Most markets for fine paper have long been plagued by overcapacity because producers rushed to take advantage of a business where demand is growing more rapidly than it is in many other pulp and paper segments. Demand for coated and uncoated fine paper—used in applications such as books, copy paper for office copiers, high-end catalogs, and annual reports—is soaring in China and other emerging markets. As a result, the European and North American incumbents now anticipate a rosier future.

Indeed, the hope that China's booming demand will solve overcapacity problems is shared by Western producers of many commodities, including steel. But for the fine-paper producers, battling for share in a 72-million-metric-ton world market, celebrations may be premature. Several forces are working in parallel to turn fine paper—the most exclusive class of products in the printing- and writing-paper industry—into a globally interconnected and more competitive business. Western producers will find it even harder to sell their offerings at a profit.

Winds of change

In emerging markets, demand for fine paper, made from chemically produced (wood-free) pulp, is expected to grow by 4.3 percent a year until 2009. Yet this growth will give Western producers only temporary relief. Fine-paper capacity is exploding throughout Asia, particularly in China. The result will be continued overcapacity in what is already a largely global 26-million-ton market for the high-end, coated grades of fine paper.

Today trade in the 46-million-ton market for the lower-end, uncoated grades of fine paper takes place mainly within regional markets where supply and demand are fairly balanced. But if companies in countries such as Brazil and Indonesia go through with their plans to build new low-cost capacity, it will be competitive across the globe, despite the cost of transportation. The outcome is likely to be overcapacity in an emerging global paper market.

Competition is rising in other paper markets as well. The printing and writing category, for example, includes not only fine paper but also the simpler coated and uncoated grades of "publication paper" made from mechanical (ground-wood) pulp produced, among other means, by grinding logs (Exhibit 1). Technological advances that blur the distinction between grades of paper, on both the supply and the demand side, will make the markets for all such paper products more interconnected.

China and the flows of trade

Just a couple of years ago, Western producers became starry eyed thinking of a market of 1.3 billion people consuming paper at something close to Western levels. They have now come to realize that China's government and entrepreneurs want domestic capacity to satisfy demand. China's coated-paper output is expected roughly to double, to more than four million tons, by 2008—well above projected growth in demand—assuming that the country's economy grows by 8 percent annually (Exhibit 2). China could thus transform itself from a net importer into a net exporter in only a few years. Its surging capacity will create new flows in the trading of coated paper and, indirectly, the trading of uncoated paper as well, with ominous implications for Western fine-paper companies.

The paper producer Asia Pulp & Paper (APP) China is currently building a machine that could produce 700,000 tons of coated paper annually at its Dagang mill. Finland's UPM and Japan's Oji Paper are investing jointly, or planning to invest jointly, in new machines with a capacity of some 500,000 tons each in China. Although this factory will boast state-of-the-art capacity, its production costs will fall in the middle of the Asian cost curve, so it will be competitive with European and North American imports, as well as with high-cost capacity in Asia.

As these and other investments in new coated-paper capacity come onstream in China, its demand for European paper will inevitably soften. The new capacity will also continue to displace Chinese imports of South Korean coated paper, which has higher production costs. South Korean exports have increasingly been redirected to North America, challenging not only its domestic producers but also European paper companies, which see it as their most important export market. Overall export volumes from South Korea now total almost one million tons—3 to 4 percent of global demand for coated paper.

The competitiveness of North American mills tends to swing with the dollar's exchange rate. To sustain themselves when the dollar is strong, they must rely on high productivity. But for most companies, high productivity depends on scale and technology, and no major state-of-the-art capacity has been built in North America for a long time. Meanwhile, South Korean mills have grabbed market share aggressively by taking advantage of North America's growing demand and weakening competitiveness. North America is a net importer, and its high-cost assets are less competitive than mills in South Korea, so marginal export mills there set prices in the United States. If these South Korean producers can continue to sell at the marginal cost, as much as 10 to 15 percent of North American assets (those at the higher end of the cost curve) could prove to be uncompetitive (Exhibit 3).

European producers, which ship some 600,000 tons a year to North America, have so far managed to increase their transatlantic exports. But they may eventually find that they cannot compete with Asian companies. A few years from now, not only South Korean but also some Chinese capacity will be battling for market share in North America. This development could severely limit the ability of European players to go on off-loading excess capacity in their export markets when demand weakens at home. The export tonnage could be trapped in the European market, with subsequent pressure on prices—and margins.

Although China isn't currently expanding its capacity to produce uncoated paper, it is well on its way to transforming trade flows in those grades too. China doesn't have enough forests to support the raw-material needs of its coated production, so it is importing huge amounts of fiber: logs, wood chips, pulp, and recycled paper. These imports have spurred foreign producers with access to inexpensive fiber—primarily in South America and Southeast Asia, where trees grow fast and wages are low—to expand their pulp production capacity greatly and to scale up their plans for expansion. Many of these companies have toyed with the idea of adding even more capacity, on top of the investments so far announced. If the current pace of construction continues over a sustained period, the result is going to be overcapacity that will cut pulp prices and wipe out the cost advantages now enjoyed by producers with access to South American and Southeast Asian fiber.

Should that happen, these companies might decide to use some of their pulp to produce paper themselves, and they would choose to focus on uncoated paper because it is simpler to make. Here they will be highly cost competitive. Several companies, including Brazil's Votorantim Pulp and Paper, have considered building integrated mills to produce pulp and uncoated paper, mainly for export markets. This new capacity in uncoated grades would put pressure on prices and have a profound impact on all producers—but particularly European and North American fine-paper companies, with their relatively high costs. China's high demand for raw materials for its coated-paper production could thus indirectly result in overcapacity and a globally interconnected market in the uncoated segment as well.

Rising Asian production and exports of mostly uncoated-paper applications (such as books, notepads, and Post-it notes) are other threats facing Western producers. For products that don't require very short turnaround times (unlike magazines and catalogs, for example), Asia's bid to be not only the world's manufacturing house but also its printing house is quite plausible. With such products sourced in Asia and increasingly exported to North America and Europe, demand for paper will fall in these regions.

Elastic capacity and blurring grades

Does it matter for producers of coated paper what happens to the trade flows of uncoated paper? The answer is yes, for a reason that has grown in prominence over time but is only now coming into full force: the blurring of paper grades, on both the supply and the demand side.

On the supply side, paper capacity is becoming more and more elastic. In the past, a particular machine tended to produce either coated or uncoated paper; now, "swing" machines that can produce both are increasingly popular. For European producers, this elastic capacity supports the coated market (a core grade for many) when demand weakens by allowing them to switch some capacity to the uncoated market. But the converse is also true: producers are starting to coat their papers when they can't sell their uncoated ones. Overcapacity in either will therefore change the balance in the other. Producers of uncoated paper—a market where supply and demand are now fairly balanced—could well find this equilibrium under assault.

There is also another reason for the importance of both trade flows to all producers of printing and writing papers: from the customers' perspective, grades have become increasingly similar. Until recently, printing papers (such as coated wood free, coated mechanical, and uncoated mechanical) were not really interchangeable, because of distinct differences in brightness, gloss, and smoothness. But product development has substantially improved the characteristics of lower-quality grades. Printers and publishers care less and less about whether they use coated wood-free, coated mechanical, or even uncoated mechanical paper if it runs well on their printing machines, with minimal total costs.

This development opens up a wide space for substitution among more price-sensitive buyers—and for price pressures. It also reinforces the move toward a more globally interconnected printing- and writing-paper industry in which supply and demand reflect trade flows that depend on one another in both direct and more subtle ways.

Don't get stuck in the middle

What can North American and European players do to win in this challenging global environment, characterized by overcapacity, emerging low-cost contenders, and price pressures?

For small and midsize producers, or for those that don't see fine paper as a core business, the best option may eventually be to sell out. So far, sellers seem to have captured most of the value in the pulp and paper consolidation game because buyers have often overpaid for their acquisitions and incurred heavy debt burdens as a result. Companies that decide to stick it out would do well to recognize that the problem of overcapacity will remain—but now on a global level—since fine-paper companies will need a long time to build the balance sheets for the massive restructuring and consolidation required to improve the market.

Fine-paper producers have traditionally tended to opt for an ever-widening portfolio of products offering something for everyone. One producer claims to have 1,350 standard coated fine-paper products with varying basis weights, coatings, and sizes. Companies then try to promote such portfolios by raising expenditures on brand building and marketing. More often than not, this approach has created increasingly complex, costly to manage supply chains and generated high and hard-to-recover expenses for product development and marketing. Fine-paper producers have, in other words, taken a middle-of-the-road position, trying to cater to everyone and failing to provide any of their customers with a distinctive offering.

We see two possible ways forward.

Low-cost producer

One route leads to a distinctive, low-cost position based on extremely high productivity and strategically advantaged sources of raw materials. Producers taking this approach would likely have a limited product range, with an optimal fit to their production equipment and relatively simple services. R&D would be limited because, if the price is right, customers won't care very much about the nuances of products from different suppliers. One large purchaser of printing paper we know uses five different producers to supply the same paper grade for exactly the same printed application. In these circumstances, the idea that today's suppliers can differentiate themselves through the distinctiveness of their products seems far fetched.

A low-cost position increasingly depends on access to inexpensive raw materials. The first of two options is recycled paper, the world's most widely used source of pulp. Western players vying for a low-cost position should consider taking stakes in wastepaper collection systems at home and abroad. Sweden's Holmen, for instance, is co-owner of a company that collects wastepaper in Portugal and Spain for the company's paper mill outside Madrid.

The second option is virgin fiber from the southern hemisphere—mainly South America and Southeast Asia, with their fast-growing plantations—and, potentially, from untapped regions in Russia, where forest land is plentiful and cheap. European and North American companies should consider mergers, acquisitions, and greenfield investments in these remote areas because, even with today's high transportation costs, producers with access to the cheapest wood can often export paper to other regions and still undercut local producers. The Swedish-Finnish forestry group Stora Enso, for example, announced last year that it was buying land for plantations in Brazil and had an interest in building a second pulp line at the Veracel mill it owns jointly with Brazil's Aracruz Celulose.

These days, the pulp and paper industry is so global that companies shouldn't see value chains as confined to a single region: the geography where a company produces rolls or sheets of paper can be far away from the market where it intends to sell them. Some major European producers choose to export certain kinds of paper to North America from their highly productive European mills rather than manufacture them in their own North American ones. Likewise, European producers could conceivably make paper somewhere else more cost effectively and then export it back to Europe.

Western producers with production capacity in the southern hemisphere or in Russia should spend much of their R&D on breeding (improving their trees from generation to generation) and on technologies to improve the cost advantages of fiber from these regions. They should probably also focus on a narrow, commodity-like product range such as cut-size products—copy paper, for instance—to optimize the advantage of access to raw materials.

Applications provider

For companies that can't or don't want to occupy the ultralow end of the cost curve, another strategy may be available. This strategy would be based on a superior understanding of what customers and end users really need—and of how to provide it in a way that keeps them loyal to particular offerings.

The route in question focuses on the paper's end product. Any producer that chooses this option has to make itself relevant to end users by offering paper that fully matches their specific applications. The producer should understand the practical problems facing not only printers but also advertisers and publishers, for instance. It must also offer sets of logistical and other services that are perfectly tailored to the needs of individual customers. By supplying custom-made paper and reducing inventories, such a company will squeeze waste from its value chain and therefore cut its costs. R&D will probably have to be more extensive than it is for low-cost producers but should focus sharply on a few applications.

So far, the paper industry's best examples of this applications provider approach compete in packaging. A number of producers work closely with their customers to develop innovative packaging formats; some of them have such an intimate knowledge of the appropriate materials that they will even take over a customer's packaging line. Sonoco, a general-packaging provider with roots in the paper industry, invites its customers to discuss and solve specific problems at specialized Sonoco centers. It has long generated unusually high returns.

Yet producers face significant challenges working outside their normal turf in the value chain and delivering distinctive paper applications rather than rolls of paper. For one thing, they will need to learn a new set of skills that are now uncommon in the industry. It isn't good enough merely to do what an immediate customer asks, since that approach may saddle the producer with unnecessarily complex and costly operations. Instead, the producer must have an independent view of where, in the entire supply chain, value resides or can be created and an interest in working with other players in the chain to maximize that value.

The overriding aim should be to minimize the total cost of the entire end-user application—say, a magazine—and not just the paper's cost. A paper producer could, for example, work with a limited set of printers to offer publishers a small number of magazine templates optimally suited, in size and paper, to the printers' equipment. Another possibility would be to cooperate with an ink producer to ensure the best combination of paper and ink, at the lowest total cost.

Which course is more attractive: focusing on low costs or providing customer-oriented applications? The choice will depend on an individual player's current position, competitive advantages, and aspirations. But if today's fine-paper producers don't want the structural shifts now transforming their industry to sweep them aside they must start moving away from the middle of the road.