Decision or Indecision

Andrew_Gibson · February 28, 2022, 2:32pm

It’s time to talk about lumber

Another Sunday morning, a time to look back on the past week and plan ahead for the new week.

As we have noted in past posts, the three most active months in the building industry are now right in front of us. Tuesday is March 1st, the traditional start of the spring building season. With that comes the foremost question being asked by sawmills, wholesalers, stocking distributors, lumber yards, and builders. Is the forest products industry adequately prepared for the increase in business expected between now and Memorial Day? At B+P, we think not.

This current lumber market reminds us of the age-old Angel /Devil scenario. You know the cartoon. The character needs to make a difficult decision. On one shoulder is the Devil, whispering in your ear all those negative thoughts. On the other shoulder is the Angel, whispering and reinforcing all the positives. In lumber right now, that decision is buy or don’t buy. There is widespread industry indecision and uncertainty. Quite the dilemma. What to do?

If you haven’t prepared for your March or April inventory needs, you will be a contributor to higher prices over the short term. Why do we say this? Reread our newsletter from last week. Until the supply/demand equation can be rebalanced, the lumber markets will continue to trade on volatility. Very few industry participants want to own inventory.

In our view, there are three reasons why this occurs. First is financial. We understand the lumber industry is made up of a variety of players; some large, some not so large, some medium, and some high-volume strategic players. And none are created equal due to a variety of reasons. We believe you can figure out these reasons. That said, they all have cash and/or credit limitations. They may want to build inventory when they think the opportunities exists, but just don’t have the financial wherewithal to absorb the position. We understand this, you buy according to your means.

Second is space. We all hear the common lament, “I would buy more but just don’t have the space.” A valid excuse, up to a point. If you have the financials to support a larger inventory position, you can almost always find a place to store the inventory. Look around for a nearby reload, a commercial warehousing operation, or your local distribution channel. Be creative, use one, or a combination of all three to warehouse and build inventory. These opportunities are there for you. Develop your plan and start the process. It’s not that difficult. These relationships will pay dividends over the long term.

The third reason why buyers don’t build inventory? This is the easy one. They have no plan, are inept, don’t care, or are just plain lazy. As we said last week, they don’t want risk, so they give up on the reward. This reason is both short sighted and myopic. These are the buyers that continue to complain about pricing, lack of product availability, and are perpetually chasing the market. As we like to say, no plan, all pain.

Don’t get us wrong. This market indecision and uncertainty is neither new, nor a solitary event. There is always risk and volatility. Sometimes more, sometimes less. Market movement can be cyclical or countercyclical in nature depending on timing and market disruptions.

As with any other business, you’ll only take out of the lumber industry the effort you’re willing to put into it. The more you know, the better decisions you’ll be able to make. Don’t sit there at your desk with an Angel on one shoulder and the Devil on the other. Ultimately, it’s your decision. You can have a plan, be proactive, lead the market, or instead, be constantly chasing price and availability. Ditch the Devil, hire the Angel.

Fundamentals

Although this market keeps moving higher in price, with solid underlying support, we found trading to be more of a grind this past week. As we witnessed last spring, with higher prices comes increased caution from the demand side of the equation.

There are several reasons for this buyer caution. Let’s take a look,

First and foremost is strong mill order files and extended lead times. As we all know, order files are rather subjective. Lead times appear more genuine. We all have experienced the ongoing transportation issues whether it be rail car or trucks. At these price levels, buyers are hesitant to purchase inventory needs that are scheduled to ship the third or fourth weeks of March, or in some cases, the first week of April. If you have a purchasing plan, you can adjust accordingly. If you’re one of the many unprepared, you’re perpetuating the problem.
Availability. At virtually all levels of the supply chain, there is a general lack of product offerings. Broken tallies are making mixed cars and trucks difficult to cover, and what is available, is pretty much the items most buyers don’t need.
Because of these first two issues, there has been quite a bit of double and triple buying of product with buyers “hoping” they have enough inventory on order, and in the shipping queue, to have them ready for spring business. We all know what happens when you employ the hope strategy. Increased pain somewhere down the line.
Then there is the financial side of purchasing. If you’re a full-service dealer, everything you stock, and sell, has gone up in price. Whether it be lumber, panels, windows or doors, demand and logistical issues have weighed on prices. Aside from inventory and inventory turns, there is also payroll and accounts receivables. How much cash can you generate to cover this increased cost of business, and how much more can your credit line get stretched?

On top of these obvious issues for the industry, you can add in weather events, production curtailments, fiber availability issues and from this past week, global geopolitical events. Let’s not overlook the macroeconomic ramifications from the Russian invasion of Ukraine. We saw what happened to the global energy complex, grain markets, metals, and currency. This all has an indirect impact on your business.

With this continued caution, we expect higher prices until the supply/demand equation returns to a semblance of balance. Mills keep producing and at some point, over the near term, the ongoing transportation issues will get resolved. Until that tipping point arrives, get used to those “where is my load” phone calls. Industry caution, coupled with buyer unpreparedness, will support this market a while longer.

Technicals

Even though we had a holiday shortened trading week in lumber futures, overall activity felt a bit disjointed. Add in the underlying strength and support in the cash markets, coupled with this futures pricing structure, and we continue to see a price disconnect between fundamentals and technicals.

Why a disconnect? We’ve discussed this ongoing basis situation for the past two weeks. Beginning with trading on Tuesday, the March contract, in essence, becomes a sawmill with a two-week order file. At the close Friday, the March contract settled at $1312.40. This is a $52.60+ discount to current cash levels at $1365 and higher. If you are a carload buyer of lumber, the March contract remains your least expensive option to purchase wood. That being said, we were pleasantly surprised to see 50 March EFP transactions posted by the CME on Friday.

Why disjointed? Over the 4 trading days last week, we saw the March contract trade in a rather wide range for a liquidating contract heading into spot month trading. With moderate trading volumes through the week, open interest was able to see a net gain of 45 positions. Once again, we see a gain in OI as a positive sign. In some instances, a bullish signal. Either way, this increase in participation adds additional liquidity to the contract. The week ended with position squaring ahead of the weekend and spot month trading this Tuesday.

We expect to see increased volatility in the lumber contract between now and expiration on March 15th. Why? Several reasons. First is the March discount to cash. With this discount, commercial longs are compelled to hold their positions, either anticipating higher prices to exit on long profit taking, or to take delivery via the EFP process. Either way is a win. For those non-delivering shorts, they will be forced to exit their positions prior to expiration. Any imbalance in these positions as both sides look to liquidate will spike volatility.

Second, spot month trading brings no limit daily trading up to, and including, expiration day. With March at a discount to cash, we would think most longs at this juncture are in a fairly less risk situation. On the other hand, any increased activity in the cash markets to the upside, would more than likely, initiate a possible short squeeze situation for those shorts needing to exit their positions ahead of expiration.

Third, new daily limit rules for the back months will be in effect beginning with trading on March 7th. We covered that change in last week’s post. For further clarification, you can consult the CME website.

Several other items of interest we’ll be watching this week will be; the May contract basis, the back month spreads, primarily the May/July, and any new life of contract highs that may be made in the next 2 weeks. We have mentioned on several occasions, we monitor these life of contract highs against prior year cash levels to help in determining value in both cash and futures for those specific contract months. In a backwardated price structure as we currently have, the back month life of contract highs can present hedge opportunities.

One last note, we are also anticipating some changes to be made to the lumber futures contract specifications over the next several months. Specifics are pending, but the changes will be a positive step to increase market participation and improved liquidity. We’ll pass on more information as it becomes available from the CME.

Dollars and Sense

Case-Shiller. This past Tuesday, the S&P released the results of their S&P CoreLogic Case-Shiller Home Price Index year over year. Included were the 20-City Composite Index and the National Index. In 2021, both the City Index and the National Index increased at a record pace by 18.6% and 18.8% respectively over the 2020 prices. In December, the City Index increased for the first time in 5 months and was actually above forecasts. As a reference, the National Index covers the 9 US Census divisions. Higher home prices were attributed to the usual culprits, property location, low housing inventory, increased material costs, and the velocity of home sales. The expectation is for a flattening of the increased price curve due to higher mortgage rates and inflationary headwinds.

Federal Housing Finance Agency. Also on Tuesday, the FHFA released their US House Price Index on a year over year format. This index covers the average price for single-family houses having their mortgages guaranteed by both Fannie Mae and Freddie Mac. On a year over year basis, house prices were up 17.6% compared to the 2020 prices. We will undoubtedly see the same headwinds affecting these home prices as noted above.

Home Depot / Lowes. Both Home Depot and Lowes issued press releases this past week reviewing Q4 2021 financial results. HD saw their sales increase by 11% in the quarter, while Lowes sales grew by 5%. Both are forecasting higher sales for 2022 and capturing a greater share of the professional contractor segment of the business. Additional details can be found on their websites. We find it encouraging that both are anticipating additional R&R business for 2022 and growth in the pro portion of their business.

MBA. The weekly report from the Mortgage Bankers Association of America was less than encouraging this past week. Actually, trending to the bearish side of the spectrum. Their latest report indicated a total drop in mortgage applications with the purchase segment falling 10.1% and the refinance portion 15.6% lower. This was the lowest level in applications since December 2019 and the biggest decrease since April 2020. The fixed average 30-year mortgage rate was once again on the rise pushing 1 basis point higher to 4.06%. This is the highest rate since July 20219. We don’t expect these numbers to really get any better moving forward given an interest rate increase for March, elevated home prices, low inventory of available housing stock and higher inflation numbers.

US Census Bureau. Housing news didn’t get any better with the US New Home Sales report on Thursday. US New Home sales dropped 4.5% in January from the December 2021 numbers. This was based on a SAAR of 801,000 in January against a forecast of 806,000 and the December 9 month high of 839,000. The drop was due to all the factors listed above in the other housing reports. On the price side, the median sales price of new houses sold in January was $423,300 compared to the year prior number of $373,200. The average price moved from $418,600 to $496,900 in January. The only real positive in the report was the supply of new homes for sale was up by 3%. One would have to believe the pool of potential home buyers to be on the decline given home prices, mortgage rates, inflation, etc. Time will tell.

National Association of Realtors. Not to pile on to end the week but Pending Home Sales reported by the NAR were down 9.5% in January versus the same time in 2021. Signed contracts to purchase existing homes in the US dropped 5.7% from December 2021 from the industry forecast of a 1% increase. This was the third consecutive monthly decline. Activity in all 4 US geographical regions declined on a year over year basis. It appears the housing industry has not gotten off to a good start for 2022. Perhaps we’ll see more positive news as the year progresses.

Economic Calendar. There is not much in the way of housing or construction news this coming week. Tuesday at 10 am we’ll see the January Construction Spending report, and Wednesday will be the weekly mortgage information from the MBA. To review the entire calendar, jump on over to Trading Economics and hit the “Calendar” tab for the day-by-day global financial reports. Lots of information to digest.

Anecdotal Thoughts

West Fraser. There was no real official announcement made this past week, but West Fraser is indicating they will be taking their BC sawmill operations from a 4-day production schedule down to 3 days. Reason cited was the inability to be adequately supplied with empty rail cars by the CN to be loaded. This has caused a build in finished inventories at these mills. It will be interesting to watch West Fraser sales activity over the coming month. We’ll also need to keep an eye on CN car cycling in March. You sure don’t want to be caught over-inventoried once mill direct shipping gets back on schedule.

Canfor. We’re sure most of you saw the news regarding Canfor’s sale of their shuttered Mackenzie sawmill complex. The mill facility was sold to Peak Renewables. In addition, the forest tenure was sold to two First Nations bands. More detailed information can be found on Canfor’s website. Of interest to us, where was the timber being shipped from the tenure after the sawmill closed? And if it was being shipped to other Canfor sawmills in the region, how will this affect their production moving forward? Think Fort St. John and Chetwynd.

Oil. We had mentioned earlier in this post, the global economic ramifications in other commodity markets due to the Russian invasion of Ukraine. In particular, the impact it will have on global oil prices and availability. In particular to the forest products industry, the effects on transportation, specifically rail and truck. Stay tuned.

Complacency. With the modest increase in lumber prices, coupled with slower activity on the week due to limited product offerings, we talked with several people across the industry sensing a downside correction in the market. We’re not sure whether we’ll chalk this up to a genuine shift in markets, a hope strategy, a lack of preparation, or complacency. We don’t know about you, but we believe there is gas left in the tank on this current market rally.

As always, we’re glad you could join us this week for our take on the lumber industry. We appreciate your support. With better weather ahead, and the days getting longer, we’re expecting another burst of buying activity over the next couple of weeks. Be prepared. Filter out the noise and listen to the facts. Be engaged. Stick to your plan. The last place you want to be is holding high priced inventory once the markets begin to correct.

As usual, should you have questions, comments, or suggestions, we can be reached on the following social media platforms,