It’s time to talk about lumber

Andrew_Gibson · January 31, 2022, 3:55pm

Finally, a week of market correction and a different type of volatility. Most of the past two weeks, this volatility was decidedly one sided. Now we are seeing a change in market dynamic and market make up. Over the last two weeks, the lumber markets were transfixed as the speculative long squeeze played out in futures. Most industry participants stayed out of the way and retreated to the sidelines. No doubt a prudent move. What comes next?

Panic or Prepare?

As this current market dynamic changes, we see two scenarios playing out over the short term. Why the short term? Because we believe this price correction in the lumber markets will be neither lengthy nor deep.

The most active building months of the year are March, April, and May. Moderating weather and longer days signal the unofficial start of the construction season. Buyers now find themselves out of sync with this seasonal uptick in business. After missing the last cyclical low in lumber pricing in mid-November, the majority resorted to panic mode purchasing to cover a portion of their Q1 inventory needs. In the process, they were forced to chase the market higher at increasing higher price levels.

This panic buying has now compounded itself as market and price fundamentals have now tipped the other direction. Now these unprepared panic buyers are faced with a market correction to the downside while holding overpriced inventory. Their options are now rather limited. They can continue to hold this high-priced inventory and hope prices bounce higher or judiciously work to liquidate their position and average cost lower. We all know, hope is not a strategy. This panic buying now turns to price and profit pain through the liquidation process. You all know this lumber advice; your first loss is your best loss. Work to lower your exposure to your high-priced inventory and be prepared to buy at lower price levels.

We may sound like a broken record here, but on the flip side of the panic buyer is the prepared buyer, the buyer with a purchasing strategy. These are the buyers that plan two weeks ahead, a month ahead, two months ahead, and a quarter ahead. They have a handle on their current inventory and what they will need moving forward. None of this just in time buying for this group. They bought the last cycle low in November and have been slowly adding to their positions moving forward. Slowly cost averaging higher to remain below current market pricing. These buyers have used the volatility in futures to manage risk by forward pricing and hedging their cash purchases.

Now with the market correcting, they are now in the position to pivot with the market. No need to dump inventory, no need to panic. The strategy here is to lower your inventory exposure to buy into weakness as prices work lower. As we mentioned earlier, we expect this window of opportunity to be short in length due to the time of year, and seasonally better business ahead. While the unprepared buyers try to pick a price to re-enter the market, the strategic buyers will be timing the market. Most mill order files are two weeks or sooner. We anticipate a short 30-day window to take advantage of these price corrections. Focus on your A-list items first. Again, buy into price weakness where you can find it. Average cost lower whether it be the cash market or March futures. Use all the tools at your disposal. Build your inventory position to get yourself through March and April. Anticipate a gradual liquidation of inventory through May ahead of Memorial Day. This should get us back to the historical cyclical price trend for the second half of 2022.

Will you be the panic buyer and be forced to liquidate your high-priced inventory just to then turn around and chase the market higher on the bounce? Or will you be the strategic buyer and have a plan in place to follow market pricing, and more importantly, market timing? Panic or prepared, your choice.

Fundamentals

Fundamentals. Those real, tangible reasons why lumber prices move up, down, or sideways. Prior to this last price cycle move, fundamentals played a primary role in moving lumber prices off their lows back in November. Real, fundamental reasons; old growth harvest concerns, disruptive weather events, transportation issues, genuine order files, real reasons why lumber prices would move higher. Once a solid price base had been established by these fundamentals, speculative technical traders decided it was time to follow the trend. As with this current correction in lumber futures, the volatility began after the expiration of the November contract. Before long, these speculative longs pushed the January contract to extreme premiums over cash. From here, the unprepared, irrational panic buyers joined in on the cash side to support higher prices.

At that point, fundamentals took a back seat to the mania in the futures market. Higher prices in both cash and futures, coupled with extreme basis, brought us to our current situation. Along the way, lumber fundamentals played second fiddle to speculative futures participants. Quite the recipe for our latest price correction. Unexpected? No. Check out our prior newsletters. Producers played along with futures by selling lesser volumes at increasingly higher prices to reel in the panic buyers. The lumber markets became disjointed and dysfunctional.

The past 8 trading sessions in lumber futures shows us what happens when the buying stops and the selling begins. Once again, the market focus reverts back to the technical side of the business versus the fundamental side of the business. As the limit down days piled up, more potential cash buyers headed for the sidelines. At this point, fundamentals took the lead since very few people were now interested in cash. Mill inquiry has slowed considerably. All the while, the mills were telling the industry they had no wood to sell. In addition, they were having transportation issues and were unable to ship in a timely fashion.

Now the real fundamental side of the business is showing itself. Rail car loadings are actually increasing. Transit times are improving. Mills are getting empty cars and looking for offers on prompt loadings. On the flip side, trucking remains difficult. That said, truck mills now have prompt wood available, particularly in SYP. The mills will make sure this wood ships.

This is what happens to lumber markets when the focus deviates from the fundamental side of the business. Real supply versus real demand. Not managed fund money speculatively driving lumber prices higher because they can.

Now is the time to pivot back to fundamentals. Engage with the mills, ask the right questions, push for the correct answers. Get back to trading lumber on real supply and real demand. Your time to buy will be short with this current price correction. Be prepared. Remember, it’s a timing issue, not a price issue. Always is, always will be.

Technicals

After a rather long 8 sessions slide lower, lumber futures settled in the positive on Friday. Not only in the green, but limit bid on the day. This means the expanded daily price limit is in effect for Monday trading. Now let’s take a more detailed look at this past week’s activity.

Monday, Tuesday and Wednesday saw the lumber futures contract settle down the daily expanded limit on very light volumes. Although these were light volume trading days, we did see a build of 52 positions in open interest. Normally a bullish indicator but difficult to determine in a plunging market. Aside from the consecutive limit down days, a key feature of interest worth watching was the extreme basis move over those 3 days. From Monday through Wednesday’s trading, the basis in March moved from a +$126.30 to +$206.30. May was even more noteworthy moving from +$227.80 to an extreme +$307.80. It’s no wonder cash market participants moved to the sidelines. Why buy cash 2x4 #2 WSPF at $1225 and higher when you could buy the March contract at $1010 and lower. In fact, March dipped below the $1,000 price level on Thursday for a daily low at $963.70.

What precipitated the change of direction on Thursday? Short covering of hedged positions, outright short profit taking, sub $1,000 in March attractive for forward pricing jobs, or some fund algorithmic trading program flashing a buy signal? Hard to tell what started the buying, but undoubtedly all of the above contributed to the overall buying interest in March. Thursday’s session didn’t settle in the green, but the settle did stop the expanded limit down moves over the past 6 trading days. Large volume trading day at 1353 contracts traded, but also of note was the drop in open interest by 85 positions. Again, not a bullish indicator.

Buying interest then reemerged on Friday pushing March back higher on a limit move day. Why the buying interest? Most likely the same reasons stated above. Also, for the technical traders, an inverted hammer candle was left on Thursday’s March chart. When this candle formation is found after a long price decline, it will usually signal a price reversal. In this instance it did with confirmation found with Friday’s limit up close. Does this mean March futures will continue higher? With less than 32 trading days until March expiration, and only 21 trading days until March 1st, we would expect to see March gradually trade sideways, to lower, searching for convergence against a lower cash price structure. For those waiting to buy $600 wood, we don’t see this short time frame to allow for such a violent drop in either cash or March futures. Remember what we said above. Moderating weather is ahead of us going into the three most active building months of the year.

As with cash, futures forward pricing levels will be predicated more on timing than price. Don’t try to guess a level or throw darts at your futures chart. Dig into the technical indicators involving the March contract to find direction. This is how managed money finds direction, and since they are sometimes the largest active participant in lumber futures, it would behoove you to engage in some of their market tactics. For short term consideration, let’s keep it simple and use the daily high and low from Thursday as points of resistance and support. The daily high at $1035.80, the low at $963.70. Should neither price level hold, catch up with us on Twitter throughout the week as we will recalculate.

Dollars and Sense

MBA Mortgages. Mortgage applications were 7.1% lower for the week ending January 21st. This was the largest drop in two months. Applications for purchase fell 1.8% while those to refinance were 12.6% lower. No real surprise here with the average fixed rate 30-year mortgage moving to 3.72% from the previous week’s average of 3.64%. This rate is the highest since March 2020. With treasury yields moving higher, the expectation is for mortgage rates to mirror these moves. Especially with the Fed considering four interest rate hikes for 2022. Higher rates, coupled with increased inflationary pressures, doesn’t bode well for prospective homeowners.

Case-Shiller. From Standard & Poor’s, the latest S&P CoreLogic Case-Shiller 20-city home price index was up 18.3% year over year in November 2021. Although this is the lowest percentage move higher since May, it was marginally higher than the forecast at 18%. The national index was a bit better, up 18.8% year over year, but lower than the 19% reported for October. The national index covers all of the nine US census reporting divisions. Price growth remains strong in several US housing markets. Will this trend continue through 2022?

Federal Housing Finance Agency. Sticking with the home price theme, the FHFA House Price Index for November was up 1.1% from October. Year over year, this is an increase of 17.5%. Although the monthly number was higher, the increases have been trending lower since last spring and summer. Access and affordability appear to be the main culprits. According to the FHFA, their “HPI is the nation’s only collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities.” HPI data is reported on both a monthly and quarterly basis using seasonally adjusted, purchase only information provided by both Fannie Mae and Freddie Mac. It would appear there will be some price increase challenges for some US markets moving forward.

New Home Sales. From the US Census Bureau. December new home sales were 11.9% over the November rate at a SAAR of 811,000. This exceeded market expectations of 760,000. This was the highest level reported since March of 2021. The median sale price was $377,700 which was 3.4% higher than December 2020. The average sale price was $457,300, a 13.8% increase year over year. The inventory of new homes for December sat at a six-month supply which was 9.1% lower than November. We would expect these numbers to be better if the housing industry could get the completions number under control rather than focusing on the starts and permits report.

Pending Home Sales. Last but not least, the US Pending Home Sales report released this past week from the NAR. Contracts to buy previously owned houses dropped 3.8% in December, well below the forecast of a .2% decrease. This was the largest decrease in pending home sales in 8 months. The expectation is for existing home sales to be 2.8% lower in 2022 as housing supply and home prices weigh on the market. I’m sure we can include higher mortgage rates and inflationary headwinds.

Economic Calendar. Not a lot of housing/construction reports due out this coming week. Tuesday at 10 am, the December month over month Construction Spending report will be released followed by the weekly MBA mortgage report at 7 am on Wednesday. Expectations are for a slowing in purchase applications and a further drop in refinancing applications. How much closer to 4% will we see the 30-year average interest rate move from last week?

Anecdotal Thoughts

FOMC Meeting. Several points of interest from this past week’s FOMC meeting. Current interest rates will remain unchanged until March at which time the Fed will announce a rate hike. Also of note, every FOMC meeting moving forward could consider additional rate hikes as needed. The expectation is for rate hikes to occur in March, June, September, and December although the pace of these hikes could proceed faster as determined by the Fed. On the topic of quantitative easing, the process of reducing the balance sheet is anticipated to begin sometime this summer as the interest rate increases begin to take effect. Although inflation has been more “transitory” than expected, the Fed believes the rate of inflation will decrease over the course of the year.

Inventory Availability. Over the course of the recent plunge in lumber futures, we are anticipating additional hedged inventory and basis traded wood to become available over the short term. If you own hedged inventory, now would be a could time to lift those hedges, take your profit, and work to liquidate a portion of that position to rebalance your inventory. It has also been noted that wood destined for Vancouver, and offshore markets, has been diverted to US markets due to continuing port congestion and vessel availability. Talk to your mill contacts and see if any of this inventory will suit your needs. And while we are talking about ports, get with your favorite European importers as we’re seeing an increase in on ground inventories at some US ports with additional inventory in transit. Since port space is limited, most importers are actively marketing this wood coming available over the next 3 weeks.

Low Grade. Keep an eye on low grade availability over the near term. This past week, we noticed some build in mill inventories of low-grade production. This usually indicates an increase in production of those corresponding upper grades since mills don’t intentionally run low grade material. Low grade is downfall from upper grades and usually sold on an accumulated basis. If mills have quantities to sell, it’s more than likely there will be offerings of higher grades not far behind.

SYP. Undoubtedly, everyone has noticed the price reductions and product availability in most SYP items. Why? The easy answer here is over-production. That’s part of the reason. The other is lack of treater participation in the SYP markets. Treaters account for almost half the SYP production purchased in the US. Needing to buy some inventory? In addition to your favorite sawmill partners, spend some time talking with your favorite treater. They will need to build more inventory for the first half of 2022. Stay in contact with them and gauge their interest in the SYP markets. A close relationship with your treater will pay dividends when it comes to buying your bright needs this spring.

We have covered quite a bit of information for the week ahead. Use it to your advantage. Stay engaged with your customers, stay engaged with your suppliers. If you don’t understand how the lumber futures market works, learn! If you thought the past 2 weeks were volatile, get ready, there’s more coming our way. Plan ahead and be prepared. Don’t get caught up in the “noise”, focus on the fundamentals.

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We have found Twitter to be quite engaging with the lumber community. Become a part of those daily discussions of real time topics. That said, we’ll be back again next Sunday to talk more about lumber. Until then, enjoy your week ahead.