a50192533.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, 2011
or
o
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)
       NASDAQ
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act
Yes oNo 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 o  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 (or for such shorter period than the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x  No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). 
Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) 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.
o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 in Rule 12b-2 of the Exchange Act.
 
Large Accelerated Filer o
 
Accelerated Filer x
Non-Accelerated Filer o (Do not check if a smaller reporting company)
 
Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in rule 12b-2 of the Act).
Yes o No x
At June 30, 2011, the aggregate market value of the non-voting equity units of the registrant held by non-affiliates was approximately $141,717,000.
 
The number of the registrant’s limited partnership units outstanding as of February 17, 2012 was 4,410,226.
 
Documents incorporated by reference: None
 
 
 

 
 
Pope Resources, A Delaware Limited Partnership
Form 10-K
For the Fiscal Year Ended December 31, 2011
Index
 
Part I
  Page
       
 
3
 
16
 
19
 
19
 
20
 
20
       
Part II
   
       
   
    21
 
24
   
   
26
 
52
 
53
   
   
78
 
78
 
79
       
Part III
   
       
 
80
 
84
   
   
95
 
97
 
98
       
Part IV
   
       
 
98
   
105
 
 
2

 
 
PART I
 
Item 1. BUSINESS
 
OVERVIEW

           When we refer to “the Partnership,” “the Company,” “we,” “us,” or “our,” we mean Pope Resources, A Delaware Limited Partnership and its consolidated subsidiaries. References to notes to the financial statements refer to the Notes to the Consolidated Financial Statements of Pope Resources, A Delaware Limited Partnership included in Item 8 of this form.

           The Partnership currently operates in three primary business segments: (1) Fee Timber, (2) Timberland Management & Consulting (TM&C), and (3) Real Estate. Fee Timber operations consist of growing and harvesting timber from the 175,000 acres that we own or manage as tree farms. Activities in the Timberland Management & Consulting segment are centered on raising and investing capital from third parties for private equity timber funds, and thereafter managing those funds for the benefit of all investors. Our Real Estate segment’s operations are focused on a portfolio of approximately 2,800 acres in the Puget Sound basin of Washington. This segment’s activities consist of efforts to enhance the value of our land by obtaining the entitlements and, in some cases, building the infrastructure necessary to enable further development. 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.poperesources.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. As indicated above, our Fee Timber operations consist primarily of growing, harvesting, and marketing timber to export brokers and domestic manufacturers. In addition, our tree farms generate other revenues from sources such as cell tower, brush, and mineral leases. The 175,000 timberland acres that we own or manage under the banner of this segment break down into two categories. The first of these categories consists of the approximately 70,000-acre Hood Canal tree farm, located in the Hood Canal area of Washington, and the 44,000-acre Columbia tree farm located in southwest Washington. Management views the Hood Canal and Columbia tree farms as the Partnership’s core holdings, and manages them as a single operating unit. When we refer to these two tree farms we will describe them as the Partnership’s tree farms. We have owned the Hood Canal tree farm, substantially as currently comprised, since our formation in 1985, and we acquired the bulk of the Columbia tree farm in 2001.
 
This segment also includes as a second category the operations of ORM Timber Fund I, LP (Fund I), ORM Timber Fund II, Inc. (Fund II), and ORM Timber Fund III (REIT) Inc., (Fund III, and collectively with Fund I and Fund II, the Funds), which are consolidated into our financial statements. The Funds’ operations are based on 61,000 acres of timberland located on the west side of the Cascade Mountain range in Washington and Oregon. Fund I acquired 24,000 acres of timberland in the fourth quarter of 2006, Fund II acquired 12,000 acres of timberland in the fourth quarter of 2009, and 25,000 acres in the third quarter of 2010. Fund III has not yet acquired property. We will refer to tree farms owned by the Funds as the Funds’ tree farms. When referring to the Partnership’s and Funds’ tree farms together we will refer to them as the Combined tree farms. Our Fee Timber segment produced 92%, 89%, and 72% of our consolidated revenue in 2011, 2010, and 2009, respectively.
           
Inventory. Timber volume is generally expressed in thousand board feet (MBF) or million board feet (MMBF). In the discussion below, inventory and projected harvest level data for the Partnership’s tree farms is presented separately from that of the Funds’ tree farms. In addition, we define “merchantable timber inventory” to mean timber inventory in productive timber stands that are 35 years of age and older.
 
 
 
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In 2011, total inventory on the Partnership’s tree farms decreased 15 MMBF. This decrease resulted from the harvest of 51 MMBF, from which 2 MMBF was previously deferred, and was partially offset by inventory growth, as well as shifts in age-class layers as standing timber reached 35 years of age and began to be included in merchantable timber inventory.
 
The Partnership’s merchantable inventory is spread among five-year age classes as follows (volumes in MMBF):
 
     
December 31,
 
2011
2011
2011
2010
Age Class
Pulpwood
Sawtimber
Total
Total
35 to 39
15
67
82
69
40 to 44
13
65
78
80
45 to 49
5
26
31
33
50 to 54
2
8
10
13
55 to 59
2
10
12
12
60 to 64
2
18
20
39
65+
9
57
66
68
 
48
251
299
314
 
Merchantable inventory for the Funds decreased by 11 MMBF as a result of 39 MMBF of timber harvested in 2011, offset by inventory growth, the shift in new age-class layers as standing timber reached 35 years of age, and adjustments as a result of ongoing cruises. The Funds’ merchantable inventory is spread among age classes as follows (volumes in MMBF):
 
     
December 31,
 
2011
2011
2011
2010
Age Class
Pulpwood
Sawtimber
Total
Total
35 to 39
17
76
93
87
40 to 44
14
87
101
104
45 to 49
9
40
49
49
50 to 54
6
42
48
50
55 to 59
4
16
20
22
60 to 64
0
3
3
6
65+
2
8
10
17
 
52
272
324
335
 
As of December 31, 2011, total merchantable inventory volume from the Combined tree farms was estimated to be 623 MMBF, which compares to estimated merchantable timber inventory volume of 649 MMBF at December 31, 2010.

Timber inventory volume estimates are updated annually. Of the timber stands older than 24 years, 10% to 20% are physically re-measured each year using a statistical sampling process called “cruising”. Adjustments are made for depletion of areas harvested, growth (using suitable growth and yield calculations), changes in acres and associated timber volume resulting from acquisitions, dispositions, and reclassification of acres as available or unavailable for harvest.
 
 
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The dominant timber species on the Partnership’s tree farms is Douglas-fir, which has unique structural characteristics that make it generally preferable to other softwoods and hardwoods for the production of construction grade lumber and plywood. A second dominant species on the Partnership’s tree farms is western hemlock, which is similar in color and structural characteristics to a number of minor timber species, including Sitka spruce and the true firs. These species are thus purchased and manufactured into lumber generically, and referred to as “whitewoods”. In addition to Douglas-fir and the whitewoods, other species on the Partnership’s tree farms include red alder, other minor hardwoods, and western red cedar. The merchantable timber inventory on the Funds’ properties contains a greater proportion of whitewoods than do the Partnership’s timberlands.

The Partnership’s total merchantable timber inventory as of December 31 for both 2011 and 2010 is distributed among species as follows (volumes in MMBF):
 
Species
 
2011 Volume
   
Percent of total
   
2010 Volume
   
Percent of total
 
Douglas-fir
    214       72 %     227       72 %
Western hemlock
    37       12 %     38       12 %
Western red cedar
    15       5 %     15       5 %
Other conifer
    12       4 %     12       4 %
Red alder
    18       6 %     19       6 %
Other hardwood
    3       1 %     3       1 %
Total
    299       100 %     314       100 %
 
The Funds’ total merchantable timber inventory as of December 31 for both 2010 and 2011 is distributed among species as follows (volumes in MMBF):
 
   
2011 Volume
   
Percent of total
   
2010 Volume
   
Percent of total
 
Douglas-fir
    185       57 %     195       58 %
Western hemlock
    90       28 %     90       27 %
Western red cedar
    2       1 %     3       1 %
Other conifer
    33       10 %     33       10 %
Red alder
    12       3 %     13       4 %
Other hardwood
    2       1 %     1       - %
Total
    324       100 %     335       100 %
 
The Partnership’s tree farms as of December 31, 2011 include approximately 114,000 acres. Of this total, approximately 96,000 acres are designated productive acres, meaning land that is capable of growing merchantable timber and where the harvesting of that timber is not constrained by physical, environmental or regulatory restrictions. The Funds’ tree farms as of December 31, 2011 totaled approximately 61,000 acres, of which more than 52,000 were designated productive acres. Readers will note in the acreage table below that 30% of the Partnership’s acreage and 25% of the Funds’ acreage is in the 25-34 year age classes, much of which will begin moving from pre-merchantable to merchantable timber inventory over the next five years. As of December 31, 2011, total productive acres are spread by timber age-class as follows:
 
 
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(in thousands)
                               
Age
 
12/31/2011
         
12/31/2011
         
12/31/2011
       
Class
 
Partnership Acres
   
%
   
Funds Acres
   
%
   
Combined Acres
   
%
 
Clear-cut
    3.4       3 %     1.7       3 %     5.1       3 %
0 to 4
    5.2       5 %     2.2       4 %     7.4       5 %
5 to 9
    11.2       12 %     2.7       5 %     13.9       9 %
10 to 14
    12.3       13 %     3.0       6 %     15.3       10 %
15 to 19
    6.7       7 %     3.4       7 %     10.1       7 %
20 to 24
    12.4       13 %     7.2       14 %     19.6       13 %
25 to 29
    17.2       18 %     6.9       13 %     24.1       16 %
30 to 34
    11.5       12 %     6.1       12 %     17.6       12 %
35 to 39
    5.5       6 %     7.2       14 %     12.7       9 %
40 to 44
    4.3       4 %     5.7       11 %     10.0       7 %
45 to 49
    1.5       2 %     2.7       5 %     4.2       3 %
50 to 54
    0.6       1 %     1.9       4 %     2.5       2 %
55 to 59
    0.7       1 %     0.7       1 %     1.4       1 %
60 to 64
    0.8       1 %     0.2       - %     1.0       1 %
65+
    2.5       2 %     0.4       1 %     2.9       2 %
      95.8               52.0               147.8          
 
 
Long-term Harvest Planning. Long-term harvest plans for the Partnership tree farms and the Funds’ tree farms reflect the different time horizons associated with the two groups of timberlands. Plans for the Partnership timberlands are designed to maintain sustainable harvest levels over the long term, assuming indefinite ownership. Plans for the Funds’ tree farms, on the other hand, reflect the different mix of age classes and the fact that the Funds’ tree farms have over two times the percentage of merchantable acres (36% for the Funds’ productive acres are over 35 years versus 17% for the Partnership tree farms).  In addition, the harvest level for the Funds’ tree farms is developed to maximize total return during the investment period which will result in additional harvest variability between years (and may vary from 15 MMBF to 45 MMBF in a given year).

In response to a dramatic downturn in log prices in 2008, we began deferring harvest volume from the Combined tree farms and continued doing so through 2010. Beginning in 2010, the reduction in Russian log imports to China led to an opportunity for North American log producers to supply a larger portion of the growing Chinese market. Over the course of 2010 and into 2011, log export volumes to China continued to surge, resulting in log prices that were unexpectedly high during the first half of 2011. In turn, timberland owners took advantage of opportunities to harvest deferred volume into a strengthening log market. By the second half of 2011, however, the Chinese government restricted credit to try to curb inflation and slow down the pace of building. This resulted in the buildup of inventory and, in turn, a weakening of fourth quarter demand and pricing. The continued weakness in domestic log demand associated with a slow recovery in U.S. home building combined with stronger but more volatile export markets is expected to result in log production that will modulate over and under our long-term planning targets.

Over the next three to five years, assuming a continuation in log market price recovery, we expect to take advantage of spikes in demand and corresponding pricing opportunities to increase the harvest volume from the Partnership’s tree farms to include an additional 25 MMBF (see table below) deferred during the recent economic downturn. Similarly, harvest from the Funds’ tree farms will incorporate 9 MMBF of deferred harvest volume. As described above, the base level of harvest from the Funds’ tree farms will be relatively high to account for the disproportionately large number of acres stocked with older merchantable timber. The planned annual harvest level for each ownership, along with cumulative deferred volumes, can be found in the table below:
 
 
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(amounts in MMBF)
       
Accumulated
 
   
Planned Annual
   
Volume Deferral
 
   
Harvest Volume
    2008-11  
Partnership Properties
    44       25  
Fund Properties
    36       9  
Total
    80       34  
 
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 to international customers and to domestic manufacturers, the former through log exporting intermediaries. While domestic manufacturers historically represent the largest consumer of our sawlogs, 2011 marked the first time that they slipped behind export markets as a percent of total sawlog production.

Historically, Japanese customers have paid a premium for the highest quality logs from which visually appealing beams for residential construction are produced. U.S. mills, on the other hand, manufacture mostly framing lumber requiring structural integrity for wall systems that are concealed by drywall. The logs required by U.S. sawmills do not have to be of as high a quality and are more of a commodity relative to the Japanese market, and thus command a lower price. In recent years the export market for logs in the Pacific Northwest has been migrating from a market highly focused on Japan to a market that now includes more volume to China. In late 2010, China overtook Japan as the largest importer of Pacific Northwest logs. Sawlogs sold to China are used chiefly for cement forming, pallets, and other low-end uses that can be satisfied with the commoditized logs traditionally purchased by domestic sawmills. The lower average sawlog quality and more diverse species mix flowing to China, combined with  the limited volume of high quality Douglas-fir flowing to Japan, has resulted in a narrowing of the export premium received for sales of logs into these export markets relative to the domestic market. In 2011, the U.S. home building industry was still in a slump, with low lumber demand and pricing making it hard for U.S. mills to compete for logs. However, domestic mills were able to sell significant volumes of lumber into the Chinese market, allowing them to better compete for log supply.

The logs that we sell to China, Japan, and Korea are actually sold to U.S.-based brokers who in turn sell directly to offshore customers. The decision to sell through intermediaries is predicated on risk management. Mitigation of foreign exchange risk, loss prevention, and minimizing cash collection risks inform our decision to sell through brokers. For the years 2005 through 2009, the percentage of our annual production sold into export markets ranged from 6% to 15%. However in 2010, our export mix surged to 33% and peaked again at 45% in 2011 as demand from China continued to climb. 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, hauling costs to export ports, and ocean transportation costs.

Customers. Logs from the Combined tree farms are sold to export intermediaries located at the ports of Longview, Tacoma, Port Angeles, and Olympia, Washington and Astoria, Oregon. The Partnership sells its logs from its own tree farms and from the Funds’ properties domestically to lumber mills and other wood fiber processors located throughout western Washington and northwest Oregon. Whether destined for export or domestic markets, the cost of transporting logs limits the destinations to which the Partnership can profitably deliver and sell its logs.

The ultimate decision on where to sell logs is based on the net proceeds we receive after considering the delivered log prices from a prospective customer and the hauling cost needed to get logs to that customer. In instances where harvest operations are in close proximity to a mill relative to the export yard of a broker, we will take advantage of favorable haul costs over selling to an export customer whose yard may be a greater distance from a harvest unit. The higher net delivered log value earned by selling to the domestic mill will, in such instances, result in sales of logs originally intended for Asia being diverted to domestic markets. As such, delivered log prices that we realize are influenced by marketing decisions predicated on a net return rather than merely focusing on the delivered per MBF log price.
 
 
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Pacific Lumber & Shipping, with logs flowing to export markets, was the largest customer for our Fee Timber segment in 2011, representing 28% of segment revenue. The Combined tree farms delivered logs to 50 separate customers during 2011, compared to 43 during 2010.

Competition. Most of our competitors are comparable to our 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 timber from the Combined tree farms will enable it to compete effectively in these markets. However, our products are subject to some competition from a variety of non-wood and engineered wood products as well as competition from foreign-produced logs and lumber.

Forestry and Stewardship Practices. Timberland management activities on the Combined tree farms include reforestation, control of competing brush in young stands, thinning of the timber to achieve optimal spacing after stands are established, fertilization, and road maintenance. During 2011, we planted 803,000 seedlings on 2,000 acres. This compares to the years 2010 and 2009 in which the Partnership planted 657,000 and 815,000 seedlings on 1,800 and 1,900 acres, respectively. Seedlings are generally planted from December to April, depending on weather and soil conditions, to restock plantations that were harvested during the preceding twelve months. Planting will vary from year to year based upon harvest level, the timing of harvest, and seedling availability. Management’s policy is to return all timberlands to productive status in the first planting season after harvest.

 All harvest and road construction activities are conducted under the forest practice rules and regulations of the applicable state. These regulations are comprehensive sets of rules that require project-specific permits that govern a defined set of forest operations.  For example, an application for harvest or road construction must address soil stability and potential impact to public resources. In many cases we consult third-party, state-qualified, geo-technical consultants to promote safety and regulatory compliance. In addition to new road construction, existing roads are maintained to the standards of the applicable state forest practices act in order to minimize siltation of nearby streams and avoid slope failures.

In Washington, beginning in 2000, all roads were required to be evaluated for hazards and scheduled for upgrading or deconstruction (abandonment), if needed, by the end of 2015. We developed a compliance schedule for our roads in Washington and it was accepted by the state. At the beginning of 2011, our efforts were on track to complete all maintenance activities by 2015. Due to the economic downturn, the state established a process in 2011 to extend the timeframe for these requirements, allowing an additional five years to complete the necessary work. The Partnership will exercise this option for some of the Fund properties. Oregon does not presently have a similar road maintenance and abandonment plan requirement.

Sustainable Forestry Initiative (SFI®). Since 2001, we have been a member of the SFI forest certification program, an independent environmental review and certification program that promotes sustainable forest management, focusing on water quality, biodiversity, wildlife habitat, and species protection. With our voluntary entry into this 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 sustainably while continually seeking ways to improve our management practices. We believe this commitment is an important business practice that contributes positively to our reputation and to the long-term value of our assets.

Beginning in 2007, SFI third-party audits increased in frequency from every three years to annually. We were re-certified in 2011, which includes both the Partnership and the Funds properties. We believe this certification allows us to obtain the broadest market penetration for our logs while protecting the core timberland assets of the Partnership and the Funds.
 
 
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Timberland Management & Consulting
 
Background. In 1997, the Partnership formed two wholly owned subsidiaries, ORM, Inc. and Olympic Resource Management LLC (“ORMLLC”), to facilitate the Timberland Management & Consulting activities. Our TM&C segment earns management fees and incurs expenses resulting from managing property on behalf of third-party owners and investors. Since the launch of our timberland private equity fund strategy in 2003, the activities in this segment have consisted primarily of attracting third-party investment capital for the Funds and then acquiring and managing properties on behalf of the Funds.

ORMLLC has placed capital for Fund I and Fund II with a total acquisition value of $150 million, which includes our co-investment of $28 million. In November 2011 we had our initial close of Fund III with commitments totaling $51 million, including our co-investment of $7 million. The final close for Fund III is planned for June 2012 with a targeted total fund size of $100 million. At that level, no additional co-investment will be required from the Partnership. However, if Fund III reaches its maximum size of $150 million in capital commitments, the Partnership will be required to make an additional $500,000 co-investment. These Funds afford us greater economies of scale in the management, acquisition, and disposition of timberland than would be possible with the Partnership’s investment capital alone. In addition, we earn management fees that are paid by the Funds for managing the Funds and the Fund’s timberland portfolios. Due to control features, as defined in accounting guidance, that result from our management of the Funds, the Funds are consolidated into our financial statements, resulting in the elimination of $2.4 million, $1.5 million, and $908,000 of management fee revenue in 2011, 2010, and 2009, respectively. These fees are eliminated through a corresponding decrease in operating expenses for the Fee Timber segment.
 
Operations. The TM&C segment’s key activity is to provide investment and timberland management services to the Funds and to other third-party timberland owners. We anticipate growth in this segment as we continue to manage the Funds, and any future funds successfully established by the Partnership. The TM&C segment represents 0%, 1% and 3% consolidated revenue for each of the years ended December 31, 2011, 2010 and 2009, respectively, after the elimination of the fees generated from asset and timberland management of the Funds.

The primary activity of this segment is the building and managing of diversified timberland portfolios for third-party investors and the Partnership. Management views this objective as the primary means of increasing the Partnership’s total timberland base, through our co-investment, while at the same time improving overall management economies of scale, limiting acquisition costs, and generating fee income. We earn annual asset management fees for managing this capital once timberland properties are acquired, annual timberland management fees, and log marketing fees based on harvest activity from the Funds’ tree farms. At the end of the fund term, if a fund achieves threshold return levels, we earn a carried interest incentive fee. As mentioned earlier, accounting guidance requires that all fees generated from managing the Funds are eliminated as a result of consolidation of the Funds into the Partnership’s financial statements. The elimination of these fees results in a decrease in the otherwise reported cost per acre of managing the Funds’ tree farms under our Fee Timber segment as well as eliminating the revenue generated from managing the Funds in the TM&C segment. An effect of these eliminations is to make the Fee Timber results look better and the TM&C results look correspondingly worse.

Fund I closed in August 2005 and has $58 million invested in two tree farms totaling 24,000 acres. Fund II closed in March 2009 and has $92 million invested in four tree farms for a combined total of 37,000 acres. In addition to the acquisition value of $150 million from the first two funds, we have capital commitments of $51 million for Fund III. We are currently raising capital for the final close of Fund III, as well as evaluating suitable timberland acquisitions for that fund.

In the past, this segment’s activities included the provision of forest management, acquisition, and disposition services to third-party timberland owners for a fee. These services generally have taken the form of a long-term management services contract, as well as specialized consulting assignments. The last of these agreements was terminated in July 2009 after a four-and-a-half year tenure. From the late 1990s through the termination of this agreement, the Partnership acted as manager on over 1.5 million acres of timberland in Washington, Oregon, California, and British Columbia. However, management considers such opportunities to be sporadic and difficult to predict, and does not include them in long-term planning for this segment.
 
 
9

 
 
Marketing. We market our private equity timber funds to accredited investors with an interest in investing alongside a manager with a specific regional specialization and expertise. Our Funds fill a unique niche among timberland investment management organizations due to our degree of co-investment, relatively small size, and regional specialization. Additional 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. Our 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. The Funds are the primary customers and users of TM&C services.

Competition. We compete against both larger and comparably sized companies providing similar timberland investment management services. There are approximately 22 established timberland investment management organizations competing against us in this business. The companies in this group have access to established sources of capital and, in some cases, increased economies of scale that can put us at a disadvantage. Our value proposition to investors is our long track record of success in the Pacific Northwest and our co-investment in each of the Funds.
 
Limitation on Expenditures. The 1997 amendment to Pope Resources’ Limited Partnership Agreement authorizing launch of the Investor Portfolio Management Business (“IPMB”) limits our cumulative net expenditures incurred in connection with the IPMB to $5.0 million including debt guarantees. As of December 31, 2011, cumulative expenditures incurred in pursuit of IPMB opportunities, including guarantees, were less than cumulative income generated. Therefore, cumulative net expenditures as of December 31, 2011 against the $5.0 million limit are zero.

Real Estate

Background. The Partnerships real estate activities are closely associated with the management of its timberlands. Management continually evaluates timberlands in terms of the best economic use, whether this means continuing to grow and harvest timber, seeking a rezone of the property for sale or development, or working with conservation organizations and the public on a sale. After timberland has been logged, management has a choice between four primary alternatives for the underlying land: reforest and continue to use as timberland, sell as undeveloped property, undertake some level of development to prepare the land for sale as improved property, or hold as property slated for later development or sale. Generally speaking, the Real Estate segment’s activities consist of investing in and later reselling improved properties, and holding properties for later development and sale. As a result, revenue from this segment tends to fluctuate substantially, and is characterized by relatively long periods in which revenue is relatively low, while expenses incurred to increase the value of the Partnership’s development properties may be higher. However, during periods of decreased demand, soft costs and infrastructure investment are minimized so as to minimize negative cash flows. When improved properties are sold, income is recognized in the form of sale price net of acquisition and development costs. The Partnership has a 2,800-acre portfolio of property for which management believes there to be a higher and better use than timberland.

Operations. Real Estate operations focus on maximizing the value of the Partnership’s real estate portfolio. For Real Estate projects, management secures entitlements and/or infrastructure necessary to make development possible and then sells the entitled property to a party who will construct improvements. In addition, this segment works to negotiate conservation easements (CE) that typically encumber Fee Timber properties to preclude land from future development. The third and final area of operations in this segment includes leasing residential and commercial properties in the Port Gamble townsite, and leasing of a commercial office building in Poulsbo. The Real Estate segment represents 8%, 11%, and 25% of consolidated revenue in 2011, 2010, and 2009, respectively.
 
 
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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 this portfolio vary considerably depending on the specific location and zoning of each parcel. This range extends from land that has commercial activity zoning where unit values are valued on a per-square-foot basis to large lots of recently cutover timberland where value is measured in per-acre terms. In general, value-adding activities that allow for the highest and best use of the properties include: working with communities and elected officials to develop grass roots support for entitlement efforts, securing favorable comprehensive plan designation and zoning, acquiring easements, and obtaining preliminary plat approvals.

Master planned communities in Gig Harbor, Kingston, and Port Gamble, Washington make up approximately 26% of the acres in our development property portfolio. During 2011, there were no sales generated from these projects although we did transfer 7-acres out of our Gig Harbor project to the City in exchange for waiving park impact fees on the residential portion of the project. Notwithstanding market inactivity, management believes the carrying values of the development properties do not require adjustment as the basis in each of these projects incorporates very low historic costs set at the time of the Company’s formation. Due to each 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.

Gig Harbor. Gig Harbor, a suburb of Tacoma, Washington, is the site of a mixed-use development project that includes a 16-acre retail/commercial site, 28 acres of business park lots, and 200 acres of land with residential zoning. In December 2008, management completed a preliminary plat submission for the 200-acre residential portion of this project that called for 554 single-family and 270 multi-family lots. A 20-year development agreement was approved in late 2010, followed by preliminary plat approval received in early 2011. Key provisions of the development agreement and plat approval include: (a) extending the project approval from 7 to 20 years; (b) reserving sufficient domestic water supply, sanitary sewer, and traffic trip capacity on behalf of the project’s 824 residential units; and (c) waiver of park impact fees in exchange for a 7-acre parcel of land for City park purposes. All components of this project have transportation, water and sewer capacities reserved for full build-out. Management has been in discussions with a number of different interested parties for sale of subsets of both the single- and multi-family portions of this project.

Bremerton. The West Hills area of Bremerton, Washington is the site of a 46-acre industrial park which is being developed in two phases that will result in a total of 24 lots. Construction on the 9 lots that make up phase I was completed in 2007. One lot has been sold from Phase I. At the completion of the sale of Phase I lots, infrastructure spending and marketing will commence for Phase II.

Kingston. The Partnership owns a 356-acre property in Kingston that is named “Arborwood” with plans for the development of 663 single-family and 88 multi-family lots. Final approval of a preliminary plat and a 15-year development agreement was completed in February 2010. Further development will not proceed until the market demonstrates an increased appetite for residential lots. The Partnership owns an additional 366 acres bordering this project, which has zoning for 5-acre lots.

Hansville. The Partnership owns a 149-acre residential development project in Hansville called “Chatham”, with 19 parcels ranging from 3 to 10 acres in size. Construction was completed in late 2007 and the lots are currently being marketed for sale. One lot was sold from this project in 2011.
 
 
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Port Ludlow. Port Ludlow represents a 256-acre property located just outside the Master Planned Resort boundary of Port Ludlow, Washington. In December 2008, a submission for plat approval was made to Jefferson County. Preliminary plat approval is expected in early 2012 and, if obtained, will allow for up to 54 lots ranging from 1 to 1.5 acres each, with the balance of the property designated as open space. Development beyond the point of plat approval will not commence until demand for rural residential lots improves.

Rural Residential. Management launched the Rural Lifestyles program to capitalize on higher-and-better-use real estate values. These properties are typically non-contiguous smaller lots 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. As is the case with much of the Real Estate portfolio, investments in the Rural Lifestyles program have been restricted to costs necessary to achieve entitlements, while deferring construction costs until such point in time when market conditions improve.

Commercial Properties
Poulsbo. In May 2011, the Partnership purchased a 30,000-square foot commercial office building in Poulsbo, Washington. The building has a long-term tenant with a five-year, triple net lease that began in late 2010. We are in the process of finalizing a sale of our current headquarters building in Poulsbo which, if consummated as anticipated in 2012, will result in the transfer of our headquarters location into a portion of the newly acquired Poulsbo building. This newly acquired building also contains additional square footage available for expansion as well as rental to third parties.

Port Gamble. The Partnership currently owns and operates the town of Port Gamble, Washington, northwest of Kingston on the Kitsap Peninsula. Port Gamble was designated a “Rural Historic Town” under Washington’s Growth Management Act 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. Operations at Port Gamble include commercial and residential lease activities, as well as the wedding and events business.

The Partnership’s antecedent, Pope & Talbot, Inc. (P&T), operated a sawmill at Port Gamble from 1853 to 1995. Starting in 2002, management worked both directly and indirectly through P&T to remedy environmental contamination at the townsite and millsite and to monitor results of the cleanup efforts. After contamination was discovered at the townsite, millsite, and in the adjacent bay, the Partnership entered into a settlement and remediation agreement with P&T pursuant to which both parties were allocated responsibility for cleanup costs. Under Washington law, both Pope Resources and P&T were “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. Following a series of actions under the U.S. Bankruptcy Code that began in 2007, P&T has been liquidated, leaving the Partnership as one of few potentially liable persons.

During 2011, the Department of Ecology (DOE) submitted the draft Baywide and Millsite Remedial Investigation (RI) and Feasibility Study (FS) reports for public comment. In response to feedback received during the public comment period, the DOE decided to perform additional testing and revise the RI/FS reports. The revised RI/FS reports are expected to be issued in the first half of 2012 and will be among the data that will inform a cleanup action plan anticipated to be filed with a consent decree later in 2012. The development of a cleanup action plan includes formalizing cost estimates and how costs will be shared between responsible parties, which will be reflected in the Partnership’s environmental remediation accrual liability where and when appropriate.
 
 
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Following a period of heavy rain in mid-December 2010, oil from some long-buried tanks surfaced on the millsite leading to a separate remediation effort at Port Gamble. The site was remediated and we received a “No Further Action” letter from the DOE during the third quarter of 2011 confirming we have no further obligations for the project.

           See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations – Real Estate – Environmental Remediation Costs.”

Marketing. Marketing efforts were limited given the soft markets for land and real estate.  Marketing related to Development Properties in 2011 was centered on residential, commercial, and industrial lands for sale through traditional brokerage and real estate listing services.  Commercial Properties marketing was designed to increase visitation to and exposure of Port Gamble, thereby boosting retail sales, which led to improved lease-up of the townsite’s commercial, industrial, and residential spaces.

Customers. Management typically markets properties from the Real Estate portfolio to private individuals, residential contractors, and developers of commercial property. Customers for rental space in the Port Gamble townsite consist of both residential and commercial tenants.

Competition. Development and Commercial Properties compete with local and regional peers that offer land for sale or property for lease.

Transportation. Land values for the Real Estate portfolio are strongly influenced by transportation options between the western side of Puget Sound where properties are located and the Seattle-Tacoma metropolitan corridor. Transportation options between these areas separated by bodies of water include the Tacoma Narrows Bridge or one of several car/passenger ferries. Ferry transportation within the 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.

Employees

           As of December 31, 2011, the Partnership employed 45 full-time, salaried employees and 3 part-time and seasonal personnel, who are distributed among the segments as follows:
 
Segment
 
Full-Time
 
Part-Time/
Seasonal
 
Total
Fee Timber
 
15
 
-
 
15
Timberland Management & Consulting
 
5
 
-
 
5
Real Estate
 
14
 
3
 
17
General & Administrative
 
11
 
-
 
11
Totals
 
45
 
3
 
48
 
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.
 
 
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Government Regulation
 
In the operation and management of its tree farms, the Partnership is subject to federal and state law. Washington’s Forest Practices Act, in effect since 1974, is among the most rigorous in the nation. In 2006, in concert with its Forest and Fish Law, Washington received a federal multi-species Habitat Conservation Plan (HCP) designation covering its forest regulations, meant to give timberland owners 50 years of regulatory stability. There is an adaptive management element to the HCP, where new scientific findings may result in some new or modified regulations which could result in increased costs, additional capital expenditures, and reduced operating flexibility.
 
In Oregon, the laws governing forest practices have the same objectives as in Washington, but lack both some of the rigor of Washington’s regulatory overlay and a counterpart to Washington’s HCP. Whereas in Washington there is a complex application process for forest practices that may take in excess of 30 days, in Oregon the landowner notifies the state of the landowner’s operational intentions, and the regulations are enforced as part of compliance oversight of ongoing operations rather than as part of the notification phase.
 
The following are indicative of potential changes to the regulatory climate that could affect forest practices in both states:
 
 
A revised Northern Spotted Owl Recovery Plan was made available to the public on June 30, 2011. According to the U.S. Fish and Wildlife Service (USFWS), “Recovery plans are guidance, not regulatory, documents and should be adaptable so that they can incorporate the best available information as new science emerges. In an effort to best incorporate new data and to most effectively implement the varied recovery actions, the USFWS developed multiple, collaborative implementation teams, management teams, and a scientific review panel. Team and work group members represent Federal agencies, the states, tribes, private industry, environmental organizations and academic institutions, and facilitate Recovery Plan implementation and recovery of the threatened spotted owl.” Regarding the role of private forests in the Plan, the USFWS states that “The revised plan does not lay out specific details on a role for non-federal lands in recovery. Rather, the USFWS recommends ongoing dialogue and collaborative decision-making with state agency partners and citizens as the best way forward.”  On February 29, 2012 the USFWS released its proposed critical habitat designation for the Northern Spotted Owl, doubling the amount of land across three states (Oregon, Washington, and California) so designated as critical habitat and for the first time including private forests.  Upon preliminary review of the proposal it appears that small portions of our Columbia and Fund I tree farms are included in the expanded habitat and we are undertaking to assess any impact on operations.  In the past, when this process was used for other species’ recovery plans, much of the initially included private land was later deleted as a result of public comment submitted during the 90-day review period that follows publication of the map.  In the instance of the bull trout, private land in Washington State was withdrawn from the recovery plan on the merits of the State’s HCP that adequately addressed protection of fish bearing streams in forest operations.  A similar outcome for spotted owl habitat on private lands is not certain, but possible.
 
 
A lawsuit in Oregon resulted in a ruling by the 9th Circuit Court of Appeals that water channeling structures such as culverts on logging roads are, in fact, point sources of pollution, with the potential impact of requiring an EPA discharge permit for each such structure, numbering millions of such permits across the nation. On December 12, 2011 the U.S. Supreme Court issued an order calling for the views of the U.S. Solicitor General on certiorari petitions filed by the state of Oregon and by the Oregon Forest Industry Council. The petitions asked the Supreme Court to review and reverse the 9th Circuit’s decision that storm water runoff from forest roads is a “point source” pollutant requiring a federal pollution discharge permit. This action is no guarantee that the Supreme Court will take the case, but indicates that the Court appreciates the significance of this case. The Solicitor General is expected to file his brief by mid-year 2012. Legislatively, several members of Congress are sponsoring a bill that may codify the “silvicultural exemption” to the Clean Water Act, which was effectively overturned by the 9th Circuit’s ruling. Although the initial attempt to push this bill through Congress failed, the same language was included in the Appropriations Bill that recently passed Congress and will stay the implementation of the 9th Circuit Court ruling until October, 2012, providing time to see if the Supreme Court will decide to hear the case.
 
 
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State budget shortfalls are affecting state regulatory agencies. We expect that states will impose new, or increase existing, fees for the conduct of forest practices.
 
Regulatory Structure. Growing and harvesting of timber is subject to numerous laws and government policies intended to protect public resources such as wildlife, water quality, 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 (GMA). 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.

Growth Management. Land holdings throughout Washington 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. Oregon also has growth management provisions in its land use laws which served as a model for Washington’s growth management provisions. Oregon's land use laws are generally more stringent outside of urban areas, especially in commercial forest lands where residential conversions are often outright disallowed.

Forest Management Practices. Forest practice regulations 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.

           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 Forests and Fish Law became the basis for revised forest practices rules and regulations. The Washington Forest Protection Association produced the Forest and Fish Report, which provided the basis for the Forests and Fish Law, through the collaborative efforts of Washington’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 of Washington.
 
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 a Forest Practices Habitat Conservation Plan (HCP) for Washington. This 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 meets the requirements for aquatic species designated by the federal Endangered Species Act.
 
 
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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 siltation of streams caused by roads, harvest operations and other management activities.  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.  In Washington, the Road Maintenance and Abandonment Planning (“RMAP”) section of the Forest Practices Rules and Regulations has been in place since 2001, under which all sedimentation problems associated with forest roads must be mitigated by 2015.  The Partnership is on schedule to complete the necessary work to meet the 2015 deadline, which will largely address the issue of non-point pollution consisting of sedimentation originating from the Partnership’s forest operations.  The mitigation process has been complicated by the 9th Circuit Court ruling that forest roads are point sources of pollution and will thus require discharge permits as discussed earlier.

The regulatory and non-regulatory forest management programs described above have increased operating costs and resulted in changes in the value of the Combined timberlands. Management does not expect to be disproportionately affected by these programs in comparison 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.
           
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, numerous 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.
 
RISK FACTORS
 
We are subject to statutory and regulatory risks that currently limit, and may increasingly limit, our ability to generate 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, events that focus media attention upon natural disasters and damage to timberlands have at various times brought increasing public attention to forestry practices. Additional regulations, whether or not adopted in response to such events, 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, particularly in the case of the Funds. Specific examples of such regulations are cited above on page 14 in our discussion of government regulation.
 
 
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Moreover, the value of our real estate investments, and our income from Real Estate operations, is 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 land entitlements 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 effect on our investments. These investments often are highly illiquid and thus may not generate cash flow if and when needed to support our other operations.
 
Consolidation of sawmills in our geographic operating area may reduce competition among our customers, which could adversely affect our log prices. In the past we have experienced, 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, which considers the Combined tree farms, 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, increase 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. Any such material adverse impact on timber revenue and income as a result of regional mill consolidations will also indirectly affect our Timberland Management & Consulting segment in the context of raising capital for investment in Pacific Northwest-based timber funds.
 
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 our operating area depends heavily on U.S. housing starts. Recent economic events have dramatically slowed U.S. housing starts, which has reduced demand for lumber. In addition, imported lumber from Canada and increasing market acceptance of engineered wood products have acted to hold down the price of lumber. To the extent the housing crisis continues the negative impacts on our operating results could continue. The export markets for Pacific Northwest logs are significantly affected by fluctuations in United States, Japanese and, increasingly, Chinese and Korean economies, as well as by the foreign currency exchange rate between these Asian currencies and the U.S. dollar, as well as ocean transportation costs.
 
We and our customers are dependent upon active credit markets to fund operations. We sell logs from our Fee Timber segment to mills and log brokers that in most circumstances rely upon an active credit market to fund their operations. Our Real Estate sales are also often dependent upon credit markets in order to fund acquisitions. To the extent the ongoing economic crisis exacerbates existing borrowing restrictions that impact consumer credit generally, we expect consumers to respond by reducing their expenditures, and those reductions may have the effect of directly reducing our revenues and of indirectly reducing the demand for our products. Any such outcomes could materially and adversely impact our results of operations, cash flows, and financial condition.

We may incur losses as a result of natural disasters that may occur, or that may be alleged to have occurred, on our properties. Forests are subject to a number of natural hazards, including damage by fire, hurricanes, insects and disease, and during periods of unusually heavy rain and snowmelt, flooding and landslides may damage homes and personal property. Changes in global climate conditions may intensify these natural hazards. Severe weather conditions and other natural disasters can also reduce the productivity of timberlands and disrupt the harvesting and delivery of forest products. While damage from natural causes is typically localized and would normally affect only a small portion of our timberlands at any one time, these hazards are unpredictable and losses might not be so limited. While management believes we follow sound forest management and risk mitigation procedures, and all forest operations meet or exceed the rules and regulations governing forest practices in Washington and Oregon, we cannot be certain that we will not be the subject of claims based on allegations that we acted improperly in managing our property. These claims may take the form of individual or class action litigation, regulatory or enforcement proceedings, or both. Any such claims could result in substantial defense costs and divert management’s attention from the ongoing operation of our business, and if any such claims were successful, may result in substantial damage awards, fines or civil penalties. Consistent with the practices of other large timber companies, we do not maintain insurance against loss of standing timber on our timberlands due to natural disasters.
 
 
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We have certain environmental remediation liabilities associated with our Port Gamble and former Port Ludlow resort properties, and those liabilities may increase. We currently own certain real estate at Port Gamble on the Kitsap Peninsula and, up until mid-2001, owned real estate property within the resort community of Port Ludlow in Jefferson County in western Washington. 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.
 
Management continues to monitor the Port Gamble and Port Ludlow cleanup processes closely. The $2.2 million remediation liability balance as of December 31, 2011 represents our best current estimate of the remaining cleanup cost and most likely outcome to various contingencies within both locations. Where possible, the Company records to the most likely point estimate within the range and when no point estimate within the range is better than another, the Company records to the low end of the range of possible outcomes. These liabilities are based upon a number of estimates and judgments that are subject to change as the project progresses. Statistical models have been used to estimate the liability for the aforementioned matters and suggest a potential aggregate range of loss of zero to $4.8 million which represents a two-standard-deviation range from the mean of possible outcomes generated by the modeling process used to estimate the liability.
 
We compete with a number of larger competitors that may be better able than we to absorb 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.

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 a change in tax law (or interpretation of current tax law) caused the Partnership to become subject to income taxes, operating results would be adversely affected. We also have three taxable subsidiaries.

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. 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 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. There were no expense reimbursements in 2011 while reimbursements for expenses in 2010 were less than $1,000.

 
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UNRESOLVED SECURITIES AND EXCHANGE COMMISSION COMMENTS

None

PROPERTIES

           The following table reconciles acreage owned as of December 31, 2011 to acreage owned as of December 31, 2010. As noted previously, we own 20% of the Funds, and this table includes the entire 61,000 acres of timberland owned by the Funds. Properties are typically transferred from Fee Timber to the Real Estate segment at the point in time when the Real Estate segment takes over responsibility for managing the properties with the goal of maximizing the properties’ value upon disposition.
 
(acres in thousands)
 
Timberland Acres by Tree Farm
 
Description
 
2010
   
Acquisitions
   
Sales
   
2011
 
                         
Hood Canal tree farm (1)
    70.5             (0.5 )     70.0  
Columbia tree farm (1)
    43.6                     43.6  
      Subtotal Partnership Timberland
    114.1       -       (0.5 )     113.6  
                                 
Fund I tree farms
    23.9                       23.9  
Fund II tree farms (2)
    37.2                       37.2  
      Subtotal Funds' Timberland
    61.1       -       -       61.1  
                                 
Total Fee Timber acres
    175.2       -       (0.5 )     174.7  
Total Real Estate acres (see detail below)
    2.8                       2.8  
Grand total acres
    178.0       -       (0.5 )     177.5  
                                 
(1) A subset of this property is used as collateral for the Partnership's long-term debt, excluding debt of the Funds.
(2) A subset of this property is used as collateral for Fund II's long-term debt.
 
 
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Real Estate Acres Detail
 
Project Location
 
2010
   
 Acquisitions
   
Sales
   
2011
 
                         
Gig Harbor
    251                   251  
Bremerton
    46                   46  
Kingston - Arborwood
    356                   356  
Kingston - 5-acre zoning
    366                   366  
Hansville
    152             (3 )     149  
Port Ludlow
    256                     256  
Port Gamble townsite
    167                     167  
Other Rural Residential
    1,242             (13 )     1,229  
Total
    2,836    
             -
      (16 )     2,820  
 
The following table provides dwelling unit (DU) per acre zoning for the Partnership’s owned timberland and development properties as of December 31, 2011 and land sold during 2011:
 
Current Real Estate Land Inventory by Zoning Category
   
2011 Sales from RE Portfolio
 
Zoning Designation
 
Acres
   
Acres
   
$/Acre
   
Total Sales
 
Urban zoning - residential
    587       2     $ 187,000     $ 374,000  
Urban zoning - commercial
    98                          
Historic Rural Town
    86                          
1 DU per 5 acres
    708                          
1 DU per 10 acres
    131                          
1 DU per 20 acres
    868       14       10,857       152,000  
1 DU per 40 acres
    45                          
1 DU per 80 acres
    251                          
Forest Resource Lands
    26                          
Open Space
    20                          
Total
    2,820       16     $ 32,875     $ 526,000  
 
LEGAL PROCEEDINGS
   
None.
   
MINE SAFETY DISCLOSURES
   
Not applicable.
 
 
20

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

           The Partnership’s equity securities are listed on NASDAQ and traded under the ticker symbol “POPE”. The following table sets forth the 2009 to 2011 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:
 
Year Ended December 31, 2009
 
High
   
Low
   
Distributions
 
 First Quarter
  $ 22.89     $ 15.61     $ 0.20  
 Second Quarter
    28.98       18.52       0.20  
 Third Quarter
    25.28       21.56       0.20  
 Fourth Quarter
    25.25       22.32       0.10  
Year Ended December 31, 2010
                       
 First Quarter
  $ 28.89     $ 23.32     $ 0.10  
 Second Quarter
    28.90       25.02       0.10  
 Third Quarter
    28.00       24.00       0.25  
 Fourth Quarter
    38.61       26.62       0.25  
Year Ended December 31, 2011
                       
 First Quarter
  $ 48.00     $ 35.02     $ 0.25  
 Second Quarter
    49.00       40.81       0.25  
 Third Quarter
    50.29       39.02       0.35  
 Fourth Quarter
    47.50       38.00       0.35  
 
Unitholders

As of February 3, 2012, there were 4,410,226 outstanding units, representing 263 holders of record. Units outstanding include 61,998 that are currently restricted from trading and that were granted to 16 holders of record who are either management employees or members of the managing general partner’s board of directors. The trading restriction for these units is lifted as the units vest. These restricted units vest over a four-year vesting schedule, either ratably over four years or 50% on the third anniversary of the grant date and the remaining 50% upon reaching the fourth anniversary.

Distributions

All cash distributions are at the discretion of the Partnership’s managing general partner, Pope MGP, Inc. (the “Managing General Partner”). During 2011, the Partnership made two quarterly distributions of 25 cents per unit and two of 35 cents per unit that totaled $5.3 million in the aggregate. In 2010, we made two distributions of 10 cents per unit and two of 25 cents per unit, totaling $3.2 million in the aggregate.

The improvement in log prices and return to more normal harvest levels after deferring considerable volume from 2008 to 2010 served to inform a $0.10, or 40% increase in quarterly distribution in the third quarter of 2011. This increase was on top of a $0.15, or 150%, increase in quarterly distribution in the third quarter of 2010 to 25 cents per unit. The Managing General Partner, in its discretion, determines the amount of the quarterly distribution and regularly evaluates distribution levels. The Partnership recognizes that current economic conditions warrant continued sensitivity to the stewardship of cash balances. As such, the quarterly determination of distribution amounts, if any, will reflect the expectations of management and the Managing General Partner for the Partnership’s liquidity needs.
 
 
21

 
 
Equity Compensation Plan Information

The Partnership maintains the Pope Resources 2005 Unit Incentive Plan, which authorizes the granting of nonqualified equity compensation in order to provide incentives to align the interests of management with those of unitholders. Pursuant to the plan, the Partnership issues restricted unit grants with vesting ranges between two and four years on the anniversary of the grant. The terms of these grants require that the grantee remain an employee as of the vesting date. As of December 31, 2011 there were 58,500 unvested and outstanding restricted units of which 29,750 units are scheduled to vest in 2012. Previously, the Partnership maintained the Pope Resources 1997 Unit Option Plan pursuant to which unit options were granted for purposes similar to the 2005 incentive plan. Upon the adoption of the 2005 Unit Incentive Plan, the Partnership ceased making further awards under the 1997 plan. As of December 31, 2011 there were fully vested options outstanding for the purchase of 5,500 units with a weighted average exercise price of $16.35. Additional information regarding equity compensation arrangements, including the new 2010 incentive compensation program, is set forth in Note 6 to Consolidated Financial Statements and Item 11 - Executive Compensation. Such information is incorporated herein by reference.

Repurchase of Equity Securities

In December 2008 we announced a unit repurchase plan pursuant to which the Partnership was authorized to repurchase limited partner units with an aggregate value of up to $2.5 million. Since that time, we have increased the aggregate value of units authorized for repurchase to $5 million and extended the repurchase plan to allow for repurchases through December 2012. As of December 31, 2011, there remained an unutilized authorization for unit repurchases of $2.5 million. There were no Partnership unit repurchases under this 2008 plan during 2011. On December 31, 2010, the Partnership repurchased 334,340 units from a single shareholder, outside the scope of the formal repurchase program, for $35.50 per unit (which excludes a $0.05 per unit commission paid on settlement).  The units represented 7.2% of the total units outstanding at that time and were retired.
 
Performance Graph

The following graph shows a five-year comparison of cumulative total unitholder returns for the Partnership, the Standard & Poor’s Forest Products Index and the Wilshire 4500 for the five years ended December 31, 2011. 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.
 
 
22

 
 
Chart
 
Issuance of Unregistered Securities

           The Partnership did not conduct any unregistered offering of its securities in 2009, 2010, or 2011.
 
 
23

 
 
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 audited consolidated financial statements and related notes included with this report.
 
(Dollars in thousands, except per unit data)
    Year Ended December 31,  
Statement of operations data
 
2011
   
2010
   
2009
   
2008
   
2007
 
Revenue:
                             
Fee Timber
  $ 52,729     $ 27,674     $ 14,847     $ 23,551     $ 35,514  
Timberland Management & Consulting
    -       31       601       944       1,344  
Real Estate
    4,545       3,487       5,030       3,683       15,037  
Total revenue
    57,274       31,192       20,478       28,178       51,895  
                                         
Operating income/(loss):
                                       
Fee Timber
    16,899       9,703       3,724       6,294       15,215  
Timberland Management & Consulting
    (1,515 )     (1,250 )     (375 )     (543 )     (883 )
Real Estate (1)
    (349 )     (809 )     1,663       (1,111 )     5,163  
   General and Administrative
    (4,188 )     (4,731 )     (3,733 )     (3,951 )     (4,782 )
Total operating income
    10,847       2,913       1,279       689       14,713  
                                         
Net income (loss) attributable to unitholders
  $ 8,754     $ 2,038     $ (272 )   $ 1,162     $ 15,508  
                                         
Earnings (loss) per unit – diluted
  $ 1.94     $ 0.43     $ (0.07 )   $ 0.23     $ 3.22  
                                         
Distributions per unit
  $ 1.20     $ 0.70     $ 0.70     $ 1.60     $ 1.36  
                                         
Balance sheet data
                                       
Total assets
  $ 230,408     $ 235,837     $ 187,080     $ 165,411     $ 148,550  
Long-term debt, net of current portion
    45,793       50,468       28,659       28,169       29,385  
Partners’ capital
    75,759       70,990       83,126       87,817       96,644  
Debt to total capitalization (2)
    33 %     37 %     26 %     25 %     24 %
 
(1)
Real Estate operating results in 2011, 2010, 2009, and 2007 included $977,000, $875,000, $30,000, and $1,878,000, respectively, of environmental remediation charges.
(2)
Debt-to-total-capitalization ratio is calculated with the numerator equal to long-term debt of the partnership plus 20% of the Funds’ debt, divided by the sum of the aforementioned numerator and Partner’s capital.
 
 
24

 
 
Free cash flow, a non-GAAP measure, provides users of financial statements an indication of liquidity and earnings performance. Since this measure starts with cash provided by 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.
 
(Dollars in thousands)
  Year Ended December 31,  
Free cash flow (3):
 
2011
   
2010
   
2009
   
2008
   
2007
 
Cash provided by operations (4)
  $ 21,660     $ 8,950     $ 662     $ 3,952     $ 12,113  
Plus:
                                       
Net (income) loss attributable to noncontrolling interests (5)
    (173 )     1,218       950       1,018       402  
Less:
                                       
Principal payments
    (30 )     (1,038 )     (1,418 )     (1,342 )     (1,481 )
Change in operating accounts and non-cash charges (6)
    (905 )     (3,295 )     (585 )     44       2,528  
Capital expenditures, excluding
                                       
     timberland acquisitions (7)
    (1,911 )     (941 )     (1,224 )     (1,715 )     (2,294 )
Free cash flow
  $ 18,641     $ 4,894     $ (1,615 )   $ 1,957     $ 11,268  
                                         
Other data
                                       
Acres owned/managed (thousands)
    178       175       150       405       430  
Fee timber harvested (MMBF)
    90       53       32       38       55  
 
(3)
Management considers free cash flow, a non-GAAP measure, 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 cash provided by operating activities.
(4)
In the third quarter of 2009, the Partnership changed its classification of cash flows to include real estate development capital expenditures within cash flows from operating activities. Prior to the end of the third quarter, these expenditures were reported within investing activities within the Partnership’s statement of cash flows. Presentation of prior periods has been revised for consistent treatment of these expenditures for all periods presented.
(5)
Backs out the impact of the Funds and IPMB on Pope Resources’ free cash flow.
(6)
Non-cash charges exclude cost of land sold, depletion, depreciation and amortization, and capitalized development activities.
(7)
Fund II acquired 25,000 and 12,000 acres of timberland in 2010 and 2009, respectively, and the Partnership acquired 1,180 acres of timberland in 2008. Fund I acquired 24,000 acres of timberland in 2006. The cost of these acquisitions was not included in the calculation of free cash flow.  In addition, $3.2 million to acquire a Poulsbo, WA commercial office building in 2011 is also excluded.
 
 
25

 
 
MANAGEMENTS 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 managements 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. Some of the issues that may have an adverse and material impact on our business, operating results and financial condition include economic conditions that affect consumer demand for our products and the prices we receive for them both domestically and overseas, particularly in certain parts of Asia; government regulation that affects our ability to access our timberlands and harvest logs from those lands; the implications of significant indirect sales to overseas customers, including currency translation, regulatory and tax matters; the effect of financial market conditions on our investment portfolio and related liquidity; environmental and land use regulations that limit our ability to harvest timber and develop property; access to debt financing by our customers as well as ourselves; the impacts of climate change and natural disasters on our timberlands and on surrounding areas; and the potential impacts of fluctuations in foreign currency rates as they affect demand for our products and customers’ ability to pay. From time to time we identify other risks and uncertainties 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), is 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 the Funds. Operations in this segment consist of growing timber to be harvested as logs for sale to export brokers and domestic manufacturers. The second most significant business segment 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 selling larger parcels to buyers who will take the land further up the value chain, either to home buyers or to operators and lessors of commercial property. Since these land projects span multiple years, the Real Estate segment may incur losses for multiple years while a project is developed, and will not recognize operating income until that project is sold. In addition, within this segment we sometimes negotiate and sell conservation easements (CE’s) on Fee Timber properties to preclude future development. Our third business segment, which we refer to as Timberland Management & Consulting (“TM&C”), is raising and investing capital from third parties for private equity timber funds, and thereafter managing those funds for the benefit of all investors.

Our current strategy for adding timberland acreage is centered on our private equity timber fund business model, which consists of raising investment capital from third-party investors and investing that capital, along with our own co-investment, into new timberland properties. We have raised two timber funds that have acquired a combined $150 million of timberland properties. Our 20% co-investment in the first two Funds, which totals $28 million, affords us a share of the Funds’ distributed operating cash flows while allowing us to earn asset management and timberland management fees as well as incentive fees based upon the overall success of each fund. Management also believes that this strategy allows us to maintain more sophisticated expertise in timberland acquisition, valuation, and management than could be cost-effectively maintained for the Partnership’s timberlands alone. We believe our co-investment strategy also boosts our credibility with existing and prospective investors by demonstrating that we have both an operational as well as a financial commitment to the Funds’ successes. We are in the process of raising a third fund with a target total Fund III size of $100 million. To date, we have closed on $51 million of committed capital for Fund III, $7 million of which represents our co-investment. The Funds are consolidated into our financial statements, with the income attributable to equity owned by third parties reflected in our Consolidated Statement of Operations under the caption “Net (income) loss attributable to noncontrolling interest-ORM Timber Funds.”
 
 
26

 
 
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 attributes such that the respective product prices in each market 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. We do not manufacture lumber, but the price of finished lumber affects the demand and pricing for logs. Although the lumber market is volatile, it can provide considerable information about trends that will affect our harvest decisions. Log markets are affected by what is happening in the spot lumber markets, but pricing shifts typically adjust monthly or quarterly rather than daily. Log price volatility is also moderated because logs are used to produce products besides lumber (especially pulp). The market for timberland tends to be even less volatile, with pricing changes that lag behind both lumber and log markets. This is largely a function of the longer time horizons utilized by timberland investors, where the short-swing fluctuations of log or lumber prices are moderated in acquisition modeling. We monitor the lumber market because activity there can presage log price changes. We are constant participants in the log market as we negotiate delivery prices with 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.

Land held for sale in western Washington by our Real Estate segment is suitable primarily for residential and commercial building sites. The markets for these products have recently suffered along with regional and national markets, producing a decline in our sales. The challenges of our Real Estate segment center around how and when to “harvest” a parcel of land and capture the optimum value increment by selling the property, balancing the long-term risks of carrying and developing a property against the potential for income and positive cash flows upon sale

Our revenue, net income and cash flows increased in 2011 from 2010 and 2009 primarily as a result of increased demand for logs in China. Markets for logs in Japan and Korea were stable for most of this period, with renewed strength in late 2011 from Japan. Increased export lumber demand from China also contributed indirectly by helping our sawmill customers increase lumber exports at a time when domestic lumber demand is still soft due to depressed housing markets. Macroeconomic factors that reflect or influence the health of the U.S. housing market and have a bearing on our business revolve around employment growth, tight credits markets, and the supply of foreclosed homes. These factors resulted in exceedingly low housing starts in 2009, 2010 and 2011, which negatively impacted our revenues, net income and cash flow. While these macroeconomic factors did not materially improve in 2011, their impact in 2011 on our business was overshadowed by the strength of log export markets.
 
Currency exchange rates and ocean freight rates influence the competitiveness of our logs in Asian export markets as well as the competitiveness of our domestic sawmill customers in the context of their Asian lumber exports relative to imported lumber from Canada, Europe, or the Southern Hemisphere. We sell our export logs to domestic intermediaries who then export the logs. Exchange rates impact the ability of these intermediaries to compete in Asian markets with logs that originate from Canada, Russia, or the Southern Hemisphere. In 2011, the U.S. dollar weakened against the Canadian, Australian and New Zealand dollars, the Japanese yen and Korean won, and Russian ruble. This relative currency weakness increased the attractiveness of our logs to Asian markets.
 
 
27

 
 
Our consolidated revenue in 2011, 2010, and 2009, on a percentage basis by segment, was as follows:

Segment
 
2011
   
2010
   
2009
 
Fee Timber
    92 %     89 %     72 %
Timberland Management & Consulting
    - %     - %     3 %
Real Estate
    8 %     11 %     25 %
 
Additional segment financial information is presented in Note 11 to the Partnership’s Consolidated Financial Statements included with this report.

Outlook

Remaining harvest volume deferred from prior years totaled 34 MMBF as of December 31, 2011 and provides us the flexibility to respond to strength in log markets by increasing our harvest level above our current planned harvest level for 2012 of 75-85 MMBF, which includes 28 MMBF from the Funds. Export log markets are expected to provide continued price support until the domestic market recovers. Log markets in early 2012 have slowed compared to the demand seen in the fourth quarter of 2011, but are showing signs of improvement.

We expect some improvement in operating results for our Real Estate segment with anticipated closings of properties in 2012.

General & Administrative costs in 2012 are expected to be comparable to 2011.
 
RESULTS OF OPERATIONS

The following table reconciles net income (loss) attributable to unitholders for the years ended December 31, 2011 to 2010 and 2010 to 2009. In addition to the table’s numeric analysis, the explanatory text that follows describes many of these changes by business segment.
 
 
28

 
 
YEAR TO YEAR COMPARISONS
(in thousands)
             
   
2011 vs. 2010
   
2010 vs. 2009
 
             
   
Total
   
Total
 
Net income (loss) attributable to unitholders:
           
2011 period
  $ 8,754        
2010 period
    2,038     $ 2,038  
2009 period
            (272 )
   Variance
  $ 6,716     $ 2,310  
                 
Detail of earnings variance:
               
Fee Timber
               
Log price realizations (A)
  $ 7,306     $ 4,028  
Log volumes (B)
    18,076       8,421  
Depletion
    (6,589 )     (3,168 )
Production costs
    (9,254 )     (2,905 )
Other Fee Timber
    (2,343 )     (397 )
Timberland Management & Consulting
               
Third-party management fees
    -       (531 )
Other Timberland Management & Consulting
    (265 )     (344 )
Real Estate
               
Land and conservation easement sales
    554       (1,199 )
Environmental remediation liability
    (102 )     (845 )
Timber depletion on HBU sale
    (150 )     6  
Other Real Estate
    158       (434 )
General & administrative costs
    543       (998 )
Net interest expense
    (540 )     (137 )
Debt extinguishment costs
    1,250       (113 )
Noncontrolling interest
    (1,391 )     268  
Other (taxes, investment related)
    (537 )     658  
Total change in earnings
  $ 6,716     $ 2,310  
 
(A) Price variance calculated by extending the change in average price realized by current period volume.
(B) Volume variance calculated by extending change in sales volume by the average log sales price for the
  the comparison period.
 
 
29

 
 
Fee Timber

Revenue and Operating Income

Fee Timber results include operations from 114,000 acres of timberland owned by the Partnership and 61,000 acres of timberland owned by the Funds. Fee Timber revenue is earned primarily from the harvest and sale of logs from these timberlands which are located in western Washington and northwestern Oregon and, to a lesser extent, from the ground leases for cellular communication towers, gravel mines and quarries, together with the sale of other resources from our timberlands. Our Fee Timber revenue is driven primarily by the volume of timber harvested and the average log price realized on the sale of that harvested timber. Fee Timber expenses, which consist predominantly of depletion, harvest and transportation costs, vary directly and roughly proportionately with harvest volume and the resulting revenues. Revenue and costs related to harvest activities on timberland owned by the Funds are 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, 2011, are as follows:
 
(in millions)
Year ended
 
Log Sale
Revenue
   
Mineral, Cell
Tower & Other
Revenue
   
Total Fee
Timber
Revenue
   
Operating
Income
(Loss)
   
Harvest
Volume
(MMBF)
 
Pope Resources Timber
  $ 29.5     $ 1.5     $ 31.0     $ 13.6       50.7  
Timber Funds
    21.6       0.1       21.7       3.3       39.5  
Total Fee Timber 2011
  $ 51.1     $ 1.6     $ 52.7     $ 16.9       90.2  
                                         
Pope Resources Timber
  $ 20.7     $ 1.6     $ 22.3     $ 9.5       42.3  
Timber Funds
    5.1       0.3       5.4       0.2       10.7  
Total Fee Timber 2010
  $ 25.8     $ 1.9     $ 27.7     $ 9.7       53.0  
                                         
Pope Resources Timber
  $ 13.3     $ 1.5     $ 14.8     $ 4.0       32.5  
Timber Funds
    -       -       -       (0.3 )     -  
Total Fee Timber 2009
  $ 13.3     $ 1.5     $ 14.8     $ 3.7       32.5  
 
Fiscal Year 2011 compared to 2010. Fee Timber revenue and operating income increased $25.0 million and $7.2 million, respectively, in 2011 from 2010. The increases were the result of a 70% increase in harvest volume from 2010 to 2011 in addition to an $81/MBF, or 17%, increase in average realized log price. The harvest volume increase reflects our response to the improvement in the export market that began in 2010 and continued through 2011. We harvested 27 MMBF more than the 2011 planned harvest of 63 MMBF in response to stronger export markets. This additional volume was only a portion of the deferred volumes that accumulated during the years 2008-2010 on the Combined tree farms when we held back on harvesting due to very weak markets. The export market to China was the driving force for increases in log prices as the China market purchased logs typically directed to domestic sawmills. The operating income increase was relatively smaller than the revenue increase as a result of a higher proportion of harvest from the Funds and the corresponding higher depletion expenses that come with newly acquired properties.  In addition, we experienced increased road maintenance costs, which grew from $812,000, or 21%, of Combined tree farm operating expenses in 2010 to $2.4 million, or 41%, of Combined tree farm operating expenses in 2011 as roads were being prepared for higher levels of future harvest operations.
 
Revenue and operating income for the Funds increased $16.5 million and $3.1 million, respectively, from 2010 to 2011. A nearly fourfold increase in harvest volume coupled with a $78/MBF, or 16%, increase in log price were the factors responsible for the increases. The increase in income for the Funds was less dramatic than the increase in revenue would suggest because of the high depletion rates on Fund properties in addition to a $1.1 million increase in road maintenance costs from 2010 to 2011.
 
 
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Fiscal Year 2010 compared to 2009. Revenue and operating income increased in 2010 from 2009 due to a 63% increase in harvest volume and a $76/MBF, or 19%, increase in log prices. Harvest volume increased as both export log markets strengthened relative to 2009 and new export lumber markets to China emerged. The planned harvest for 2010 was 32 MMBF from the Partnership timberlands and no harvest from the Funds, however we responded to improved export and domestic market conditions by harvesting more volume from both ownerships.
 
We deferred harvesting from each of the Funds’ tree farms in 2009 and the first quarter of 2010 in anticipation of weak log markets. However, we began harvesting from the Funds’ tree farms during the second quarter of 2010 in response to improvements to domestic and export log markets and continued harvesting through the end of year to take advantage of higher prices. We harvested 11 MMBF from the Funds’ tree farms in 2010 compared to no harvest in 2009. The Funds collectively generated revenue of $5.4 million in 2010 compared with $28,000 of revenue in 2009. The 2010 operating income of $166,000 for the Funds is a $460,000 improvement over 2009’s operating loss of $294,000 as a result of a 10.7 MMBF increase in harvest volume and a small Fund I land sale in 2010. Fund operating income as a percentage of revenue reflects the high basis relative to the historic Partnership timberlands and, as a result, higher depletion expense than the Partnership timberlands.
 
Log Volume

Log volume sold for each year in the three-year period ended December 31, 2011 was as follows:
 
Volume (in MMBF)
 
2011
   
% Total
   
2010
   
% Total
   
2009
   
% Total
 
Sawlogs
                                   
Douglas-fir
    55.2       61 %     35.0       66 %     22.4       69 %
Whitewood
    18.0       20 %     7.1       13 %     1.1       3 %
Cedar
    1.4       1 %     0.9       2 %     0.8       2 %
Hardwoods
    2.4       3 %     0.9       2 %     0.8       3 %
Pulpwood
                                               
All Species
    13.2       15 %     9.1       17 %     7.3       23 %
Total
    90.2       100 %     53.0       100 %     32.5       100 %
 
Fiscal Year 2011 compared to 2010. Harvest volume increased by 37 MMBF, or 70%, from 2010 to 2011 with 29 MMBF, or 77%, of that increase attributable to a boost in Fund harvest. A large percentage of the Funds’ previously deferred volume was harvested in 2011 to take advantage of favorable pricing. This elevated the Funds’ share of Combined volume mix from 20% in 2010 to 44% in 2011. As described above, the twin decisions to accelerate harvest from both the Partnership’s and Funds’ tree farms came in response to demand from China that took hold during 2010 and continued through 2011. The shift in year-to-date Combined species mix that saw whitewood volume increase from 13% in 2010 to 20% in 2011, primarily at the expense of Douglas-fir volumes which declined to 61% in 2011 from 66% in 2010, can be attributed to the incremental China export demand, which is largely indifferent to species mix. Since the incremental increase in whitewood log prices greatly exceeded the lift in Douglas-fir prices, and we expected that this surge in whitewood prices would be short-lived, we emphasized the harvesting of timber stands with whitewood as the predominant species. This emphasis played well into boosting harvest volumes from the Funds’ tree farms where the inventory has a heavier whitewood component. Our cedar and hardwood volumes are minor components of the overall mix and they stayed relatively consistent year over year, while pulpwood saw a slight decline from 2010 to 2011, even as pulpwood prices rose 23% from 2010 to 2011.
 
 
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Fiscal Year 2010 compared to 2009. Harvest volume increased by 21 MMBF, or 63%, from 2009 to 2010. Strong Chinese export markets, and to a lesser extent Korean markets, prompted our decision to increase harvest volume above 2009’s level. This strong export market has helped support domestic sawlog prices despite a soft domestic lumber market as domestic sawmills have had to increase log prices to compete for volume diverted to export markets. Many of our sawmill customers are able to afford higher log prices due to the emergence of a new export lumber market in China, for which many of these customers are producing a significant proportion of their overall lumber volume. Log volumes harvested in 2009 included a higher proportion of pulpwood due to our decision to focus harvest on lower quality timber stands to conserve higher value sawlog volume for better future market conditions.

Log Prices

Logs from the Combined tree farms serve a number of different domestic and export markets, with domestic mills historically representing our largest market segment. During the fourth quarter of 2010 and through 2011, however, logs destined for export markets represented the largest share of our total log sales, as the China market accepted lower quality than what has traditionally defined an export log. As a result, virtually all of what used to be sold to domestic mills instead flowed to the China market during this period. Beginning in the middle of 2010 and through most of 2011, the relative strength of the China export market has been a driving force for much of our log pricing. In contrast to the Japan export market that has historically consisted of the top end of the quality spectrum with a particular preference for Douglas-fir, the China market not only accepts a log quality that is comparable to that which typically goes to the domestic market but is also relatively indifferent as to softwood species.

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 two-year period ended December 31, 2011 was as follows:
 
     
Fiscal Year
 
           
∆ from 2010 to 2011
 
 
     
2011
   
$/MBF
   
%
   
2010
 
       Sawlogs
Douglas-fir
  $ 609     $ 81       15 %   $ 528  
 
Whitewood
    546       100       22 %     446  
 
Cedar
    923       6       1 %     917  
 
Hardwood
    573       71       14 %     502  
       Pulpwood
All Species
    383       72       23 %     311  
       Overall
      567       81       17 %     486  
                                   
 
The 2011 average log price increased $81/MBF, or 17%, over the 2010 average log price. This was principally due to a $102/MBF, or 19%, year-over-year increase in export price in addition to a $100/MBF, or 22%, increase in whitewood prices, and a $72/MBF, or 23%, increase in pulpwood prices. We targeted some stands with a heavier mix of pulpwood during 2011 to take advantage of this uptick in price which was driven by short supplies of residual chips due to a decline in lumber produced from domestic sawmills.
 
     
Fiscal Year
 
           
∆ from 2009 to 2010
 
 
     
2010
   
$/MBF
   
%
   
2009
 
       Sawlogs
Douglas-fir
  $ 528     $ 93       21 %   $ 435  
 
Whitewood
    446       137       44 %     309  
 
Cedar
    917       100       12 %     817  
 
Hardwood
    502       56       13 %     446  
       Pulpwood
All Species
    311       15       5 %     296  
       Overall
      486       76       19 %     410  
                                   
 
 
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The overall log price realized in 2010 increased $76/MBF, or 19%, compared to 2009, primarily due to the same export/domestic market dynamics mentioned above. In addition, the 2009 average log price reflected a high percentage of low value pulpwood compared to that seen in 2010’s totals, 23% vs. 17%, respectively. Notwithstanding the overall improvements in year-over-year average log prices from 2009 to 2010, the increase was not sufficient to recover the $96/MBF decline in the average price between 2008 and 2009.

Douglas-fir: Douglas-fir is noted for 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 have historically been very dependent upon the level of new home construction in the U.S. Douglas-fir log prices realized in 2011 reflect some softening of this direct link between Douglas-fir sawlog prices and domestic housing starts offset by a dramatic increase in demand from China for various species of softwood sawlogs and a continuing demand from Japan for the highest grades of Douglas-fir logs. Douglas-fir prices increased $81/MBF, or 15%, when comparing 2011 to 2010, due primarily to strong export markets.
 
The rally in Douglas-fir sawlogs prices from the lows of 2008 and 2009 began in early 2010 with participants in the domestic supply chain for lumber increasing demand for logs in response to declining inventories. This increase in domestic demand coincided with an increase in export market demand from China, and to a lesser extent Korea. The aforementioned lumber inventory issue was largely addressed by domestic producers in the first quarter of 2010 and with the continued softness in housing starts, we saw sawmills quickly return in the second quarter to lower production levels. There was, however, continued strength in the export market to China which created competition for Douglas-fir sawlogs and other softwood species. The 2010 price realized on Douglas-fir sawlogs was up $93/MBF, or 21%, from 2009 as a result of the aforementioned competition between domestic mills and export markets. The two-year $174/MBF, or 40%, increase in Douglas-fir log price more than reversed the $102/MBF, or 19%, decline in price from 2008 to 2009.

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. Historically, there has been a modest export market for whitewood logs, with most of this volume going to Korea. This changed during 2010 and continued through 2011, as the China market sustained its appetite for softwood logs, with little apparent regard or discrimination as to species. To the extent we were able to access whitewood stands, we harvested this species preferentially to take advantage of its higher relative price lift resulting from surging export demand. This strategy benefitted the Funds’ tree farms more than the Partnership tree farms because the former contain a higher proportion of whitewood and the Partnership’s whitewood stands tend to be at higher elevations and not easily accessible during winter. In 2011, whitewood prices increased $100/MBF, or 22%, from 2010 due to the export demand for this species. The price realized on whitewood sawlogs in 2010 was up $137/MBF, or 44%, versus 2009, also driven by the relative strength in the export log markets in 2010 compared to 2009. Even more pronounced than the two-year improvement noted above for Douglas-fir, the realized price for whitewoods in 2011 was $237 per MBF, or 77% higher than 2009’s average realization of $309 per MBF.

Cedar: Cedar is a minor component in most upland timber stands and is generally used for outdoor applications such as fencing, siding and decking. Although there is a link between demand for these products and housing starts, this link is not as strong as with most other softwood species. Cedar prices remained flat, increasing $6/MBF, or 1%, from 2010 to 2011. A small spike in demand from buyers in 2010 helped drive a $100/MBF, or 12%, increase in cedar prices over 2009.

Hardwood: “Hardwood” can refer to many different species, but on our tree farms, hardwood stands primarily consist of red alder. The local mills that process red alder sawlogs are using the resource to manufacture lumber for use in furniture and cabinet construction. Hardwood prices increased $71/MBF, or 14%, in 2011 over the prior year. This was on top of a $56/MBF, or 13%, year-over-year increase from 2009 to 2010 in response to the continued demand for lumber, which came at a time when some mills had relatively low inventories in 2010.
 
 
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Pulpwood: Pulpwood is a lower quality log of any species that is manufactured into wood chips. These chips are used primarily to make a full range of pulp and paper products from unbleached linerboard (used in paper bags and cardboard boxes) to fine paper and specialty products. The pulpwood market has enjoyed relative strength in recent years as a direct result of sawmills taking significant downtime in response to the slowdown in housing starts. Sawmills typically provide the bulk of the chips used by pulp manufacturers, so curtailed sawmill production helped to push up the price of pulpwood logs sold directly to pulp mills as a primary alternative raw material source. During 2011, pulpwood prices increased $72/MBF, or 23%, when compared to 2010. This compares to 2010, when pulpwood prices were up $15/MBF, or 5%, compared to 2009.

Customers

The export market for logs in the Pacific Northwest has been migrating over the last couple of years from a market highly focused on Japan to a market that includes more volume to China and Korea. During the third quarter of 2010, China eclipsed Japan as the largest export log destination from the Pacific Northwest. The Japan market historically required a higher quality log relative to the domestic U.S. market, and is willing to pay a premium for such logs. Under this historical pattern, domestic U.S. sawmills and export customers in Japan had complementary segments of the market. Due to the lower valued end-uses of products manufactured in China and Korea, including concrete forms and pallets, these log markets tend to seek the full complement of domestic and export sorts, as well as a broader range of species such as whitewoods, from the Pacific Northwest. The resultant lower average sawlog quality and more diverse species mix flowing to China and Korea has resulted in a narrowing of the export premium received for sales of logs into these markets. Combined with a higher absolute demand for export logs, this new and broadened source of demand for sawlogs in the Pacific Northwest is expected to continue to exert pricing pressure on domestic mills that have been competing with these offshore sources of demand for Pacific Northwest sawlogs. These new outlets for lower quality logs have helped to diversify our customer mix away from domestic mills that are more heavily dependent on the U.S. home building market.
 
The ultimate decision on where to sell logs is based on the net proceeds we receive after considering the delivered log prices from a prospective customer offset by the hauling cost needed to get logs to that customer. In instances where harvest operations are in close proximity to a mill relative to the export yard of a broker, we will take advantage of favorable haul costs over selling to an export customer whose yard may be a greater distance from a harvest unit. The higher net delivered log value earned by selling to the domestic mill will, in such instances, result in sales of logs originally intended for Asia being diverted to domestic markets. As such, delivered log price movements are influenced by marketing decisions predicated on a net return rather than merely focusing on the delivered log price.

Annual harvest volume and average price paid each year in the three-year period ended December 31, 2011 was as follows:
 
   
2011
   
2010
   
2009
 
Destination
 
Volume
   
%
   
Price
   
Volume
   
%
   
Price
   
Volume
   
%
   
Price
 
Export brokers
    40.6       45 %   $ 628       17.7       33 %   $ 526       4.9       15 %   $ 581  
Domestic mills
    36.4       40 %     565       26.2       50 %     520       20.2       62 %     410  
Pulpwood
    13.2       15 %     383       9.1       17 %     311       7.3       23 %     296  
Total
    90.2       100 %   $ 567       53.0       100 %   $ 486       32.5       100 %   $ 410  

 
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Fiscal Year 2011 compared to 2010. Export brokers purchased 45% of total year-to-date volume compared to 33% during the same period in 2010. In addition, export brokers increased the price they paid by $102/MBF, or 19%, on a year-over-year basis. Nearly all of this increase in volume came at the expense of domestic mills, which purchased 40% of our mix in 2011 compared to 50% in 2010. Notwithstanding the loss in total volume purchased, domestic mills increased prices paid by $45/MBF, or 9%, in an effort to compete with export brokers for logs being sold to the export market. Pulpwood buyers saw a slight decline in logs sold in 2011 compared to the same period in 2010, notwithstanding a $72/MBF, or 23% price increase during the same period. This price increase reflects higher pulp mill demand for whole log chips resulting from sawmill production curtailments

Fiscal Year 2010 compared to 2009. Logs sold to export brokers increased to 33% from 15% of volume in 2010 and 2009, respectively, while volume sold to domestic mills declined to 50% from 62% in 2010 and 2009, respectively. This is a direct result of volume diverted to the Chinese and Korean export markets. Export volumes generated a $61/MBF, or 10%, price decrease as a result of the shift from high-quality and high-priced logs sold to Japan in 2009 versus lower quality logs sold into Chinese and Korean markets in 2010. Logs sold to domestic mills increased in price by $116/MBF, or 28%, as domestic mills competed for log volume with the Chinese and Korean export markets. As a percentage of overall volume, we delivered fewer logs to the pulpwood market in 2010 compared to 2009, although prices increased $15/MBF, or 5%. As discussed earlier, this was a result of harvesting lower quality timber in 2009 with a higher proportion of pulpwood to preserve higher quality sawlogs for a later time when markets improved.

Another way to look at the impact of these growing export markets is to combine the domestic and export log volumes, which increased $155/MBF, or 35%, in value between 2009 and 2011, from $443/MBF in 2009 to $598/MBF in 2011. This more than offset the 19% decline in value between 2008 and 2009 of these combined export and domestic log volumes, which declined from $545/MBF in 2008 to $443/MBF in 2009.  This decline between 2008 and 2009 would have been much steeper had we not had access to these higher levels of export log demand in China and Korea. The combined export and domestic log volumes increased $53/MBF, or 10%, over the four-year period from 2008-2011 from $545/MBF to $598/MBF in 2011.

Harvest Volumes and Seasonality

The Partnership owns 114,000 acres of timberland in western Washington and the Funds own collectively 61,000 acres of timberland in western Washington and western Oregon. We are able to conduct year-round harvest activities on the Hood Canal tree farm and on 12,000 acres of the Funds’ properties because these properties are concentrated at low elevations. In contrast, the Columbia tree farm and the 49,000-acre balance of the Funds’ properties are at a higher elevation where harvest activities are generally not possible during the winter months when snow precludes access to the lands. Generally, we concentrate our harvests from the Hood Canal tree farm in those months when weather limits operations on other properties, thus taking advantage of reduced competition for log supply to our customers and improving prices realized. As such, when these various tree farms are combined, we can operate so that the pattern of quarterly volumes harvested is flatter than would be the case if looking at one tree farm in isolation.

The percentage of annual harvest volume by quarter for each year in the three-year period ended December 31, 2011 was as follows:
 
 
Year ended
    Q1       Q2       Q3       Q4  
2011
    34 %     21 %     13 %     32 %
2010
    22 %     27 %     30 %     21 %
2009
    27 %     22 %     20 %     31 %
 
We entered 2011 with momentum from the burgeoning Chinese export market that began in earnest in the second half of 2010. As the first quarter progressed, we moved quickly to further ramp up harvest activity to meet the demand from our export customers. We were poised for a seasonal second quarter slow-down that did not come to fruition until the third quarter. We experienced another spike in demand during the final quarter of the year, wherein we cut nearly a third of the annual volume in response to that demand.
 
 
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We entered 2010 with a plan to defer harvest volume in response to our expectation of continued weakness in log markets resulting from a slowdown in housing. That plan called for no harvest from the Funds. However, as the year progressed and export and domestic markets showed improvement, we gradually increased harvest volume commensurate with the increase in demand, which for us hit its peak in the third quarter. By the third quarter of 2010, we had gained confidence in the impact of the China log market and added volume to meet the surges in export and domestic demand.

In 2009, our harvest was weighted to the first and fourth quarters to take advantage of higher seasonal prices. For 2009, we pushed more than the usual amount of our harvest into the fourth quarter to take advantage of an uptick in market demand and increased prices driven by depleted inventories throughout the supply chain.

The following factors enhance our flexibility in responding to fluctuating markets, whether these fluctuations are seasonally driven or not: we do not own any mills or processing facilities that require a minimum volume furnish; low focus on quarterly earnings fluctuations as a result of our thinly traded and followed security; and our practice of permitting excess harvest units so that we have a ready pool of potential harvest units to draw on for expanded market demand.

Cost of Sales

Cost of sales for the Fee Timber segment consists of harvest and haul costs and depletion expense. Harvest, haul, and depletion expenses all vary directly with actual harvest volume. Harvest costs will vary by terrain, with steeper slopes requiring more expensive cable systems with a high labor component, while more moderate slopes can be harvested with mechanized equipment and lower relative labor costs. Harvest and haul costs represent the direct cost incurred to convert trees into logs and deliver those logs to the point of sale. Depletion expense represents the cost of acquiring or growing the harvested timber. The applicable depletion rate is derived by dividing the aggregate cost of timber, together with capitalized road expenditures, by the estimated volume of merchantable timber available for harvest at the beginning of that year. The depletion rate is applied to the volume harvested in a given period to calculate depletion expense for that period. Readers should note that, because of the relatively recent acquisition dates, and thus relatively higher acquisition costs, of the Funds’ tree farms, the depletion rates associated with harvests from those properties is considerably higher than for harvests from the Partnership’s tree farms. 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 35-years-and-older merchantable timber

Each year, the depletion rate is adjusted to account for “layers” of harvest volume exiting the pool and new “layers” of 35-year old timber volume and cost entering the pool. The depletion rate is then applied to future volume harvested to calculate depletion expense.

Fee Timber cost of sales for each year in the three-year period ended December 31, 2011 was as follows:
 
($ in millions)
 
Harvest, Haul
         
Total Cost
   
Harvest Volume
 
Year ended
 
and Other
   
Depletion
   
of Sales
   
(MMBF)
 
2011
  $ 18.2     $ 11.8     $ 30.0       90.2  
2010
    8.9       5.2       14.1       53.0  
2009
    6.0       2.0       8.0       32.5  
                                 
 
 
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Cost of sales more than doubled from 2010 to 2011 primarily as a result of a 70% increase in Combined harvest volume. The increase in costs was compounded by a shift in harvest volume away from the Partnership tree farms, with a lower historic cost and attendant depletion rate, to include more volume from the Funds’ tree farms, with a higher depletion rate reflective of a more recent and higher cost basis. In 2011, volumes were weighted 56% and 44% from Partnership and Funds, respectively. In 2010, harvest volumes were weighted 80% and 20% from the Partnership and Funds tree farms, respectively. Harvest, haul, and other costs were also higher in 2011 over 2010 as we harvested from several units requiring higher cost cable logging and contractors were successful in negotiating higher prices for their services.

Cost of sales increased $6.1 million in 2010 from 2009 primarily as a result of a 63% harvest volume increase from 32 MMBF in 2009 to 53 MMBF in 2010, and because we harvested a significant portion of our 2010 harvest from the Funds’ timberlands, which have a much higher depletion rate than the Partnership’s legacy properties. Depletion expense increased $3.2 million in 2010 relative to 2009. Of this increase, $2.5 million is due to harvest of 11 MMBF from the Funds’ tree farms that did not occur in 2009 and $639,000 is due to the harvest volume increase from the Partnership’s tree farms.

Fee Timber cost of sales, expressed on a per MBF basis for each year in the three-year period ended December 31, 2011, was as follows:
 
                   
                                       Year ended
 
Harvest, Haul
and Other
 
Depletion
   
Total Cost of
Sales
 
2011
  $ 203     $ 130     $ 333  
2010
    167       98       265  
2009
    184       62       246  
 
Costs of sales increased $68/MBF in 2011 over 2010 with the increase split about evenly between harvest-and-haul costs and depletion expense. The per MBF increase in harvest, haul and other reflects increases in both logging costs due to the addition of units requiring higher cost cable logging as well as in increase in haul costs as a result of longer distances to customers. Cable logging costs were affected by a shortage of contractors in the wake of the industry-wide slowdown of 2008-2010 in which numerous contractors went out of business. In 2011, high export log prices stimulated an industry-wide increase in harvest that exceeded contractor capacity, allowing contractors to demand higher prices for their services. During the same 2008-2010 period many log trucks were converted by their owners to highway freight hauling configuration, creating a shortage of log trucks and thus resulting in slightly higher haul costs when harvest activity rebounded in 2011.

Depletion expense increased $32/MBF, or 33%, in 2011 compared to 2010. This is attributable to a significant increase in the relative harvest from the Funds’ tree farms from 2010 to 2011. The Funds’ share of the Combined harvest total was 44% in 2011 compared to 20% in 2010.

Harvest, haul and other costs per MBF decreased $17/MBF in 2010 relative to 2009. This reduction is attributable to a decrease in pulpwood volume harvested which carries a higher harvest cost per MBF than sawlogs.

We use a pooled depletion rate for volume harvested from the Partnership’s tree farms that divides the combined book basis of the merchantable timber for both tree farms by the combined merchantable volume for both tree farms. On the other hand, for the Funds we calculate separate depletion rates for each of the six Fund tree farms and then present them for this report in terms of a blended aggregate rate. In 2009, we used and reported only the pooled depletion rate for volume harvested from the Hood Canal and Columbia tree farms as we had no timber harvest from the Funds’ tree farms.
 
 
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Depletion expense resulting from timber harvest for each year in the three-year period ended December 31, 2011 was made up of the following:
                               
   
Year ended December 31, 2011
 
   
Partnership
         
Funds
         
Combined
 
Volume harvested (MMBF)
    50.7       56 %     39.5       44 %     90.2  
Rate/MBF
  $ 63             $ 217             $ 130  
Depletion expense (in thousands)
  $ 3,171             $ 8,587             $ 11,758  
 
                               
   
Year ended December 31, 2010
 
   
Partnership
         
Funds
         
Combined
 
Volume harvested (MMBF)
    42.3       80 %     10.7       20 %     53.0  
Rate/MBF
  $ 62             $ 236             $ 98  
Depletion expense (in thousands)
  $ 2,640             $ 2,529             $ 5,169  
 
                 
   
Year ended December 31, 2009
   
Partnership
         
Combined
Volume harvested (MMBF)
    32.5       100 %     32.5
Rate/MBF
  $ 62             $ 62
Depletion expense (in thousands)
  $ 2,001             $ 2,001
 
Partnership depletion consists primarily of historical timber cost that has been owned by the Partnership for many decades, as well as the Columbia tree farm property, most of which was acquired in 2001. As relatively newer acquisitions when compared to the Partnership tree farms, the Funds’ tree farms carry a higher depletion rate than our depletion pool for the Partnership tree farms. The increase in 2011 Combined depletion rate over the same period in 2010 reflects the increase of the Funds’ share of harvest from 20% in 2010 to 44% in 2011. In 2009, none of the harvest was sourced off of the Funds’ properties.  The decrease in the Funds’ depletion rate is attributable to the shift of merchantable timber into volumes available for harvest from non-merchantable inventory from 2010 to 2011.

Depletion expense is generated from the harvest and sale of timber and periodically from Real Estate sales when land is sold with standing timber. Depletion expense generated from Real Estate sales is typically de minimis and, as was the case in 2011, is excluded from the Fee Timber depletion analysis.
 
Operating Expenses

Operating expenses for Fee Timber include management, silviculture and the cost of both maintaining existing roads and building temporary roads required for harvest activities for the 114,000 acres owned by the Partnership and the 61,000 acres owned by the Funds. Operating expenses for the Fee Timber segment increased 53% in 2011 to $5.8 million from $3.8 million in 2010. The increase in year-to-date expenses over the prior year is attributable to increased road building and maintenance costs to facilitate an increase in harvest levels and to prepare roads for future harvest on newly acquired Timber Fund lands. Combined road maintenance costs for 2011 were $2.4 million, compared to $812,000 in 2010, or 41% and 21%, respectively, of Combined operating expenses for the two years. Operating expenses increased $644,000, or 21%, from 2009 to 2010. The increase in operating expense in 2010 over 2009 is due to the increase in activities to prepare tree farms for the 63% increase in harvest volume in 2010 relative to 2009. Operating expenses on a per-acre basis remained essentially flat from 2009 to 2010 due to the addition of 25,000 acres acquired by Fund II in the third quarter of 2010.
 
 
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Timberland Management & Consulting

Revenue and Operating Income

The Timberland Management & Consulting (TM&C) segment primarily develops timberland investment portfolios on behalf of the Funds. As of December 31, 2011, the TM&C segment managed two private equity timber funds representing $150 million of acquired commercial timberlands. Equity capital in these funds includes a co-investment by the Partnership of 20% of total fund equity capital with the remaining 80% coming from third-party investors. As of December 31, 2011, we have committed capital of $51 million for our third private equity timber fund, ORM Timber Fund III, which included our co-investment of $7 million. We are planning on completing fund raising for this fund by June 2012 with targeted total capital commitments of $100 million. The Partnership will provide a co-investment of between 5% and 10% of total committed capital in the third fund with the balance coming from third-party investors.
 
See Accounting Matters ~ Critical Accounting Policies and Estimates ~ Timber Fund Management Fees for more information on accounting for management fees paid by third-party investors.
 
Revenue and expense generated through the management of the Funds is accounted for within the TM&C segment, accounting guidance requires us to consolidate the Funds’ financial performance into our financial statements because of the governance control the Partnership is deemed to have over the Funds. As such, all fees associated with managing the Funds are eliminated in our consolidated financial statements. The revenue generated from management of these Funds represents an expense to the Fee Timber segment which is also eliminated when the Funds are consolidated into the Partnership’s financial statements with the portion of those fees paid by third-party investors reflected as income (loss) in the Partnership’s consolidated income statement under the caption “Net (income) loss attributable to noncontrolling interests-ORM Timber Funds”. Funds I and II are owned 20% by the Partnership and, as a result, 80% of these management fees are paid by third-party investors. Fees will only be earned for management of Fund III after capital has been placed in timberland investments. We generated a total of $2.4 million, $1.5 million, and $908,000 of management fee revenue in 2011, 2010, and 2009, respectively, each of which was eliminated in consolidation along with a corresponding decrease in operating expenses for the Fee Timber segment. At the close of 20