Farm Forestry New ZealandSell now, harvest later - Bring forward your forest cash receipts
Howard Moore, New Zealand Tree Grower August 2012.
Section EI 1 of the Income Tax Act 2007 allows anyone selling standing timber to spread their income for tax purposes. That is useful, but it may be more useful to spread the cash receipts – that is, to sell the logs forward. It might be nice to be paid for the trees three or five years before they are cut.
Of course sawmillers will not pay for logs until they get them, but that is not a problem if we introduce a third party. Suppose the grower sells the logs to a local sawmiller after pre-selling the revenue from that sale to a separate investor. The grower gets the cash, the sawmiller gets the logs, and the investor gets a return over the period based on a fixed discount rate and the movement in log prices.
In this situation the grower has issued a forestry derivative, an investment which behaves like a forest. The grower has simply pre-sold some of his own forestry return together with the log price risk. The buyer can be anyone. The buyer’s presence does not disturb the growing of the trees, or the delivery of logs from the forest to the mill.
Simple in concept
The concept is relatively simple. Log prices are published by grade. The revenue from the sale of a known quantity of logs of that grade on a particular date is easily determined, and the investor can be protected from the risk of default with normal commercial securities.
The average log prices in dollars per cubic metre for radiata pine in New Zealand are regularly published by Agrifax. A sampling of the records indicates the following movement in the prices of key grades over the last six years.
| Dollars per cubic metre | P1 | KS | S1/S2 | Pulp |
|---|---|---|---|---|
| Feb 2006 | 124 | 60 | 85 | 37 |
| Feb 2010 | 124 | 81 | 88 | 47 |
| Feb 2012 | 132 | 79 | 98 | 51 |
In February 2006 a grower planning to harvest in February 2012 might forward sell the revenue from a fixed tonnage of pulp logs. The price at which he would sell forward would be the price in February 2006 discounted at perhaps seven per cent a year for six years 2006 to 2012. The investor would give him the money in return for the grower’s promise to pay the actual price on harvest.
When the grower gets the harvest receipts in 2012, he would redeem his promise to the investor, paying him the current published pulp log price as required under his contract.
Using figures from the published log prices above for this example.
| Assumed log price for February 2012 = Actual log price in February 2006 | |
|---|---|
| Actual log price February 2006 | $37 |
| Weighted average cost of funds | 7 per cent a year nominal |
| Discount factor for 6 year delay | 1.07^6 = 1.501 |
| Derivative price Feb 2006 = net present value of assumed February 2012 log price | |
| Derivative price February 2006 | $37 divided by 1.501 = $24.65 |
| Actual price realised for logs in February 2012 | $51 |
| Buyer's return on investment | $51 divided by $24.65 = 2.069 12.9 per cent a year |
If the buyer had bought a derivative for P1 logs instead he would have earned less.
| Actual log price February 2006 | $124 |
| Derivative price February 2006 | $124 divided by 1.501 = $82.63 |
| Actual price realised for logs in February 2012 | $132 |
| Return on investment | $132 divided by $82.63 = 1.598 = 8.1 per cent a year |
Timing
The fact that the outcome depends on timing and the movement in log prices is its attraction. The investor is buying the log price risk and the return that goes with it, so that he can make a profit from holding or trading the derivative as he chooses. The grower could borrow from the bank, but if he sells a derivative instead he has no interest rate risk. Whatever the interest rates do, his obligation to the buyer is based solely on log prices – and he has the logs.
With the derivative –
- The grower can realise some of his harvest cash flow in advance and reduce his exposure to log price risk
- The investor can get a medium-term forestry investment which is easy to price, easy to trade and with no risk of losses from fire or windthrow
- The log buyer is unaffected, he receives the logs for processing at the time of harvest and pays on normal terms.
The concept can apply equally well to continuous canopy mixed hardwoods or any other forests, provided there are recognised log grades with regularly published prices. The reason for promoting the derivative is that it might encourage more investors into the industry and a wider discussion on the prospects for New Zealand log prices. Both would be welcome.
Howard Moore is the director of AuCrop Ltd.
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