Risk vs Reward

Andrew_Gibson · February 21, 2022, 4:05pm

It’s time to talk about lumber

A common thread continues to make its way into just about every conversation we have had the past couple weeks. We’re sure you’re hearing it also. How can the industry be so underbought, and under inventoried, heading into the three most active building months of the year?

Sure, we’re hearing this primarily from producers and the wholesale community, but truthfully, who on the retail/builder end of the business would admit to this? Pretty much none of them. Of course, that doesn’t mean this situation doesn’t exist. We all know it does, otherwise demand wouldn’t be so constant, and prices wouldn’t be continuing higher.

Everyone is more than willing to point fingers as to why the industry is in this predicament. We believe it all boils down to risk versus reward.

This imbalance in supply and demand is not new. We often experience this issue several times a year, every year. This is what brings price volatility into the lumber markets. Sometimes, this imbalance is more acute than other times. Is this market volatility new? Nope, just more frequent. And why is that? We look back to 2008 and the Great Recession.

Why 2008? For those in the industry, home building was booming. It was time for everyone to buy a part of the American Dream. Just about everyone could get a mortgage, whether they were qualified or not. Times were good. Housing starts were hitting the 2 million mark. Lumber was flowing uninterrupted through the supply chain. Everyone was making money.

Then came the financial crisis. Corporate lending ground to a halt. Liquidity was squeezed. Companies downsized, were acquired, or just disappeared. The Big Short had arrived and the government scrambled to keep the economy from crashing.

And then there was housing. Up to this point, there was limited risk in the home building industry. New homes were being built as quickly as land could be developed and material shipped to the job sites. New homeowners, with mortgages in hand, were ready to buy. Little risk, lots of reward. There was no real need for inventory management. All you had to do was keep the wood coming to your yard and get it shipped to the contractor.

We all know what happened when the music stopped and there weren’t enough empty chairs. Housing starts plummeted. Cash flow dried up and credit lines got squeezed. There was amble inventory in the pipeline with no end user to ship to. Housing starts went from 2 million down to approximately half a million. Virtually no one was left unscathed. The industry had to step back and tighten its collective belt.

Why the long story? What’s the point? As the building industry regrouped, inventory and cash preservation went hand in hand, and was at the forefront of just about every business decision. Everyone in the lumber distribution pipeline needed to reevaluate their inventory management programs. Everyone now had to evaluate risk.

From 2008, up to now, we have seen a rather profound shift in purchasing habits. Most volume buyers have scaled back their car purchasing due to costs, transit times, and exposure to price risk. Those buyers are now more apt to concentrate on a purchasing strategy of mill contracts, some speculative buying, fill in distribution trucks between car arrivals, and the occasional forward pricing opportunities that may present themselves. Car buyers purchasing fewer cars, car buyers purchasing more trucks, truck buyers purchasing fewer trucks and the smaller buyers moving to mixed trucks from straight length trucks.

Where does that leave us now? Take a look around the industry. We keep hearing people saying reloads are packed with wood. We continue to see the growth in wholesale distribution. The industry has been shifting towards more just in time buying versus the old tried and true strategy of buying a half a year’s worth of inventory in November and December. The same amount of wood is out there, just in more hands.

In today’s business climate, the lumber industry has become more risk adverse. Nobody wants to buy and hold inventory today. The comfort level appears to be that of spreading the inventory risk around from the mill to the wholesalers, reloaders, importers, and stocking distributors. In an attempt to avoid risk and volatility, a good portion of the industry has added to it by not owning and building inventory. Most buyers today have given up a portion of reward by spreading around their lumber inventory risk. For most, it hasn’t exactly worked the way they had planned.

Fundamentals

Very little has changed this past week on the fundamental side of the lumber business. Sawmills continue to produce wood, but transportation issues remain. How bad are the rail issues in BC? We’re sure many of you saw the late week email from a prominent BC sawmill operation explaining their difficulties in securing cars from the CN. For those unaware, this past week, the above company ordered 84 empty cars to load. The railroad allocated them 25 cars. By weeks end, only 10 cars were actually spotted. Their list of backlogged orders just increased by 74 cars.

As mentioned above, lumber inventories are now spread around in various regional markets. Outtake has been steady but replenishment a challenge. While trying to avoid inventory risk, the entire supply chain has become disjointed. As we all know, once the unprepared portion of the industry decides to buy, it’s the distribution and port wood that’s depleted first.

That’s where we stand today. There is less short-term availability of product against increased demand. With moderating weather and increased building activity right around the corner, the situation will only get worse before it gets better. Add in the higher prices, and credit limits are constantly under pressure.

This inability to build inventory over the short term will support higher prices. The situation is only exacerbated by the indecision and uncertainty of buyers who every day decide “I’ll wait” or “let’s see what print does” and in the process continue to chase higher prices. These buyers are banking on their hope strategy, but we all know how that turns out.

What do we do now? As noted in our last newsletter, we expect the lumber markets to remain active into March and through April. It will take time for these transportation issues to resolve themselves, but they always do. Forest products car loadings are slowly on the rise with rolling cars transit times improving. Backlogged orders will need to ship first with contract and committed business. Then the mills can focus on their cash order file. For those of you who remember 2018, so far, this year is quite similar. Once product began shipping in a timely manner, the supply/demand equation corrected to a level of equilibrium, then pricing faded into May and into the summer months. We expect a similar outcome this spring.

If last year is any indicator of where we might find price relief, the week of May 10th was the turning point. Whether you have a purchasing strategy or not, your timing in and out of this current market situation will be crucial.

Technicals

For those not aware, CME Globex lumber futures will be closed Monday for Presidents Day. Now for the big news from last week. On Thursday of last week, the CME released Special Executive Report (SER) 8927 expanding the daily price limit for lumber to $57mbf until their next scheduled daily price limit reset in May. In addition, “should either of the nearest two listed contract months that are subject to a daily limit settle at limit, the daily price limits for all contract months shall increase to $86mbf.” This change will be effective March 7, 2022. Because this takes effect March 7, the March contract will already be the spot trading month with no daily limits. The new limit rule will be based on limit moves in May or July. Until the reset in May, the new limit rule will apply to either the May or July contract settling at limit. You can find the complete SER 8927 on the CME website.

Renewed buying on Monday settled March at limit bid, follow through buying on Tuesday then settled March at the expanded limit bid. Wednesday settled in the green for the day, up $29.40. A quick glance at the current CFTC report indicates Managed Money adding to their long position, while we saw short covering by Swap Dealers and Commercial interests. But just when most traders anticipated the March contract to set a new life of contract high this past week (current LOC high is $1338.20), buying ran out of steam. Thursday trading had the March contract back at limit, but this time $30.00 lower. The selling continued into Friday with March closing out the week at $1270.00. With the board closed Monday, there are only 5 trading days until March spot month trading. This brings increased margin requirements and no daily trading limits.

Several other notes of interest from last week’s trading. In what is usually a bullish scenario, Open Interest added a total of 220 positions to finish the week at 2740. Conspicuously absent was zero EFP’s posted on the week. We’ll discuss this later. March continues to liquidate in an orderly manner with all the back months picking up open interest volumes. Wednesday saw the May contract set a new life of contract high at $1256.50. We are always cognizant of tracking LOC highs and lows for hedging and forward pricing opportunities. We also saw a marginal contraction of the back month spreads Wednesday through Friday. We’ll keep an eye on those.

Let’s backtrack to EFP’s. We had considerable debate this past week on Twitter regarding EFP opportunities in the March contract. As always, we appreciate the feedback we receive from other industry experts on the matter, and the information shared. We had noted, with the March contract trading at a discount to current cash levels, that the EFP process is now the least expensive option IF you are in the market to purchase rail cars of lumber. Also included in the discussion were correlation values for non-contract “other” items and ship times for EFP’s. As we have previously noted, you do not have to wait until contract expiration to reconcile an EFP transaction. I have actually seen EFP’s transacted almost a month prior to the contract expiration. Also, if you have a track record with a participating sawmill, the EFP cars can usually be slotted into the particular mills current shipping schedule. There were 24 EFP’s transacted the week prior, and I would venture a guess that most of those cars will be shipping in the next week, or two. Just as a buyer uses an EFP as a purchasing tool, the mills use them as a selling tool. With this said, be engaged. If you’re not looking at these EFP opportunities, you’re missing out on profit opportunities.

Dollars and Sense

PPI. According to the Bureau of Labor Statistics this past Tuesday, the US Producer Price Index increased by 1% in January over a revised December increase of .4%. The market forecast was for a .5% increase. Not good news. In the past 12 months, including January, the PPI has increased 9.7%. This is a slight reduction from the 9.8% increase registered for December. We’re all waiting for the upcoming Fed rate news. Stay tuned.

West Fraser. West Fraser Timber released their Q4 2021 financials this past week. Although raw numbers were quite robust, earnings were negatively impacted by ongoing transportation issues. Adjusted EBITDA results were reported for lumber, North American engineered wood products (including panels), pulp & paper, and their European engineered wood products. Particulars can be found on their website. West Fraser also offered 2022 guidance for lumber (both SPF & SYP), North American OSB, European OSB, and pulp & paper. Of interest, management expects SPF and SYP shipments to be equal at 3-3.2 bbf. Given market dynamics, it’s not difficult to understand the growth in their SYP business.

Later in the week, West Fraser announced a Renewal of Normal Course Issuer Bid entitling them to purchase up to 10,194,000 Common shares of the Company representing approximately 10% of the public float as of February 14. This new NCIB will begin on February 23. As mentioned above, details can be found on the West Fraser website. Plowing that cash right back into the company is a positive move.

Canfor. Two news releases by Canfor, one involving lumber, the other pulp. On the lumber side, Canfor announced they will permanently reduce production at their Plateau sawmill in Engen, BC by 150 million bf. They are making this adjustment in production capacity to better align the mill with the available fiber supply in the region. Canfor will make partial mill closure and eliminate one of three production lines currently operating at Plateau. They anticipate these changes taking affect at the end of Q2 2022. Canfor will, however, be making a capital expenditure of $14 million at Plateau to improve manufacturing efficiency and flexibility on the two remaining production lines. After all the changes, annual production capacity at Plateau will be 370 million bf.

Canfor Pulp Products will be taking a minimum 6-week curtailment of BCTMP production at their Taylor Pulp mill due to ongoing transportation difficulties. Inventories have reached capacity at Taylor with this curtailment reducing BCTMP production by a minimum of 25,000 tons. Canfor will be monitoring the supply chain situation to assess opportunities for a restart. In the meantime, what will happen to the chips normally shipping to Taylor?

Resolute. And let’s not forget the news out of Montreal this past week from Resolute. On Valentine’s Day, Resolute reached an agreement with LP to acquire their 50% equity interest position in two joint ventures involving I-joist production facilities in Quebec. LP will remain the exclusive distributor of these engineered products. We would believe the synergies involved with Resolute’s sawmill production capabilities, coupled with their manufacturing expertise, will drop additional profit dollars to their bottom line.

Mortgages. The MBA’s weekly mortgage update was less than spectacular. The average fixed 30-year mortgage rate once again moved higher to 4.05% in the week ending February 11. This is the highest rate since October 2019. The average loan size also increased to $453,000. A new record loan amount. Mortgage application were down 5.4% on the week with the refinance index 8.9% lower and the purchase index off by 1.2%. This was a drop of 8.1% from the previous reporting week.

Housing Market Index. For the second consecutive month, the NAHB/Wells Fargo Housing Market Index dropped in February to 82 from January’s reading of 83. The February 2021 Index was at 84. Anything above 50 is considered a positive reading. The Index tracks builder confidence in the new single-family housing market. Construction costs and higher interest rates were cited as contributors to the decline. Of the three Index components, current sales conditions were up 1 point to 90, buyer traffic dropped by 4 points to 65, while the sales expectation component in the next 6 months was 2 points lower at 80. As we can all expect, construction costs and interest rates, coupled with inflation, will continue to weigh on the housing market.

Existing Home Sales. On the positive side, US Existing Home Sales for January were up 6.7% over the downwardly revised drop of 3.8% in December. Forecasts were for 6.1 million units sold against the actual SAAR of 6.5 million. This was the highest level in a year. Total housing inventory set a new all-time low of 860,000 units available with a median price for all housing types at $350,000. This is according to the NAR. We anticipate the inventory number to remain on the low side given the current difficulties being experienced in the new housing segment of the market.

US Housing Starts & Permits. Since most of you have already reviewed the US Census Bureau’s release on January housing starts and permits, we’ll forgo the headline SAAR numbers in favor of the actual numbers. Scrolling through the report, and doing some math, you’ll find the actual numbers month over month and year over year aren’t as rosy for single-family builders. Actual total permits, not on a seasonally adjusted basis, were off over 13% month over month, but marginally higher year over year by 2.87%. Single-family were up 1.7%, but down 1.4% respectively. This is the third consecutive month the year-on-year number has been lower. Mutli-family was mixed with the January number almost 32% lower over December, but slightly over 10% higher year over year. Actual single-family starts numbers are even worse. January month over month starts numbers were over 6% lower than December while the year over year number was almost 2% lower. Actual starts are being supported by the multi-family segment which was up by 4% in January month over month and slightly over 10% year over year. Given the supply chain issues with building materials, and the ongoing labor availability, it’s not difficult to understand why the trend is weighted to the multi-family sector of the homebuilding industry. Simple economies of scale. It just may take a bit longer, than what most industry experts expected, for single-family construction to get back on track.

Anecdotal Thoughts

De ja vu. Is it just us, or does anyone else think this current lumber market reminds them of 2018? Aside from the price levels being lower in 2018, the overriding factor in setting up the market structure was rail transportation issues in Canada. Cold weather, short trains, not enough empty cars for the mills to load, and production stacking up at the sawmills. Sound familiar now? Yep. And do we remember what happened to prices in 2018 once the wood started shipping in a timely manner? Indeed, we do. You couldn’t get out of the way fast enough to avoid the plummeting prices. The correction was steep, and long lasting, taking well into the year to finally find a bottom. Will history repeat itself? Perhaps. But we don’t think to the extent we saw in 2018. That said, you better be prepared. If you think these higher prices are painful, just wait, it might be worse on the next correction lower.

Boston Rate. If there is any doubt as to the truck purchasing strategy, one only needs to be following Boston rate RL print. The current price structure is reflecting a need by buyers for smaller volume purchases if the shipping times for the products aren’t too extended. Smaller volumes, hopefully quicker turns, and the ability to balance inventories. Again, all predicated on “reasonable” ship times.

SYP. This might be a good opportunity to pick up some SYP inventory before treaters and truss manufacturers get reengaged to build spring inventories. Both 2x4 and 2x12 remain tight, but 2x6, 2x8, and 2x10 present value if you’re able to species switch. Don’t think too long, some mills may be switching to RED or contemplate splitting back 2x8 should 2x4 remain get tight. Check with your customers and get some feedback. Better yet, visit some jobsites and check to see if your customers have already made the switch.

Fir. Buying your Fir inventory solely from US mills? Make sure you’re checking with the Canadian mills for their DF and HF offerings. Studs and RL loadings of 2x4 through 2x10 can oft times be very competitive depending on the delivery destination. Worth the effort to keep an eye on those north of the border offer sheets.

This past week was interesting indeed. In fact, most weeks in the lumber industry are always interesting. Whether it be the cash markets, or the futures board, opportunities can usually be found. You just have to have a plan and be involved.

Markets and pricing will remain active as buyers work to build their inventories against better weather and the spring building season right around the corner. Don’t be uncertain or distracted. You can either be proactive, or a chaser. Be decisive.

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