Game On? Or Sitting in the Stands? | By Mike Clark

Andrew_Gibson · March 6, 2022, 7:09pm

It’s time to talk about lumber

March has arrived and so has the beginning of the spring building season. Weather has started to moderate across the US with winter now in the rear-view mirror. Next Sunday brings daylight savings time and longer workdays. The days will get warmer, and the ground will begin to thaw. It’s time to dig those foundations and get the framing packages ready to ship. If you’re in the forest products industry, this is the time of year you’ve been waiting for. The big question now? Are you ready?

Game On or Sitting in the Stands?

The next 3 months are, arguably, the 3 most active building months of the year. It’s game time. Have you been following your purchasing plan? Are you adequately stocked with inventory and ready to go? Or have you been sitting in the stands continuing to make knee jerk decisions? Not following the markets, buying as you run out of inventory, no clear direction, no purchasing strategy.

We’re pretty confident that most of the demand side is still in the stands. How do we know this? Even though everyone knows March, April, and May business is right in front of us, there has been a total lack of urgency to plan ahead. No due diligence, just an increase in complacency. It all goes back to what we talked about in last week’s newsletter. There are very few entities throughout the supply chain today that want to hold inventory risk. Most lose sight of the big picture and tend to fret about the here and now. They get paralyzed with indecision and uncertainty. In their minds, the best decision is to make no decision. Perpetual procrastination until it’s too late in the game for a win. Their unpreparedness, their inability to buy, and their lack of desire to build inventory continues to support higher prices.

Because these buyers have no plan, they believe the cyclical high in the market is right around the corner, and they don’t want to get caught holding high priced inventory. A rather oxymoronic thought process, always believing the top of the market is just ahead, but never planning to buy and build inventory in the first place.

From our point of view, the past two weeks have been rather dull. So uninspiring, it appears to us that most buyers have been lulled into the above-mentioned state of complacency. Their days are kept busy checking on every purchase order they have placed. Their purchasing strategy for the week is to shop the same inquiry, every day, hoping to see a break in the market. With spring building season here, and business activity ready to ramp up, this complacency will soon turn to the oft seen scrambling to replenish inventory as it goes out the door. That scrambling will then turn into panic as all the relatively quicker shipping product is gone.

We all know how this will end, and it’s not good. At some point between now and Memorial Day, the bulk of the transportation issues will resolve themselves and this overheated, over inflated price structure will peak and then collapse. We saw it happen late last spring, we’ll see it happen again. You’re either a player with a plan, or not. It’s either game on or continue to sit in the stands and be a spectator. Your choice.

Fundamentals

To buy or not to buy. As mentioned above, everyone is getting busier, but most are concerned about these current price levels. What to do. Here’s what we think. Last spring, we saw prices surpass the $1700 mark. Will it happen again? We believe so. Why? Like any other commodity market, the price levels last spring set a benchmark price for the sawmills to try shoot for again this spring. It’s similar to chart gaps on a futures price chart. Gaps, whether they be on the upside or downside, almost always get filled, sooner rather than later. The same with cash prices. Been to $1700 once, we’ll try it again. That’s how the lumber markets work.

Let’s take a look at the quantitative side of the question. Over the past 2 years of daily price history in the lumber market, 1% of the days were higher than $1500. In that same time period, 16% of the days were over $1000 up to $1500. Given the time of year, $1500 appears to be easily attainable.

Let’s take this one step closer and look at last year’s daily price history. In 2021, 20% of daily prices were in a range from $1,000 to $1250. We’ve been there in the first week of March this year. Move onto the next bracket and we’ll find that 16% of daily prices were $1250 up to $1700. Currently, we are sitting in that range at the beginning of the spring building season. Can today’s price structure move to $1700 of higher? Absolutely. Should you build some inventory at today’s price levels? If you don’t have a choice, by all means buy $1400. By looking at the daily price history over the last 2 years, $1400 would be a competitive price point against $1700 or higher. Given the current supply side issues, we believe $1700 and higher is a foregone conclusion.

Now let’s look at the fundamental side of the business. Once again, we are experiencing another market disruptor, the Russian invasion of Ukraine. Market disruptors bring uncertainty and indecision. Keeping to the geopolitical theme, we’re also witnessing the “risk on” nature of the commodities markets. Increased volatility due to the global uncertainty. Risk moves to these physical commodities. Our expectation is for lumber pricing to follow the lead of oil, gasoline, natural gas, grains, copper and precious metals such as gold and silver.

Then there is the fundamental side of lumber. We all know the issues here. Mills, in most instances, have genuine order files and lead times due to ongoing transportation issues. Most participants on the demand side are digesting previous purchases quicker than they can replenish. There is an ongoing imbalance between short term and long-term inventory coverage. New construction activity will be on the increase followed by an anticipated jump in R&R as consumers begin spring projects. Until the supply/demand equation returns to some semblance of balance, product availability will remain tight supporting higher prices.

Technicals

This past Tuesday was March 1st and the beginning of spot month trading. The March futures contract will remain in liquidation mode up to expiration on March 15th. Spot month trading also means no daily price limits. Also of note, beginning with Monday’s trading session, daily price limits will increase to $57 with the expanded limit moving to $86. These new daily limits will remain in effect until May. The CME calculates the daily limits twice a year and is in the process of determining the new limits for the second half of 2022. For particulars, you can access the CME website to review Rulebooks / Chapter 201, Random Lengths lumber, and SER-8927 for additional details on the new daily trading limits.

As March liquidates, we continue to see volumes increasing in the back months via position rolling and the spread trade. On a not so positive note, this past week we saw a daily decline in overall open interest Monday through Friday. We’ll begin this week at 2486 open positions.

May basis started the week at a rather robust +$171.30, but by week’s end had narrowed to +$89.20. Does May remain a buy opportunity at these levels? We’re not enthused. We do, however, find the new life of contract highs made this past week in May, July, and September of interest when considering a risk management strategy moving forward. Do your homework. The first week of July in 2021 saw lumber cash pricing at $710. Is selling July at new life of contract highs an opportunity? We believe so. We will also monitor the back month spreads for value.

In previous posts, we have discussed on numerous occasions, the advantages of the EFP process in finding price value. This past week saw 40 EFP’s transacted for a total of 131 March EFP’s to date. For those industry participants, congratulations for using the futures contract as a forward pricing tool for physical delivery. More profits for your bottom line, well done. Also of note, there were 20 EFR’s posted last Monday by the CME. An EFR is an “exchange for risk”, defined as “a privately negotiated simultaneous exchange of an Exchange futures position for a corresponding OTC swap or other OTC instrument.” We expect additional EFP’s to be posted this week as existing positions are reconciled.

With 7 trading days to expiration in the March contract, coupled with the new daily price limits, we expect increased volatility until March 15th. These next 7 trading sessions will weigh on the industry as a variety of participants will be looking for near term market direction. As we explained earlier, the path of least resistance at this point is higher. Be prepared.

Dollars and Sense

Construction Spending. According to the US Census Bureau, construction spending in the US was up 1.3% in January compared to December 2021. This beat market expectations of a .2% increase. Public construction spending gained .6% supported by increases in both residential and nonresidential activity. Increases were also seen in new single-family residential construction, transportation, and in the manufacturing segment.

Canfor. This past Tuesday, Canfor announced their Q4 and 2021 year-end financial results. Not surprising to anyone, 2021 was a record setting year for Canfor. Several of the report highlights,

All-time high operating income of $1,908.1 million and a net income per share number of $10.74. Adjusted net per share was $12.16. This was on year-to-date sales of $7,684.9 million.
Higher production and shipping volumes of lumber in both Europe and the US South. Noted were production and shipping issues in BC for both lumber and pulp.
Completion of Canfor’s acquisition of Millar Western Forest Products and their solid wood operations in Alberta. Also included are the associated forest tenures. This acquisition adds 630 million bf of production to Canfor’s overall production capacity.
The announced sale of Canfor’s shuttered sawmill in Mackenzie, BC. Combined proceeds from the sawmill and associated forest tenures totaled $70 million.

Additional information and other financial particulars can be found on the Canfor website.

CP Rail. In member voting completed on February 28th, The Teamsters Canada Rail Conference issued a notice to members that 96.7% of votes were in favor of strike action against CP Rail. These union members include engineers, conductors, train persons, and yard persons. Issues cited for the strike mandate were related to wages, benefits, and pensions. Ongoing mediation with the federally appointed mediator/conciliator is scheduled for March 11-16. Should rail strike action be taken, CP Rail will usually continue operations with management personnel. As with previous strike activity by rail unions in Canada, the federal government then legislates workers back on the job. We’ll continue to follow the situation until resolution.

Mortgages. We were a bit surprised by the weekly information released this past week by the Mortgage Bankers Association of America. In the week ending February 25th, total US mortgage applications dropped .7%. This was the 4th consecutive weekly decline. Results were mixed with applications to purchase 1.8% lower while those to refinance were actually up by .5%. The average fixed 30-year mortgage rate increased 9 bps to 4.15%. With the expectation of higher rates over the long term, it will be interesting to follow both application components moving forward.

Anecdotal Thoughts

West Fraser. This past Monday, West Fraser announced that they would be participating in Raymond James’ 43rd Annual Institutional Investors Conference this Monday. Of note will be a hosted conversation with West Fraser’s President and CEO, Ray Ferris. You can access the event via the West Fraser website. We would expect some good fundamental and financial information to be shared by Mr. Ferris covering the forest products industry as a whole and West Fraser in particular. Stay tuned.

Spring Breakup. We know it happens every year, but it’s always worth keeping an eye on spring break-up in both the US and Canada. Most of the industry doesn’t follow this yearly event as closely as they should. The time leading up to break-up is when mills build out their log decks for the first half of the year. As warm weather increases, fiber procurement becomes more difficult due to the heavy equipment being used to log and the soft terrain. Of particular note over the past 2 years has been increased costs associated with labor issues and availability, cost of logs, allowable cut issues, and trucking expenses tied to both fuel and labor. On the positive side, stumpage rates have moderated. Either way, you can’t produce lumber without the logs. We’ll be following this topic throughout the year.

Risk On. If you haven’t been following the commodity markets in general over the past 2 weeks, you had better. While our industry focuses on lumber, in both the cash and futures side of the business, we also need to be aware of other tradeable commodities and the impact they have on our industry. Whether the impact is direct, or indirect, this current “risk on” situation in the commodity markets is rather unsettling. Oil and gas for the transportation markets, copper for industrial uses, interest rates for borrowers, or grains for food consumption, they are all adding to the overall inflationary scenario that has an effect on our everyday lives. Be tuned in, you need to be in the know.

Produce Season. Can the ongoing truck transportation issues get any worse? Yes, they can. Once again, we’re heading into the spring growing season and produce season in particular. We all know what happens when produce needs to be moved from field to markets. Truck availability will only worsen as the fruit and vegetable producers will out bid lumber and panel producers to move their perishable loads. This situation normally impacts the eastern half of the US, but with transportation issues in both truck and rail, expect shipping difficulties across a wider geographical footprint this season.

Canfor. Got to thinking about Canfor some more. Following their acquisition of Millar Western, it is estimated Canfor has approximately $1.1 billion of cash on hand. The big question, what will Canfor do with this excess cash position? Our first thought, additional diversification inside Canda but outside of BC, perhaps additional acquisitions in Alberta, Ontario, or Quebec? Not out of the realm of possibility after Interfor gobbled up Eacom. How about their options outside of Canada? According to most industry pundits, long term growth in North American forest products will be focused on the US South. Canfor currently has 11 sawmill operations in the region, adding to that production footprint would not be difficult. How about outside North America? Canfor could very easily purchase the remaining 30% of Vida they don’t already own. Quite the predicament. All that cash and what to do with it? A good problem to have for future growth.

Thanks again for joining us this week for our take on the lumber industry. We appreciate your support. We remain bullish in our outlook on the lumber markets over the near term. That said, be prepared. Take the time this week to work the phones and gauge market structure and direction. Be engaged. Stick to your plan. The last place you want to be in this market is not having enough product for your customers when they need it.

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