Wednesday, October 19, 2005

Burn the Boxes

Paul, I wanted to first just delve a little more into the impact of these natural gas price increases. I know you don't you use a tremendous amount. But it sounds like even in your system, you're seeing the way it can impact the cost curve steepening it quite dramatically. Is there any way you can give us a sense of what it is doing to cash costs at facilities, which are being powered by natural gas?

So asked an analyst on yesterday’s Packaging Corporation of America conference call. PKG, as the stock goes by, makes cardboard and corrugated boxes—the containers that contain the stuff that get shipped all around the country.

Such containerboard manufacturers are the nearest thing to an economic temperature gauge we have, and PKG is a company worth paying attention to when earnings season comes around.

Best of all, the CEO is much easier to understand than Alan Greenspan.

According to PKG, the economy’s temperature is pretty healthy. Not only were September volumes were up year over year for the first time since spring, but, as the CEO said on the conference call:

And I have to tell you that the first 8 days of October have been very, very good -- our bookings are 8% better than last year, and our billings are 6% better. But 8 days a season does not make. And so it is still going to come down to December. We put our best pencil on December, and we came up where we came up. And maybe there's a little upside to that, but it's far too early to say that.

But back to that analyst’s question about “the impact of these natural gas price increases.” The answer was a long one, but worth following:

Yes, some strange things happened when the cost of a material doubles. And the best way -- the best example that I can give you is at our Filer City Mill. And again, as you said, we don't use much gas. Our first line of defense against high gas costs is not to use gas if possible. And we got our consumption down to 5% only in the third quarter, which is pretty low.

But at Filer City, we make roughly 1,100 tons a day there. And in the third quarter, we virtually made it essentially with burning coal. And rough number, our energy cost at Filer City -- and we consider Filer City a first-quartile mill cost-wise -- a little under $30 a ton would be the energy cost; that is on running coal.

Now what is going to happen to us at Filer City and at our other mills is winter weather. You've got to heat the buildings. And a rough, rough number, it takes 20 tons of water to make a ton of paper, and all that water has to be heated. So you got energy to heat colder water. And as a result, your steam load will probably increase, again at Filer City maybe 50,000 pounds an hour. So you got a choice -- you could sustain production at say 1,100 tons, but you've got to use gas probably on the last 75 tons, natural gas, because our coal boilers max out if we try to make more steam. Or you can make 75 tons less and use coal.

When you look at the numbers, it is astounding. On that last 75 tons, our energy cost goes from less than $30 a ton to almost 200 -- almost a seven-fold increase. And why is that? Because gas costs seven times more than coal roughly.

So I guarantee you that with $200 energy costs, we have -- our cash cost is higher than the selling price. On the first 1,150 tons, we are in good shape. So that's a long-winded answer, but I think it illustrates my point in what gas costs can easily do if you are paying current market price, $13, $14 per million BTUs is, it has the ability to take a first quartile mill to a fourth quartile mill in one fell swoop because of that large increase.

Now there are ways to mitigate that; if you have the ability to switch to other fuels. But on the margin, where you have a choice of fuels, those last tons as they are burned on gas, it's hard for me to believe that they would not be above cash cost in virtually any mill around.

In short, the incremental cost of linerboard at that particular plant went from $30 a ton to $200 a ton.

Following this disclosure, one of Wall Street’s Finest actually asked the most insightful question on the call:

Why don't you burn your competitors' boxes?

To which the CEO responded in his folksy, decipherable, comprehensible, plain-spoken, non-Alan Greenspanish fashion:

You know, I'll tell you something; that end is not as dumb as it sounds. Because right now, the BTU value, the cost per million BTUs if you burned old corrugated containers, it is about $7.50 a million BTUs; gas is at $13. So strange world when you can burn old corrugated containers as fuel value.

Strange world indeed.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.


Will Acworth said...

terrific catch. really brings into view the impact of higher energy prices. question -- does ths company, or any other in the manufacturing sector -- try to lock in energy costs through some kind of hedge? Either a long-term contract from a supplier, or some type of derivatives contract?

econjohn said...

great post as usual, jeff. only tangentially related but i thought of you when i heard this:

Indianapolis Star reports
Interest in record Powerball jackpot lagging

The head of Indiana's lottery suspects high gas prices are to blame.

Esther Q. Schneider, executive director of the Hoosier Lottery [said] "We're just not seeing the big excitement we have in other years for smaller jackpots."

Schneider said Powerball ticket sales are about 30 percent below predicted sales based on the volume generated by other big jackpots[...]

Scot Imus, executive director of the Indiana Petroleum Marketers and Convenience Store Association, said [...] "My intuition tells me that if customers are now spending $50 or $60 at the fuel island, they're probably less likely to go in and buy chips or soda, or a lottery ticket."

bubbles said...

nice find.

Aaron Koral said...

Nice post Jeff on rising natural gas costs and how that can impact a profitable business. My only comment here is, how happy must coal suppliers like Arch Coal be at the usage of their product as a substitute for natural gas at the margin? One can only guess that with increased demand this winter for coal, in lieu of higher natural gas prices, coal suppliers should have a merry Christmas this year (I could be wrong though...)

BelowTheCrowd said...

Virtually all commercial users of natural gas hedge themselves to some degree. But you can't hedge indefinitely. A commercial property I'm involved in was on a five-year contract. Even after renegotiating and extending the contract a few years ago, the cost has been under $4.

But the contract will expire at the end of the year and nobody's willing to sell long term contracts at anything much below spot right now. The big oil and gas companies may talk about their belief that the long-term sustainable price is much lower, and as Jeff has noted previously, they're not doing much new exploration because they say it isn't justifiable at their long term target prices.

But their selling practices suggest that perhaps they don't really have all that much faith in their own internal forecasts. They're not willing to enter long term contracts at anything close to the prices that would be justified by their own official long-term expectations.

So, the bottom line is that while there are hedges out there, the longer the prices stay high, the more the hedges will get used up and the spot market prices passed along.

Jeff Matthews said...

Coal is indeed a logical winner, but coal has its own problems when it comes to bringing that natural gas price umbrella down to profits--one being it takes a lot of energy to bring a ton out of the ground; two being it takes a lot of labor to bring coal out of the Eastern mines...and both these are in short supply.

Just check the recent news from Massey.