Why I Expect Lumber Prices to Fall

Includes: CUT, XHB
by: Charles Armstrong

Here's a chart of lumber futures prices over the last month. Of particular interest is the big upward movement starting on January 28th. Between then and this last Friday, lumber TWICE went up the session limit of $10 / thousand board feet (mBF).

At the beginning of the month, I was bearish on lumber because I suspected housing starts have not actually increased whatsoever (and at the time I took a short position, only to be stopped out in accordance with my personal trading philosophy); however, now I am even more bearish because I think this pricing run-up neither makes sense nor is in any way sustainable.

Quick background about the market. The random length lumber futures contract (what most people mean when they say "lumber") is used extensively by lumber industry participants - that is timber harvesters and construction companies - to hedge against erratic price movements in the cash market (the price you get at your local mill on any given day).

The biggest factor affecting lumber prices is the US housing market. When the housing market is booming, lumber skyrockets. When home construction is depressed, so too the lumber market. There is very little else driving lumber prices, as most of the lumber we use is grown domestically, we export almost none of it, and what lumber we do import comes almost exclusively from Canada.

Now that that's out of the way... a recent article from Reuters basically comes to the following conclusions as to why the price has shot up:

  1. There are fewer mills currently in operation (many had closed down when the housing market dried up), creating a minor supply shock in the cash market and sending prices up.
  2. There is an expected increase in in demand as the result of the approaching "Spring building season".
  3. A "realtor survey" showed pending home sales were up 1% in December.

My reason for being bearish on lumber right now is that I believe there is a logical fallacy at play in the market. Follow me here on this treatise:

  • If the housing market picks up (i.e. demand increases)
    • Lumber inventories (i.e. supply) should be pressured and may diminish.
    • If inventories stay the same or diminish
      • The price should go up.

This is basic supply and demand, but I've made each bullet cascading to point out the conditional nature of how the market, in theory, responds. The other way for the price to go up would be as follows:

  • If lumber inventories diminish (i.e. supply decreases)
    • If the housing market moves sideways or picks up (i.e. demand stays the same or increases)
      • The price should go up.

Note the difference between the two cases. In the first, demand is the driving conditional; in the second, supply. Also note, and this is what's important, that demand, and demand alone, has an effect on the other predictive variable in the equation. That is to say, when demand changes, there is NECESSARILY an effect upon the supply. (Yes, I know, it's possible that demand has been perfectly predicted and supplies tailored to meet the expected demand, but this is incredibly unlikely in a market based upon a fungible commodity such as lumber.)

When supply decreases, on the other hand, there is by no means any necessary or expected response in demand. Demand could stay the same, demand could increase, demand could decrease. There's simply no way to know, or even extrapolate, based on supply alone.

What we have in the lumber market is the second scenario. Supplies seem to be diminishing because of the drawdown in milling operations. However, that in and of itself, in theory anyway, should not cause the price to go up. For that to happen, we'd need to see that demand has at least not diminished, or at best, has increased. If this were the other way around, if we knew that demand really was increasing, we could infer that supply was likely to decline, and the facts about the mill drawdowns would confirm this, and we could say that yes, indeed, lumber prices ought to go up.

However, we cannot say that demand for lumber is increasing, we can only say that supply looks like it might be decreasing, and there is at best a possibility that demand is on the rise, depending on how much faith you put in a self-reported survey from an industry with a financial incentive to look make itself look healthy.

As for the "spring building season" mentioned in the Reuters article, it's important to note that this is buying by retail lumber dealers in anticipation of the season. This is not a construction company buying lumber to build a house. Unless that lumber is actually used, it will just sit on the shelf, delaying future orders and adding to the supply.

Of course, we can talk about what a market should or shouldn't do in theory, about what's the right or wrong expected price movement based on any set of information, but the truth is that a market cannot be right or wrong. A market simply is. Lumber is trading at over $270 / mBf because someone was willing to buy a contract at that price, and someone was willing to sell.

However, while the market itself cannot be wrong, the participants in the market can be. Extrapolating that supply is decreasing based on mill slow-down is an assumption, and it can be incorrect. Believing the housing market is picking up is an assumption, and it too can be incorrect. If two people, a buyer and a seller, have the same incorrect assumptions, the price they agree on will force the market in a particular direction, and this will happen regardless of the assumptions' validity.

Now, this buyer and this seller, they might be right. It might be the case that lumber supply is falling, and that demand is picking back up, but personally, I don't think so. I don't think the housing market is picking up, and I don't think supplies are in any way close to depleted enough to cause a significant shortage. Housing starts declined in December, you can read the reports on the Random Lengths website (a sort of trade-mag for the lumber industry); do we have any reason beyond the above "realtor survey" to believe they have increased since?

Again, maybe. Maybe I'm wrong about this, it's very possible, but I simply don't see housing starts increasing enough to justify this price run up.

Again, I could be wrong. I could be dead wrong and the US housing market might be ready to explode and the decline in mill output might cause a serious supply shock, but even so, in closing, let me drop a little perspective. The last time lumber was consistently trading above $260 / mBF was May - August 2007. Between then and now, it broke the $260 barrier only one other time: August 2008.

Disclosure: No positions