could be a precursor of a broader global recovery in the short term.

Figure 8: NBSK price delivered to China, US spot price (US$/t)

Source: RISI

Softwood versus hardwood we expect the pendulum to start to swing in favor of softwood Given divergent supply dynamics we expect hardwood and softwood pulp markets to eventually decouple. However we do not feel we are there yet; we believe the industry still has some capacity to adjust to market disconnects.

Paper mills cannot change pulp furnish that quickly so the adjustments take time and can be hard to observe. We believe these grade swings are under-appreciated in the markets

Figure 9: Europe/N America NBSK less Eucalyptus price, $/t

Figure 10: China NBSK less Eucalyptus price, $/t


When the price gap becomes pronounced certain paper mills can consume more hardwood in place of softwood and vice versa. These swings are regulated by the impact on final product quality as well as production equipment; some older machinery would have issues processing the weaker hardwood fiber. Such mills may lose operating efficiency if they alter the

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furnish, having to run slower to use the weaker hardwood fiber. In some cases these adjustments can involve a blend of multiple fibers, for instance, using a mix of recycled fibers plus softwood in place of hardwood.

Some pulp mills can swing between hardwood and softwood production. If the price gap is wide enough mills can justify the incremental cost to pull in a different type of wood from forests that are a further distance from their mill.

Between summer 2013 and summer 2014 the softwood premium over hardwood in both Western Europe and North America surged from $30-40 to a record $210-215 per tonne. The historic average is a $55 softwood premium (and that average is inflated by recent trends).

In China the softwood premium rose to $155 in September from a $10 softwood discount back in summer 2013. The 10-year average premium is $70 and the peak was $220 (realized back in 2011).

We believe these exaggerated price gaps eventually encouraged market adjustments with paper mills consuming more hardwood and pulp mills producing more softwood.

As a result, the hardwood/softwood price gap has narrowed sharply, particularly in China.

In China, via a combination of hardwood price increases and softwood price erosion, the gap has narrowed to only $15, the lowest in about 20 months and a fraction of the historic average.

We believe markets are starting to compensate for the relatively more attractive softwood as buyers who had compromised product quality/operating efficiency to capitalize on cheap hardwood move back towards softwood.

The benefits may not be immediately apparent, though the recent Chinese softwood price increases may be an early indicator of this occurring.

There is risk buyers may hesitate to shift back to softwood if they expect the recent hardwood rally to be short lived. With the recent start of CMPC's new 1.3 million tonne line buyers may assume the hardwood markets will come under incremental pressure once those tonnes enter the market later this year.

Demand We believe growth in market pulp volumes has outpaced the underlying consumption of pulp from tissue, printing and writing and paperboard markets.

Global market pulp shipments rose 2% in 2014. This follows 2.5% growth in 2013. 2014 growth equated to about 1.1 million tonnes. This is consistent with the long term average.

Pulp producers often point to tissue as the key source of market pulp demand growth. But building paper machines is not the same as producing finished goods (and consuming raw materials such as pulp). Tissue production growth has been healthy, but not nearly as strong as suggested by headline capacity expansion. The global tissue market grew 2% last year or about 700,000 tonnes. Most, but not all, new tissue lines would be pulp driven (about half existing global tissue capacity is waste-based though recent growth has been weighted towards pulp-based tissue capacity).


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But the global tissue market is much smaller than printing and writing. The demand decline in printing and writing more than offset the growth in tissue. Global printing and writing demand fell 1.2% last year-or just over 1.1 million tonnes.

Some consumer paperboard mills also use market pulp. We do not have strong data on this specific market segment, but assuming 2% demand growth this may have added 400,000-800,000 tonnes of pulp demand.

Over the past 4 years printing and writing demand has declined 5.3 million tonnes while tissue demand is up about 3.8 million tonnes. Global market pulp shipments are up nearly 6 million tonnes over this period.

Therefore, combined tissue/printing and writing demand has declined 1.5 million tonnes since 2011 while global pulp shipments are up nearly 6 million tonnes. We are not convinced paperboard demand alone can bridge this gap.

Figure 11: Global apparent consumption, 000 tonnes Figure 12: Global annual demand growth tissue + printing & writing vs market pulp, 000 tonnes


China remains an important but opaque driver China has been the driving force behind global pulp market growth for the past 15 years.

Since 2010 Chinese pulp volumes have increased on average 75,000 tonnes per month. Over this same timeframe monthly demand in the rest of the world has grown an average of 15,000 tonnes.

Data suggest that underlying Chinese paper/board demand growth has moderated significantly in recent years. In fact, the Chinese industry trade association reports that total Chinese paper/board consumption fell 3% in 2014. Admittedly this decline was primarily driven by newsprint, a non pulp-consuming product.

Tissue demand growth is healthy (though well shy of the rate of tissue supply growth) but this has not been enough to fully offset slower growth, or even declines, in other product areas.

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Reports indicate Chinese paper/board markets remain broadly oversupplied with high finished good inventories, suggesting that Chinese fiber purchases could potentially be outstripping the real underlying demand trend.

Figure 13: Chinese paper/board capacity growth, 000 tonnes

Source: RISI and UBS estimates

Another large component of China's impact on the pulp market is opportunistic buying; not only substituting pulp grades in production (hardwood/softwood) but also replacing internal pulp production with purchased pulp, depending on market circumstances.

China has fairly high pulp production costs and some Chinese paper companies have been known to substitute purchased market pulp for their internally produced pulp when purchased pulp prices approach their own production costs.

But this is usually price-sensitive demand and tends to reverse as soon as market pulp prices rise. As can be seen in the following chart Chinese purchases tend to peak when pricing is at its trough and sink when pricing is at its highest.

Figure 14: World pulp shipments to China vs BEK selling price to China

Source: PPPC and RISI

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RISI estimates average Chinese hardwood pulp costs are about $550 per tonne, about $200 per tonne above their estimate of the average global cost.

Over the past few years this level has approximated an inflection point in Chinese pricing.

Figure 15: Hardwood pulp delivered to China, $/t (w/avg cost)

Source: RISI

Another unknown most acute in China is grade swings amongst pulp furnishes. Over the past several years the Chinese government has targeted significant closures of old higher cost pulp and paper capacity on environmental grounds. The Chinese paper/board markets remain materially oversupplied so it is hard to determine to what extent these closures have been enforced (benefits are not apparent in the markets).

That said recent data shows substantial step-downs in production/consumption of nonwood pulp in China. Over the past 20+ years while chemical pulp and recovered fiber demand surged exponentially in China, consumption of nonwood pulp was relatively stable.

But more recently, reported nonwood pulp consumption in China has contracted materially. Since 2010 nonwood pulp has declined by nearly 5.5 million tonnes, or 42%. The rate of decline moderated from 2.5 million tonnes in 2013 to only 0.74 million tonnes in 2014. According to the Chinese Paper Association the country made/used about 7.5 million tonnes of nonwood pulp in 2014.

The decline in nonwood pulp consumption may be the manifestation of the government closure efforts.

Much of this nonwood pulp appears to have been offset with paper grade pulp. While nonwood pulp declined 5.4 million tonnes since 2010 over the same period wood pulp consumption grew 6.8 million tonnes.

During the first quarter 2015 reporting season both Mercer and Suzano management expressed the view that Chinese government-enforced closures were indeed creating incremental pull on market pulp.

We admit we have been overly bearish on pulp pricing the past 1-2 years, potentially under-estimating the dynamic of falling nonwood pulp consumption in

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China. But we would caution against assuming this trend will continue. We do not expect Chinese nonwood pulp production to fall to zero. In fact, there has been a modest revival of interest in straw pulp in the USA. And it is possible some of the reduction in nonwood volumes is just a price-driven dynamic which could reverse were wood pulp prices to rally sharply.

Figure 16: Chinese fiber demand, 000 tonnes Figure 17: Chinese nonwood pulp demand, 000 tonnes


Figure 18: Chinese wood and nonwood pulp consumption, 000 tonnes

Source: China Paper Association

Another hard-to-measure dynamic is the movement between dissolving/paper grade pulp production. Several years ago there was a wave of investment converting some paper pulp capacity in China to dissolving pulp. But with very weak dissolving markets returning to paper grade pulp production could be attractive. There is limited visibility into these swings, but recent reports suggest some movement back towards paper grade and away from dissolving pulp in China.

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Supply Our most significant concern regarding the pulp markets remains the sheer magnitude of supply growth planned for the next several years.

RISI estimates bleached chemical market pulp capacity growth will average 2.3 million tonnes per year 2014-17, about double historic annual demand growth. We believe this capacity number could prove low given the number of projects we are tracking (see tables in the back of this section).

We see potential for annual capacity growth to average 3.4 million tonnes 2014-18, more than 2.5x the 20 year historic annual growth rate. We expect supply growth to accelerate moving through this period.

Assuming that demand continues to grow about 2.5% a year we see risk that global pulp operating rates will fall from 91-92% to below 85%.

Figure 19: World chemical market pulp capacity Figure 20: World chemical market pulp capacity change kt

Source: RISI, UBS estimates Source: RISI, UBS estimates

Figure 21: World market pulp consumption growth Figure 22: World market pulp operating rate

Source: RISI, UBS estimates Source: RISI, UBS estimates

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We are not convinced the markets have felt the full force of recent capacity growth, yet. 3 mills with combined 3+ million tonnes of capacity started in late 2013/2014. That equates to about 2.5 years average annual demand growth. Historically the approximate 55 million tonne chemical pulp market sees about 1.3 million tonnes annual demand growth.

Reported world pulp production increased about 1.2 million tonnes in 2014 (including a 300,000 tonne inventory build). This is only a fraction of the gross supply growth. This partially reflects timing of mill starts with two of the lines not producing until the middle of the year and the slope of the ramp up curve. In fact, Oji has only just started producing dried pulp on the 500,000 tonne line they started last year, up until now they have made far less common wet pulp. There were also some offsets in 2014 with a 400,000 tonne Spanish mill shutting and the temporary idling of a mill in Maine (the Maine mill subsequently restarted under new ownership and has apparently just finished the ramp up phase).

This spring CMPC started production on a new 1.3 million tonne pulp line in Brazil. In addition, restarts and other smaller projects could add at least 800,000 tonnes if/when fully ramped. Combined, this could equate to nearly 2 years of theoretical demand growth.

The pressure does not appear likely to abate in 2016; pulp lines with 6 million tonnes are expected to start up. Klabin is expected to start a 1.5 million tone line. APP is targeting a late 2016 start of a large new mill in Indonesia. Lately there have been reports that the project may slip into 2017 but also that the project scale has expanded to 2.8 million tonnes (from 2 million). In addition to these, we estimate that other smaller projects could add a further 1.5 million tonnes; this includes Domtar and International Paper's planned conversions to fluff/paper grade pulp from uncoated free sheet/bleached board, respectively.

Admittedly much of this activity is targeted for the second half of 2016 with even greater implications for 2017.

Looking to 2017 and beyond there are additional projects with about 5 million tonnes of capacity which we believe have a fairly high probability and 16 million tonnes of potential new additions in aggregate.

Finland is a region to watch closely in terms of pulp supply growth. While not exactly intuitive, there are 3 organizations studying the prospect of major world scale pup lines in Finland. At least 1 of these projects is proceeding, Metsa's planned net addition of 800,000 tonnes. Finnpulp has launched an environmental impact assessment for its proposed world-scale expansion.

We estimate about 75% of the planned expansions are hardwood based.

2013-14 capacity growth was absorbed with much less disruption than we had feared, but we would caution against extrapolating that to future growth.

A smattering of closures offset the bulk of 2013 growth. Also the Ilim expansion in Russia ultimately experienced a very gradual ramp with the mill only reaching its stride in late 2014.


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Figure 23: Major global pulp capacity changes 2013

Company 000 tonnes country grade timing

Eldorado 1500 Brazil hardwood 4Q12 Ilim 500 Russia softwood mid 2013 Resolute -120 Canada softwood early 2013 Domtar -120 Canada softwood early 2013 Jari -410 Brazil hardwood early 2013 Sodra -375 Norway soft/hardwood Aug-13 Sappi -300 US hardwood spring 2013

total 675 Source: Company reports, industry sources and UBS estimates

In comparison, 2014 offsetting closures were relatively limited. Ence shut a 400,000 tonne line in Spain. Old Town in Maine (200,000 tonnes) briefly shut but has since reopened under new ownership. This is against 3+ million tonnes of new capacity.

There were several large greenfield projects. But in addition, there have been numerous expansions on existing lines in aggregate we estimate these added the equivalent of a new world-scale greenfield pulp line. With so much attention on the large new mills we believe the markets could be under-appreciating the cumulative impact of these smaller expansions.

Figure 24: Major global pulp capacity changes 2014-15

Company 000

tonnes

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Suzano 1500 Brazil hardwood late 2013

UPM 100 Uruguay hardwood late 2013

Stora Enso/Arauco 1300 Uruguay hardwood mid 2014

Oji 500 China hardwood mid 2014

Mondi 100 Russia hardwood 2H 2014

Eldorado 200 Brazil hardwood 2014

UPM 100 Uruguay hardwood mid 2014

Old Town Pulp -200 USA hardwood 3Q 2014

Ence -410 Spain hardwood 2H 2014

Sappi 180 USA hardwood 2H 2014

UPM 100 Uruguay hardwood 2014-15

CMPC 1300 Brazil hardwood 2015

UPM 170 Finland hwd/soft 2015

Svetlogorsk 400 Belarus hwd/soft 3Q15

Expera (Old Town) 200 USA hwd/soft 2015

Portucel 70 Portugal hardwood 2015

total 5610

Source: Company reports, industry source and UBS estimates

In addition to the list above, the Jari mill in Brazil has restarted with the intent to produce dissolving pulp. But we understand the mill has some ability to flex back


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to eucalyptus. Recent reports suggest the mills is putting at least some hardwood paper grade pulp on the market.

In aggregate we estimate nearly 6 million tonnes being added next year (not adjusted for timing/mill ramp).

Figure 25: Select major global pulp capacity changes 2016

Company 000 tonnes country grade

target start

Klabin 1500 Brazil hardwood/fluff 1Q 2016 APP 2800 Indonesia hardwood 2H 2016

IGIC -100 USA hardwood (integration) 2016

Double A 300 France hardwood 2016 Domtar 515 USA fluff/softwood 2H16 International Paper 400 USA fluff/softwood 2H16 Sodra 320 Sweden softwood 2016

total 5735 Source: Company reports, industry sources and UBS estimates

Even beyond this, the project pipeline remains robust. But as previously mentioned many of these projects are fairly preliminary and could still be canceled or delayed. But we believe at 5 million worth of projects are fairly likely to proceed.

Figure 26: Potential major global pulp capacity changes 2017 and beyond

Company 000

tonnes country grade target start

Fibria 1750 Brazil hardwood 4Q17

Metsa 800 Finland soft/hard 2017

Arauco -550 Chile hwd (convert

to dissolving) 2017

Eldorado 2300 Brazil hardwood 1H18

Lwarcel 750 Brazil hardwood 2019

Sveza 1200 Russia soft/hardwood 2020

Braxcel 1500 Brazil hardwood 2021

CRPE 2200 Brazil hardwood 2018+

Arauco 1500 Chile hardwood tbd

Eco Brasil 1500 Brazil hardwood tbd

Finnpulp 1100 Finland softwood tbd

Angara 1250 Russia softwood tbd

Stora Enso 900 China hardwood tbd

Source: Company reports, industry sources and UBS estimates

Offsets to new supply?

If new supply pressures prices too far we would expect some higher cost mills to shut. However, it is not entirely clear what or how much will be taken out. As discussed elsewhere, many of the highest cost mills sit in China and owners seem willing to flex the mills up/down with market pricing.


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With each addition of a new 1+ million tonne pulp mill the global cost curve seems to flatten a bit. There is some capacity to be squeezed out, but not likely enough to offset growth in the magnitude we are forecasting over the next few years.

Just over 50% of world hardwood pulp capacity is integrated into papermaking. We are not convinced global papermakers will opt to shut integrated pulp lines and rely on purchased market pulp instead.

In fact, as integrated paper makers have adjusted paper capacity down to match to shrinking demand many mills have continued to operate associated pulp lines, maintaining a revenue stream from the asset. International Paper and Domtar's planned conversions are current examples of this trend.

Implications of the stronger US dollar Pulp trades globally in US dollars, so the recent surge in the trade weighted US dollar has some implications for the pulp market.

Generally speaking a strong dollar is unfavorable for global pulp pricing.

The strong dollar makes pulp less affordable for key buyers in Europe (still about 30% of global market pulp shipments by destination).

Additionally, pulp mills in markets such as Brazil, Russia, Finland and Canada should see improved profitability with sales denominated in US dollars but costs in a depreciating local currency. This should afford more room for competitive pricing.

Currency should have minimal direct impact in the Chinese market other than the potential for more competitive offers into China from global producers in markets with weaker currencies.

There are also some potential secondary impacts to consider.

While not our base case, in theory the weaker euro could make European papermakers more competitive on global markets and may provide support for paper production in this key market pulp consuming region. European printing and writing paper production is off 5.5% year to date in 2015.

The European graphic paper markets are oversupplied and the industry has maintained a high reliance on exports (about 30% of printing and writing production) even when the euro was stronger.

In late 2014 there was a new round of capacity closure announcements to address the oversupply in the European markets. In general we see these closures as negative for global market pulp to the extent that they either reduce demand for purchased pulp or free up formerly integrated pulp to be sold on the open market.

We do not expect the recent decline in the euro to significantly alter announced closure plans and continue to see a modest negative for the global pulp markets.

Since last fall NBSK prices delivered to China have declined roughly 10%, measured in US dollars. But translating this into Russian ruble the price is up 40% (and in January at the ruble trough, in ruble prices were up 65% from September).

In Russian ruble terms recent pricing is 35% higher than the 5-year average. In US dollars the current price is 12% below the 5-year average.


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Measured in both Russian ruble and Brazilian real local currency pulp prices stand at some of the highest levels in 20 years.

Figure 27: NBSK delivered to China US$, ruble/t Figure 28: Eucalyptus pulp delivered China, US$, real/t

Source: RISI, FactSet Source: RISI and US Federal Reserve

On the flip side the weaker euro has materially raised pulp costs for European buyers. In 2014 Europe accounted for 31.5% of global pulp deliveries.

Measured in euros both eucalyptus and NBSK prices have touched highs not seen since mid 2010.

Figure 29: Pulp prices delivered to Western Europe

Source: RISI, US Federal Reserve

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Statement of Risk

Overall, the paper and forest products industry is highly sensitive to shifts in supply and demand. Consequently, the key risks are weak demand, as evidenced by general economic conditions, or increases in supply, in the form of capacity additions. We believe these could cause market imbalances and lead to price declines. Severe input cost inflation can also reduce industry profitability. The paper/forest industry uses significant financial leverage and weaker profitability can impede their ability to service their debt burdens.


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Required Disclosures

This report has been prepared by UBS Securities LLC, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS.

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UBS Investment Research: Global Equity Rating Definitions

12-Month Rating Definition Coverage1 IB Services2

Buy FSR is > 6% above the MRA. 45% 37%

Neutral FSR is between -6% and 6% of the MRA. 43% 33%

Sell FSR is > 6% below the MRA. 12% 20%

Short-Term Rating Definition Coverage3 IB Services4

Buy Stock price expected to rise within three months from the time the rating was assigned because of a specific catalyst or event. less than 1% less than 1%

Sell Stock price expected to fall within three months from the time the rating was assigned because of a specific catalyst or event. less than 1% less than 1%

Source: UBS. Rating allocations are as of 31 March 2015. 1:Percentage of companies under coverage globally within the 12-month rating category. 2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months. 3:Percentage of companies under coverage globally within the Short-Term rating category. 4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were provided within the past 12 months.

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UBS Securities LLC: Gail S. Glazerman, CFA; Andreas Bokkenheuser. UBS Ltd Stockholm branch: David Hallden. UBS South Africa (Pty) Limited: Nishal Ramloutan, CFA. UBS AG Hong Kong Branch: Edwin Chen.


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Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report.

Additional Prices: International Paper, US$49.09 (24 Jun 2015); Stora Enso, 9.50 (24 Jun 2015); UPM, 16.15 (24 Jun 2015); Klabin, R$18.80 (24 Jun 2015); Weyerhaeuser, US$32.25 (24 Jun 2015); Fibria, R$43.69 (24 Jun 2015); CMPC, P1,762.50 (24 Jun 2015); Source: UBS. All prices as of local market close.


21

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