Industry Observations: It’s All About the Incentives
In the first two articles of this series, we introduced the basic business fundamentals of supply and demand and working markets during the COVID-19 crisis. In our final article, we will explore how incentives are driving management behaviors in the COVID-19 economic environment. I’ll also provide insight into why the free market capitalistic economy can be summarized in one simple phrase – “It’s All About the Incentives.”
It’s All About the Incentives
During the Great Recession, a simple conversation with the President of a very successful independent sawmill really opened my eyes on how incentives drive management decisions. Lumber prices dropped sharply to unprecedented low levels as a fallout of the Great Recession. Many sawmills were bleeding cash with most capital projects paused or abandoned. Most sawmill operations hunkered down with the goal of keeping their workforce intact and staying cash flow positive.
I will refer to the President of this sawmill as “Mr. Lumber.” During this tough time, Mr. Lumber took a different approach than his competitors – he built a new sawmill! The logic he shared with me was simple…
Mr. Lumber’s Incentives:
- Equipment manufacturers are more motivated to sell equipment at cheaper prices.
- Engineers and project workers such as electricians, fabricators, welders, and millwrights are more readily available and likely to work for lower fees.
- Undertaking capital projects allows you to ride out periods of low to no profitability by aligning downtime with reduced demand.
Mr. Lumber was motivated to undertake a project because he could save significant money. He was also willing to forgo production when margins were the lowest. Now that is a smart businessman operating with a long-term focus!
Now that we understand Mr. Lumber’s incentives, let’s explore how different segments of our industry are incentivized to behave during the COVID-19 crisis.
Timberland Owner Incentives
With forecasts indicating lumber demand will slow over the next 18 months, sawtimber stumpage markets will most likely remain soft. This may cause many private non-industrial timberland owners to reconsider final harvests that consist mostly of sawtimber. Many of these owners are intermittent sellers (once a year, once every few years, or longer) incented to wait for higher stumpage prices.
Corporate timberland owners (REITs, Institutional investors, etc.) will most likely consider some reduction in sawtimber sales. However, their incentive most often is to generate revenue to meet quarterly and annual targets. Given increased demand from the pulp and packaging segment, both ownership groups will most likely continue to prioritize pulpwood sales in the near term. These actions show how different incentives drive different behaviors for these two ownership groups.
Pulp and Packaging Manufacturer Incentives
The recent surge in demand for pulp and packaging products and the response by manufacturers have been great examples of capitalism at work. COVID-19 dramatically increased demand for home deliveries and spiked the overall demand for many consumer goods. The majority of these goods were shipped in a paper box or container. Manufacturers responded by increasing production to meet the growing demand. During the COVID-19 crisis, incentives drove consumers to rely more on home deliveries. In turn, pulp and packaging manufacturers increased production. This example shows how personal and business decisions influenced behaviors that benefit both consumers and manufacturers.
Sawmill Operator Incentives
Having previously worked for a privately-owned and a corporate-owned lumber company, I can say incentives for each of these owners are often very different during an economic downturn. Like Mr. Lumber, private sawmills prioritize the integrity of their workforce, banking relationships, and presence in the local community in times of uncertainty. Many successful private sawmills are proactive and look for opportunities such as cheaper capital projects and talent acquisition from competitors. This strategy emphasizes the long-term outlook for privately-owned sawmills.
During uncertain times, corporate owners often prioritize hitting the easily measured quarterly metrics to satisfy Wall Street and industry analysts. Inventory levels, balance sheet ratios, cash balances, and other easily measured metrics can rule the day in the short-term. This can often be at the expense of the long-term goals and can be detrimental to employees, supply chain partners, customers, and local communities. Corporate-owned sawmills most often have a different set of incentives which result in different behaviors.
Wood Supply Chain Incentives
The impacts of COVID-19 have only added to the challenges facing participants in the wood supply chain. Those in the supply chain will continue to follow the adage “tell me how you will incentivize me, and I will tell you how I behave”. In response to the COVID-19 issues, we may see a downturn in stumpage purchases by wood suppliers. Many wood suppliers and loggers will likely focus on liquidating inflated stumpage ledgers accumulated because of wet weather over the past 18 months. Many suppliers may also frown upon lump sum stumpage purchases in the near term. Once again – understand the incentives, and you can predict the behaviors.
During normal times or during a pandemic, our free market and capitalistic economy works. Whether observing general supply and demand fundamentals, the dynamics of working markets, or incentive driven decision making, the relentless pursuit of profits by all participants in our economy is a beautiful thing to watch.
Stay safe and have a great summer.