(FORTUNE Magazine) – To see why papermakers often feel cursed and occasionally blessed, take a look at machine No. 35 at Champion International's mill complex in Courtland, Alabama. One of the largest industrial machines in existence, No. 35 took two years to build and cost $395 million. It is higher than a five- story building and a third longer than a football field. To squeeze and dry the paper, it uses 30-foot-wide cylindrical rolls--200 of them--that cost $10,000 and up each. A perforated suction roll made of stainless steel goes for $600,000, while a granite roll that presses a texture into the paper surface costs $750,000. Every 60 seconds, this leviathan generates a stream of office paper more than half a mile long and 29 feet wide.

The agony is that all those acres of paper are a commodity: Champion doesn't set the price, the market does, and if the price is too low--as it often is in this business-No. 35 keeps spitting out paper that sells for barely more than it costs to make. The ecstasy is that when the market pushes the price high--as it's doing right now-No. 35's paper earns profit margins of 60% to 70%. The effect on the bottom line is breathtaking: Champion's earnings per share could leap from 9 cents last year to $5.14 this year. Says CEO Andrew Sigler: "We're going to make a helluva lot of money in the next two years."

It's the same story, more or less, at America's other papermakers. Prices are rising faster than ever before, some grades costing twice as much as a year ago. You see it in more expensive books, newspapers, and writing paper. To paper companies it's a torrent after a long drought. And yet, in this bizarre business, such news is decidedly mixed.

Reason: The paper industry has always had a hard time coping with prosperity. Like a drunk with money in his pocket, paper companies spend their new riches on more machines that spew out tons of paper and push prices back down. "This industry is characterized by chronic overshooting of capacity," says professor Jeffrey Arpan of the University of South Carolina. "It is sort of the nature of the beast."

While it's definitely early to say, this time just could be different. Loaded with debt, companies need to repair their balance sheets. Sticky local regulations and nasty environmental laws make new construction dicey. Raw material is hard to find. And maybe papermakers have learned something from their past mistakes. "I don't think there are idiots who run this industry," says J. Carter Fox, chairman and CEO of Chesapeake, a maker of tissue and packaging products. "Even with prices at 1994 levels, you cannot justify new capacity."

So what will papermakers do with all their new money this time? Says analyst Linda Lieberman of Bear Stearns: "It makes more sense to buy than to build." That means the next three or four years could see the rapid consolidation of this underperforming, highly fragmented industry. With share prices high, it's a great time to buy with stock.

Family-controlled firms, plentiful in the paper industry, may need to sell out in order to settle inheritance questions or family disputes. Other companies will seek to build up strong business lines and divest weak ones. Says analyst Kathryn McAuley of Brown Brothers Harriman: "The only way that companies will be able to increase market share is to go out and gobble up other companies. I am certain we will see a lot more consolidation." One way to make money in commodities is through economies of vast scale. Says Chesapeake's Fox: "Some small players with sales of $1 billion to $3 billion are going to drop out. Because the cycle is up, there is a feeling that now is the time for transactions, acquisitions, and divestitures." Of course, any benefit from all this activity would be short term: The result would be an industry of commodity-selling behemoths slugging it out.

Nevertheless, sensing a seller's market for paper assets, several companies have already hung out the for sale sign. St. Joe Paper in Jacksonville announced in March that it was selling its linerboard mill for an estimated $550 million. The news promptly pushed St. Joe's stock up several points. James River, America's ninthlargest papermaker, is considering the disposal of both its communications paper and packaging businesses to concentrate on its Northern bathroom tissue, Brawny paper towels, and Dixie cups. Mead Paper, the seventh-largest manufacturer, has put on the block its mill in Kingsport, Tennessee, which makes copier paper for the highly competitive office market. A public sign hasn't yet appeared on the bluest-chip property in this flurry of paper shuffling, but many believe it is already on the block. That property is Scott Paper, the eighth-largest U.S. producer and maker of the well-known bathroom and facial tissue. For exactly 12 months Scott has been under the thumb of CEO Albert J. Dunlap, an experienced broker of paper companies who arranged the sale of Crown-Zellerbach and Lily-Tulip in the 1970s. As Bear Stearns's Lieberman points out, "Dunlap is a master at restructuring old assets and reselling them. It is his history and track record."

Dunlap, who has acquired the nickname "Chainsaw" for his enthusiasm at cost cutting, has spent the past year cleaning up Scott's operations for a sale. He cut the payroll, slashed through the managerial ranks, and ripped out operations tangential to its core tissue business, notably its printing and publishing papers lines, which he sold for $1.6 billion to a South African group.

Dunlap's makeover has produced the hoped-for results among investors, who have bid up the stock to $84, more than twice the price when Dunlap arrived. He is profiting handsomely, not just from a rich pay package (see box) but also because he has bet $4 million of his own money on Scott stock since he took the job. Dunlap encouraged other executives to load up as well and started paying the board of directors in stock instead of cash.

Exactly who might buy Scott, and how much they would pay, remain imponderables. Other tissue makers such as Kimberly Clark and Procter & Gamble are probably disqualified by antitrust considerations. A foreign company, such as Unilever, wouldn't be so proscribed. Dunlap is uncharacteristically coy on the subject of Scott's availability. Four board members who spoke with Fortune likewise refused comment.

The sale of Scott would be a relief to other papermakers, who regard Dunlap and the publicity he receives as an annoyance. Some competitors, none of whose stock has doubled in the past year, dismiss his performance as numberless management. To them, Dunlap is a kind of financial mechanic who plays for short-term results at the risk of damaging the company's prospects for the long haul.

Says Jim McNutt, president and CEO of Jakko Poyry Consulting, an established industry advisory group in Tarrytown, New York: "When you hire Dunlap, you know his history: He maximizes value by finding buyers and carving up the company. When you hire an exterminator, you don't expect him to cater a full-course dinner."

Dunlap, who speaks loudly and seldom in the passive voice, is unfazed by the reaction. Says he: "With all due respect, look at the people running the companies. How long have they been there? How many outsiders have come into this business? I don't think I can name one. Paper is a necessary industry, but how many dynamic events in it have taken place?"

"Dynamic" is not an adjective most people would use to describe the industry. "Traditional," "tight-knit," and "inbred" seem more fitting. The CEOs tend to be single-company men who rose in the same organizations for 25 to 30 years and who surround themselves with people who agree with them. That's why they all tend to do the same thing at the same time. Very few break the mold.

A half-dozen firms are still connected by blood to their founders. The chairman of Wisconsin's Consolidated Papers, George W. Mead, leads a company that his great-grandfather helped start 101 years ago. A third-generation Stone named Roger runs Stone Container in Illinois, and a fourth-generation Weyerhaeuser named George sits on the board of Weyerhaeuser. Three Glatfelters hold director's jobs at P.H. Glatfelter, a Pennsylvania maker of book and cigarette paper. And at Westvaco, which makes printing papers and packaging products, retired CEO John Luke is the father of current CEO John Luke Jr., the brother of Chairman David Luke, and the father-in-law of vice president and secretary John W. Hetherington. Pankaj Ghemawat, a professor of business administration at Harvard Business School, says, "This is not an industry where you hear much about leading-edge ideas being adopted."

Another problem: Whereas steel producers are gravitating toward more flexible, cost-efficient mini-mills, paper companies are going the other way--bigger is better. So large have paper machines become that the addition of only one can boost industry capacity in a grade of paper by 2% or 3%, creating oversupply and weakening prices. Yet producers feel they have no choice. Big new machines, like Champion's mammoth No. 35 at Courtland, are ferociously efficient. This year, with all of Courtland's machines running at close to capacity, the plant should produce an operating profit margin of 15%. Contrast that with a smaller, older Champion operation in Hamilton, Ohio. It also has five machines, but the newest was built in 1921, and they produce just one-sixth as much paper, mostly specialty writing and printing grades. Partly because Hamilton has to buy expensive pulp on the open market, unlike Courtland, it will struggle to break even in 1995.

New machinery would seem to make economic sense. But when everybody buys at the same time, as papermakers did in the late 1980s, the machines not only cancel out each other's competitive advantage but also destroy the balance between supply and demand. Says analyst McAuley of Brown Brothers Harriman: "These companies go out and buy a strategy report from a consulting group, and they see a need to expand. What they don't realize is that everyone else has read the same report and is doing the same thing."

In the most grotesque example, coated-paper producers in the U.S., Canada, and Europe invested $10 billion in 26 new paper machines between 1988 and 1993. This raised available capacity for catalogues and magazines by 40%. When advertising fell off and demand weakened in the early 1990s, prices tanked. From nearly $1,300 per ton in 1989, coated paper had plunged to around $900 a ton by early 1993.

Not until last year did demand for paper finally catch up to supply. When it did, prices firmed, then took off. After selling for as little as $478 last April, offset paper now costs $815. Papermakers aren't shy about making up their losses in a hurry. Says Dan King, president and CEO of Wausau: "We are still raising prices every chance we can get."

Newsprint has gone up less dramatically, but that hasn't stopped newspaper publishers from protesting loudly. Strikes at some Canadian paper mills have reduced supply and helped push prices from a low of $420 per ton in February 1994 to $675, effective in May. A number of newspapers have raised prices, laid off editorial workers, and shrunk their news hole. Two drama-filled stories in the New York Times about the price increases might have led readers to believe that freedom of the press had somehow been endangered.

No investors are complaining. The cascade of price hikes has sent security analysts scurrying back to their spreadsheets to recalculate the impact on company profits, and it will be substantial. In addition to Champion's dramatic increase, analysts estimate Boise Cascade will swing from a $3.08 per share loss in 1994 to a $4.75 per share profit in 1995, for example, and Georgia-Pacific should see earnings more than triple.

Before they start figuring out how to spend their newfound wealth, paper companies face less glamorous work. High on the agenda is paying off some of the debt that piled up in the early 1990s. As companies competed to build the newest and snazziest machines, the industry's debt exploded from about 60% of net worth in 1986 to close to 120% by 1993.

The next item is satisfying the growing public appetite for paper made from recycled material. The industry already recovers about 40% of the paper it uses and aims to reach 50% by 2000. Makers are happy to supply recycled paper but point out that it is lower in quality and costs more. Since the fibers in recycled material have already been squeezed at least once by the rollers of a paper machine, they are inherently weaker than fibers that come from virgin pulp. Manufacturing costs are higher because existing paper machines must be retrofitted to accept wastepaper and don't run as efficiently. C. Wesley Smith, executive vice president of International Paper, estimates the recycled premium at 10% to 15%.

That premium is getting another push from the run-up in waste-material prices. Mixed-waste paper, which was bringing $25 a ton in San Francisco last year, now costs $80. Old newspapers, which recyclers were paying $30 a ton to get rid of in 1994, now command $80 a ton. Producers say supplies of office waste will remain tight because the practical limits of collection have been reached. Curbside pickups in Houston, for instance, made wastepaper so expensive that the city wants Champion to find other sources of supply.

A backlash is also growing in the industry against the environmental imperatives behind recycling. In theory, recycling reduces the felling of trees and the filling of landfills. In fact, trees are a renewable resource, and paper companies routinely plant more than they harvest. "We will have more trees tomorrow than we have today," says Richard Olson, executive vice president of Champion International. Nor is there any shortage of landfills. Companies insist that abundant acreage in the Western U.S. remains unused, as does sufficient acreage within shipping distance of big cities in the East. Says IP's Smith: "I believe there is plenty of landfill capacity. We have to get smarter about how we use it."

The Republican-controlled Congress may lift two other environmental bogies off the industry's back. Under the 1973 Endangered Species Act and subsequent laws, the spotted owl, the marbled murrelet, and certain breeds of salmon have been listed as threatened or endangered, putting their habitats off limits in the vast federal timberland of the Pacific Northwest. The timber yield on such lands has fallen from 11 billion board-feet in the 1980s to less than four billion board-feet now, creating shortages and pushing up wood pulp prices.

Help may be on the way. In March the House Appropriations Committee made it easier to harvest timber on federal lands by eliminating one of the legal roadblocks to logging that opponents have used under environmental laws. The birds and fish will still get to keep part of their habitats, but the amount of salvage timber that can be cut from federal land could be doubled. The Senate Government Affairs Committee has passed a similar measure.

Still incomplete is the Environmental Protection Agency's drive to enact "cluster" rules that would reduce the discharge of dioxins into the air and water to below measurable levels. Dioxins are toxic chemicals formed from chlorine compounds used in bleaching pulp and paper. An intensive industry campaign has already cut dioxin emissions to minuscule levels measured in parts per quadrillion. To reduce them further would cost $11.5 billion by 1999, claims the American Forest and Paper Association, and provide scant benefit. A final decision on the cluster rules is due later this year.

Even if the cluster rules are delayed or eliminated, the growing number of legal restrictions on big industrial developments--zoning rules, discharge permits--will hamper paper's efforts to expand production. Some executives believe new mills have become a thing of the past. Says W. Craig McClelland, chairman and CEO of Union Camp: "If you are going to grow, you are going to stay on your own site and add a machine."

If the paper industry can restrain its excess on the supply side, little appears on the horizon that will dampen demand. The notion that electronics will render paper obsolete seems to be receding further into the future. The paperless office appears one of those trends whose time has come and gone, like the eight-track stereo cartridge and the convertible auto-airplane. The profusion of copiers, printers, and fax machines ensures a continuing need for a communications medium more tangible than ether. Likewise, magazines and catalogues that vibrantly reproduce four-color photographs and artwork seem little threatened by VDT screens. Anyone who has read the contents of his favorite magazine on a computer quickly reconsiders the idea of canceling his subscription.

One class of publications that may go electronic are directories, such as telephone books and industry guides. Usually printed on newsprint, their content is more important than the way it is displayed. Moreover, they require frequent updating, which makes them computer-friendly. Several paper companies are shutting down older, less efficient newsprint machines, and others are cautious about increasing production. Newsprint capacity should decline slightly over the next two years.

So the paper business appears to be headed for several prosperous years. The American Forest and Paper Association predicts demand will grow 2.4% a year through 1997, while increases in capacity, largely from productivity improvements, will not likely top 2% annually.

How long the industry can hold off building new machines is anybody's guess. But once the small companies have been merged, the family-owned firms sold, and the less efficient operations broken up, the urge to expand may become irresistible again. Say, in three to five years. "New equipment makes a faster, cheaper, better product," says Champion's Sigler. "There is a tremendous pressure to have new facilities." Besides, as you recall, it is the nature of the beast.