PART II - August 19th, 2021
CAN THE DISCIPLINE OF SELLERS RAISE THE PRICING FLOOR ??
Note: This is Part II of a two part series. If you have not read Part 1, you can start with it here.
In the US, the need for shelter drives demand for wood. About 1.3 million housing units have been built each of the last few years. The basic building component to shelter the US population has recently become the star of trader speculation - lumber futures. But where speculators trade contracts, operators buy and sell physical lumber to build someone a place to live. Extra volatility made for a very challenging 18 months in the lumber market for operators.
As lumber prices raced to record highs earlier this year, then plummeted over the past few months, the underlying demand for housing (annual basis) stayed relatively flat (approximately 1.4 million housing units). Irrational behavior on the upswing fueled the run, but underlying fundamentals of demand led to the dramatic fall (read this article about how prices can fall so fast). It wasn’t lumber producers’ and sellers’ command of markets that led to rising prices, or they would have exerted control that prevented the crash.
Why won’t producers show more pricing discipline or shut down mills to keep prices up?
Great questions, both with fundamentally different answers.
First, pricing discipline, without collusion, is an illusion. Lumber is a commodity. The market finds the price, even in this archaic industry’s process, where fragmented price discovery is conducted manually by phone. The archaic and low tech process creates a huge range of prices on any given day, providing the marginal opportunity for leverage by buyers and sellers, but buyers and sellers trend toward and establish the mean price executed.
If I’m a seller, when lumber stops selling, I drop my price. Sellers don’t have time to wait. Mills don’t have extra inventory space, nor is inventory their mandate - their mandate is low-cost production. They also have shipping contracts (rail cars or trucks) that need wood on them, and building inventory in a falling market simply postpones a loss. Speculation on future prices is not the competency of producers; they leave that to the futures traders who trade contracts.
Second, they can’t easily shut down the mill. There are raw materials coming. Not just spot buys, but raw materials contracts. There may also be union labor arrangements or severance implications. Or, CEO’s have made big promises on new mills that will be competitive at the bottom of the cycle.
There’s also another factor - people. Lumber mills are run by humans, with families, in communities. When a company decides to shut down a mill in a rural community, its impact is felt in all aspects of that community. Skilled workers go to other mills or other industries, often leaving a permanent mark on the community. It’s difficult to start a mill and only a little easier to restart a mill. Some might even argue the reverse case, as trust erodes with repeated layoffs and rehiring.
A major producer recently announced the start-up of an existing mill, previously offline. Why now? If timing the market for stock or futures traders is difficult, timing the market on mill start-up is a fool's errand. At the time of this start-up decision, months to years ago, there was no way to predict the current pricing crash. Long term demand forecasts and local economic advantages, such as labor cost and logistics, are the basis for mill start-ups, not pricing control or speculation.
The three factors that define the pricing floor for lumber
What would be required to establish a “new normal” above the last cycle lows? In Part I of this series, we started with the assertion that the cash cost of lumber production inputs sets the floor on pricing, then covered the basics of supply and demand. In Part II, we covered the lack of price control by industry participants. In the end, the pricing floor for lumber will remain unchanged: It’s driven by the cost of logs, labor and energy. If these rise, so will the pricing floor. Until then, it’s all about supply and demand.
Conclusion for investors and operators
It is difficult to calculate the industry demand to capacity ratio and compare it to the 84% rule of thumb, without the benefit of hindsight. But COVID exposed something about this ratio last year and into early 2021. When the industry operated at roughly 1.3 million housing starts in 2019, prices remained in a trading range above cash cost (producers weren’t complaining and shutting down mills), but not racing to new highs (buyers weren’t complaining about price increases). When COVID constrained demand, and then supply, only to have demand return immediately to prior levels, the system was shocked into record volatility due to those short-term cycle effects. With hindsight, it’s reasonable to assume that 2019 was near the magic 84%.
Therefore, near term, if housing starts stay around 1.3 million units, prices will remain above the cash cost floor unless producers dilute their own pricing power with extra capacity. We may see a new trading range, but it’s not a new normal. Long term, the normal floor is the cash cost of producing lumber.