It’s time to talk about lumber
Here we are two weeks into the new year and the lumber markets fail to disappoint. Supply remains tight while demand keeps forging ahead. Pricing is maintaining its upward trajectory with extended mill order files. Everyone appears optimistic for a strong start to the first quarter of this year. All is well in the lumber universe. Or is it?
If or when?
I hear this week to week, and recently, we’re starting read more about it from the industry pundits. Optimism in the lumber markets remains elevated. We’re on the path to a boom in the housing markets. Lots of pent-up demand by prospective homebuyers and historically low mortgage rates. The expectation is for a banner year in the construction industry, if we can just keep the momentum heading in the right direction.
At this point, that’s a big if. Where do we start? How about the 3, no 4, no maybe 7-8 interest rate hikes for this year? Where does that take mortgage rates? Perhaps 4%, 4.5%, maybe up to 5%? Even the Fed is surprised at the current rate of inflation. And not quite sure how persistent, or less transitory, it moves from here.
How will this affect the housing markets and the lumber industry? In simplistic terms, over time, more prospective homebuyers will get pushed to the sidelines. Higher monthly mortgage payments, coupled with greater loss of disposal income due to inflation, will have a negative effect on housing over the course of the year. The question is not if this scenario plays out, but when.
Two takeaways here, one good, one not so good. The not so good is that new construction slows, as does the need for lumber and panels. On the flip side, the good is that home builders will be able to make a dent in the backlog of jobs that need to be completed. Perhaps at this point the industry can finally get past the less than 1.3 million completions and move on to targeting the 1.6 million housing starts everyone seems to be forecasting.
The same economics will impact the R&R portion of the construction industry. Will we experience the same dynamics that drove home remodeling and renovation in 2020? We think not. The majority of the consuming public is fed up with the pandemic and the last thing they want to do is stay home. That ship has sailed.
That said, the R&R business will slow. Add in less disposal income due to inflation, and the expectation is for smaller home projects. Not very encouraging for the Big Boxes since a large part of their business depends on these do-it-yourself projects. This isn’t an if this will happen, more a when this will happen. And when this does happen, which will be sooner rather than later, that reduction in R&R business will dump program wood right back into the cash markets.
For good measure, let’s throw some wintry weather into the mix. This is neither an if, nor when question, this is a now. Another dose of nasty weather is making its way from the Midwest to the East Coast this weekend. Frigid temperatures, windy conditions and more snow to contend with to start the upcoming week. And we still have February ahead of us. These weather events tend to balance supply and demand.
We mentioned this in last week’s post. Inventory turns slow, therefore stretching supply across the distribution network. A purchasing pause to digest on ground inventories and review those purchases on order and/or in transit. And let’s not forget cash flow issues this time of year. If your credit is getting stretched by these high prices, you know the same is happening to your customers and your accounts receivables. With prices moving higher by $50m to a $100m, or more every week, you can’t raise your selling prices fast enough to cover the cost of the next truck or car of lumber you need to buy. At some point, the math stops working like it did last spring, and demand across the industry inevitably begins to slow. In some instances, the jobs get put on hold, while others get delayed, postponed, or just canceled.
Demand may slow, but at these price levels, mill production won’t. The biggest issue facing today’s markets is transportation, primarily trucking. The solution will be to ship volumes closer to end user markets. This will mean additional port locations for import wood and an increase in rail reloads for North American production. Rail traffic has been recovering since December and will eventually correct as mills will want to continue to ship as much wood as possible at these elevated prices. The markets are approaching a tipping point. Not an if prices will correct, but when.
Fundamentals
As with the historic increases in lumber prices last year, I am once more reminded of the old lumber industry adage, the cure for high prices is high prices. Sounds simple enough, but true. We have outlined some of the reasons above. Several of the other reasons, we have mentioned in previous posts. The simple fact of the matter is that sawmills produce lumber. They control the sourcing, production, most of the transportation, and more importantly the price scenario. If you have been in this industry for any amount of time, you know to take a portion of what the mills tell you with a grain of salt. Mills have an entire play book of why they price lumber the way they do, log costs, capital expenditures, labor, transportation, weather, duties, tariffs, supply, demand and order files. I’m sure we missed something, but these will do for now. Why do we bring up this topic you might ask?
Go back to mid-November of last year. Lumber prices hit a cycle bottom. Mills sensed they would be able to gain traction over prices and order file. Then the process begins. Weather driven events that impacted transportation. Okay, that only affected a percentage of mill shipments since most BC mills can ship directly East to Edmonton and beyond, thereby avoiding the rail disruptions to Vancouver. We’ll admit there were some rail delays, but most mills were receiving empty cars and were shipping product.
Enter the unprepared, late arriving, panic buyers. Instead of having a purchasing plan in place and starting to buy inventory at the cycle bottom, they waited until the mills regained the upper hand and control over pricing.
As more buyers stepped in, the US announced increased duty/tariff rates on Canadian producers. Oh no, prices will automatically increase by a minimum of 18.99%! The buying public once again hits the panic button and jumps in to buy additional volumes before the mills raise their prices. Most of us know these tariff announcements are more bluster than bite. There is little mention that this duty money sits in an interest-bearing escrow account with the US Commerce Department. And as we also know, in the last tariff reconciliation, Canadian mills were refunded a large percentage of these funds. Safe to say, this will happen again.
Sawmills now have price control. They have holiday downtime ahead, labor issues with the pandemic, increased demand, additional rail issues, and more important for them, order file, whether real, or “imagined”. Everybody decided they needed to stock up on inventory ahead of the big price increases we witnessed last spring. Unfortunately for most, market structure is not the same this go around. As we have said before, lumber pricing has run countercyclical to seasonal trend since Labor Day. Follow this thinking, and you’ll see this current market correct well before May.
For us, we saw a more cautious approach to purchasing over the past week. Buyers are spooked by the higher prices, and as stated above, the time of year. It is difficult to feel good about this market when you’re building inventory in January, and early February, at these price levels. And for some, there is additional inventory on order at these higher prices waiting to ship. There is a sense of uneasiness to this market. Everyone is now facing the inevitable realization of a market correction. High prices cure high prices. Not if we see a correction, but when we see the correction.
As noted above, as R&R business slows for the Big Boxes, additional program wood will be dumped into the cash markets. Not a good sign. We have also seen disruptions and delays at Western Canadian ports due to ongoing global shipping issues. That said, we expect to see more of the wood destined for the ports, or sitting at the ports, get diverted to US markets. Not a good sign. Has anyone else noticed the additional mill offerings this past week, or lists of European wood transiting to US ports? Lead-times for the week of February 7th, we would expect sooner. Not a good sign. European importers offering out wood for the week of February 14th or sooner? If importers anticipated higher prices, they would normally wait to price the shipments for 2 weeks or sooner. It now appears they’re attempting to move as much volume as they can to lock in current price levels. Not a good sign. And one final market indicator we noticed this past week. It would appear that some SYP items are becoming more available as inquiry has slowed this past week. Item of note to us is 2x8 SYP. If 2x8 SYP is more readily available, and mills are looking to move production, what’s that say about 2x4 pricing and availability? If the expectation is for 2x4 SYP prices to continue higher, why would these mills not be ripping their 2x8 back to 2x4?
High prices will cure high prices. Now is the time to be alert and watch for changes in market make-up. Changes in supply as well as changes in demand. It’s not a matter of if there will be a change in market make-up, it will be a matter of when. Be prepared!
Technicals
As we expected, expiration week brough increased volatility to the lumber futures market. Some subtle changes, some not. The January futures contract expired Friday at $1237.10 with 22 open positions remaining. The expectation is that these are EFP positions to be reconciled over the next several days. In total this past week, we saw 57 January EFP’s. Not bad considering the contract’s continuing premium to cash. Or on the other hand, congratulations to those forward priced individuals that had the plan, and foresight, to buy the contract at cycle lows ahead of expiration, and at a discount to current cash levels.
One item not to have changed, has been the continued participation of long speculative managed money keeping the March and May contracts at a premium to current cash levels. Does any rational cash trader really want to chase the speculative premium in futures? Obviously, there are more than enough irrational cash traders pushing prices higher. Enough said.
There were also several items of note we were following this past week. Lumber futures open interest was able to breach the 2,500 positions level early in the week but couldn’t sustain that level as the week wore on. Considering the volatility, and it being expiration week, lumber futures open interest was only able to show a 47-position increase for the week. Not bearish, but not overly bullish given the week’s activity.
For those of you that use basis trading as an inventory strategy, now is the time to monitor the March basis. This past week, we saw the March basis expand from a -$79.00 on Tuesday to a -$129.00 on Thursday. By comparison, the average March basis in 2020 was approximately +$60.00. Take advantage of these basis opportunities in the March contract. Once again, we don’t know where cash pricing levels will be in March, but with this expanded March basis, we do know you can own wood substantially under the market when your position is exited properly and in a timely fashion. These are profit making opportunities! Be prepared.
Also, of note this past week were the new life of contract highs made in the March, May, July, and September contracts. Now would be a good time to compare those prices against cash price levels in the corresponding time frames from 2021. Are there hedge opportunities in the back months? We believe so. One example is the May contract closing Friday at $1207.20. That makes for a basis against current cash of -$7.20, or May at a $7.20 premium over cash. Do we think cash pricing will be over $1207.20 in May? We would expect not.
Once again, watch the back months for value. With the increased volatility we have experienced over the past 2 years, there is almost always an arbitrage opportunity to consider. As with cash, watch for changes in the futures market make-up. Beginning with Tuesday’s trading (CME Globex Lumber futures is closed Monday for the MLK holiday), the March contract will now have to trade on its own merits as spot month. Be alert and be prepared!
Dollars and Sense
US Mortgages. The Mortgage Bankers Association of America reported a modest increase in mortgage application for the first week of January. Applications to purchase were up 1.4% while those to refinance dropped by .1%. Compared to a year ago, purchase applications were 17% lower with finance applications off by 50%. The average contract interest rate for a 30-year fixed-rate mortgage increased to 3.52%. This is the highest rate since March 2020. The expectation is to see additional activity in the purchase segment as prospective homebuyers attempt to stay in front of anticipated rate increases through 2022.
US Inflation. The original Fed plan was to allow inflation to run either side of the 2% level to help in stimulating the US economy. As the percentage increased, the Fed explained this would be just transitory in nature, not to be concerned, they had the situation well in hand. It appears the Fed plan has gone from in hand, to out of hand, as the annual inflation rate in the US jumped to 7% in December. This is the highest level since 1982 and an increase from 6.8% in November 2021. Expect inflationary pressure to remain into 2022.
PPI Inflation. According to the US Bureau of Labor Statistics, producer prices for final demand in the US rose marginally by .2%. in December over the November number. In addition, the annual producer inflation rate was lower for December at 9.7% compared to the record November rate at 9.8%. Let’s keep an eye on whether ongoing Fed policy can help in correcting this situation.
US Rate Hikes. A report from Reuters this past week highlighted anticipated Fed monetary policy tightening for 2022, with an initial interest rate hike considered for March. The expectation is for 3 rate hikes for 2022 as the Fed looks to reduce their bloated balance sheet. Some industry pundits estimate it may take more than 3 rates hikes to get inflation under control. Considering the Fed’s track record to date, we’ll keep our fingers crossed.
Bank of Canada. On a similar note, the Bank of Canada is expected to raise their benchmark interest rate by 25 basis points this month. It had previously been scheduled for April. Estimates call for a total of 5 rate hikes in 2022 bringing the Canadian rate to 1.5% by the end of the year. Something to watch as both the US and Canadian central banks grapple with increased inflationary trends.
Economic Calendar. The week ahead is heavy to housing news. On Tuesday at 10 am, the NAHB January Housing Market Index will be released. Wednesday brings us the weekly MBA mortgages rates and applications report at 7 am. Also, on Wednesday at 8:30 am, the December US Housing Starts and Permits report will be released by the Census Bureau. As usual, keep a close watch on the completions number. And on Thursday, we’ll get a look at the December US Existing Home Sales report at 10 am. Lots to see, lots to digest, and lots to think about in the housing sector this week.
Anecdotal Thoughts
WWPA Lumber Statistics. Below are some October production numbers released by the WWPA.
In October, North American softwood lumber production dropped 6.4% year over year. The US showed a 7.4% decline while Canada was 5.7% lower year over year.
The numbers for operating rates in both the US and Canada were rather flat with US operating rates at 84% and Canada 78%. Although operating rates were flat, it should be noted above that production was lower in both countries,
Keeping in line with the flat operating rates, and the production decrease, North American softwood lumber consumption dropped by 7.8%. Year over year the US saw a decline of 6% with Canadian consumption off by 20.1%.
US softwood lumber imports increased month over month by 8.6%. Although imports from Canada were up by 11.2%, the year over year imports showed a 6% drop. Non-Canadian imports were 7.4% lower month over month and 23.9% lower versus October 2020. 9.3% of the month over month decline was seen in European imports.
In the US, log exports dropped 2.6% month over month with declines seen in exports to China and Japan, while exports to Canada were up by 11.3%.
US/Canada Trucking. We saw conflicting reports this past week on cross border trucker vaccination requirements. On Wednesday, Canada announced it would allow unvaccinated Canadian truckers to cross into the US. This reversed an earlier government decision that required all truckers to be vaccinated against Covid. Prime Minister Trudeau dropped the requirement under pressure from the Canadian trucking lobby and the government opposition party. Reasons given were a disruption in cross border trade, existing driver shortages, and the inflationary impact on the Canadian economy. Fast forward a day later and the requirement was rescinded by the Canadian government over vaccination and quarantine requirements. It appears Prime Minister Trudeau will have to return to the drawing board to get this issue resolved.
As always, we believe you’ll find value in our weekly thoughts and insights on the lumber industry. We appreciate your support. Feel free to be in touch. Questions, comments, recommendations, we’re here to help. Contact us at,
bandplumber55@gmail.com
bplumber@substack.com
@MikeCla58829893
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