Last week, we anticipated some degree of volatility surrounding the expiration of the January futures contract on the 14th. Fast forward a week. To say we experienced some market volatility this past week would be an understatement. Although cash pricing maintained uneven strength, the March futures contract lost a total of $165.00 over the course of 4 trading sessions from Tuesday through Friday. Needless to say, this precipitous drop in lumber futures pricing in the March contract, and the back months, caught the attention of cash traders. Now for the $64,000 question, where do cash and futures prices go from here? The question everyone was asking on Friday.
Hold or Fold?
For most industry participants, this question brings anxiety. What to do now? Do you continue buying at these elevated cash prices or wait? If you have been chasing this market higher, and buying as needed, you’ll be hard pressed to fold. Then you would run out of inventory. Your unpreparedness, as pricing moved higher, caused panic buying and monetary pain. Lost profit opportunities and now credit issues. Unfortunately, your options are limited at this point. Now you will have to balance your inventory needs until we see a more definitive market direction. As usual, the unprepared buyers, with no purchasing strategy, are stuck. Their anxiety continues.
For those with a purchasing strategy, your ability to pivot in volatile markets will present opportunities. You have built your current inventory position over the last 60 days. You were buying into weakness on the last price cycle low and judiciously added to your position through forward pricing the November contract. Once your base pricing was in place, you were able to cost average as the lumber market pushed higher. Your ability to have on ground inventory, product in transit, and lumber on order has allowed you to keep pace with price appreciation. In addition, you were able to take advantage of the extreme premium in the futures market to hedge on ground inventories and basis trade a portion of your future needs. All the while supplying your customers with product in a timely and profitable manner.
While the unprepared buyers try to decide whether to hold or fold their inventory position, the strategic buyer is now able to search for value in this current market structure. With a cost average trailing current prices you will now be able to profitably liquidate your inventory in anticipation of lower market prices. As prices work lower toward your break even cost structure, you will now be in the advantageous position to once again buy into market weakness and average cost lower. All without compromising your inventory integrity. Because you were prepared and have a plan, you now hold all the cards. You own inventory, it’s priced right, and now you’re in position to take advantage of market weakness. It pays to have a plan!
Fundamentals
After the price volatility we witnessed in lumber futures this past week, does this mean we’ll see cash prices immediately tip over and plummet lower? We don’t think so. More of a gradual rollover, then a slide lower as opposed to a plummet. We anticipate a more organized move to the downside. We also don’t expect an extended retreat lower in prices. The duration of this market correction will not be as lengthy, nor will pricing drop to levels most buyers are anticipating. We know the industry mindset, virtually everyone thinks the market will go to zero. Everyone wants to buy the bottom. Everyone picks a price level at which they say they will buy, only to change their mind as prices work lower.
You know the drill; everyone is fixated on price. Herein lies the problem. Buying cycle bottoms is a function of timing, not pricing. Always is and always will be. This is why the vast majority of the industry ends up back in chase mode once the market corrects back to the upside. You can either formulate a buying strategy with a focus on timing, or as most do in the industry, just hope you are making the right decision at the right time. And we all know how that turns out. Hope is not a strategy.
Let’s look at this market timing in more detail. There are numerous factors to weigh in making your decisions. Most obvious to us is the supply/demand equation. We’ve heard this song before on the supply side. First are the production issues. Log availability, labor issues tied to Covid, extreme cold affecting sawmill machinery, and extended lead times due to all of the above. I know it’s hard to believe, but this isn’t the first cold January ever experienced in Canada. The outlier here is Covid. But according to industry reports, overall production output in Canada has changed little over the last several months. We would guess that continued automation in sawmills is having a positive impact.
This time of year also brings the annual transportation issues. We all understand how the snow and cold affects rail and trucking. Once again, this happens every winter. The rail issues always work themselves out as weather moderates and the supply of empty cars returning to the mills increases. It doesn’t hurt matters knowing the sawmills will want to load as many cars as possible while cash prices remain over $1200 mill. Is Covid an issue in transportation? Of course, it is. On the other hand, the vast majority of lumber moving from Canada to the US is via rail, not truck.
Now, let’s flip that album to the demand side of the equation. No matter the housing market location, the same weather mentioned above affects home building activity in the US, and the demand for lumber. In the northern part of the country, it’s cold wintry weather. In the US south, you can always expect wet and unstable weather conditions. Overall demand for product slows this time of year.
You can also add into the mix buyer fatigue, elevated prices, and credit issues. Product affordability once again impacts product availability. At these price levels, how much inventory can everyone in the distribution chain afford to buy? How far does the purchasing budget get stretched as inflationary pressures increase the cost of virtually every inventory item you stock?
At this point, one would think the home builders might want to take a step back and focus on the increased backlog of unfinished properties. Doesn’t really add to their overall profitability to keep starting houses they can’t finish on time. How about all the anticipated DIY business at the big box level? Big expectations last spring, that didn’t pan out, and then contributed to the overall crash in lumber prices. We’re guessing there have been some adjustments to their business plan for this spring. Who really wants to spend more time at home?
Why do we bring up these topics for discussion? It’s simple. Although there is an expectation for short term market demand to slow, the sawmills will continue to make lumber. They make while we sleep! Why would they do this you might ask? How about $1200m FOB-mill for starters. Depending on the sawmill input costs, it’s like printing money at these price levels. Especially as higher production mills reduce unit cost of product. Curtailing production at a sawmill is like turning an aircraft carrier, it takes time. On top of that you still have fixed costs including that inventory of logs in your log decks. Expect production to outpace demand over the near term.
There will be a price correction. Look for the signs; mill offer sheets, prompt loading items, shorter order files, and outbound mill sales calls. This process never begins all at once, but follows a progression starting with product availability. Also be aware of basis hedged wood that will now enter the cash markets as short hedgers unwind positions. Be aware and be prepared. Although we expect this price correction over the short term, we don’t anticipate a lengthy or deep correction in pricing. Certainly not what we experienced last spring. Why? The markets continue to run countercyclical. In plain speak, better weather ahead brings us into the prime spring building season. There will need to be another build in inventory to carry the lumber distribution chain from March, into April, and into May before seasonal business slows ahead of Memorial Day.
There’s a lot of planning to be done over the next several weeks to put yourself into a position of inventory strength. It’s time to review, and update, your purchasing strategy. For those of you that fail to plan, as Brian Mills would say, “good luck”.
Technicals
We always expect some price volatility around the expiration of every lumber futures contract. That said, this past week proved to be quite exceptional as the spot month March contract dropped an astounding $165.00 over just 4 trading sessions. With Monday trading closed due to the MLK holiday, Tuesday closed down the $30.00 daily limit. This primed Wednesday to trade with the expanded $45.00 daily limit which it was more than happy to oblige. Of course, this expanded limit rule then rolled into both Thursday and Friday leaving most of the industry rather stunned, and scratchy their collective heads, as the trading week came to a close. This might be a good time to review Howe’s Limit Rule!
Let’s look at some of the particulars. First off, we had been telling you about the extraordinary premium futures was carrying over cash. The primary drivers behind this premium in futures was managed money, and the lesser-known non-reportable segment of contract participants. We could not emphasize enough how fundamentally disjointed this was for the lumber futures market structure. As we said last week, why would any rational cash lumber trader chase a premium in the futures contract supported by a segment of participants with virtually zero active interest in the underlying cash? This speculative premium in futures, over the long term, was destined to collapse. This past week we saw the bubble burst. For some industry participants, unexpected. For those of you following our weekly musings on the market, this rather violent move to the downside in lumber futures was fully expected.
Aside from the consecutive limit down days last week, lumber futures trading volumes decreased as the week wore on, no doubt attributable to the limit trading days. Of note, total open interest once again dropped below the 2,500-position level by week’s end with a weekly net loss of 16 positions. Friday’s trading was a microcosm of daily activity for the week. March saw light rolling into May, some outright liquidation, and some daily two-sided trade ahead of weekend position squaring.
Lumber futures structure remains in backwardation, although now, all traded months are at a discount to current cash levels. For those looking to lock in pricing for future business, those forward pricing opportunities now exist. At the close on Friday, the March contract was an $81.30 discount to cash while the May basis ballooned out to a +$182.80. Will we see greater expansion in basis for either month moving forward? We believe so, but we expect this time frame to be rather narrow as cash pricing begins to adjust to the futures discount. Why? Because basis convergence is virtually a certainty. The closer we get to March 1st, the narrower this basis will become. At that point, the March contract becomes the equivalent of a sawmill with a two-week order file. Traders then have the option to buy whichever price is better, whether it be cash or to take delivery through the EFP process.
Once again, we will watch market make-up in lumber futures. Most managed money participants are technical traders with very little interest, or knowledge, of the underlying lumber cash markets. Chart observation, with clear levels of support and resistance, will be critical moving forward in gauging market direction. To follow these technical traders, we must follow these technical indicators. The more we can understand their trading strategy, the better we can make decisions. If you are solely a cash trader, with little or no interest in lumber futures, then you are severely limiting yourself in understanding overall lumber market dynamics. You can’t control what you don’t understand. Be informed, knowledge is power.
Dollars and Sense
Mortgages. According to the MBA, mortgage applications increased 2.3% for the second week of January. Purchase applications were up by 7.9% while applications to refinance were down by 3.1%. This was the lowest level for refinancing in over two years. It would appear that applicants to purchase are attempting to stay ahead of the increased rate hikes through 2022. For the 4th consecutive week, the average fixed 30-year mortgage rate increased to 3.64%. This was the highest level since March 2020. How many prospective home buyers will continue to get pushed to the sidelines as mortgage rates increase? Time will tell.
Existing Home Sales. Some good, and not so good news, from the NAR. The good news is that existing home sales in the US for 2021 totaled 6.12 million. This is an increase of 8.5% from 2020. Existing home sales inventory sits at 1.8 months’ supply. The not so good news, December existing home sales fell by 4.6% from the November total. Existing home sales had been on a 3 month roll before this drop in December. This will be worth watching as interest rates increase in response to increasing inflationary pressures and the impact on consumer incomes.
NAHB. The NAHB/Wells Fargo Housing Market Index dropped by 1 point in January to a reading of 83. The HMI gauges builder confidence. The Index is comprised of three components; current sales conditions which was unchanged at 90, sales expectations which dropped by 2 points to 83, and buyer traffic which also fell by 2 points to 69. Readings above 50 are considered positive, while those below are deemed negative. Not overly encouraging.
Canadian Housing. As reported by the Canada Mortgage and Housing Corporation, December housing starts in Canada dropped by 22% over the November figures. Actual starts at 236,106 missed expectations of 270,000 for the month. We’ve never really known what to think about Canadian housing starts. Of course, a drop of 22% can’t be very positive for the industry.
US Housing Starts/Permits. We’re going to guess here that most of you saw the headline numbers released by the Census Bureau on Wednesday morning. That said, here are the actual numbers on a not seasonally adjusted rate for single-family starts and permits, month over month (December vs November) and year over year. Actual starts in December were down by 9.5%. The year over year number was better with starts up by 4%. On the permit side, actual permits for December were up less than 1.5%. Year over year, permits were lower by over 3%. Also of note, completions remain under the 1.3 million level at 1.295 million. It’s always worth the time to scroll through the report and gauge the actual numbers versus the seasonally adjusted numbers.
Economic Calendar. Another week of housing reports ahead. Tuesday morning at 9 am, we’ll see the FHFA US Housing Price Index, and the S&P/Case-Shiller Home Price Index. How high can home prices escalate? We’ll find out. Wednesday at 7 am is the MBA weekly mortgage report on purchase and refinance applications, plus the 30-year mortgage rate. Also on Wednesday, we’ll see the December New Home Sales report. At 2 pm, the Fed Interest Rate decision will be announced. How will the markets react? Finally, on Thursday at 10 am, the December Pending Home Sales report will be released. We would expect some positive news here as buyers try to close before additional mortgage rate increases.
Anecdotal Thoughts
BNSF. The BN announced this week they want a federal judge to prevent two of their unions from going on strike in February. The bone of contention is a new attendance policy by the BNSF set to go into effect February 1st. Lots of verbal banter being exchanged between the BN and the union as they present their cases in news releases. We’ll keep following this story and any impacts it may have on the forest products industry.
Collective Thoughts. Although most of our week was focused on the rather dramatic price drop in lumber futures, we did notice a couple items of interest in the cash markets. First, availability of 2x4-9’ stud trims in ESPF appear to be more prevalent. Not widespread availability, but availability, nonetheless. A bell weather item in all US markets, so we’ll keep an eye on them moving forward. Second, the same is holding true for some SYP items. Last week we mentioned 2x8 for prompt loadings. Rather strange considering 2x4 SYP is so tight and expensive, or is it? You would think the mills would be ripping the 2x8 to 2x4 to gain the rather massive premium in price. Thirdly, we’re seeing more Euro volumes transiting to US ports. Most arrivals are for the weeks of February 21st and February 28th. What makes this noteworthy is that fact that the material is priced at current market levels. Normally, prices don’t get assigned to this open market wood until it is nearing the port in hopes of garnering higher prices. There’s the feeling that the importers are attempting to move this wood at higher prices now, before they see lower prices when it arrives at the port. We’ll keep watching as this develops.
Quite the interesting week. Of course, we expect more volatility ahead as both the cash and futures markets work to sort themselves out. As always, be prepared and be ready to act.
Once again, we would like to take this opportunity to say thanks for your support. Your feedback has been insightful and encouraging. We appreciate the interaction. Questions, comments, recommendations? You know where to find us,
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