Doing the Math

Recovered fiber prices—like other commodity prices—vary as supply and demand factors change. This fluctuation in price can have a significant effect on a company's profitability. One option that recovered fiber mills have for hedging volatile fiber prices is to take advantage of lower prices by increasing the number of days of inventory they have on hand when prices fall. This is hardly a sure-fire method of managing costs, however, as holding inventory comes with its own set of risks.

Because of the cost of holding additional inventory, mills that consume recovered fiber should analyze a series of factors before making this decision. These factors include:

• Location—How close is the mill to its sources of fiber?
  
• Competition—Are other recovered fiber consumers in proximity to the mill? Is the mill in an area with strong export activity?
• Transportation—What is the road infrastructure? Is trucking readily available? Is there rail service?
• Forecasted operating rate—At what percentage of capacity will the mill be running?
• Warehouse availability—Is adequate storage capacity available in proximity to the pulper? If storage is not available close by, what is the distance and cost? What is the cost of the additional insurance? Does the warehouse have an adequate sprinkler system for the additional inventory? If trailers are used for storage, will the inventory be used prior to the 21 days specified by the ISRI (Institute of Scrap Recycling Industries Inc.) Paper Stock Domestic Transaction guidelines for accepting, rejecting or downgrading fiber?
• Time of year—Is a holiday approaching that would require an inventory buildup because of transportation limitations and processing plant holiday schedules? Is seasonal bad weather approaching?
• Fiber generation outlook—Will seasonal or economic factors affect generation in the near term?

The answers to these questions vary by mill; there is no one right answer to any one question. If a mill is operating in an optimal environment—one in which adequate storage is adjacent to the pulper—the savings realized through holding additional inventory could be minimal. As with all other fiber purchases, costs include fiber, freight and capital.
 

Far From Optimal
When a mill's circumstances diverge from this optimal setting, however, the costs could quickly outstrip any savings realized by holding more recovered fiber in inventory. If the additional inventory is stored in another area of the mill, for instance, additional labor and handling costs will result. If storage is off site, the costs accumulate more quickly. These additional costs include:

• Cost per square foot of warehouse space—Bale weight must be taken into account, as different bale weights/sizes require varying square footage requirements;
• Costs of the additional handling necessary (offload and reload);
• Transportation costs to mill;
• Additional insurance costs on the inventory; and
• Security, if applicable.

Also, the more handling the bales require, the more susceptible they are to breakage and fiber loss. The percentage of loss varies by grade, though it generally falls somewhere between 1 to 5 percent. The additional inventory also will require rotating over a longer time than inventory acquired in a more timely fashion.

Other potentially costly factors can include:

• Dirt accumulation over time can raise dirt count on paper machines. Dirt count that exceeds limits can cause downgrades or even disqualification with respect to grade-dependent quality specifications on a paper machine.
• Aged paper may require additional bleaching or dyes.
• Higher inventory levels could increase a mill's fire risk.

Calculating the Cost
How do these costs add up? Let's look at a hypothetical example that shows a mill's potential costs of holding additional recovered fiber in inventory.

The mill: A 750-tons-per-day (TPD) mill typically holds seven days of inventory on hand, or 5,250 tons.

The decision: Mill management decides to increase that inventory by seven days, or by an additional 5,250 tons. The cost of this recovered fiber is $150 per ton, and the average freight costs are $22.50 per ton. Total landed cost is $172.50.

The question: What is the cost of holding this additional seven days of inventory, and is it saving the mill money overall?

To answer this question, several costs should be considered: inventory valuations, financing costs and storage costs, as well as the cost of fiber loss during storage because of additional handling. Because future prices are uncertain, these costs are calculated for two scenarios—those incurred in an "up" market and those incurred in a "down" market.
 

Scenario 1: "Up" Market
Financing Costs. The working capital requirement to purchase the additional inventory is $905,625 (5,250 tons at $172.50 per ton). The financial cost of carrying inventory is typically expressed as an opportunity cost and estimated by using the business' cost of capital. In this case, if the mill's cost of capital is 8 percent, the financial carrying costs would equal $6,038 per month.

Storage Costs. The costs associated with storing additional inventory vary depending on bale size. If the mill's average bale weight is 1,500 pounds, the additional inventory equates to 7,000 bales. (Other typical weights are shown in Table 1, below, as well.) For our example mill, the cost of storing the additional seven days' inventory for one month is $35,000.
 

Cost of Fiber Loss. In addition to warehousing costs, excess handling of the additional inventory is likely to increase fiber loss. Table 2 outlines the cost of this fiber loss for our example. If fiber loss is estimated conservatively at 2 percent, the cost for our sample mill would be $18,113.

For the sample mill, the total cost of holding an additional seven days of inventory (5,250 tons) for three months would be $141,227. This would bring the cost of these tons to a total of $1,046,852 ($905,625 plus $141,227), or $199.40 per ton. This is 15.6 percent higher than the landed cost of the fiber.

As this example shows, laying in the additional inventory is only an effective hedge if the landed fiber cost rose more than 15.6 percent during the three-month period. Otherwise, the inventory build would be detrimental to the mill's bottom line.

Scenario 2: "Down" Market
What happens in the same scenario if the fiber cost drops $30 per ton in one month? What will the effect on the mill's bottom line be?

Inventory Devaluation. In this scenario, the mill enters the month with the extra seven days of inventory. At this point, the mill's inventory would immediately be devalued by a total of $157,500 ($30 per ton across 5,250 tons).

Financing Costs. The mill follows a first-in, first-out (FIFO) inventory management process and draws down this extra inventory within the first seven days of the month at a rate of 750 tons per day. As a result, the carrying costs would be just $755, 12.5 percent of the monthly cost of $6,038 (8 percent interest on the landed cost of the 5,250 tons, which was $905,625).

Storage Costs. Storage costs may vary, depending on the type of contract the mill has with its warehouse. One of two scenarios is likely. Either the mill will have excess storage costs for the entire month ($35,000) or if the mill has a variable cost contract, for one week (25 percent of $35,000, or $8,750).

Cost of Fiber Loss. Finally, the fiber loss would remain the same at 2 percent for the additional handling of the bales at $18,113 (Table 2).

In this scenario, the mill would have excess costs of $185,118, assuming the most favorable storage cost solution. Across the mill's monthly consumption of 22,500 tons (and assuming a 30-day operating month), the excess inventory held at the beginning of the month increases the cost of the fiber consumed by $8.23 per ton across all of the tons consumed.

As these examples show, the benefits of holding additional inventory to hedge recovered fiber price risk is tricky. This is especially the case in an industry without reliable and authoritative econometric models for forecasting prices.

A mill can lay in additional inventory on the expectation of rising prices, but without an accurate forecast, any hedge will only be as good as the prognosticator's insight into the market. While increasing inventory when prices are low can be an effective hedge, Forest2Market recommends that mills approach this strategy cautiously and do the math first.
 

Barbara Wright Hudson is manager of Forest2Market's recovered fiber practice, where she is responsible for sales of Market2Mill, the company's suite of services for buyers and sellers of recycled fiber and for managing product evolution and development. Currently, these services include a monthly recovered paper price report and a quarterly benchmark. She can be contacted at 704-540-1440, ext. 35, or at barbara.hudson@forest2market.com.