Russia: a booming market presents its own challenges.

With demand rapidly increasing. Russia's paper industry is doing well. But scratch the surface and there are a host of problems remaining. The Russian paper industry was once a massive enterprise spewing out millions of metric tons of pulp, paper and board each year. Like other industries in the Soviet era, production was controlled from the center under the direction of a planned economy. However, output collapsed with the break-up of the USSR and the road back to health has proved difficult (see sidebar on page 43).

Slowly but surely, that journey is under way. And while it is would be ludicrous to suggest that there are not a great many obstacles ahead, there can be little doubt that the Russian pulp and paper industry is gradually becoming a force to be reckoned with once again. And that fact alone is attracting a lot of interest from pulp companies, papermakers and machine builders.

Russia boasts a population of some 145 million and as the International Monetary Fund's assistant director for the northeastern division, David Owen, pointed out recently, there is little doubt that the economy is doing well by almost any measure. "Real GDP growth was almost entirely negative in the period up to 1998. But following the crisis, activity recovered very rapidly. Growth has been strong in every year since the crisis. It's averaged about 6% a year. That's just below the rate of growth--7.25% a year--that's required to double real GDP over a decade, which President Putin has set as a target." (See Figure 1.)

Owen also pointed out that there has been a marked reduction in capital flight, the country's foreign currency reserves have grown significantly, and external debt has been more than halved since the 1998 crisis. Not only that, but the country's stock market has shown steady rises and Russia now has an investment grade credit rating from Moody's. On the flip side, Owen believes that inflation remains on the high side and any dramatic fall in oil prices could leave the economy vulnerable to setbacks.

Aside from worries over oil prices, Russia watchers are also concerned with recent trends on the corporate front as several of the so-called "oligarchs" perceived to be critical of President Putin have come under pressure in various ways. The Yukos oil company affair is one of the most high profile of such cases. Nonetheless. Vladimir Putin's personal approval ratings are high ahead of a presidential election and the economy is doing well, so analysts are hopeful that the economic climate will remain favorable in the foreseeable future.

PAPER TRAIL

Needless to say, when the broader economy is doing well the paper industry tends to be buoyant and Russia is no exception. Margaret Leach is one of the leading experts on the market and the latest report from her consultancy, Pyrabelisk, shows a number of positive signs across the sector. "Consumption of paper and board has almost doubled over the last five years. Consumption of corrugating materials and cartonboards has more than doubled in the period, with strong increases also in the consumption of printing and writing papers, especially cut sizes and coated printing papers, label papers and tissue," she explained (see Figure 2).

According to Leach, the major pulp mills are running at close to their full capacity and exports have climbed rapidly to reach almost two million metric tons in the past few years. Pulp imports are also on the up, but volumes are relatively small and the country is still very much a net exporter.

On the papermaking side, newsprint is by far the most dominant sector in terms of volume and much of it is exported to Eastern Europe and the Middle East. Pyrabelisk fully expects domestic consumption to grow rapidly in this sector too, as more independent publishing companies find their way in the market and as commercial advertising norms take hold across the country.

Containerboard production is also growing rapidly for a number of reasons. The Russian economy is a growth driver and as the market opens up multinational retailers are expanding and consumers are becoming used to the standards common in Western Europe. As a result, quality is likely to become a goal for many of the players seeking a competitive advantage.

MOVING ALONG

Of course, it is not only multinational retailers that are moving into the Russian market; international pulp and paper groups are keen to find a foothold in the market as well. After a few false starts--and some high-profile disasters like AssiDoman--International Paper and Mondi (via its Neusiedler unit) both appear to be making good progress at the heart of the Russian paper industry.

IP has been hard at work developing the capabilities of its Svetogorsk pulp mill where output has risen steadily over the past few years. Meanwhile, Neusiedler took control of Syktyvkar in 2002--one of the country's largest integrated mills. The company has already integrated the mill into Neusiedler's management system and is well on the way to certifying some 1.6 million hectares of sustainable forestland. Product and process quality has been upgraded and new cut-size cross-cutters have been introduced as the mill's paper capacity has climbed to 700,000 metric tons/yr. Pulp capacity stands at 650,000 metric tons/yr and this year the group is planning a further [euro]6.6 million investment to build two new pulp storage towers with a capacity of 5,000 [m.sup.3].

As Neusiedler's CEO. Gunther Hassler, pointed out, "We are certainly very happy with our progress to date. All our expectations for the mill have been met and even surpassed, so we are very happy with the development and the future potential of the site."

Hassler agrees that the business environment can be difficult for companies used to operating in Western Europe, but he believes that Neusiedler's commitment to maintaining an all Russian management team (there is one exception) has make the task easier.

"Absolutely, it's tough to manage and operate there--it's certainly not a country where things just happen by themselves--but we have put our own corporate structure in place using Russian managers and we provide them with support," he said. "Often, that will be in the form of specialist teams that go in to do certain jobs, but when that's finished they come home. We don't want to keep teams of expats working out there and we've found that the Russian managers are quite capable and they are really quick in taking on the knowledge we can provide."

Aside from the operational issues, Hassler is also happy with the way the market has performed. Although he cautions against the hype of some analysts who are predicting a new Russian boom, he does foresee a "realistic" 7%-8% annual growth. "It's low compared to some of the numbers you see going around, but 7%-8% is certainly better than Western Europe and more importantly, it gives us the opportunity to grow."

Not that Hassler is going to bet the farm on this new market though, even if it does offer excellent potential. As he points out, it is still early days and Syktyvkar still has to prove that the progress made to date is sustainable. "We're not going to jump into some big capex spree, but we are definitely looking at a number of possibilities right now focused on Syktyvkar," said Hassler.

FOLLOW THE MONEY

Comments such as these have certainly piqued the interest of the machine builders and suppliers. Scenting the capex trail, companies such as Metso, Voith, and Honeywell have all strengthened their presence in Russia recently. As Hans Muller, CEO of Voith Paper, pointed out, "Recent political and economic conditions have created the need to significantly strengthen and expand our presence and capabilities in Russia."

Among those working on the front line for Voith is Thomas Schaible in the technical sales team and he is confident that Russia offers some interesting new business prospects. "It will be busy. Basically, it's going to be rebuilds for the next couple of years as I don't think anyone is going to build a new mill or even put in a new machine for a while yet. But there is still quite a lot of potential in those rebuilds."

Schaible reckons there could be up to 20 rebuilds up for grabs in the country over the next two years on top of the projects that Schaible has already been busy on personally in the graphic paper area, including a rebuild and grade change for PM 1 at Vyborg and the replacement of a headbox on PM 8 at the Kondopoga mill. Looking further ahead, Voith is doing a case study on a grade change at Solikamsk which may result in a major rebuild of one of the four lines and at Kondopoga plans are being drawn up for the possible installation of a LWC line.

"It is quite interesting at the moment," says Schaible. "There are lots of big plans, but we've also had many other inquiries for smaller rebuilds for quality and runnability improvements, for example, adding double doctors, steam boxes, DuoCleaners and so on."

Schaible points out that per capita paper consumption has risen from 17 kg/yr to around 37 kg/yr over the past five years, so there are bound to be a host of opportunities on offer.

It appears that the Metso team agrees. According to Petri Polonen, vice president of sales, paper machines, the market is certainly worth following closely at this stage even if in the short term the 20 or so smaller rebuilds form the main investments across Russia's paper industry. "If you look a little bit further, say 5-10 years time, you can see that this is a growing market and it's really one of the only directions that the European market can grow," he says. "You have one of the biggest fiber resources in Europe in the northwest of Russia, energy is still quite cheap and there are low labor costs."

According to the big suppliers, Russia is about 15-20 years behind Western Europe in terms of mill technology and even though there are a large number of paper machines sitting idle, most believe that the short term focus will be on getting the larger machines up to modern environmental and production quality standards, while the smaller units will be abandoned or eventually replaced by new lines.

Some of these projects are already moving ahead. Aside from Voith's ongoing projects at Kondopoga and elsewhere, for example, Metso is carrying out a [euro]40 million rebuild at the Segezha Pulp and Paper Mill with an extensive rebuild of their production line for extensible sack kraft paper. The modernized PM 10 is due to restart this summer.

WHO OWNS WHAT

Despite this activity, it may be harder for pulp and paper companies to follow through on other large projects at this time. Although clearly required and justified in terms of consumption growth, it is possible that the major capex flows required to bring the industry up to date could be tricky to get through.

As suppliers, papermakers and industry analysts all point out, one of the main brakes on the sector at the moment stems not from market forces, but from Russia's recent economic history. In shifting toward a market economy, many assets previously owned by the state--including pulp and paper mills--were sold off in a somewhat haphazard style. As a result, a conflicting group of technocrats, politicians and businessmen have laid claim to any number of enterprises, some with more dubious claims than others.

One of the most infamous cases in the paper sector revolves around Ilim Pulp, a dispute that has been raging for over two years. llim is one of the largest pulp and paper concerns in Russia and competing ownership claims have led to the fight for control of the Bratsk and Kotlas mills being dubbed the "War in the Woods". At one stage, armed police temporarily seized control of the Kotlas HQ before the standoff was defused. It has yet to be fully established who ordered the raid.

Ilim Pulp Enterprise (IPE) has fought to retain control of the mills against a rival claim from Continental Management. Continental is the forest industries division of Oleg Deripaska's Base Element company and Deripaska is alleged to be one of Russia's socalled oligarchs.

Today, the feud has developed more along the lines of a hostile takeover, but the fight is being conducted without the benefit of any real legal framework. The two sides now believe a settlement is possible, but the battle has prompted at least one analyst to note that Russia's legal system on ownership is even worse than that of Indonesia under the Suharto regime.

On top of that, the general mood of uncertainty has unsettled everyone in the industry, especially those responsible for investing the large sums of money needed to bring the industry up to date. As one major supplier noted, "Struggles about ownership are one of the main bottlenecks in terms of development the product lines of the industry."

CHANGING ATTITUDES

Jaakko Poyry's area director for Russia and the CIS, Aleksei Novitsky, is in full agreement that ownership issues represent a real barrier to progress for the Russian pulp and paper industry. However, he also believes that even if that were sorted out, securing investment could still be a problem.

"The technical people are really quite good with the machines they have, but the problem is that the companies don't really have a middle management," he said. "There's the situation at the moment where Russian management have gone off to learn the language of western business, but they still lack a sense of what it truly means in terms of being transparent about business plans and getting investment from the banks."

As Novitsky points out, Russian banks are often not in a position to lend, while investors or partners in the West are put off by a lack of transparency, as well as the ongoing concerns over ownership. "If they want investment, they're going to have to open up their books. Otherwise, they're going to be financing out of cash flow and that can't be good for them."

For overseas investors such as IP and Neusiedler, such problems are obviously not an issue. Plus, as Novitsky points out, "They got the best mills." For domestic companies, though, the challenge remains.

Overall, Novitsky remains cautiously optimistic about the prospects for the sector as a whole, especially in terms of the demand for tissue and better quality board grades. Still, there is no question that the Russian paper industry has a lot to deal with--even if demand is booming now:

* ownership remains a huge issue

* many of the mills are situated well away from their markets

* a legacy of "forest mining" has increased the difficulty and cost of securing fiber

* even in forest-rich Russia, infrastructure is a problem--both for getting road access to the trees and for getting the finished product to market.

RUSSIA'S ECONOMIC GROWTH

Year                   2000   2001  2002  2003

GDP Growth             10.1%  5.1%  4.7%  7.3%
Industrial production  11.9   4.9   3.7   7.0
Capex                  17.4   8.7   2.6  12.5

Source: World Bank

Figure 1: Russian GDP Growth

PULP & PAPER PRODUCTION (1000 metric tons)

Year           2001   2002

Total Pulp     6,178  6,506
Total P & B    5,540  5,856
Total Paper    3,433  3,569
Total Board    2,107  2,287
P & B Exports  2,339  2,538
P & B Imports    407    502

Source: Pyrabelisk

Figure 2: Russian pulp, paper and board production

WHAT YOU WILL LEARN

* How demand in Russia is pushing utilization rates to the maximum.

* Why quality improvements are becoming vital.

* Why ownership issues are acting as a brake on investment.

* How tissue and board grades are set to grow in a fast growing economy.

ADDITIONAL RESOURCES

* Neusiedler web site: Neusiedler.com.

* International Paper Co. web site: InternationalPaper.com.

RELATED ARTICLE: RUSSIA: A BRIEF RECENT HISTORY

After the disintegration of the Soviet Union late in 1991, Russia's economy went into decline for the next half decade. The economy began to improve as painful market reforms were implemented, but much of that impetus was lost when budget deficits and an opaque business climate could not hold back the effects of a global currency crisis when it hit in 1998. The ruble collapsed and the government defaulted on its international debts, generating a serious economic crisis.

The economy has recovered since then as higher oil prices and structural reform have helped push GDP growth up by an average of 6% in recent years. However, many industries--including pulp and paper--still suffer from a legacy of under-investment and business practices are not always transparent. Establishing legal ownership is an especially difficult area.

According to figures from the U.S. government, Russia's 2002 GDP was generated as follows:

* agriculture:  5.8%
* industry:    34.6%
* services:    59.6%*

* Author's note: Many Russian manufacturers exploit transfer pricing regimes through trading companies and as a result services may show a greater percentage of the total as a result

JIM KENNY, CONTRIBUTING EDITOR/EUROPE

ABOUT THE AUTHOR

Jim Kenny is contributing editor/Europe, for Solutions! magazine, and is based in Brussels, Belgium. He is the former vice president of editorial for Paperloop and today heads his own company, DSI. Contact him by phone at [phone], or by email at [e-mail].

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