Forestry's upturn may sow seeds of new setback

VANCOUVER (Reuters) - A recent run-up by Canadian forestry stocks has investors in the downtrodden sector basking in a warm glow, but that could fade as quickly as it appeared if the industry returns to its self-destructive tendencies.

Higher prices for pulp, lumber and oriented strand board have boosted shares of companies like Domtar Corp (UFS.TO: Quote), up 415 percent from a year ago, Canfor Pulp Income Fund (CFX_u.TO: Quote), up 521 percent, West Fraser Timber (WFT.TO: Quote), up 73 percent and Canfor Corp (CFP.TO: Quote), up 105 percent.

Lumber prices are at four-year highs, which will allow a cut next month in the export tax Canadian companies pay on shipments to the United States.

That will mark the first time the tax rate, designed to restrict Canadian lumber during weak markets, has gone down since the Canada-U.S. softwood trade agreement was signed in 2006.

But with U.S. housing construction still weak, the higher lumber prices are being attributed to inventory re-stocking at a time when supply is constrained because of years of sawmill shutdowns in both Canada and the United States.

Therein lies the quandary for investors: Will producers keep the good times rolling by showing restraint, or will they try to cash in for short-term profit and restart some of the idled production, as they have in the past?

"If you're asking me, do I think there will there over-production, the answer is, probably yes," said Paul Quinn, an analyst at RBC Capital Markets in Vancouver.

Kevin Mason of Equity Research says he recently heard a chief executive lament the industry's traditional lack of supply discipline. Not long after that, the same CEO's company announced it was preparing to restart a long-idled mill.

Quinn cautions the sector's fragmentation makes it difficult to predict or restrict production. For every public giant like West Fraser or Canfor there are many more private single-mill producers.

Mason says the depth of the economic downturn, especially in the United States, may offset the industry's tendency to rush back into production. He says the recession may have left both producers and buyers more pessimistic about the future than they normally would be.

That said, the first signs of stepped-up output are starting to emerge. West Fraser said on Friday its Canadian mills ran near full capacity in the first quarter, and it was wet weather that cut production at its southern U.S. operations.

It too warned that prices may retreat again as other companies ramp up their mills.

OSB AND PULP

Production constraints have also been credited as part of the reason oriented strand board (OSB) prices have rebounded, but analysts say some of that was due to the wet weather in the U.S. South.

"Once near-term supply constraints are resolved, we expect prices to fall back below normalized levels," Canadian Imperial Bank of Commerce cautioned investors in a note this week that was nonetheless upbeat about the industry's long-term outlook.

Pulp producers have benefited over the past year from unexpectedly high demand from China, but Mason worries the high prices are squeezing demand and will have to drop in the third and fourth quarters.

"Some papermakers say they aren't buying pulp because it's too expensive," said Mason, adding that the relative difference between pulp and paper prices is the widest he has ever witnessed.

The higher prices are also enticing some companies that produce pulp largely for their own paper-making operations to offer more on the open market. That could aggravate the potential for an excess in supply.

Prices for paper have increased in the quarter, but observers warn it will take a general economic improvement before the industry's other sectors rebound.

Newsprint makers plan another price increase in May, but CIBC's note to investors remarked: "Given the poor track record of newsprint producers actually implementing the announced price increases, the final outcome remains in doubt."

Despite any concerns about short-term bumps in the road for the Canadian forestry sector, the long-term optimism remains, especially for lumber.

Raymond James analyst Daryl Swetisloff predicted last month that lumber was set to enter a "super cycle" fueled by an eventual rebound in housing demand as well as by tighter output, caused in part by the mountain pine beetle outbreak, which has damaged large areas of British Columbia's forests.

The potential for a rebound has drawn some new players into the lumber market. Eacom Timber Corp (ETR.V: Quote) is set to take over the Domtar's lumber operations in Eastern Canada.

Conifex Inc, which last year bought an idled sawmill in Fort St. James, British Columbia, is set to buy another idled mill in MacKenzie, British Columbia. Conifex, created by a number of industry veterans, is currently privately held.

With a long-term upturn being predicted, the question investors may want to ask themselves is whether they are willing to ride out the bumps and the downside risks to get there.

($1=$1 Canadian)

(Reporting by Allan Dowd;editing by Rob Wilson)