Timber Economics of Natural Catastrophes By Jeffrey P. Prestemon, John M. Pye, and Thomas P. Holmes 1 Abstract The United States regularly suffers losses of timber from a variety of catastrophic events, including hurricanes, wildfires, ice storms, and pest outbreaks. Such catastrophes can hurt timber producers through their effects on production, and prices if damages are widespread. These two forms of risk, production and price, have traditionally been examined independently of each other, but when damages are widespread the risks to production and price are not independent, they are joint. The joint nature of the risks substantially complicates the optimal response of landowners to such risks. Clarifying the implications of this joint risk is the central point of this paper. Fine-scaled events can cause investment losses to owners of killed timber but when catastrophes are widespread, salvage activities across a landscape depress prices and inventories, expanding the impacts to producers of timber undamaged by the event. While salvage gluts drive down prices in the near term and depress inventories, longer-term inventory effects can increase prices even higher than before. This would imply that when disasters first strike, owners of undamaged timber should delay harvesting, but some disturbance agents have temporal and spatial autocorrelations, which affect their medium-term production and price risks, complicating this simple rule of thumb. When disasters are prolonged over several years, as often happens with southern pine beetle, owners of undamaged timber must weigh the promise of future price rebounds against the increased production risks faced during those years of delay. Other agents have different temporal and spatial characteristics, this paper outlines the implications of these characteristics on the joint nature of price and production risk and their implications for optimal harvest decisions. 1 Respectively, Research Forester, Ecologist, and Research Forester, Southern Research Station, USDA- Forest Service, PO Box 12254, Research Triangle Park, NC 27709. INTRODUCTION Timber producers in the southern United States face a number of uncertainties in deciding whether and when to invest in timber production and in deciding when to harvest a particular stand of trees. These uncertainties include those related to production (production risk) and prices (price risk). Production risks include inaccuracies in projecting merchantable volume, quality and growth rates over time, inaccuracies in evaluating the yield effects of intermediate stand treatments, and unforeseen volume and timber quality losses caused by natural events including catastrophes. Catastrophes can be at stand and landscape scales. Stand-level catastrophes affect only small geographic areas and therefore have negligible effect on the larger timber market. Landscape scale catastrophes affect large geographic areas, and if sufficiently severe will affect market prices. Among the large scale catastrophes commonly seen in the South are southern pine beetle epidemics (Price, et al., 1998), fusiform rust (Pye, et al., 1997), hurricanes (Sheffield and Thompson, 1992), wildfires (Brenner, 1991), and ice storms (Halverson and Guldin, 1995). Because the damages from catastrophes are non-homogeneous (Holmes, 1991), they induce wealth transfers. At least in the short run, timber consumers gain at the expense of producers. If a catastrophe causes a large enough loss in inventory that prices are increased (Prestemon and Holmes, 2000), then the remaining producers may benefit at the expense of consumers. Private and public efforts to reduce stand risks from these kinds of disasters might, in other words, have positive economic payoffs, at least for some kinds of disasters (de Steiguer et al., 1987; Hesseln, et al., 1998). Given that natural disasters can influence both price and production risks, it is clear that price and production risks are jointly distributed, a factor that has been largely ignored in the theoretical literature on timber production. The goal of this paper is to describe the jointness of price and production risks arising from large- scale natural catastrophes such as those experienced by timber producers in the South. We begin by discussing in general terms how price and production risks affect timber production behavior. Next, we characterize the price risks that are generated by disasters, focusing on the price depression from the salvage glut and a potential price enhancement generated by inventory reductions from these disasters. We then describe how knowledge