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Editor’s Note. This is the third installment of a new Money Morning series highlighting investment opportunities created by the global bull market in commodities .

By Don Miller

Contributing Writer

There’s a classic squeeze going on in the timber markets right now.

As you might expect, the U.S housing slump is reducing demand for finished lumber. Meanwhile, timber, pulpwood, and paper prices are rising worldwide but curiously, profit margins are eroding.

What’s up with that?

The global commodity boom has created a supply/demand price imbalance between the four distinct industry sectors that rely on timber as a raw material. In fact, that imbalance is a huge mismatch. And savvy investors may be able to wring substantial returns from the winner.

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You see, timber companies have shrewdly maintained monopoly-like control of raw materials to hold the line on prices, despite the economic downturn.  They are doling out enough and only enough supply to maintain sufficient revenue streams to pay the bills.  Meanwhile, their downstream relatives are suffering.

In a sense, timber owners are weathering the storm.  And when the storm is over, their profits should explode.

It’s a complicated scenario being driven by a number of economic factors including the declining U.S. dollar, classic market demand/supply ratios, emerging markets growth, and even export quotas and tariffs.

Investors who tune in may catch lightning in a bottle. The end game could send timber company profits and your portfolio soaring in the next 12 months to two years.

Let’s take a look.

Housing Slump Wreaks Havoc on Lumber Mills

As lumber prices have swooned to a five-year low, wood has been piling up at lumber mills.  Sawmills throughout the United States and Canada have been reeling since the second quarter of 2007, when lumber prices collapsed to below the cost of production.

Here’s what’s happening now:

• In the United States, single-family-housing starts dropped 1.7% in April to a seasonally adjusted annual rate of 692,000 units, the lowest monthly production rate since January 1991, and a jaw-dropping 42% below 2007.
• U.S lumber consumption is expected to drop, from 64 billion board feet to 43 billion board feet from 2006 to 2008.  A drop of 21 billion board feet in the span of three years is simply staggering, equal to the total production of the Top 20 softwood lumber producers in the U.S. market for all of 2007.
• North American lumber at the Chicago Mercantile Exchange has fallen as low as $209 per thousand board feet, down a whopping 56% from its peak of $473 in 2004 at the apex of the housing boom.
• Lumber companies in the Billion Board Foot Club, a measurement of the largest lumber companies in the world, was reduced from 22 to 15 in 2007. Six of the victims to be cut were in North America.

Particularly hard-hit are the big lumber mills in Canada, which ship much of their production to the United States. The key factor was the unprecedented run-up in the Canadian dollar .  With sales denominated in U.S. dollars and costs accrued in Canadian dollars, a wide range of Canadian producers were running in the red and simply ran out of money.

In addition, Canada mills must pay a 15% duty to ship lumber into the United States. That puts the price at those mills at about $175 per thousand board feet, said Gerry Van Leeuwen, vice president at International Wood Markets Group. a Vancouver-based lumber consulting firm. There is just no way anyone is making any money, he added.

In the past, sawmills only needed to wait for interest rates to decline before ramping up production. Now, however, they will have to wait until the housing glut is over before lumber demand gets back to normal.

And that’s not likely until mid-2009 at the earliest.  Our advice is not to bet the farm on lumber companies right now.

Global Growth Buoys Pulpwood and Paper Mills

Meanwhile, pulpwood and paper has been in a strong bull market for almost two years.  Demand for paper and pulp remains strong from overseas markets, in particular. And that demand doesn’t appear likely to ebb anytime, soon.’

Overall, world paper demand is moving ahead, buoyed by accelerating growth in Asia.  The surge in paper demand in Asia is driving a huge appetite for both virgin pulp and recycled fiber.  In 2006, alone, China’s imports of wood pulp jumped 150% to 7.5 million tons.

Increased exports have also helped pulpwood prices. The weak U.S. dollar makes it cheap enough for pulp and paper companies to purchase products in the United States and ship them overseas.

On top of that, demand from European utility companies for wood pellets should keep pulpwood prices elevated.  Believe it or not, European utilities have turned to wood chips to produce power in order to lower their greenhouse gas emissions in accordance with the Kyoto protocol .

So you would think paper and pulpwood mills would be humming along, bringing in record profits.

Don’t make that bet.

The Big Squeeze

There is a huge fly in the ointment for pulpwood-and-paper mills.

Paper mills, of course, rely on pulpwood as raw material. Pulp mills, in turn, operate on small logs and wood chips a byproduct of lumber production. And, as you might expect, the weak market has lumber mills cutting back on production. This is forcing pulpwood mills to rely on buying more logs or raw timber, says Daniel Stuber, of Forest2Market.com. The lack of available chips has produced a big demand for small, lower quality logs.

The fact is, pulp mills are using twice as many logs as they normally would to satisfy production levels.  And they’re getting hit right in the wallet.

One of the bright spots for timberland owners is the demand from the pulp-and-paper industry, Stuber said. Land owners have been withholding stands with larger trees until saw-timber prices rebound, but they have been able to generate revenue through thinning practices and harvesting younger stands.

In other words, conditions are forcing the pulpwood mills to buy timber no matter what the price or go out of business.

The higher cost of pulp is being passed straight along to the paper mills. And they’re frantically trying to pass those increases along to purchasers.

Blake Hutchison, director of purchasing for the Menomonee Falls, WI-based printer Arandell Corp.. says that most, if not all paper mills increased prices for 2008 by 5% to 7%.

But they still can’t keep up with soaring pulp prices.

Keep in mind that even with the recent price increases, paper mills are still losing money, Hutchison said.

So don’t bet the farm on pulpwood and paper mills, either.

Line Your Pockets with Timber

The truth is, timber owners are sitting back, biding their time, and withholding their high-quality tracts of timber until the market recovers.  When the markets turn around, look for timber owners to cash in -and in a big way.

When that happens, you can join them.

Until recently, all the advantages of investing in timber have been limited to large investors with deep pockets.  For smaller investors the saplings of the investment world investing in timber has been prohibitively expensive.

The United States has about 500 million acres of potentially productive timberland, more than two-thirds of which is now privately held. Environmental restrictions and loss of land to development pressures have greatly reduced the global availability of timberland.

Reduced cutting on public lands has increased the value of private forests, and has also   increased imports from international sources. In 2004, for the first time ever, the United States became a net importer of wood

Most U.S. timber is owned by timber investment management organizations (TIMOs). Worldwide, TIMOs have attracted more than $20 billion of investment from institutional investors.  For instance, Harvard Management, which invests $27 billion of the university’s endowment and pension money, has 10% of its assets in timber.

But now there are public companies that are available as investment vehicles for the small investor.  Here are a few to consider:

Claymore Global Timber ETF (CUT ): Launched in November 2007, this exchange-traded fund (ETF) tracks the Clear Global Timber Index. which includes companies that own or manage forested land, harvest the timber from it, and produce finished products. Companies that do not own or manage forested land and harvest trees are excluded from the index.  It has broad exposure to the industry and that might be a drawback for now.  Listed among its top 10 holdings are Weyerhaeuser Co. (WY ), International Paper Co. (IP ), and other paper and lumber companies.

Rayonier Inc. (RYN ) — Operating as a real estate investment trust (REIT), Rayonier owns 2.5 million acres of timberland in the United States, New Zealand and Australia.  It also produces a small amount of finished lumber and cellulose products.  Despite the economic slowdown, Rayonier has grown earnings at a 24% annual clip for the last five years, and has a history of positive surprises to analysts’ estimates.

Plum Creek Timber Co. Inc. (PCL ) Also a REIT, Plum Creek owns 8 million acres of timberland (all in the United States) and is focused primarily on owning and managing timberland, although it also sells plywood and wood chips.  It is 66% owned by mutual funds. with Invesco Ltd. (IVZ ) currently ranking as its largest stakeholder.  Plum Creek has a 25% operating margin and its dividend yield has averaged 4% over the last five years.

[Editor’s Note . Writer Don Miller is a frequent Money Morning contributor, and actually wrote about China. Agricultural Commodities. Uranium and Housing for Money Morning ‘s groundbreaking Outlook 2008 economic forecasting series. The current Cashing in on Commodities series has so far covered Coal-and-Uranium fuels, as well as Crude Oil. Next up: Cashing in with Mutual Funds ].

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