Future Demand for U.S. Flue-Cured Tobacco:

Heat-Not-Burn vs Nicotine SolutionMay 13, 2015

Dr. Blake BrownHugh C. Kiger Professor

Agriculture & Resource EconomicsCollege of Agriculture & Life Sciences

U.S.6%

Brazil16%

Zimbabwe6%

PRC59%

Other 13%

2014 World Flue-Cured Production 4.49 million MT

Global Supply of Flavor Style Flue-Cured: U.S., Brazil and Zimbabwe

20042005

20062007

20082009

20102011

20122013

2014E2015P

0

200

400

600

800

1000

1200

ZimbabweUSBrazil

Source Brazil & U.S.: Universal Corporation. “World Leaf Production as of Feb 3, 2015.”Source Zimbabwe: Zimbabwe Tobacco Association “Weekly FCV Report 14.07.2014”

Domestic Use and Exports of U.S. Flue-Cured Tobacco

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 -

50,000.00

100,000.00

150,000.00

200,000.00

250,000.00

300,000.00

DomesticExports

U.S. Unmanufactured Exports of Flue-Cured Tobacco

(Tonnes farm weight)

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

20000

40000

60000

80000

100000

120000

140000

160000

WorldEU27PRC

Source: USDA-FAS

EU & US Cigarette Consumptionbillions of cigarettes

2005 2006 2007 2008 2009 2010 2011 2012 20130

100200300400500600700800 728 billion

513 billion

372 billion270 billion

EUUS

Sources: Tax Burden on Tobacco, Historical Compilation. V48, 2013 Orzechowski and Walker.Releases for consumption of cigarettes 2002-2013. Taxation & Customs. European

Commission

Market Challenges to US Flue-Cured

• Large flue-cured inventories in the global tobacco supply chain

• Unfavorable exchange rates• Continued erosion of cigarette consumption in developed

countries due to health concerns• Hostile regulatory and tax environment for cigarettes in

EU & US• Changes in nicotine delivery technology;

e.g. E-cigarettes & heat-not-burn

Market Opportunities for US Flue-Cured Farmers

• Increased demand for high quality flavor style flue-cured– bans on flavorings in cigarettes– growing market in China for “higher end” cigarettes

• Ability of US farmer for strict adherence to both production and social protocols

Tobacco products will undergo a technological revolution over the next 5-10 years

• Will non-combustibles dominate traditional combustibles in the U.S. and EU?

• How new products are regulated and taxed will greatly impact their growth

e-liquid products: “e-cigarettes”

• Sales estimated at $2.5 billion in U.S. in 2014• Estimates of slightly smaller sales in Europe• but sales are slowing• Vaping category showing dominance

– cig-a-likes category slowing in growth– Closed and open systems showing growth

• All major tobacco manufacturers have invested in e-cigarette products

“heat-not-burn” productsCONTAIN TOBACCO LEAF

• PMI introduced iQOS “Marlboro HeatSticks” in Japan and Italy– $680 million invested in reduced-risk factory in Italy

• Reynolds American introduced new heat-not-burn product, Revo, in Wisconsin in February 2015

“heat-not-burn” products

• PAX

• JTI buys

• Multitude of “Vape Pens” on market– Most can use pipe tobacco

Both categories face similar challenges

• Regulation looms– FDA has issued deeming regulations– Some municipalities have issued bans– Will regulation be less stringent than for combustibles?

• Mixed taxation at state and local level• Health community is divided• Do they yield a similar experience to combustibles? How

many smokers will switch?

“IBISWorld expects the growing popularity of e-cigs to drive the growth of international trade at an average annual rate of 2.5%, to an estimated $30.5 billion in 2019.”

IBISWorld Industry Report. Global Cigarette & Tobacco Manufacturing. P.7. June, 2014.

Impacts of Technological ChangeConsider 4 scenarios:

1. Base Case: No growth in E-Liquid or Heat-not-Burn products

2. E-Liquid products grow to $30 billion by 2019 in US &EU

3. Heat-not-burn & E-Liquid products, equally split, grow to $30 billion by 2019 in US & EU

4. Heat-not-burn products grow to $30 billion by 2019 in US & EU

Impacts of Technological Change

• E-Liquid products– Tobacco production for nicotine production– Currently 8,165 Tonnes (18 million pounds) of tobacco

for $5 billion in e-cig sales• Heat-not-burn products

– Quality of tobacco is more important than ever– Change in quantity demanded…less tobacco per

“smoke” than combustibles

EU & US Non-Combustibles grow to $30 billion by 2019US Flue-Cured Production for EU & US Markets:

US provides 20% of US&EU E-Liquid MarketHeat-Not-Burn contains 40% tobacco content of Combustible Cig

Current

2019: No Change in Tobacco Product M

ix

All E-Liquid

50/50 HN

B & E-Lquid

All HN

B -

20,000 40,000 60,000 80,000

100,000

88,904 69,186 58,931 60,981 63,036

- - 9,798 4,899 -

Tobacco Production for E-LiquidTraditional Tobacco Production

EU & US Non-Combustibles grow to $30 billion by 2019US Flue-Cured Production for EU & US Markets:

US provides 30% of US&EU E-Liquid MarketHeat-Not-Burn contains 60% tobacco content of Combustible Cig

Current

2019: No Change in Tobacco Product M

ix

All E-Liquid

50/50 HN

B & E-Lquid

All HN

B -

20,000 40,000 60,000 80,000

100,000

88,686 69,186 58,931 62,006 65,086

- - 14,696 7,348 -

Tobacco Production for E-LiquidTraditional Tobacco Production

What can we conclude?• Many unknowns

– Will either product be preferred over combustibles?

– Will E-Liquid or Heat-not-burn dominate?– How much US vs foreign tobacco will be used?– How will non-combustibles be regulated and

taxed?– How rapidly with non-combustible use grow?

What can we conclude?• Many unknowns• Using a projection of $30.5 billion in sales in US and

EU in 2019 decreases use of US flue-cured in the US & EU by 5-10 thousand Tonnes

What can we conclude?• Many unknowns• Projected $30.5 billion in sales in US and EU in 2019 may decrease

use of US flue-cured in the US & EU by 5-10 thousand MT

• BUT success by heat-not-burn could spur rapid change from combustibles to non-combustibles. Success could be characterized as:– Demonstrated lower risk than combustibles– Less strict regulation than combustibles– Lower taxation than combustibles– Consumer adoption over combustibles and preference

over e-liquid products

What can we conclude?• Many unknowns• Projected $30.5 billion in sales in US and EU in 2019 may decrease

use of US flue-cured in the US & EU by 5-10 thousand MT• BUT success by heat-not-burn could spur rapid change from

combustibles to non-combustibles

• Domination by E-liquid products could cause US tobacco production to be larger than if heat-not-burn dominates…but production would be very different

What can we conclude?• Many unknowns• Projected $30.5 billion in sales in US and EU in 2019 may decrease

use of US flue-cured in the US & EU by 5-10 thousand MT• BUT success by heat-not-burn could spur rapid change from

combustibles to non-combustibles• Domination by E-liquid products could cause US tobacco production

to be larger than if heat-not-burn dominates

• If heat-not-burn dominates over E-Liquid products:– Quantity demanded of tobacco could be smaller– But needed acreage may be larger– Producers will earn higher premium for high

quality tobacco for heat-not-burn