The world looks just a little brighter in 2006.

It may not point to a massive change in the fortunes of the paper industry, but 2006 does show some signs of improvement despite the challenges ahead.

A new year, a new start. Well, that's what many managers in the global paper industry will be hoping for after a 2005 that saw some of the industry's biggest names report a series of sell-offs, lay-offs, write-downs and shutdowns in a bid to recapture some profitability.

Of course, there was some good news too. Global growth figures in most regions were positive, if unremarkable, with the exception of Asia, which was dominated by strong GDP growth in China even as the Beijing government attempted to curb overheating in the market.

Meanwhile, consumption patterns were actually quite buoyant as well, even if low-end pricing underlined the endemic damage created by the industry's tendency to drive overcapacity.

Last year was also marked by a huge spike in energy costs worldwide, which tended to negate even the best efforts of many companies striving to get their share prices moving in the right direction. For many, this is set to be a recurring theme that will dominate in 2006 as well as companies struggle to get to grips with increases in power prices as well as other inputs such as chemicals and transport costs.

[GRAPHIC OMITTED]

Commentators believe the industry could have fared worse and with widespread reports of old capacity being shuttered in mature markets, there is hope that the sector may have "grasped the nettle" on capacity. Although as one analyst noted, "We all live in hope, but personally I don't have great expectations that we're seeing enough [shutdowns] to make a huge impact."

However, the global experience is relatively good overall. Consumption generally continues its long-term upward trend as the world's consumers become better off and in certain regions--China especially--demand is booming to such an extent that it is rapidly shifting global trade flows.

NORTH AMERICA REBUILDS

In North America, the prospects for 2006 could well be influenced by a number of events that took place in 2005. Among the big news for the year. International Paper (IP) produced its new strategy based on uncoated woodfrees and packaging and at the same time announced massive asset sales to reduce debt.

[GRAPHIC OMITTED]

With a stronger balance sheet and some cash in the bank, IP made its own statement on where it believes the global pulp and paper industry will do well this year by speculating about new investments in Brazil, packaging projects in China, expanding Svetogorsk in Russia and looking at bolt-on corrugated businesses in Eastern Europe and the Mediterranean areas.

As one industry commentator pointed out, though, the deal doesn't do much in terms of dealing with structural overcapacity in North America and it remains to be seen if investors would even be happy if the company takes on major investments at this time. So for 2006, IP at least looks as though it may be a bit busy with a major reorganization and clear-out, leaving management with more pressing matters to focus on than global expansion.

Another big U.S. player, Weyerhaeuser, is also following the rationalization trend. Closures were announced at the Prince Albert pulp and paper facility in Canada and a specialty pulp mill and a large-log sawmill in Washington. And Steve Rogel, chairman, president and CEO said, "These are the first, but by no means the final steps. We will continue to take the actions necessary to make Weyerhaeuser a more competitive company and generate greater returns while returning cash to our shareholders."

However, a few analysts tended to think that companies such as Weyerhaeuser could see a slightly better trading environment in 2006, especially if an anticipated recovery in containerboard does actually materialize.

As one New York based analyst noted, "I think companies such as SSCC (Smurfit-Stone Container) are at last doing something about the overcapacity, although it's still a major problem. Smurfit-Stone said recently that it is closing about 20% of its corrugated container facilities. OK, not until 2008, but at least if some of these older machines go and the economy stays on course then there should be some benefit." As such, further downsizing certainly looks like it will be a recurring theme for 2006.

Another big move in 2005 was the bid by Koch Industries to take on Georgia-Pacific for some US$ 13 billion and change. Some commentators even suggested that this might herald a return to another big merger and acquisition frenzy in the sector, given that Kappa has joined forces with Jefferson Smurfit in Europe just a couple of months before. Others are more skeptical, however.

According to the analysts at Citibank, "After a two-year respite, M & A activity began to pick up in the second half of 2004 and continues today. We do not see this as the beginning of a new global consolidation wave as industry balance sheets need to be repaired. Instead, we see cash-rich financial buyers swooping in to acquire non-strategic or poorly performing turnaround opportunities from larger industry players seeking to bolster their balance sheets."

As a privately held group that has focused mainly on oil and energy until now, Koch certainly falls into the cash rich category. David Koch is reported as saying that he believes his group's "commodity manufacturing" expertise could help reduce George-Pacific's manufacturing costs and streamline its production processes, while reduced debt levels will allow the company to invest in G-P's facilities. But whether the group's hopes of translating its production skills to the paper sector are likely to bear fruit is something that will certainly be worth following in 2006 and beyond.

In the meantime, the deal does indicate a genuine shift in the landscape of the paper industry insofar as it underlines the interest in the sector from private equity firms. Indeed, the new board of the Kappa/Smurfit combination includes no less than nine directors from the financial sector--five from Madison Dearborn, two from Cinven and two from CVC Capital Partners.

As one analyst explained, "It's a slightly unusual situation. A lot of these private equity firms are able to offer access to cheaper finance than a stock market listing, plus you don't have all the burdens that go with compliance. Added to that, industry shares are generally trading pretty low these days, so I personally think we'll see a lot more interest this year."

EUROPEAN SLOG 

In fact, Jefferson Smurfit kicked off 2005 with the spin-off of its Munksjo specialty paper business to The EQT III Fund for approximately EUR 450 million, signaling previous private equity interest in the sector. But outwith the successes of the sell-off and the Kappa deal, Smurfit's year was fairly typical of several of the big European producers in operational terms.

"Difficult market conditions" meant that the region's packaging sector was characterized by a sluggish pricing regime, especially in the first half of the year. General economic weakness, the relative strength of the euro, the introduction of new recycled container-board capacity in 2005, and higher input costs were also blamed for relatively weak results among the major European players on the board side.

The Finns also had a major strike that hit profits in the middle of the year and the Swedes were faced with the fall-out--quite literally--from a major storm that felled large plantation areas in south and central Sweden. On the face of it, not a great spring-board for 2006.

However, Jefferson Smurfit did signal price increases on both kraftliner and recycled containerboard grades in the fourth quarter to "reflect, in part, rising input costs and modestly improving market conditions in some European product markets," so could there be a glimmer of hope for the new year?

As Jefferson Smurfit Chairman, Gary McGann, noted, "While there are initial indications of improved industry conditions across Europe, it is still a market characterized by excess industry capacity. It is likely to stay that way unless there is either a sustained improvement in demand or industry-wide recognition that difficult market conditions necessitate rational capacity decisions. Indeed, the announced price increases do not fully recover the significant increase in input costs."

[GRAPHIC OMITTED]

Elsewhere in Europe, there is some cautious optimism among companies such as Stora Enso, UPM and Holmen, and although the word rationalization features heavily in comments from almost all the big groups, most remain hopeful of slightly better times to come going into the new year.

Even while noting the effects of energy and other input costs, Magnus Hall, CEO of Holmen, was rather on the bullish side when discussing the prospects for the news and magazine papers business. And that is a situation that hasn't been seen for a few years now.

Hall reported that the order situation looks strong and is looking for higher prices for newsprint, magazine grades and the group's paperboard products this year. Of course, Hall probably has to sound enthusiastic as Holmen is about to start up a new newsprint machine in Madrid, Spain. The 300,000 tonne/yr machine from Voith will cost EUR 300 million and will produce MF newsprint, primarily for daily newspapers.

M-Real's President and CEO, Hannu Anttila, also noted that demand for the company's main products is forecast to remain reasonably good and average prices of coated magazine paper and uncoated fine paper are expected to rise slightly. The company will almost certainly be posting a loss for 2005, but even so, at least the markets are moving in the right direction.

Stora Enso's CEO, Jukka Harmala, did note, "The pulp and paper industry, and Stora Enso as a company, are suffering from poor profitability." However, Stora Enso has embarked on a major efficiency drive and fully expects to reap better returns in 2006/2007. The group's Profit 2007 and Asset Performance Review (APR) initiative is aimed at boosting pre-tax profits by EUR 300 million and reducing capacity by about 400,000 metric tons in the short term.

In the longer term, though, the company is staking its future competitiveness on a global strategy that involves sourcing fiber from low-cost locations in Latin America and Eastern Europe and leveraging the firm's expertise in fast-growing markets.

In fact, just at the end of last year, Stora Enso signed a letter of intent to start a joint venture with Chinese board producer Foshan Huaxin Packaging Co., further expanding its presence in Asia. At the same time, the group completed a series of land purchases in the southern part of Brazil and in Uruguay with the intention of establishing 100,000 hectares of plantations. As the company explained, "The plantations will serve as a competitive fiber supply for Stora Enso's possible future pulp and paper production in these countries."

[GRAPHIC OMITTED]

Commenting on the outlook, Harmala said that European demand for advertising-driven grades is expected to improve, leading to upward pressure on demand and prices for publication papers early in 2006. Further increases are also expected in uncoated fine paper and possibly even some board grades.

UPM is also predicting higher pricing for magazine grades and newsprint as Europe's ad spend climbs and price increases are being pushed through now, although fine paper grades look to be in a weaker position. The cost of energy remains a hot topic, although the group has invested in its own generating capacity. For investors, though, the big news is the successful startup of new woodfree capacity in China at the Changshu mill.

UPM's President and CEO, Jussi Pesonen, said, "The startup of Changshu's new paper machine was very successful. During its first months of operation, we established a solid customer base. The machine achieved positive operating profit in September. Demand for its fine papers has developed as projected and prices are firm. Advertising driven paper has continued to be in good demand. Average prices have been raised somewhat since the summer. Prices outside Europe have continued to show a positive trend and are well above those in Europe and further price increases are expected as of the beginning of the year."

Despite all this restructuring and an evident firming of prices across the product range, practically all the major European producers have seen their debt ratings downgraded in recent months, indicating that not everyone sees 2006 as the turnaround year for the sector.

ASIAN DREAMS

European companies have been making a big impact in Asia for a few years now as companies such as UPM and Stora Enso pursue their investment plans in the region. But arguably Norske Skog's acquisition of a full shareholding in the PanAsia Paper Company is the main piece of action as 2006 gets under way.

Norske Skog paid US$ 600 million to Abitibi-Consolidated for its shares in PanAsia (now called Norske Skog PanAsia) in a deal that makes Norske Skog the largest newsprint producer in the world and in Asia. A quarter of the company's production capacity is now located in Asia as the group now fully owns five modern newsprint mills in China, South Korea and Thailand.

Overall, the markets in Asia appear to be moving past the frothy exuberance seen in previous years, but there's no question that growth in demand is moving along nicely in many of the main markets. Unfortunately, it looks like the paper industry is once again managing to stay ahead of the consumption curve as step changes in capacity take effect and prices slip in several areas.

As one market watcher commented, "Pulp prices look soft going into 2006 along with board, woodfrees, and recovered paper--although newsprint actually seems to be doing OK. On the other hand, there are plenty of people out there who will tell you this is a short-term blip and demand will rapidly catch up with supply. The problem with that is that there really is lots of cash out there just waiting to create more supply."

Of course, Asia is far from being a single market. Japan operates with relatively few outside companies, relying on others for its fiber supplies, while India's fast growing economy and geography present their own opportunities and challenges.

Going into 2006, though, all eyes are on China and the most recent forecasts from industry consultants show an almost unstoppable surge of growth that will have a major impact on the structure of the global paper industry.

A recent report from Jaakko Poyry indicates that North American producers are already feeling the effects of a slowdown as Chinese production ramps up to serve its own home markets. But the consultant believes that margins will be slim and hugely competitive for anyone brave enough to enter the dragon's den.

Jaakko Poyry is predicting that China will see paper and board demand growth of 5%/yr until 2020 and local capacity is swelling fast to fill the demand. "A total of around a 15 million tonne increase in capacity has been announced in China for completion in five years from 2005 onwards and more announcements are expected for 2007-2010," the consultant says. Inevitably, that will mean even more downward price pressure in the medium term.

It is hard not be awed by the scale of the expansion taking place though. In the five years from 2000, APP China's capacity has grown from around 1.8 million metric tons/yr to almost 3.0 million metric tons/yr. Nine Dragons has gone from 600,000 metric tons/yr to almost 2.5 million metric tons/yr and Shandong Chenming has added around 1.5 million metric tons of capacity from just 300,000 metric tons/yr in 2000.

FIBER FEVER

Expansion such as that witnessed in China cannot take place without fiber, of course. Part of that demand will be met by higher recovered paper imports from North America and Europe and an upgraded recovery infrastructure in Asia. Much will depend on securing fiber sources in China and elsewhere though.

Stora Enso, for example, is already hard at work building up plantation resources in Guangxi Province where it has approximately 60,000 hectares and others are following suit. But Latin America is likely to play a rapidly increasing role in the fiber equation for years to come--not just in China, but around the globe.

Aracruz and Stora Enso's 50/50 Veracel market pulp joint venture in Brazil highlights the opportunities on offer. The 900,000 metric ton/yr mill offers Stora Enso access to low-cost hardwood pulp and the group may well announce further expansion with Veracel 2 or even more pulp capacity based on the other plantations it owns in Brazil and Uruguay.

Not that other groups have been slow to see the potential. Votorantim Celulose e Papel's CEO, Jose Luciano Penido, recently announced progress on a million metric ton/yr bleached eucalyptus pulp mill to be built in Rio Grande do Sul that will cost some US$ 1.3 billion to build. Completion on this project is envisaged in 2011.

Before that though, Suzano gets started this year on building a one million metric ton/yr pulp mill in Bahia in the south of Brazil. Kvaerner, Andritz, Metso and Siemens are EPC contractors for the scheme and the new Mucuri unit should start producing toward the end of 2007, propelling Suzano into the world's top ten pulp producers.

In terms of the general economy. VCP points to adverse macroeconomic conditions in Brazil relating to high interest rates, but the group believes that 2006 will see inflation curbed and an even brighter revival across the paper industry.

Jefferson Smurfit is already a big fan of Latin America and the group reported another solid financial performance in 2005, following record results in 2004. JSG's new corrugated facility in Chile is also doing well and, as the company said, "Latin America continues to perform strongly, although its year-on-year comparisons are now becoming tougher. In particular, Mexico, JSG's largest country of operation in this region, is reporting reduced growth and is being negatively impacted by rising input costs."

As one market watcher noted, "Latin America is patchy, but reasonably attractive. Countries such as Argentina and Colombia are relatively strong and Venezuela is doing well with its oil wealth, although there are obviously some challenges doing business there."

LOOKING AHEAD

Overall then, there are plenty of positives for 2006. Consumption is growing steadily, overcapacity is being addressed in some mature markets and the emerging economies offer some interesting prospects for those willing to brave the challenges.

Overshadowing it all, of course, is the prospect of consistently high energy costs that will feed through in several different guises as transport, chemicals and other input costs serve as a drag on the industry's plans for growth and improved profitability. In the meantime, keep a lookout for private equity companies circling overhead.

ABOUT THE AUTHOR

Jim Kenny is international editor 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].

[ILLUSTRATION OMITTED]

WHAT YOU WILL LEARN:

* Why restructuring is underway in North America.

* Reasons for cautious optimism in Europe.

* How development in China is changing trade flows in pulp and paper.

ADDITIONAL RESOURCES:

* "Global Outlook: Fair to Middling," by Alan Rooks, Solutions!, January 2005. To access this article, type in the following product code in the search field on www.tappi.org: 05JANS022. Or call TAPPI Member Connection at 1 800 332-8686 (US); 1 800 446-9431 (Canada); [phone] (International). TAPPI and PIMA members can access archived articles for free.

* "Europe 2005: It has to be better than 2004, hasn't it?" by Jim Kenny, Solutions!, January 2005. Product Code: 05JANS030.

* "Finland's Paper Industry Sees a Silver Lining," by Jim Kenny, Solutions!, September 2005. Product Code: 05SEPSO31.

* "Sweden Sees Restructuring Allied with New Investment," by Jim Kenny, Solutions!, November 2005. Product Code: 05NOVSO30.