a5629247.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
 
FORM 10-K
 
(Mark one)
 x 
Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2007
 
or
 
 __
Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.  For the transition period from  __________ to
Commission File No.  1-9035

Pope Resources, A Delaware Limited Partnership
(Exact name of registrant as specified in its charter)
 
Delaware
 
91-1313292
(State of Organization)
 
(IRS Employer I.D.  No.)
 
19245 Tenth Avenue NE, Poulsbo, WA   98370
(Address of principal executive offices, Zip Code)

Registrant's telephone number, including area code: (360) 697-6626

Securities registered pursuant to Section 12(b) of the Act:

 
Title of each class
Name of each exchange on which registered
   Depositary Receipts (Units)                    NasdaqGSM
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
 Yes
___
No
  X  

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.
 Yes
___
No
  X  
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.
 Yes
_X_
No
      
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    X 
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and larger accelerated filer” in Rule 12b-2 in Rule 12b-2 of the Exchange Act.  
Accelerated Filer ____
Accelerated Filer   X 
Non-Accelerated Filer ____
 
Indicate by check mark whether the registrant is a shell company (as defined by rule 12b-2 of the Act). Yes ___   No    X   

At June 30, 2007, the aggregate market value of the non-voting equity units of the registrant held by non-affiliates was approximately $ 184,815,000

The number of the registrant’s limited partnership units outstanding as of February 19, 2008 was 4,658,870.

Documents incorporated by reference:  None
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Pope Resources, A Delaware Limited Partnership
Form 10-K
For the Fiscal Year Ended December 31, 2007
Index
 
 
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71
 
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88
     
 
93

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PART I

BUSINESS

OVERVIEW

Pope Resources, A Delaware Limited Partnership (the "Partnership"), was organized in 1985 as a result of a spin-off by Pope & Talbot, Inc.  (“P&T”), Pope & Talbot Development, Inc. and other P&T affiliates, of certain of P&T’s timberland and real estate development assets.

The Partnership currently operates in three primary business segments: (1) Fee Timber, (2) Timberland Management & Consulting, and (3) Real Estate.  Fee Timber operations consist of growing and harvesting timber from our tree farms.  Timberland Management & Consulting, through our subsidiary, Olympic Resource Management LLC (“ORMLLC”), provides timberland management and forestry consulting services to owners of timberlands as well as providing general partner and timberland management services on behalf of ORM Timber Fund I, LP (the “Fund”), which owned 24,000 acres of timberlands in western Washington as of December 31, 2007.  Our total equity investment in the Fund is $11.7 million, which represents a 20% interest in the Fund’s total invested capital of $58.0 million.  Real Estate operations consist of efforts to enhance the value of our land investments by obtaining the entitlements and, in some cases, building the infrastructure necessary to make further development possible.  Further segment financial information is presented in Note 11 to our consolidated financial statements included in this report.  Copies of the Partnership’s Securities Exchange Act reports and other information can also be found at www.orm.com.  The information contained in or connected to our web site is not incorporated by reference into this Annual Report on Form 10-K and should not be considered part of this or any other report filed with or furnished to the SEC.

DESCRIPTION OF BUSINESS SEGMENTS

Fee Timber

Operations.  Our Fee Timber segment consists of operations surrounding management of the Partnership’s core assets: the Hood Canal tree farm, which consists of 70,000 acres located in the Hood Canal area of Washington, and the 43,000-acre Columbia tree farm located in southwestern Washington State.  The Partnership views its two tree farms as core holdings and manages them as a single operating unit.  We have owned the Hood Canal tree farm, substantially as currently comprised, since our formation, and we acquired the bulk of the Columbia tree farm in 2001.  Operations on the tree farms consist of the growing of timber and the subsequent harvesting and marketing of timber and timber products to both domestic and Pacific Rim markets.  Our Fee Timber segment produced 68%, 53%, and 78% of our consolidated revenue in 2007, 2006, and 2005, respectively.

Beginning in 2007 this segment also includes operations of the Fund, which is consolidated into our financial statements.  The Fund acquired 24,000 acres of timberland in the fourth quarter of 2006.  We harvested 5 million board feet (MMBF) from these timberlands in 2007.   Harvest and other operations of the Fund are not expected to contribute significantly to income as a separate depletion pool is applied to this harvest volume.  The depletion charge is expected to approximate net stumpage realized (delivered log price less harvesting and transportation cost) from the harvest.  Olympic Resource Management LLC is the Fund’s general partner and earns management fees and incurs expenses resulting from managing the Fund.  These fees are eliminated in consolidation of our financial results.

Inventory.   Inventory information presented below includes only the Hood Canal and Columbia tree farms.  The Fund tree farms are broken out and discussed separately.

We define “merchantable timber inventory” to mean timber inventory in productive timber stands that are 35 years of age and older, which represents management’s estimate of when merchantable value would be assigned to the timber in a timberland sale.  As of December 31, 2007, the tree farms’ total merchantable inventory volume was estimated to be 356 MMBF, which compares to estimated merchantable timber inventory volume of 392 MMBF at December 31, 2006.  The decline in merchantable inventory from 2006 to 2007 results primarily from harvest of merchantable stands, less the growth of remaining stands of timber.  The Fund’s merchantable inventory as of December 31, 2007 was 50 MMBF.
 
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The Partnership’s merchantable inventory is spread among five-year age classes as follows:

     
December 31,
 
Age Class
   
2007
Volume
(in MMBF)
   
2006
Volume
(in MMBF)
 
35 to 39
      68       79  
40 to 44
      73       67  
45 to 49
      32       31  
50 to 54
      11       18  
55 to 59
      47       57  
60 to 64
      64       75  
 65+     61       65  
          356       392  

The Fund’s merchantable inventory is spread among age classes as follows:

   
December 31,
 
Age Class
 
2007
Volume
(in MMBF)
35 to 39
 
5
40 to 44
 
9
45 to 49
 
1
50 to 54
 
14
55 to 59
 
7
60 to 64
 
1
65+
 
13
   
50

Timber inventory volume is estimated using an annual statistical sampling of the timber (a process called “cruising”), with adjustments made for estimated growth and depletion of areas harvested.  This process is monitored by comparing actual harvest volume to the corresponding estimates for those stands in the Partnership’s standing timber inventory system.  This analysis looks at each harvest unit and measures the variance between the actual cut and the projected inventory volume, with specific harvest unit variances typically offsetting one another to a small net aggregate variance.  The difference between the volume reflected in the inventory for a given year’s harvest units and the amount of harvest volume actually removed from those stands is usually within one to three percent of the volume harvested.  Inventory volumes take into account the applicable state and federal regulatory limits on timber harvests as applied to our properties, including Washington State’s forest practice regulations that provide for expanded riparian management zones, wildlife habitat, and other harvest restrictions.  The Partnership annually cruises about 15% to 20% of its productive timberland acres with stand ages of at least 20 years.

The dominant timber species on the Partnership’s tree farms is Douglas-fir.  Douglas-fir is noted for its structural characteristics that make it generally preferable to other softwoods and hardwoods for the production of construction grade lumber and plywood.  In addition to Douglas-fir, inventory species on the Partnership’s tree farms include western hemlock, western red cedar, and red alder.

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The Partnership’s total merchantable timber inventory as of December 31, 2007 is distributed among species as follows:
Species
 
Volume
(in MMBF)
   
Percent of total
 
Douglas-fir
    264       74 %
Western hemlock
    45       13 %
Western red cedar
    11       3 %
Other conifer
    12       3 %
Red alder
    20       6 %
Other hardwood
    4       1 %
Total
    356       100 %

The Fund’s total merchantable timber inventory as of December 31, 2007 is distributed among species as follows:

Species
 
Volume
(in MMBF)
   
Percent of total
 
Douglas-fir
    20       40 %
Western hemlock
    17       34 %
Western red cedar
    1       2 %
Other conifer
    9       18 %
Red alder
    2       4 %
Other hardwood
    1       2 %
Total
    50       100 %

The Hood Canal tree farm has significant acreage with mature timber and even more acreage with relatively immature trees, which results in what we call a “bimodal” age class pattern that management believes is common among western U.S. timberland owners.  This bimodal pattern can be dealt with in three primary ways: (1) delay harvests of mature acres to backfill what would otherwise be smaller harvest years until the immature trees become merchantable; (2) harvest the mature acres at a rate that more closely approximates rotation age and allow later harvest cash flows to decline for some period while the younger stands mature; or (3) acquire timberland properties with age-class characteristics that fill in the trough in the bimodal pattern.  The acquisition of the Columbia tree farm in 2001 is an example of a strategic timberland acquisition where the Partnership acquired a tree farm with age-class characteristics that helped to fill in age classes where the Hood Canal tree farm was deficient.  Management believes it not only made a sound value investment on its own merits in acquiring the Columbia tree farm, but also made significant progress toward smoothing the age-class distribution of the Partnership’s timberland holdings.

The Partnership’s tree farms as of December 31, 2007 total 113,000 acres excluding the Fund’s tree farms.  Of this total, approximately 96,000 acres are designated productive acres.  The Fund’s tree farms as of December 31, 2007 totaled nearly 24,000 acres, of which approximately 20,000 of those acres were designated productive acres.  Productive acres represent land that is suitable for growing and harvesting timber and excludes acreage that is unavailable for harvest because it is in protected wetlands or riparian management zones (stream set-asides).  Productive acres also reflect deductions for roads and other land characteristics that inhibit suitability for growing or harvesting timber.  As of December 31, 2007, total productive acres are spread by timber age class as follows:

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Age Class
 
12/31/2007
 Partnership Acres
   
%
   
12/31/2007
Fund Acres
   
%
 
Clear-cut
    1,800       2 %     154       1 %
0 to 4
    9,474       10 %     590       3 %
5 to 9
    9,997       10 %     1,432       7 %
10 to 14
    9,734       10 %     1,797       9 %
15 to 19
    8,712       9 %     3,191       16 %
20 to 24
    17,297       18 %     4,195       21 %
25 to 29
    14,921       16 %     2,714       13 %
30 to 34
    5,698       6 %     3,529       18 %
35 to 39
    4,888       5 %     463       2 %
40 to 44
    4,033       4 %     518       3 %
45 to 49
    1,822       2 %     84       0 %
50 to 54
    542       1 %     660       3 %
55 to 59
    1,987       2 %     267       1 %
60 to 64
    2,675       3 %     34       0 %
65+
    2,315       2 %     535       3 %
      95,895       100 %     20,163       100 %

The Partnership's annual harvest level is derived from a long-term harvest planning model that factors in economic rotation ages of all stands, existing timber inventory levels, growth and yield assumptions, and regulatory constraints associated with the Washington State Forest Practices Act.  From this information, management develops annual and long-term harvest plans predicated on their assessment of existing and anticipated economic conditions with the objective of maximizing long-term values.  Management updates this plan periodically to take into account changes in timber inventory, including species mix, soil productivity classifications, volume, size, and age of the timber.  The long-term harvest plan is calculated using a non-declining even-flow harvest constraint, meaning that absent changes to available inventory or estimated growth rates, future harvest levels will  be as high as or higher than current levels.  Recent timberland acquisitions stocked primarily with merchantable timber have been harvested over the last two years resulting in incremental harvest volume in excess of our expected long term harvest levels.  These incremental harvests are now complete, and management expects a return to relatively consistent annual long-term harvest volume of approximately 49 MMBF for our tree farms and 8 MMBF for the Fund.  However, as discussed below in greater detail, given the relatively poor log markets experienced in late 2007 and expected to continue at least through 2008, we have decided to defer approximately 36% of our sustainable harvest.  As a result our planned harvest for 2008 is 32 MMBF on fee lands and 5 MMBF on the Fund lands.  The deferred harvest will be harvested when log markets have recovered.

Marketing and Markets.  We market timber using the manufactured log method, where we engage independent logging contractors to harvest the standing timber and manufacture it into logs that we then sell on the open market.  We retain title to the logs until delivery takes place, which normally occurs at a customer log yard.  We sell our logs both domestically and internationally through log exporting intermediaries.  Our principal international market is the Pacific Rim.  Logs going to this destination are generally sold to U.S.-based brokers who in turn sell direct to offshore customers.  Japan is by far the largest buyer of logs in the Pacific Rim market, though Korea and China represent secondary export markets that our customers sell to from time to time.  Over the last several years, the percentage of our annual production sold into export markets has ranged from 6% to 16%.  Factors that affect the proportion of our sales to export markets include the relative strength of U.S. and foreign building markets, currency exchange rates, and ocean transportation costs.

Customers.   The Partnership sells its logs domestically to lumber mills and other wood fiber processors located throughout western Washington and northwest Oregon.  The Partnership’s logs are also sold to export intermediaries located at the ports of Tacoma, Olympia, and Longview, Washington.  Whether destined for domestic or export markets, the cost of transporting logs limits the destinations to which the Partnership can profitably deliver and sell its logs.

6

 
We had two major customers in our Fee Timber segment in 2007: Simpson Timber Company and Interfor, which represented 13% and 12%, respectively, of segment revenue.  Similarly, in 2006 the Fee Timber segment had two major customers, Simpson Timber Company and Weyerhaeuser Company, which represented 29% and 19%, respectively, of segment revenue.  Mill competition for available log supply is an important factor in the harvest and sale of logs.  For a number of years beginning in the mid-1990’s, we observed in our operating areas a trend toward lumber mill ownership consolidation and mill closure.  This trend has eased over the last several years with the actual and announced openings of several new mills in the Puget Sound region.  Management believes that the current weak markets for logs and lumber may renew the trend towards consolidation in mill ownership and/or mill closure over the coming years.  These factors could cause a decline in prices realized for the Partnership’s logs.  The Partnership delivered logs to over 40 separate customers during 2007.

Competition.  Many of our competitors are comparable in size or larger.  Log sellers compete on the basis of quality, pricing, and the ability to satisfy volume demands for various types and grades of logs to particular markets.  Management believes that the location, type, and grade of the Partnership’s timber will enable it to compete effectively in these markets.  However, our products are subject to increasing competition from a variety of non-wood and engineered wood products as well as competition from foreign-produced logs.

Forestry and Stewardship Practices.  The Partnership's timberland operations incorporate management activities that include reforestation, control of competing brush in young stands, thinning of the timber to achieve optimal spacing after stands are established, and fertilization.  During 2007, the Partnership planted 1,197,000 seedlings on 2,751 acres.  This compares to the years 2006 and 2005 in which the Partnership planted 1,119,000 and 950,000 seedlings on 2,649 and 2,290 acres, respectively.  Seedlings are generally planted from December to April depending on weather and soil conditions.  The number of acres and seedlings planted will vary from year to year based upon harvest level, the timing of harvest, and seedling mortality rates on stands planted in prior years.  Management's policy is to stay current on its reforestation program, returning all timberlands to productive status as soon as economically feasible following harvest.

Sustainable Forestry Initiative (SFI®).  Since 2001, we have been a member of the SFI forest certification program.  Beginning in 2003, in conjunction with participation in the certification program, we have been subject to independent audits of the required standards for the program.  Management views this certification as an important indication of our commitment to manage our lands in a sustainable manner and to look for ways to continually improve our management practices.  We believe this commitment is an important business practice that contributes to our reputation and the long-term value of the Partnership’s assets.

In order to maintain this certification, management must document its timberland management policies against seven discrete SFI objectives: Land Management; Procurement; Forestry Research, Science and Technology; Training and Education; Regulatory Compliance; Public and Landowner Involvement in the Practice of Sustainable Forestry; and finally Review and Continual Improvement.

Beginning in 2007, SFI third-party audits increased from every three years to annually.  We were re-certified in 2007, including the newly acquired Fund lands.  Certification under SFI is currently a requirement for us to sell logs to a number of our customers in the Partnership’s geographic market.  We believe this certification allows us to obtain the best price for our logs while protecting the core timberland assets of the Partnership.

Fire Management.  Management has taken a number of steps to mitigate risk of loss from fire, which is nonetheless possible on any timberland property.  First, management maintains a well-developed road system that allows access and quick response to fires that do occur.  Second, management maintains a fire plan and program that provides for increased monitoring activities and requires all operators to maintain adequate fire suppression equipment during the summer fire season.

7

 
Timberland Management & Consulting

Background.  In March 1997, our unitholders authorized management to expand our timberland business into the Investor Portfolio Management Business (IPMB).  The IPMB has two complementary business strategies: timberland investment management and timberland management.  In 1997, the Partnership formed two wholly owned subsidiaries, ORM, Inc. and ORMLLC, to facilitate the IPMB activities.

Operations.  To date, the Timberland Management & Consulting segment’s key operation has been to provide various aspects of timberland management services to third-party timberland owners.  The Timberland Management & Consulting segment represents 3%, 5% and 14% of consolidated revenue for the years ended December 31, 2007, 2006, and 2005, respectively.

Timberland Investment Management.  The goal of our timberland investment management program is to build and manage diversified timberland portfolios for investors.  Progress toward this goal includes the 2005 closing of the ORM Timber Fund I, LP (the “Fund”) with equity capital commitments of $61.8 million.  The two-year drawdown period for the Fund ended on August 1, 2007, during which time the Fund had invested $58.5 million of its capital commitment and released investors from the remaining $3.2 million of equity capital commitment.  The $58.5 million of invested capital was used to acquire two separate tree farms in Washington State totaling approximately 24,000 acres.  These tree farms represent relatively young properties that are expected to result in a low cash-on-cash yield during the ten-year investment term.  Most of the anticipated investment return for the Fund will be generated upon disposition when a large portion of the Fund’s acreage currently stocked with pre-merchantable timber will grow into higher-value merchantable timber stands.  ORMLLC earns an asset management fee for serving as general partner of the Fund.  In addition to serving as general partner of the Fund, ORMLLC earns a management fee for providing timberland management services to the Fund.

In 2007, we began marketing ORM Timber Fund II, Inc. (Fund II), which we expect to close in the first half of 2008 with capital commitments in excess of $100 million.  Capital committed to each of these funds includes a 20% co-investment by the Partnership.  Once a fund is closed, the drawdown period begins, during which time we seek suitable properties to acquire on behalf of the fund.  The drawdown period is typically two years, but can be extended an additional year by a vote of the investors in the Fund.  Investors fulfill their capital commitment as timberland properties are acquired.

Timberland Management.  As the name suggests, our timberland management activities provide forestland management, acquisition, and disposition services to timber property owners.  These services generally take the form of a long-term contract where ORMLLC personnel provide management expertise.  In December 2004, following an 18-month bankruptcy process, a court-approved liquidation plan transferred the ownership of 522,000 acres formerly owned by Crown Pacific LP to Cascade Timberlands LLC (“Cascade”).  On January 1, 2005 ORMLLC began managing those timberlands for Cascade.  Timberland sales by Cascade in 2005 to 2007 have reduced the current acres under management for Cascade to approximately 292,000 acres of Oregon timberland.  In 2007, Cascade was the Timberland Management & Consulting segment’s major customer, accounting for 67% of segment revenue.  At the end of 2006, ORM and Cascade entered into a three-year management agreement for the Oregon timberlands that expires in 2009 or upon the earlier sale of the managed property.  It is the goal of Cascade to ultimately dispose of these assets.

Forestry Consulting.  In addition to its timberland management activities, ORMLLC also earns nominal revenue by providing forestry-consulting services to third-party owners and managers of timberland assets in Washington, Oregon, and California.  In the last three years, the majority of the field services were provided by our McCloud, California field office and staff.  We elected to close this office effective December 31, 2007 in order to focus our attention more squarely on timberland management activities.
 
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Marketing.  ORMLLC pursues third-party timberland management opportunities in the U.S. West through direct marketing to timberland owners.  Marketing and business development efforts include regular contact with forest products industry representatives, non-industry owners, and others who provide key financial services to the timberland sector.  ORMLLC’s acquisition and disposition activities keep management informed of changes in timberland ownership that can represent opportunities for us to market our management and consulting services.

Customers.  Timberland management revenue in 2007 includes one client that represented 67% of segment revenue.

Competition.  ORMLLC and its subsidiaries compete against both larger and smaller companies providing similar services.  There are approximately 19 established timberland investment management organizations competing against us in the timberland portfolio development business.  The companies in this group have access to established sources of capital and, in some cases, increased economies of scale that can put ORMLLC at a disadvantage.  Smaller regional companies compete effectively on price for limited scope consulting and land management projects.

Investor Portfolio Management Business (IPMB).  IPMB operations include timberland management and timberland investment management.  Our activities on behalf of the Fund and Fund II are examples of timberland investment management activities.  Now that Fund I has acquired timberland properties, both timberland management and asset management fees are earned from administering the Fund.  These activities are, as well as the development and marketing costs associated with Fund I and Fund II, part of the IPMB.

Limitation on Expenditures:  The 1997 amendment to Pope Resources’ Limited Partnership Agreement authorizing launch of the IPMB limits our cumulative net expenditures incurred in connection with the IPMB to $5,000,000, including debt guarantees.  As of December 31, 2007 cumulative expenditures incurred in pursuit of IPMB opportunities, including guarantees, were less than cumulative income generated.  Therefore, cumulative net expenditures as of December 31, 2007 against the $5,000,000 limit are zero.

Allocation of Income:  In addition, the 1997 amendment to Pope Resources’ Limited Partnership Agreement further specifies that income from the IPMB will be split using a sliding scale allocation method beginning at 80% to the Partnership’s wholly-owned subsidiary, ORM, Inc., and 20% to Pope MGP, Inc., the managing general partner of the Partnership.  The sliding scale allocation method will evenly divide IPMB income between ORM, Inc. and Pope MGP, Inc. once such income reaches $7.0 million in any given fiscal year.

Real Estate

Background.  The Partnership's real estate activities are closely associated with the management of its timberlands.  Management continually evaluates our timberlands in terms of best economic use, whether this means continuing to grow and harvest timber or seeking a rezone of the property for sale or development.  After logging our timberlands, management has four primary options for what to do next with the land: reforest it; sell it as undeveloped property; improve it to various levels of development for sale as improved property; or to hold it as property slated for later development or sale.

Operations.   Real Estate operations include work considered by management necessary to maximize the value of the Partnership’s approximately 2,600-acre portfolio of property that management believes has a higher-and-better-use other than timberland, and leasing residential and commercial properties in the Port Gamble town site.  The former objective is generally obtained by securing the entitlements and/or physical improvements necessary to make development possible.  The Real Estate segment represents 29%, 42%, and 8% of consolidated revenue in 2007, 2006, and 2005, respectively.

9


Development Properties

Other Land Investments.  Management recognizes the significant value represented by the Partnership’s real estate holdings and is focused on adding to that value.  The means and methods of adding value to our real estate portfolio vary considerably depending on the specific location and current zoning of each parcel.  This range extends from land that has commercial activity zoning where unit values are measured by the square foot to large lots of recently cutover timberland where value is measured in per acre terms.  In general, value-adding activities include securing favorable zoning and obtaining final plat approvals to allow for the highest and best use of the properties.

We are working on master planned communities in Gig Harbor, Bremerton, Kingston and Hansville, Washington.  Due to each respective property’s size, development complexity, and regulatory environment, the projects are long-term in nature and require extensive time and capital investments to maximize returns.  An important activity aimed at a particular portion of the value-spectrum is the development of our “Rural Lifestyles” program through which rural residential lots are marketed both to those individuals intent on owning rural residential lots and to builders interested in building homes in rural locations.

Gig Harbor.   Gig Harbor, a suburb of Tacoma, Washington, is the site of a mixed-use development originally comprising 327 acres.  After 2007 sales, the Partnership has a property inventory including a 16-acre retail/commercial site, 32-acres of business park lots, and 203-acres of land with residential zoning.  During 2007, we fulfilled our obligations relating to road and utility infrastructure improvements, allowing revenue from the 2006 sale of 6 acres zoned for retail/commercial use to be recognized.  A 6 acre business park lot sale to a local church was also completed, and we entered into a purchase contract for the remaining 16-acre retail/commercial parcel.  We are currently planning for the residential portion of this property, as development of the residential property is subject to resolution of transportation and sewer treatment plant capacity issues with the City of Gig Harbor.  The retail/commercial and business park parcels have transportation and sewer capacities reserved and are not subject to resolution of either of these issues.

Bremerton.   In 1999 the City of Bremerton approved our request for a planned 264-acre mixed-use development on our property located within the Bremerton city limits.  The development plan included 64 acres zoned for industrial use and 200 acres zoned for residential.  In 2006, the Partnership completed the sale of the 200-acre residential land.  As a condition of the sale, the Partnership constructed infrastructure in 2006 and 2007 to serve the property.  The remaining 64 acres of property zoned as industrial park is being developed in two phases with a total of 24 lots with 9 acres set aside for roads and other common area improvements.  The construction for the 9-lot Phase I was completed in 2007 and this set the stage for the sale of 2 lots at the end of the year.  The timing for the construction of Phase II will be dependent on the absorption rate for remaining Phase I lots.

Kingston.  In 2005, management successfully championed the inclusion of the Partnership’s 356-acre primarily residential development project inside the Kingston Urban Growth Area, which thereby increased the property’s potential development density and value.  After a lengthy appeals process, the Central Puget Sound Growth Management Hearings Board validated the expansion of the Urban Growth Area in 2006 to include this property with vested Urban Cluster Residential zoning.  The Partnership prepared and submitted a formal master plan and subdivision application in 2007 that calls for the development of 750 residential units.  The Partnership owns an additional 366 acres bordering this project for which Kitsap County has an option expiring in 2008 to purchase and expand the existing county park.  This neighboring property can be subdivided into 5-acre lots if the County does not exercise its option.

Hansville.    The Partnership has a 152-acre residential development project in Hansville called Chatham.  The development is the result of a plat from 1913 that consisted of 10-acre lots that management has reestablished creating a total of 19 lots.  Construction of 2,300 feet of road, utilities, and a gated front entrance was completed in 2007 and marketing is underway to sell the lots.

Rural Residential.  Management has launched the Rural Lifestyles program to sell rural residential lots after harvest is completed or with properties that have marginal timber value or are encumbered by extended logging moratoriums.  These properties are typically non-contiguous smaller lots generally ranging in size between 5 and 40 acres with zoning ranging from one dwelling unit per 5 acres to one per 80 acres.  Development and disposition strategies vary depending on the property’s unique characteristics.  Development efforts and costs expended to ready these properties for sale include work to obtain development entitlements that will increase the property’s value as residential property as well as making improvements to existing logging roads; constructing new roads; extending dry utilities; and sometimes establishing gated entrances.

10

 
Commercial Properties

Port Gamble.  We currently own and operate the town of Port Gamble, Washington, north of Kingston on the Olympic Peninsula.  Port Gamble was designated a “Rural Historic Town” under Washington State’s Growth Management Act (GMA) in 1999.  This designation allows for substantial new commercial, industrial, and residential development using historic land use patterns and densities while maintaining the town’s unique architectural character.

P&T operated a sawmill at Port Gamble, from 1853 to 1995 and for the last seven years we have been working with P&T to remedy environmental contamination at the town and mill sites and to monitor results of the cleanup efforts.  After contamination was discovered at the town site, millsite, and in the adjacent bay, we entered into a settlement and remediation agreement with P&T pursuant to which both parties allocated responsibility for cleanup costs.  Under Washington law, both Pope Resources and P&T are "potentially liable persons" based on historic ownership and/or operation of the site.  These laws provide for joint and several liability among parties owning or operating property on which contamination occurs, meaning that cleanup costs can be assessed against any or all such parties.

 Our agreement with P&T, negotiated in 2002, was intended to apportion responsibility based on this principle, with P&T bearing the larger share of responsibility based upon their role in operating the site and upon their relatively lengthy ownership.  The P&T agreement resulted in the termination of a lease by P&T to operate the mill site as well as providing for the initiation of environmental cleanup activities, the responsibility for which has been shared by us and P&T.  Under that agreement P&T took responsibility for the landfills and cleanup of Port Gamble Bay and the Partnership took responsibility of the millsite and townsite.  At the end of 2006, cleanup of the landfills and townsite were completed as both received “No Further Action” letters from the Washington State Department of Ecology.  Efforts to cleanup the millsite and sediments in Port Gamble Bay continued in 2007.  However, P&T sought bankruptcy protection under Canadian law in October 2007 and filed a petition under Chapter 11 of the U.S.  Bankruptcy Code in Delaware in November 2007.  These events involving P&T raise substantial doubt in management's view as to whether P&T will satisfy all or any portion of its remaining obligations under our settlement and remediation agreement.  Accordingly, we have increased our remediation liability by $1.9 million to reflect our current estimate of the remediation costs.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations – Real Estate – Environmental Remediation Costs.”

Marketing.  Marketing activities in the Real Estate segment during 2007 consisted of marketing residential and commercial real estate for sale and lease.

Customers.  Management typically markets its land for sale to private individuals, residential contractors, and developers of commercial property.  Customers for rental space in the Port Gamble townsite consist of both individual and commercial tenants.

Competition.  Our Real Estate activities consist primarily of adding value to current land holdings.  Once those properties are ready for development, management will in most instances seek to market the property for sale, but in some instances may consider a strategy that would involve another developer with building expertise as a joint venture partner.
 
Transportation.  Land values for our Real Estate portfolio are strongly influenced by transportation limitations between the Kitsap Peninsula and the Seattle-Tacoma corridor.  Transportation options between Seattle-Tacoma and Kitsap County include driving on the Tacoma Narrows Bridge or taking one of several car ferries.  In 2007, the Washington State Department of Transportation completed a multi-year construction project to complete a new span to the Tacoma Narrows Bridge connecting Tacoma and Gig Harbor.  Ferry transportation in our market area currently utilizes vessels that carry both automobiles and passengers from each of the communities of Kingston, Bremerton, and Bainbridge Island, respectively, to and from Edmonds and Seattle.

11

 
Employees.

As of December 31, 2007, the Partnership employed 49 full-time, year-round salaried employees and 6 part-time and seasonal personnel, who are distributed among the segments as follows:

Segment
 
Full-Time
 
Part-Time/ Seasonal
 
Total
Fee Timber
 
17
 
3
 
20
Timberland Management & Consulting
 
7
 
1
 
8
Real Estate
 
15
 
2
 
17
General & Administrative
 
10
 
0
 
10
      Totals
 
49
 
6
 
55

We closed our office in McCloud, California at the end of 2007.  The employees in that operation are not reflected in the table above.  None of our employees are subject to a collective bargaining agreement and the Partnership has no knowledge that any steps toward unionization are in progress.  Management considers the Partnership’s relations with its employees to be good.

Government Regulation

In the operation and management of its tree farms, the Partnership is subject to Federal and Washington State land use and environmental laws.  Management's objective is to be in compliance with such laws and regulations at all times.  We anticipate that increasingly strict requirements relating to the environment, threatened and endangered species, natural resources, forestry operations, and health and safety matters, as well as increasing social concern over environmental issues may result in additional restrictions on the timber operations of the Partnership.  This will in turn result in increased costs, additional capital expenditures, and reduced operating flexibility.  Management believes that the Partnership’s operating practices, assets and properties are in material compliance with all applicable Federal, state and local laws, regulations and ordinances applicable to its business.  However, there can be no assurance that future legislative, governmental, or judicial decisions will not adversely affect the Partnership’s operations.

Regulatory Structure.  The growing and harvesting of timber are subject to numerous laws and government policies to protect the environment, non-timber resources such as wildlife and water, and other social values.  Changes in those laws and policies can significantly affect local or regional timber harvest levels and market values of timber-based raw materials.  Real estate development activities are also subject to numerous state and local regulations such as the Washington State Growth Management Act.  In addition, the Partnership is subject to Federal, state, and local pollution controls (with regard to air, water and land); solid and hazardous waste management, disposal and remediation laws; and regulations in each segment and all geographic regions in which it has operations.

Endangered Species and Habitats.  A number of fish and wildlife species that inhabit geographic areas near or within Partnership timberlands have been listed as threatened or endangered under the Federal Endangered Species Act (ESA) or similar state laws in the United States.  Federal ESA listings include the northern spotted owl, marbled murrelet, a number of salmon species, bull trout and steelhead trout in the Pacific Northwest.  Listings of additional species or populations may result from pending or future citizen petitions or be initiated by Federal or state agencies.  Federal and state requirements to protect habitat for threatened and endangered species have resulted in restrictions on timber harvest on some timberlands, including some timberlands of the Partnership.  Additional listings of fish and wildlife species as endangered, threatened, or sensitive under the ESA and similar state laws as well as regulatory actions taken by Federal or state agencies to protect habitat for these species may, in the future, result in the following: an increase in operating costs; additional restrictions on timber harvests; impacts to forest management practices or real estate development activities; and potential impact on timber supply and prices.

12

 
Forestry Management Practices.  Forest practice acts in some U.S. states increasingly affect present or future harvest and forest management activities.  For example, in some states, these rules have one or more of the following impacts: limiting the size of clear-cut harvest units; requiring some timber to be left unharvested to protect water quality and fish and wildlife habitat; regulating construction and maintenance of forest roads; requiring reforestation following timber harvest; and providing for procedures for state agencies to review and approve proposed forest practice activities.  Federal, state, and local regulations protecting wetlands could affect future harvest and forest management practices on some of the Partnership’s timberlands.

Each state in which the Partnership owns or manages timberlands has developed “best management practices” to reduce the effects of forest practices on water quality and aquatic habitats.  Additional, more stringent regulations may be adopted in order to achieve the following: enhance water quality standards under the Federal Clean Water Act; protect fish and wildlife habitat; or advance other public policy objectives.

In the State of Washington, the Forest and Fish Report became the basis for revised Forest Practices Rules and Regulations that were adopted in 1999 and finalized in 2001.  The Washington Forest Protection Association produced the Forest and Fish Report through the collaborative efforts of Washington State’s private landowners; Federal, state and county governments; and Native American tribes.  The goals of these revised rules are to:

·  
Provide compliance with the Endangered Species Act (ESA) for aquatic and riparian dependent species on private forest lands;
·  
Restore and maintain riparian habitat on private land to support a harvestable supply of fish;
·  
Meet the requirements of the Clean Water Act for water quality on private forest lands; and
·  
Keep the timber industry economically viable in the State.

The proposed Water Quality Standards that the Washington State Department of Ecology adopted in 2003 have undergone Department of Ecology and public scrutiny.  As such, these rules should be sufficient to comply with the Anti-Degradation Implementation Plan as described in the Clean Water Act.  In June 2006, the U.S. Fish & Wildlife Service and NOAA Fisheries signed the Forest Practices Habitat Conservation Plan (HCP).  The HCP is a statewide program protecting 60,000 miles of streams on 9.3 million acres of forestland, set in motion by the Forests & Fish Law.  It ensures landowners that practicing forestry in Washington State meets the requirements for aquatic species designated by the federal Endangered Species Act.

The regulatory and non-regulatory forest management programs described above have increased operating costs and resulted in changes in the value of timber and logs from the Partnership’s timberlands.  These kinds of programs also can make it more difficult to respond to rapid changes in markets, extreme weather or other unexpected circumstances.  One additional effect may be further reductions in usage of (and some substitution of other products for) lumber and plywood.  Management does not believe that these kinds of programs have had a significant effect on the Partnership’s total timber harvest, although they may have such an effect in the future.  Further, management does not expect the Partnership to be disproportionately affected by these programs as compared with typical timberland owners.  Likewise, management does not expect that these programs will significantly disrupt its planned operations over large areas or for extended periods.

Water Quality.  The U.S. Environmental Protection Agency also promulgated regulations in 2000 requiring states to develop total maximum daily load (“TMDL”) allocations for pollutants in water bodies that have been determined to be “water quality impaired.”  The TMDL requirements set limits on pollutants that may be discharged to a body of water or set additional requirements, such as best management practices for nonpoint sources, including timberland operations, to reduce the amounts of pollutants in water quality impaired bodies of water.  These requirements have impacted tree farming principally through rules requiring tree farms to better minimize silt caused by roads, harvest units and other management activities from coming in contact with water quality impaired bodies of water.  TMDL targets will be established for specific water bodies in the states where the Partnership operates and these targets will be set so as to achieve water quality standards within 10 years, when practicable.  It is not possible at this time to either estimate the capital expenditures that may be required for the Partnership to stay below the targets until a specific TMDL is promulgated or to determine whether these expenditures will have a material impact on the Partnership’s financial condition or results of operations.

13

 
Washington State Growth Management Act (GMA).  Land holdings throughout Washington State are affected by the GMA, which requires counties to submit comprehensive plans that identify the future direction of growth and stipulate where population densities are to be concentrated.  The purposes of the GMA include: (1) direction of population growth to population centers (Urban Growth Areas), (2) reduction of “suburban sprawl”, and (3) protection of historical sites.  The Partnership works with local governments within the framework of the GMA to develop its real estate holdings to their highest and best use.

Item 1A.                      RISK FACTORS
 
We have certain environmental remediation liabilities, and those liabilities may increase.  We own certain real estate at the Historic Port Gamble townsite on the Kitsap Peninsula in western Washington.  We are party to an agreement with P&T, pursuant to which we and P&T allocated responsibility for cleanup costs.  Under Washington law, both Pope Resources and P&T are “potentially liable persons” based on ownership and/or operation of the site.  These laws provide for joint and several liability among parties owning or operating property on which contamination occurs, meaning that cleanup costs can be assessed against any or all such parties.  Our agreement with P&T was intended to apportion responsibility based on this principle, with P&T bearing the larger share of responsibility based upon their role in operating the site and upon their relatively lengthy ownership.  We maintain on our balance sheet an accrual that represents our estimated share of the remediation costs, and we adjust that accrual periodically based on such factors as test results, cleanup cost estimates, and related factors.
 
We increase the recorded liability if our current estimates of those costs exceed the previously established accrual, and we recognize an expense in the period reflecting the adjustment.  If our estimates are inaccurate, or if new or previously unknown facts are discovered that increase our share of these costs, we may experience adverse impacts upon our results of operations and financial condition.  In that vein, P&T’s financial condition has declined markedly in recent years, with P&T first disclosing questions about its ability to continue as a going concern in its Annual Report on Form 10-K for the fiscal year ended December 31, 2006.  Since that time we have closely monitored P&T’s financial disclosures, including its repeated attempts to restructure its credit arrangements throughout the second and third quarters of 2007 and culminating in a late October 2007 bankruptcy filing in Canada, followed in November 2007 by a Chapter 11 bankruptcy filing in the United States.  Since then, P&T has undertaken to sell substantially all of its assets.  These actions raised substantial doubt in management’s views as to whether P&T can meet all or any portion of its obligations under our settlement and remediation agreement.
 
Because of the joint and several liability that attends to the cleanup obligation, management has taken a number of steps to address our own exposure.  As such, our results for the fourth quarter and fiscal year 2007 reflect a $1.9 million charge to earnings to increase our environmental remediation liability for Port Gamble.  Second, because we have increased our estimate of the potential costs on several occasions in the past, we have revised our methodology for assessing this liability, shifting to a “Monte Carlo simulation” analysis which we hope will improve our ability to predict the actual liability for the remaining cleanup.  Third, we are in active discussions with the Washington State Department of Ecology to promote protection of the environment, optimize and appropriately allocate the remaining cleanup liabilities, and maximize our control over the remediation process.  Finally, we are monitoring the P&T bankruptcy action as an unsecured creditor in an effort to maximize any potential recovery from P&T’s remaining assets, although we have substantial doubt as to whether we will recoup any material portion of those assets because substantially all of P&T’s assets are subject to the security interests of its lenders.
 
14

 
Management continues to monitor closely both the Port Gamble cleanup process and the P&T bankruptcy proceeding; however, in light of current circumstances our addition of $1.9 million to the remediation liability reflects what management believes to be the best estimate of the remaining cleanup cost based upon an estimation method that represents the most likely outcome.
 
We compete with a number of larger competitors that may be better able than we to absorb the effects of price fluctuations, may be able to expend greater resources on production, may have greater access to capital, and may operate more efficiently than we can.  We compete against much larger companies in each of our business segments.  We compete with these companies for management and line personnel, as well as for purchases of relatively scarce capital assets such as land and standing timber and for sales of our products.  These larger competitors may have access to larger amounts of capital and significantly greater economies of scale, and they may be better able to absorb the risks of our line of business.  Moreover, the timber industry has experienced significant consolidation in recent years and, as that consolidation occurs, our relative market share decreases and the relative financial capacity of our competitors’ increases.  While management believes the Partnership is at a competitive advantage over some of these companies because of our lack of vertical integration into forest products manufacturing, our advantageous tax structure, and management’s attempts to diversify our asset base, we cannot assure readers that competition will not have a material and adverse effect on our results of operations or our financial condition.
 
Consolidation of sawmills in our geographic operating area may reduce competition among our customers, which could adversely affect our log prices.  We have experienced in the past, and may continue to experience, consolidation of sawmills in the Pacific Northwest.  Because a portion of our cost of sales in our fee timber segment consists of transportation costs for delivery of logs to domestic sawmills, it becomes increasingly expensive to transport logs over longer distances for sales in domestic markets.  As a result, a reduction in the number of sawmills, or in the number of sawmill operators, may reduce competition for our logs, may increase our transportation costs, or both.  These consolidations thus may have a material adverse impact upon our Fee Timber revenue or income and, as that segment has traditionally represented our largest business unit, upon our results of operation and financial condition as a whole.
 
We are sensitive to demand and price issues relating to our sales of logs in both domestic and foreign markets.  We generate Fee Timber revenue primarily by selling softwood logs to domestic mills and to third-party intermediaries who resell them to the export market.  The domestic market for logs in the Puget Sound region of Washington State has been impacted by imported lumber from Canada and decreased demand for lumber as engineered wood products have gained market acceptance in the United States.  These factors have had the effect of concentrating mill ownership with larger, more efficient, mill operators and decreasing the number of mills operating in the Puget Sound region.  This characteristic may result in a decrease in local demand for logs, which in turn may decrease our profitability.  In addition, the settlement of a dispute under the North American Free Trade Agreement, alleging unfair trade practices related to sales of Canadian softwoods into the United States, may result in an increase in the volume of timber available in domestic log markets, which could adversely impact log prices and, derivatively, our fee timber revenues.  Over the past decade, we have seen log prices erode in the Japanese market as competing logs and lumber from regions outside of the U.S.  and engineered wood products have gradually gained market acceptance.  These export markets for Pacific Northwest logs are significantly affected by fluctuations in U.S. and Japanese economies, as well as by the foreign currency exchange rate between the Japanese yen and the U.S.  dollar, and ocean transportation costs.
 
We are subject to statutory and regulatory risks that currently limit, and may increasingly limit, our ability to generate Fee Timber and Real Estate income.  Our ability to grow and harvest timber can be significantly impacted by legislation, regulations or court rulings that restrict or stop forest practices.  For example recent amendments to federal wildlife habitat preservation laws, intended to afford additional protections to the threatened northern spotted owl, may make it more difficult for us to harvest timber and may reduce the amount of harvestable timber on our properties.  These and other restrictions on logging, planting, road building, fertilizing, managing competing vegetation and other activities can significantly increase the cost or reduce available inventory thereby reducing income.  These regulations are likely to have a similar effect on our Timberland Management & Consulting operations.  Moreover, the value of our real estate investments, and our income from real estate operations, are sensitive to changes in the economic and regulatory environment, as well as various land-use regulations and development risks, including the ability to obtain the necessary permits and zoning variances that would allow us to maximize the revenue from our real estate investments.  Our real estate investments are long-term in nature, which raises the risk that unforeseen changes in the economy or laws surrounding development activities may have an adverse affect on our investments.  Moreover, these investments often are highly illiquid and thus may not generate cash flow if and when needed to support our other operations.
 
15

 
We are controlled by our managing general partner.  As a limited partnership, substantially all of our day-to-day affairs are controlled by our managing general partner, Pope MGP, Inc.  Among other things, the board of directors of Pope MGP, Inc. serves as our board of directors, and by virtue of a stockholder agreement, the shareholders of Pope MGP, Inc., Emily T. Andrews and Peter T. Pope, each have the ability to designate one of our directors and to veto the selection of each of our other directors, other than for our chief executive officer, who serves as a director by virtue of his executive position.  Unitholders may remove the managing general partner only in limited circumstances, including, among other things, a vote of the holders of a two-thirds majority of the “qualified units,” which means the units that have been owned by their respective holders for at least five years prior to such vote.  By virtue of the terms of our agreement of limited partnership, as amended, or “partnership agreement”, our managing general partner directly, and Mrs. Andrews and Mr. Pope indirectly, have the ability to prevent or impede transactions that would result in a change of control of the Partnership; to prevent or, upon the approval of limited partners holding a majority of the units, to cause, the sale of the assets of the Partnership; and to cause the Partnership to take or refrain from taking certain other actions that you might otherwise perceive to be in the Partnership’s best interest.  Under our partnership agreement, we are required to pay to Pope MGP, Inc., an annual management fee of $150,000, and to reimburse Pope MGP, Inc., for certain expenses incurred in managing our business.  The managing general partner also receives a special allocation of profits from our investor portfolio management business, which allocations earned in 2007 and 2006 were $0 and $77,000, respectively.  Reimbursements for expenses totaled $21,000 in 2007 and $6,000 in 2006.
 
We benefit from certain tax treatment accorded to master limited partnerships, and if that status changes the holders of our units may realize less advantageous tax consequences.  The Partnership is a Master Limited Partnership (MLP) and is therefore not generally subject to U.S. federal income taxes.  If that changed due to a change in tax law (or interpretation of current tax law) such that the Partnership became subject to income taxes, operating results would be adversely affected.  We also have two taxable subsidiaries.  The estimation of income tax expense and preparation of income tax returns requires complex calculations and judgments.  We believe the estimates and calculations used in this process are proper and reasonable but if a Federal or state taxing authority disagreed with the positions we have taken, a material change in provision for income taxes, net income, or cash flows could result.
 
16

 
Item 1B.                             UNRESOLVED SECURITIES AND EXCHANGE COMMISSION COMMENTS

None


Item 2.                                PROPERTIES

The following table reconciles acreage owned as of December 31, 2007 to acreage owned as of December 31, 2006.  As noted previously we own 20% of the Fund, and this table excludes the 24,000 acres of timberland purchased by the Fund in the fourth quarter of 2006.  Properties are typically transferred from Fee Timber to the Real Estate segment when they become more valuable as development property than timber property.  At that point the Real Estate segment is responsible for managing the properties with the goal of maximizing the properties’ value upon disposition.
 
Description
 
2006
   
Transfers
   
Acquisitions
   
Sales
   
Misc (5)
   
2007
 
Timberland:
                                   
Hood Canal tree farm (2), (6)
    70,392       (17 )     -       (91 )     -       70,284  
Columbia tree farm (6)
    42,985       -       -       -       -       42,985  
Total Timberland (6)
    113,377       (17 )     -       (91 )     -       113,269  
Land held for sale:
                                               
Bremerton - West Hills  (3)
    20       -       -       (3 )     (14 )     3  
Gig Harbor - Harbor Hill (4)
    14       -       -       (12 )     (2 )     -  
Jefferson County
    9       (9 )     -       -       -       -  
Lost Highway 1 & 2
    40       (25 )     -       -       10       25  
Oak Bay
    205       (205 )     -       -       -       -  
Hansville
    152       (137 )     -       -       -       15  
Quilcene
    27       -       -       -       2       29  
Timberland Ridge
    99       -       -       (39 )     (20 )     40  
Subtotal land held for sale
    566       (376 )     -       (54 )     (24 )     112  
Land held for development:
                                               
Bremerton - West Hills  (3)
    44       -       -       -       (4 )     40  
Gig Harbor - Harbor Hill (4)
    285       -       -       -       (34 )     251  
Heritage Park Option  (1)
    366       -       -       -       -       366  
Homestead
    38       -       -       -       -       38  
Jefferson County
    83       9       -       -       (8 )     84  
Kingston - Arborwood
    356       -       -       -       -       356  
Lost Highway 1 & 2
    -       25       -       -       -       25  
Nursery Hansville
    53       -       -       -       -       53  
Oak Bay
    -       205       -       -       -       205  
Other
    55       17       -       (11 )     (12 )     49  
Hansville
    -       137       -       -       -       137  
Port Gamble townsite
    130       -       40       -       -       170  
Shine Canyon
    69       -       -       -       -       69  
Tala Point
    268       -       -       -       (10 )     258  
Tarboo Easement
    160       -       -       -       -       160  
Timberland Ridge
    98       -       -       -       (2 )     96  
Walden
    120       -       -       -       -       120  
Subtotal land held for development
    2,125       393       40       (11 )     (70 )     2,477  
Total Real Estate Acres
    2,691       17       40       (65 )     (94 )     2,589  
Grand Total Acres
    116,068       -       40       (156 )     (94 )     115,858  
 
(1)
Kitsap County has an option to acquire this property that expires in July 2008.
(2)
This property is used as collateral for the Partnership’s $30.4 million timberland mortgages.
(3)
This property is used as collateral for $104,000 of Local Improvement District debt.
(4)
This property is used as collateral for $260,000 of Local Improvement District debt.
(5)
Misc. represents miscellaneous changes resulting from surveys, boundary line adjustments, transfers to open space, land dedicated to roads, and acreage quit claimed to others without compensation.  .
(6)
Acres owned as of December 31, 2006 were adjusted to reflect changes in timberland acreage reporting from Geographic Information System to legal acres.
 
17

 
The following table provides dwelling unit (DU) per acre zoning for the Partnership’s owned timberland and development properties as of December 31, 2007 and land sold during 2007:
 
   
Current Land Inventory (acres)
 
2007 Land Sales
Zoning Designation
 
Real Estate
Fee Timber
Totals
 
Acres
$/Acre
Total Sales
Urban zoning
 
317
               -
317
 
15
$831,335
$12,470,019
1 DU per 5 acres
 
444
904
1,348
 
         -
            -
                     -
1 DU per 10 acres
 
259
404
663
 
         -
            -
                     -
1 DU per 20 acres
 
1,189
16,075
17,264
 
141
11,243
1,585,298
1 DU per 40 acres
 
               -
2,163
2,163
 
         -
            -
                     -
1 DU per 80 acres
 
186
39,267
39,453
 
         -
            -
                     -
Forest Resource Lands
 
               -
54,203
54,203
 
         -
            -
                     -
Open Space
 
194
253
447
 
         -
            -
                     -
Total
 
2,589
113,269
115,858
 
156
$90,098
$14,055,317
 
Item 3.                                LEGAL PROCEEDINGS

  None.

Item 4.                                SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of the Partnership’s limited partners during the fourth quarter of 2007.  Pope Resources Limited Partnership Agreement was amended by the General Partner of the Partnership to bring the Partnership into compliance with a new NASDAQ requirement that requires companies listed with it to make its securities eligible for issuance in uncertificated form.  This approval, which was purely ministerial in nature, was effected by the Partnership’s managing general partner under the authority convened by the Limited Partnership Agreement.
 
18

 
PART II

MARKET FOR REGISTRANT’S UNITS, RELATED SECURITY HOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

Certain information respecting trades in the Partnership’s equity securities is quoted on the Nasdaq Global Select Market.  For many years, the Partnership's units have traded under the ticker symbol "POPEZ".  Beginning in April 2008, our ticker symbol on the Nasdaq Global Select Market will change to “POPE”.  The following table sets forth the 2005 to 2007 quarterly ranges of low and high prices, respectively, for the Partnership's units together with per unit distribution amounts by the period in which they were paid:
 
   
High
   
Low
   
Distributions
 
       
 Year Ended December 31, 2005
                 
 First Quarter
  $ 56.85     $ 19.35     $ 0.15  
 Second Quarter
    37.68       31.10       0.15  
 Third Quarter
    37.00       31.30       0.25  
 Fourth Quarter
    32.22       27.85       0.25  
 Year Ended December 31, 2006
                       
 First Quarter
    36.00       30.00       0.25  
 Second Quarter
    34.70       30.10       0.25  
 Third Quarter
    33.10       30.04       0.28  
 Fourth Quarter
    35.59       31.54       0.28  
 Year Ended December 31, 2007
                       
 First Quarter
    50.01       34.25       0.28  
 Second Quarter
    49.41       36.41       0.28  
 Third Quarter
    50.00       37.60       0.40  
 Fourth Quarter
    48.00       38.17       0.40  

Unitholders

As of February 19, 2008, there were 334 holders of record for 4,658,870 outstanding units.  Units outstanding exclude 53,250 units granted to management that are currently restricted from trading.  This restriction will be lifted upon vesting over the next four years.

Distributions

All cash distributions are at the discretion of the Partnership's managing general partner, Pope MGP, Inc.  (the “Managing General Partner”).  During 2007, the Partnership made two quarterly distributions of twenty-eight cents per unit and two quarterly distributions of forty cents per unit, reflecting aggregate distributions totaling $6.4 million.  During 2006, the Partnership made two quarterly distributions of twenty-five cents per unit and two quarterly distributions of twenty-eight cents per unit, with the four distributions totaling $5.0 million.  Management intends to continue to pay quarterly distributions in 2008 of forty cents per unit so long as the Managing General Partner, in its discretion, determines this amount to be appropriate.  Management will periodically examine distribution levels to ensure it meets the long-term objective of maximizing Partnership value.  These determinations will reflect, among other things, the expectations of management and the Managing General Partner for the Partnership’s liquidity needs given the reduction in anticipated harvest volume, and the accompanying decline in anticipated fee timber income, during the current period of relatively reduced log prices.

19

 
Repurchase of Equity Securities

The Partnership adopted a unit repurchase plan in the fourth quarter of 2007.  Under the plan, the Partnership may repurchase limited partner units having an aggregate value of not more than $5 million.  The unit repurchase period commenced on November 1, 2007 and is to continue for up to one year.  Partnership unit repurchases in the fourth quarter of fiscal year 2007 were as follows:

Total number of units purchased
    31,656  
Average price paid per unit
  $ 43.41  
Total number of units purchased as part of publicly announced plans or programs
    31,656  
Approximate dollar value of units that may be purchased under the announced plans or programs ($000’s)
  $ 3,625  

As of February 29, 2008 we had repurchased nearly 115,000 units for a total of approximately $4.5 million.

Performance Graph

The following graph shows a five-year comparison of cumulative total unitholder returns for the Partnership, the Standard and Poor’s Forest Products Index and the Wilshire 4500 for the five years ended December 31, 2007.  The total unitholder return assumes $100 invested at the beginning of the period in the Partnership’s units, the Standard and Poor’s Forest Products Index, and the Wilshire 4500.  The graph assumes distributions are reinvested.
 
20

 
graph
21

 
                         
   
12/02
 
12/03
 
12/04
 
12/05
 
12/06
 
12/07
                         
Pope resources
 
100.00
 
155.54
 
257.08
 
326.68
 
373.16
 
480.25
S&P 500
 
100.00
 
128.68
 
142.69
 
149.70
 
173.34
 
182.87
S&P Smallcap 600
 
100.00
 
138.79
 
170.22
 
183.30
 
211.01
 
210.38
S&P Forest Products
 
100.00
 
140.50
 
158.73
 
161.99
 
170.79
 
184.15
Dow Jones Wilshire 5000
 
100.00
 
131.64
 
148.26
 
157.64
 
182.66
 
193.13
Dow Jones Wilshire 4500
 
100.00
 
143.84
 
170.55
 
188.07
 
218.29
 
230.87
                         
Copyright © 2008 Standard & Poor's, a division of the McGraw-Hill Companies, Inc. All rights reserved.
www.researchdatagroup.com/s&P.htm
                   
 
Issuance of Unregistered Securities

The Partnership did not conduct any unregistered offering of its securities in 2007.

Item 6.                                SELECTED FINANCIAL DATA

Actual Results.  The financial information set forth below for each of the indicated years is derived from the Partnership's audited consolidated financial statements.  This information should be read in conjunction with the consolidated financial statements and related notes included with this report.

The measure of free cash flow provides users of financial statements a benchmark for the amount of cash available for distributions and investments after making debt payments and recurring capital expenditures.  Since this measure starts with net income, not cash flow from operations, it does not include the increases or decreases resulting from changes in working capital that are included in operating cash flow presented on the Statement of Cash Flows.  The Partnership has used the method detailed below for calculating free cash flow.  Management recognizes that there are varying methods of calculating free cash flow and has provided the calculation below to aid investors that are attempting to reconcile between those different methods.

22

 
(Dollars in thousands, except per unit data)
 
Year Ended December 31,
 
   
2007
   
2006
   
2005
   
2004
   
2003
 
Statement of operations data
                             
Revenue:
                             
Fee Timber (1)
  $ 35,514     $ 35,260     $ 44,424     $ 33,571     $ 22,916  
Timberland Management & Consulting
    1,344       3,670       7,764       1,601       2,386  
Real Estate
    15,037       27,320       4,818       4,476       1,734  
Total revenue
    51,895       66,250       57,006       39,648       27,036  
                                         
Operating income/(loss):
                                       
Fee Timber (1)
    15,215       14,592       16,320       15,126       9,669  
Timberland Management & Consulting
    (883 )     1,266       3,540       (598 )     272  
Real Estate (2)
    5,163       13,864       1,270       1,586       (476 )
   General and Administrative
    (4,782 )     (3,817 )     (3,651 )     (2,986 )     (2,842 )
Total operating income/(loss)
    14,713       25,905       17,479       13,128       6,623  
                                         
Net income
    15,508       24,910       13,684       10,176       3,528  
                                         
Earnings per unit – diluted
  $ 3.21     $ 5.23     $ 2.88     $ 2.22     $ 0.78  
                                         
Free cash flow (3):
                                       
Net income
    15,508       24,910       13,684       10,176       3,528  
Plus:
                                       
Depreciation, depletion, and amortization (4)
    5,549       7,204       11,252       5,752       3,546  
Cost of land sold
    3,854       7,818       434       209       200  
Less:
                                       
Principal payments
    1,481       1,675       1,883       1,979       1,662  
Capital expenditures, net of
                                       
     timberland acquisitions(1)
    12,162       12,177       6,756       3,260       2,017  
Free cash flow
    11,268       26,080       16,731       10,898       3,595  
                                         
Cash flow from operations
    21,983       43,571       28,909       17,854       8,641  
                                         
Balance sheet data
                                       
Total assets
    179,325       180,282       106,358       94,868       86,308  
Long-term debt
    29,385       30,866       32,281       34,164       36,114  
Partners’ capital
    96,644       87,605       66,405       54,533       46,036  
Debt to total capitalization
    24 %     27 %     34 %     40 %     45 %
Other data
                                       
Acres owned/managed (thousands)
    430       433       556       121       114  
Fee timber harvested (MMBF)
    55       55       74       60       45  
 
(1)  
The Fund acquired 24,000 acres of timberland in 2006 and we acquired 4,700 acres of timberland in 2004.  The cost of these acquisitions was not included in the calculation of free cash flow.
(2)  
Real Estate operating income in 2007, 2006, and 2005 includes $1,878,000, $260,000 and $198,000, respectively, of environmental remediation charges related to the Port Gamble townsite.
(3)  
Management considers free cash flow to be a relevant and meaningful indicator of liquidity and earnings performance commonly used by investors, financial analysts and others in evaluating companies in its industry and, as such, has provided this information in addition to the generally accepted accounting principle-based presentation of net income or loss.
(4)  
Depreciation, depletion, and amortization in 2007 included $1.3 million of depletion expense resulting from the separate depletion pool used to account for the harvest of timber from the ORM Timber Fund I, LP timberlands.  Depreciation, depletion, and amortization in 2006 included $2.7 million of depletion expense resulting from the separate depletion pool used to account for the harvest of timber from the Quilcene timberland acquisition.
 
23

 

 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
                      
This report contains a number of projections and statements about our expected financial condition, operating results, and business plans and objectives.  These statements reflect management's estimates based upon our current goals, in light of management's knowledge of existing circumstances and expectations about future developments.  Statements about expectations and future performance are “forward looking statements” which describe our goals, objectives and anticipated performance.  These statements are inherently uncertain, and some or all of these statements may not come to pass.  Accordingly, you should not interpret these statements as promises that we will perform at a given level or that we will take any or all of the actions we currently expect to take.  Our future actions, as well as our actual performance, will vary from our current expectations, and under various circumstances these variations may be material and adverse.  Some of the factors that may cause our actual operating results and financial condition to fall short of our expectations are set forth in the part of this report entitled "Risk Factors” in Item 1A above.  Other issues that may have an adverse and material impact on our business, operating results and financial condition include environmental and land use regulations that limit our ability to harvest timber and develop property and economic conditions that affect consumer demand for our products and the prices we receive for them, and other risks and uncertainties which are discussed in our other filings with the Securities and Exchange Commission.  The forward-looking statements in this report reflect our estimates as of the date of the report, and we cannot undertake to update these statements as our business operations and environment change.

This discussion should be read in conjunction with the Partnership's audited consolidated financial statements included with this report.

EXECUTIVE OVERVIEW

Pope Resources, A Delaware Limited Partnership (“we” or the "Partnership"), was organized in late 1985 as a result of a spin-off by Pope & Talbot, Inc. (“P&T”).  We are engaged in three primary businesses.  The first, and by far most significant segment in terms of owned assets and operations, is the Fee Timber segment.  This segment includes timberlands owned directly by the Partnership and operations of ORM Timber Fund I, LP (the “Fund”).  Operations in this segment consist of growing timber to be harvested as logs for sale to domestic and to a lesser extent export manufacturers.  The second most significant business in terms of total assets owned is the development and sale of real estate.  Real Estate activities primarily take the form of securing permits, entitlements, and, in some cases, installing infrastructure for raw land development and then realizing that land’s value by the selling of larger parcels to buyers who will take the land further up the value chain, either to home buyers or to operators and lessors or commercial property.  Since these land projects span multiple years, the Real Estate segment may incur losses for multiple years while a project is developed until that project is sold resulting in operating income.  Our third business is providing timberland-related services to third-party timberland owners and raising investment capital from third parties for private equity timber funds like the Fund.

As of December 31, 2007, we owned 113,000 acres of timberland in western Washington State plus 2,600 acres of real estate held for sale or development.  Our third-party Timberland Management & Consulting services have historically been conducted in Washington, Oregon, and California.

Net income for the year ended December 31, 2007 totaled $15.5 million, or $3.21 per diluted ownership unit, on revenues of $51.9 million.  For the corresponding period in 2006, net income totaled $24.9 million, or $5.23 per diluted ownership unit, on revenues of $66.3 million.  The $15.5 million net income amount for 2007 reflects a $1.9 million fourth-quarter charge to earnings to adjust our reserve for environmental remediation liabilities as described in more detail below.   For the year ended December 31, 2007, cash flow from operations was $22.0 million, compared to $43.6 million in 2006.  Net income for the quarter ended December 31, 2007 totaled $6.3 million, or $1.30 per diluted ownership unit, on revenues of $17.6 million.  This compares to net income of $7.8 million, or $1.63 per diluted ownership unit, on revenues of $16.5 million for the quarter ended December 31, 2006.

24

 
Macroeconomic factors that have a significant bearing on our business include housing starts in the U.S., and to a lesser degree in Japan; interest rates; and currency exchange rates, particularly those between the U.S. and Canada, Japan, and Europe.  The first two of these factors reflect or influence the health of the U.S. housing market.  Currency exchange rates influence the competitiveness of our domestic sawmill customers as it relates to imported lumber from Canada, Europe, or the Southern Hemisphere as well as with the competitiveness of our logs in export markets in Asia.  Our export logs are sold to domestic intermediaries who then export the logs.  A favorable US$/yen exchange rate can help these intermediaries compete in the Japanese market with logs that originate from Canada, Russia, or the Southern Hemisphere, thus increasing the price that we are able to realize from the sale of this export-quality log volume.

As an owner and manager of timberland, we focus keenly on three “product” markets: lumber, logs, and timberland.  Each of these markets has unique and distinct market factors so that they do not move up or down in lockstep with each other.  Generally, the lumber market is the most volatile as it responds quickly (even daily) to changes in housing-driven demand and to changes in lumber inventories.  Log markets will in turn be affected by what is happening in the lumber spot markets, but pricing shifts typically adjust monthly rather than daily.  Log price volatility is also moderated because logs are used to produce products besides just lumber (especially pulp).  The market for timberland tends to be less volatile with pricing that lags both lumber and log markets.  This is a function of the longer time horizons utilized by timberland investors where the short-swing fluctuations of log or lumber prices become stabilized in acquisition modeling.  We watch the lumber market because activity there can presage log price changes.  We are in the log market constantly as we negotiate delivery prices to our customers.  The timberland market is important as we are constantly evaluating our own portfolio and its underlying value as well as the opportunities to adjust that portfolio through either the acquisition or disposition of such land.

Management’s major opportunity and challenge is to grow our revenue base profitably.  Our current strategy for adding timberland acreage is centered on our timber fund business model.  For example, the Fund acquired 24,000 acres of timberland in late 2006 of which we own 20% and earn both an asset management and on-the-ground timberland management fee from managing these timberlands.  Our real estate challenges center around how and when to “harvest” a parcel of land and capture the optimum value increment by selling the property.

Our consolidated revenue in 2007, 2006, and 2005, on a percentage basis by segment, are as follows:

Segment
 
2007
   
2006
   
2005
 
Fee Timber
    68 %     53 %     78 %
Timberland Management & Consulting
    3 %     5 %     14 %
Real Estate
    29 %     42 %     8 %

Further segment financial information is presented in Note 11 to the Partnership's Consolidated Financial Statements included with this report.

Outlook

We expect 2008 revenue and income to decline from 2007 due to weakness in the real estate and credit markets which impacts both the Fee Timber and Real Estate segments.  Over the last few years we have significantly strengthened our balance sheet by reducing our debt-to-capitalization ratio and increasing our cash and short-term investments.  Our strong balance sheet provides us the opportunity to defer timber harvest and land sales until these markets improve, and management has announced an intention to take that action, reducing our forecast timber harvest for 2008 by 36% from what we consider to be our sustainable harvest level.  We also plan to look for opportunities to acquire timberland through ORM Timber Fund II, Inc. at favorable prices during the current market weakness.

25

 
Timber harvest volume in 2008 is expected to decline to 37 MMBF from 55.1 MMBF in 2007.  This represents a 33% reduction from prior year and a 36% reduction from our sustainable harvest level of 57 MMBF.  The decision to defer harvest was made in response to our expectation of continued weakness in log markets resulting from the slowdown in housing starts that is associated with widely publicized declines in the credit and housing markets.  In addition to the planned 32 MMBF harvest from our own lands, we plan to harvest 5 MMBF from the Fund’s tree farms in 2008.  This represents a 40% reduction from the Fund’s sustainable harvest level of 8 MMBF.  Revenue generated by the Fund is consolidated into the Partnership’s financial statements but does contribute commensurately to operating income as the timberlands owned by this fund have a separate depletion pool and depletion charges are expected to offset the majority of the net stumpage value realized upon harvest (delivered log price less harvesting and transportation cost).  The 80% interest in the Fund owned by third-parties is reported beneath operating income and is labeled Minority Interest-ORM Timber Fund I, LP.

We are also anticipating a decrease in Real Estate operating income, as the market for developable land has weakened in the Pacific Northwest.  Until the market improves, we expect to concentrate our Real Estate activities primarily on preparing properties for sale through obtaining valuable entitlements and completing infrastructure improvements.  Revenue generated by the Timberland Management & Consulting segment is expected to decrease as a result of the closure of our McCloud consulting office, while we expect to see a slight increase in income from this segment due a reduction in costs related to the same office closure.  The reduction in harvest levels from the Fund’s properties also is expected to reduce our Timberland Management & Consulting income.

General & Administrative costs in 2008 are expected to decline from 2007.  The primary source of this decline will be the capital structure planning costs expensed in 2007 that are not expected to recur in 2008.

RESULTS OF OPERATIONS

The following table reconciles net income for the years ended December 31, 2007 to 2006 and 2006 to 2005.  In addition to the table’s numeric analysis, the explanatory text that follows describes many of these changes by business segment.

26

 
YEAR TO YEAR COMPARISONS
 
(Amounts in $000's except per unit data)
 
             
   
2007 vs. 2006
   
2006 vs. 2005
 
             
   
Total
   
Total
 
Net income:
           
Year ended December 31, 2007
  $ 15,508        
Year ended December 31, 2006
    24,910     $ 24,910  
Year ended December 31, 2005
            13,684  
   Variance
  $ (9,402 )   $ 11,226  
                 
Detail of earnings variance:
               
Fee Timber
               
Log price realizations (A)
  $ (219 )   $ 1,813  
Log volumes (B)
    440       (11,295 )
Harvest & haul
    (1,203 )     4,583  
Depletion
    1,580       2,993  
Other Fee Timber
    19       173  
Timberland Management & Consulting
               
Management fee changes
    (433 )     (2,707 )
Disposition fees
    (1,343 )     (45 )
Other Timberland Mgmnt & Consulting
    (373 )     478  
Real Estate
               
Development property sales
    (7,409 )     14,436  
Environmental remediation
    (1,618 )     46  
Other Real Estate
    330       (1,889 )
General & Administrative costs
    (965 )     (166 )
Interest expense
    470       1,100  
Other (taxes, minority int., interest inc.)
    1,322       1,706  
Total change in earnings
  $ (9,402 )   $ 11,226  
                 
                 
(A) Price variance allocated based on changes in price using the current period volume.
 
(B) Volume variance allocated based on change in sales volume and the average log sales price for the prior period less variance in log production costs.
 
 
27

 
Fee Timber

Revenue and Operating Income

Fee Timber revenue is earned primarily from the harvest and sale of logs from the Partnership’s 113,000 acres of fee timberland located in western Washington and, to a lesser extent, from the lease of cellular communication towers together with the sale of gravel and other forest products that result from timberland operations.  Revenue from the sale of timberland tracts will also appear periodically in results for this segment.  Our Fee Timber revenue is driven primarily by the volume of timber harvested, which we ordinarily express in terms of millions of board feet, or “MMBF”, and by the average prices realized on log sales, which we express in dollars per thousand board feet, or “MBF”.  In late 2006, the Fund acquired 24,000 acres of timberland with harvest activities from these properties beginning in 2007 and consolidated into this discussion of operations.
 
Revenue and operating income for the Fee Timber segment for each year in the three-year period ended December 31, 2007, are as follows (all amounts in $ millions, except as noted).
               
 
Year ended
 
Timber revenue
Mineral,  cell tower,
and other revenue
 
Total segment revenue
 
 
Operating income
 
 
Harvest volume (MMBF)
2007
$33.5
$2.0
$35.5
 
$15.2
 
           55.1
2006
33.3
2.0
35.3
 
14.6
 
           54.5
2005
42.7
1.7
44.4
 
16.3
 
           74.2
 
Fiscal Year 2007 compared to 2006.  Revenue and operating income increased modestly in 2007 from 2006.  The increase in revenue was due to an increase in harvest volume partially offset by a decline in average price realized.  Harvest volume in 2007 increased 1% from 2006 and includes 5.3 MMBF harvested by the Fund.  The increase in harvest volume was offset in part by a decline in average log prices of $4 per MBF, representing a 1% decrease from log prices realized in 2006.  Operating income in 2007 attributed to the Fee Timber segment increased $623,000, or 4% from 2006.  This increase was due primarily to a decline in depletion expense in 2007 from 2006.  Harvest volume in 2006 included 6.6 MMBF from a separate depletion pool that carried a higher depletion rate than our other depletion pools.
 
Fiscal Year 2006 compared to 2005.  Harvest volume declined 27% from 2005 to 2006.  This decrease was due to an elevated harvest in 2005 owing primarily to our harvest of two tracts acquired in 2004.  Average log prices in 2006 were up $35 per MBF, representing a 6% increase over 2005’s log prices.  The $301,000 increase in other revenue is due primarily to an increase in gravel royalties due to increased residential and commercial construction activity in our local markets in 2006.  The decrease in harvest volume, offset somewhat by stronger prices and increased gravel royalties, resulted in the $9.1 million, or 20%, decrease in Fee Timber revenue for 2006 versus 2005.
 
Operating income in 2006 attributed to the Fee Timber segment decreased $1.7 million, or 10% from 2005.  Harvest volume from one of the 2004 acquisitions has a separate depletion pool because the property has characteristics that are different from the pooled property.  Specifically, the timber on this property at the time of acquisition was almost completely merchantable.  As a result of accounting for harvests from this particular acreage using the separate depletion pool and its correspondingly high per MBF depletion charge, the incremental harvest from this acquisition generated significant cash flow but had much less impact on operating income.  The cash generated through 2005 and into 2006 related to the timber harvested from this particular fourth quarter 2004 acquisition has served to recoup effectively its entire purchase price.
 
28


Log Volume

Log volume sold for each year in the three-year period ended December 31, 2007 is as follows:
             
Volume (in MMBF)
2007
% Total
2006
% Total
2005
% Total
Sawlogs
           
Douglas-fir
35.1
64%
38.9
71%
43.7
59%
Whitewood
6.5
12%
3.8
7%
11.0
15%
Cedar
2.2
4%
1.1
2%
4.5
6%
Hardwoods
2.7
5%
3.6
7%
5.1
7%
Pulp
           
All Species
8.6
16%
7.1
13%
9.9
13%
             
Total
55.1
100%
54.5
100%
74.2
100%

Log volume increased 1% in 2007 from the 2006 harvest.  With the weakened market for Douglas-fir sawlogs, a direct result of the soft housing market, we focused on harvest units with less Douglas-fir volume and more whitewood, cedar, and pulp.  This allowed us to take advantage of those selected log markets that remained relatively strong.  The export markets for high quality whitewood sawlogs strengthened as log exporters were able to identify low cost opportunities to ship logs to Korea.  The market for pulp and cedar strengthened as supplies declined.  This is a common occurrence during weak log and lumber markets.  Wood chips used to manufacture pulp are a by-product of lumber manufacturing so when mills reduce production, fewer wood chips are created thus increasing demand for pulp logs.  Similarly cedar sawlogs can be thought of as a by-product resulting from the harvest of Douglas-fir and whitewood timber stands.  When harvest activities decline, production of cedar sawlogs also decline while demand for this type of log is not as tightly tied to housing starts.

Log volume decreased 27% in 2006 from the elevated harvest in 2005 related to the 2004 timberland acquisitions.  The 2004 timberland acquisitions were largely harvested in 2005 and contained a relatively high volume of cedar and red alder sawlogs.  Pulp log volume as a percentage of total volume remained at 13% in 2006 when compared to 2005.

Log Prices

We have categorized our sawlog volume by species, which is a significant driver of price realized as indicated by the table below.  The average log price realized by species for each year in the three-year period ended December 31, 2007, is as follows:
           
Price $/MBF
2007
% Change
2006
% Change
2005
Sawlogs
         
Douglas-fir
$621
-7%
$669
4%
$644
Whitewood
462
4%
445
-6%
472
Cedar
1,280
17%
1,093
16%
942
Hardwoods
931
37%
681
13%
605
Pulp
         
All Species
381
42%
268
26%
213
Overall
         
All Species
607
-1%
611
6%
576
 
29

 
Douglas-fir: Douglas-fir is noted for its structural characteristics that make it generally preferable to other softwoods and hardwoods for the production of construction grade lumber and plywood.   Demand and price for Douglas-fir sawlogs is very dependent upon the level of new construction.  As construction starts have declined significantly, we have experienced a 7% decline in Douglas-fir log price realized in 2007 from 2006, a trend that led us to front-load our harvest into the earlier parts of 2007 as we have done in prior years.  The price realized on Douglas-fir logs increased 4% in 2006 from 2005 due to stronger housing starts in 2006 in the United States.  Additional lumber mills opened during 2006 in the Puget Sound area of Washington, thus creating some additional demand and upward price pressure on logs.

Whitewood: “Whitewood” is a term used to describe several softwood species, but for us primarily refers to western hemlock.  Though generally considered to be of a lower quality than Douglas-fir, these logs are also used for manufacturing construction grade lumber and plywood.  The average price realized on whitewood increased 4% in 2007 from 2006, and decreased 6% in 2006 from 2005.  As mentioned above, the whitewood export market strengthened in 2007.  Conversely, there was a decline in whitewood market prices during 2006, with this result attributable to harvesting lower quality logs in 2006 versus 2005.  Whitewood harvest volume in 2005 included a large component of high quality whitewood sawlogs from one of the 2004 timberland acquisitions which increased our average price realization in the prior year.

Cedar: Cedar is generally used for outdoor applications for fencing a decking.  Demand for these products is not as tightly linked to housing starts as our other soft wood sawlogs.  Cedar prices have increased in both 2007 from 2006 and in 2006 from 2005.  The strong price realized for 2007 and 2006 reflects a general decline in cedar volume available in the Puget Sound area with resultant upward pressure on price due to continuing demand for such logs.

Hardwood:  “Hardwood” can refer to many different species, but on our tree farms primarily consists of red alder.  The price realized from the sale of red alder sawlogs has increased steadily over the last two years with limited supply and increased demand as a result of new mills focused on hardwood lumber production in the Pacific Northwest.  The local mills that process alder sawlogs are using the resource to manufacture lumber for use in furniture construction.  Hardwood log prices increased 37% due to an increase in hardwood mill capacity in the Puget Sound area that has increased demand for hardwood sawlogs.  Notwithstanding this favorable price trend, hardwood represents a relatively minor species in our sales and timber inventory mix and this only produces a small impact on overall revenue and earnings.

Pulp:  Pulp is a lower quality log of any species that is manufactured into wood chips.  These chips are used primarily to manufacture unbleached linerboard used in paper bags and cardboard boxes.  The price realized from the sale of pulp logs is primarily driven by local pulp log inventories.  Pulp prices in 2007 were up 42% over 2006.  The increases in pulp log prices results from a decline in sawmill production and a corresponding reduction in the inventory of residual chips from lumber manufacturing.

Customers
 
   
2007
   
2006
   
2005
 
Destination
 
Volume*
   
Price
   
Volume*
   
Price
   
Volume*
   
Price
 
Domestic mills
    44.0     $ 652       44.3     $ 659       59.0     $ 632  
Export brokers
    2.5       612       3.1       700       5.3       629  
Pulp
    8.6       382       7.1       268       9.9       213  
Total
    55.1     $ 607       54.5     $ 611       74.2     $ 576  
* Volume in MMBF
                                               

Domestic mills purchased 78% of our harvest in 2007 versus 81% in 2006.  The decline in the proportion of log volume sold to domestic mills was offset by an increase in volume sold to pulp mills, where prices were 42% higher in 2007 than 2006.  Export brokers represent those log buyers that purchase our logs and then resell them primarily to the export market.  While export brokers purchased roughly the same volume, prices were 13% lower in 2007 than 2006, due to a shift from selling Douglas-fir to whitewood in the export market.  Whitewood has a lower average value than Douglas-fir.

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Domestic mills purchased 81% of our harvest volume sold in 2006, and average price realizations were 4% higher than the price realized in 2005.  The increase in price realized is due to the strong housing market experienced in 2006.  A factor in the increase in average price is the lower valued log mix in 2005 compared to 2006.  Harvest volume in 2005 included a large component of whitewood which carries a lower market value than Douglas-fir logs.  Volume sold to pulp log customers represented 13% of total volume sold for both 2006 and 2005.

Harvest Volumes and Seasonality

The Partnership’s 113,000 acres of timberland consist of both the 70,000-acre Hood Canal tree farm and the 43,000-acre Columbia tree farm.  The Hood Canal tree farm is located in the Hood Canal region of Washington State.  Most of this tree farm acreage is at a relatively low elevation where harvest activities are possible year-round.  As a result of this competitive advantage, we are often able to harvest and sell a greater portion of our annual harvest in the first half of the year when the log supply in the marketplace tends to be lower.  In 2007 our harvest was less concentrated in the first quarter of the year due in part to a lower harvest from the Hood Canal tree farm and an uncertain market for logs that led us to a more even-flow harvest schedule in 2007 versus prior years.

The percentage of annual harvest volume by quarter for each year in the three-year period ended December 31, 2007 is as follows:
                 
Year ended
 
Q1
 
Q2
 
Q3
 
Q4
2007
 
18%
 
41%
 
28%
 
13%
2006
 
40%
 
31%
 
22%
 
7%
2005
 
31%
 
30%
 
28%
 
11%

Cost of Sales

Cost of sales for the Fee Timber segment consists of harvest costs and depletion expense.  Harvest costs represent the direct cost incurred to convert trees into logs and deliver those logs to their point of sale and associated state excise taxes owed on the harvest of logs.  Depletion expense represents the cost of acquiring or growing the timber harvested.  We are using two separate depletion rates in 2007, with our primary pool used for volume harvested from the Hood Canal and Columbia tree farms and the second pool for volume harvested from tree farms owned by ORM Timber Fund I, LP.  In 2006 and 2005 we also harvested from two separate depletion pools consisting of our primary pool and the pool used for timber harvested from the timberland acquired in the fourth quarter of 2004.  Depletion expense is calculated by first deriving a depletion rate as follows:
 
Depletion rate  =
 
Accumulated cost of timber and capitalized road expenditures
   
Estimated volume of 40-year-old merchantable timber available for harvest
 
The depletion rate is then applied to volume harvested to calculate depletion expense.  In 2008 we are changing our definition of “merchantable” to 35-year and older timber.

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Fee Timber cost of sales, expressed on a per MBF basis for each year in the three-year period ended December 31, 2007, is as follows:
                   
         
Harvest,haul,
   
Total cost
 
   
Depletion cost
   
and other costs
   
of sales
 
Year Ended
 
per MBF
   
per MBF
   
per MBF
 
2007
  $ 87     $ 200     $ 287  
2006
    110       187       297  
2005
    142       179       321  
 
As described above, the depletion rate is calculated by dividing the historical cost of the timber and related capitalized road expenditures by merchantable timber volume.  That calculated rate is then applied to volume harvested.  We harvested a total of 55 MMBF in 2007, with 5 MMBF attributable to the separate depletion pool created for the ORM Timber Fund I, LP Timberlands.  The depletion rate used in these separate pools approximates the net stumpage value (delivered log price less harvesting and transportation cost) realized on the sale of this particular timber.  As such, the incremental harvest from these timberlands results in negligible net income impact even as it generates operating cash flow.
 
Depletion expense is generated from the harvest and sale of timber and some de minimis amount of depletion results from Real Estate sales when land is sold with standing timber.  Depletion expense resulting from timber harvest for each year in the three-year period ended December 31, 2007 was made up of the following:
                   
   
Year ended December 31, 2007
 
   
Pooled
   
Timber Fund
   
Total
 
Volume harvested (MBF)
    49,824       5,337       55,161  
Rate/MBF
  $ 70.31     $ 237.77     $ 86.51  
Depletion expense ($ 000's)
  $ 3,503     $ 1,269     $ 4,772  
                         
                         
   
Year ended December 31, 2006
 
   
Pooled
   
Quilcene
   
Total
 
Volume harvested (MBF)
    47,682       6,851       54,533  
Rate/MBF
  $ 68.97     $ 396.63     $ 110.13  
Depletion expense ($ 000's)
  $ 3,288     $ 2,717     $ 6,006  
                         
                         
   
Year ended December 31, 2005
 
   
Pooled
   
Quilcene
   
Total
 
Volume harvested (MBF)
    57,194       17,051       74,245  
Rate/MBF
  $ 73.29     $ 374.46     $ 142.46  
Depletion expense ($ 000's)
  $ 4,192     $ 6,385     $ 10,577  
 
Harvest costs vary based upon the physical site characteristics of acreage harvested.  Harvest units that are difficult to access, or that are located on steep hillsides requiring cable harvest systems, are more expensive to harvest.  Haul costs vary based upon the distance between the harvest site and the customer’s location.  Per MBF harvest and haul costs increased in 2007 relative to 2006 primarily due to the location of the harvest units, where logs harvested in 2007 compared to 2006 were hauled a greater distance to customer locations.  Increased fuel costs further contributed to the increase in haul costs in 2007 over 2006.  The increase in harvest and haul costs in 2006 relative to 2005 is due to increased costs from having harvested timber from harvest units located on hillsides rather than harvest units located on relatively flat ground.

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Fee Timber cost of sales for each year in the three-year period ended December 31, 2007 is as follows (all dollar amounts in millions):

Year ended
 
Depletion
   
Harvest, haul and other
   
Total cost of sales
 
2007
  $ 4.8     $ 11.0     $ 15.8  
2006
    6.0       10.2       16.2  
2005
    10.6       13.2       23.8  

Fee Timber cost of sales decreased $384,000 in 2007 from 2006 and decreased $7.6 million in 2006 from 2005.  The decrease in 2007 from 2006 is due to a decrease in the average depletion rate used on timber harvested offset by increased harvest costs.  The decrease in 2006 from 2005 is due to a reduction in harvest from both our pooled and separate depletion pool harvest units.

Operating Expenses

Fee Timber operating expenses for each of the three years ended December 31, 2007, 2006, and 2005 were $4.5 million, $4.4 million, and $4.3 million, respectively.  Operating expenses include management, silviculture and the cost of both maintaining existing roads and building temporary roads required for harvest activities.  Operating costs remained relatively consistent in all three years despite the addition of 24,000 acres owned by the Fund.  This is due primarily to the benefits of scale we enjoy as a result of adding acreage to this segment.

Timberland Management & Consulting

Revenue and Operating Income

The Timberland Management & Consulting segment generates revenue by providing timberland management and forestry consulting services to timberland owners and managers.  An additional aspect of that segment’s activities is the development of timberland property investment portfolios on behalf of third-party clients and the Timber Fund.

The Timberland Management & Consulting segment is currently managing more than 290,000 acres of timberland for Cascade Timberlands LLC and an additional 24,000 acres for the Fund.  The Cascade project includes management, consulting, and disposition services.  Revenue and operating income for the Timberland Management & Consulting segment for each year in the three-year period ended December 31, 2007, are as follows (all dollar amounts in millions):

Year ended
 
Revenue
   
Operating income (loss)
 
2007
  $ 1.3     $ (0.9 )
2006
    3.7       1.3  
2005
    7.8       3.5  

Fiscal Year 2007 compared to 2006.  Revenue and operating income for 2007 were $2.4 million and $2.2 million lower, respectively, than in 2006.  The decrease in 2007 is due to a decline in acres under management due to additional sales of Cascade’s timberlands and $1.3 million in non-recurring timberland disposition fees earned in 2006.
 
The Fund was formed by Olympic Resource Management LLC (ORMLLC) for the purpose of attracting investor capital to purchase timberlands.  The Fund had a $61.8 million capital commitment and we placed $58.5 million of this commitment in late 2006.  Pope Resources’ co-investment totaled $11.7 million, or 20% of the Fund.  The Fund is treated as a consolidated subsidiary whose results are reported under the Fee Timber segment.  Operating results attributed to the 80% third-party interest in the Fund are reported under Minority Interest-ORM Timber Fund I, LP below operating income.
 
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We are now organizing our second timber fund that we expect will total over $100 million of equity capital, with our co-investment at the same 20% level as in the first fund.  As with ORM Timber Fund I, LP we will not be required to contribute the majority of this capital until suitable timber properties are identified and acquired.
 
Fiscal Year 2006 compared to 2005.  Revenue and operating income for 2006 was $4.1 million and $2.2 million lower, respectively, than for 2005.  These decreases are due to a decline in acres under management partially offset by timberland disposition fees earned by providing such services to our primary timberland management client, Cascade Timberlands LLC.  Cascade’s sale of portions of its holdings resulted in a disposition fee earned in the first quarter of 2006 followed by a reduction in timberland management fees.  We have entered into an agreement to continue managing Cascade’s timberland from 2007 through 2009.
 
Operating Expenses
 
Fiscal Year 2007 compared to 2006.  Timberland Management & Consulting operating expenses decreased $177,000 in 2007 from 2006.  This is attributable to decreased activities associated with Cascade timberlands netted against an increase in organization costs associated with ORM Timber Fund II.
 
Fiscal Year 2006 compared to 2005.  Timberland Management & Consulting operating expenses decreased $1.8 million in 2006 from 2005.  The decrease in operating expenses resulted from the closing of two offices that were used for managing timberlands formerly owned by Cascade, and a decrease in activities surrounding capital-raising for the Fund.  Following the sale of two of Cascade’s tree farms we closed our forestry field offices in Port Angeles, Washington in late 2005 and in Sedro-Woolley, Washington in early 2006.  The Timberland Management & Consulting segment was not engaged in raising capital in 2006 but was working to locate suitable timber properties for the Fund.  This shift in activities resulted in a decline in operating expense.
 
Real Estate
 
Revenue and Operating Income

The Partnership’s Real Estate segment consists primarily of revenue from the sale of land together with residential and commercial property rents.  The Partnership’s real estate holdings are located primarily in Pierce, Kitsap, and Jefferson Counties in Washington State.
 
Results from Real Estate operations are expected to vary significantly from year to year as we make multi-year investments in entitlements and infrastructure prior to selling entitled or developed land, and from time to time we have described these results as “lumpy” in terms of their impacts on our revenues and operating cash flows.  Revenue and operating income for the Real Estate segment for each year in the three-year period ended December 31, 2007, are as follows (all dollar amounts in millions):

Year ended
 
Revenue
   
Environmental remediation expense
   
Operating income
 
2007
  $ 15.0     $ 1.9     $ 5.2  
2006
    27.3       0.3       13.9  
2005
    4.8       0.2       1.3  

Revenue in the Real Estate segment is generated through the sale of land and the rental of homes and commercial properties at the Port Gamble townsite.  Land sales include the sale of raw land which generally consists of larger acreage sales rather than single lot sales and are normally completed with very little capital investment prior to sale.  Rural Lifestyles lot sales generally require some capital improvements such as zoning, road building, or utility access improvements prior to completing the sale.  Commercial and residential plat land sales represent land sold after development rights have been obtained and are generally sold with certain infrastructure improvements.

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Real Estate segment revenue for each year in the three year period ended December 31, 2007 consists of the following (all dollar amounts in thousands):
Description
 
Revenue
   
Gross Margin
   
Acres Sold
   
Revenue/Acre
   
Gross Margin/ Acre
 
Commercial/Business Park
  $ 11,124     $ 7,155       15     $ 719.1     $ 463  
Revenue Recognized on % Complete for 2006 Closings
 
     Complete for 2006 Closings
    1,346       838    
NA
   
NA
   
NA
 
Other Land Sale
    1,018       964       91     $ 11.2     $ 11  
Rural Residential
    553       458       50     $ 11.1     $ 9  
Rentals
    982       982    
NA
   
NA
   
NA
 
Other
    14       15    
NA
   
NA
   
NA
 
2007 Total
  $ 15,037     $ 10,412       156     $ 81.1     $ 55  
                                         
Commercial/Business Park
  $ 11,637     $ 6,184       37     $ 314.5 &#