Lumber markets have been going through a tough period since mid-2018. American housing construction and home improvements are the main uses for Canadian and US lumber, and demand from home buyers softened as US interest-rate expectations started rising in the second half of 2018. At the same time, the focus in the housing market had shifted to entry-level lower-priced units, with appetite in the higher-end, ‘move-up’ and luxury categories temporarily quenched. Land-purchase, planning-permission and construction timelines had to be adjusted to accommodate this, causing market activity to slow further for a time. With demand dwindling after nine years of growth, lumber buyers could be more selective at which price points they acquired material.
Slackening demand coincided with rising supply, with lumber production-capacity additions accelerating from 2014. Last year saw over 1 billion board feet (bbf) added to a market of 70-72 bbf. The US south produced 25% more lumber in 2018 than five years earlier, more than offsetting lower output from British Columbia in Canada. The incentive to do so was record annual average prices in 2017, which sped up the construction of new mills and refitting of older operations.
Together, the pause in demand and more capacity meant that the required operating rate to fulfil demand fell from 87-89% to 81-83%. This immediately relieved the scarcity pricing prevalent in the first half of 2018. Between May and October of that year, lumber futures prices fell by more than 50%. After a brief rally in January 2019, another period of weak demand (due to a prolonged weather disruption) depressed the market again, with lumber prices falling below US$300 per thousand board feet.
Early summer saw a turning point. In addition to the temporary suspensions already in place, permanent production cuts and mill closures began to be announced. All of the listed producers, and some larger private players such as Tolko, took part in the rationalisation.
In British Columbia, historically a key lumber producing region, the 2018-2019 downturn accelerated a shut-down of mills that had to happen anyway. The province used to account for more than 50% of total Canadian output and, as the US imports large quantities of Canadian lumber, its production profile has always been closely watched. By the mid-2000s, an outbreak of mountain pine beetle that began in the 1990s had developed into a full-blown epidemic. This 5mm-long bug lays eggs under a tree’s bark and introduces a fungus that prevents water and nutrients being taken up by the tree. The tree eventually dies and, though it may stand for many years, all growth stops. Given the long life-cycle of commercial softwood trees (25-35 years), log availability in British Columbia slowly declined. Over time, log-cutting and lumber production capacity came to exceed the annual allowable ‘cut’ in the province and needed to be scaled back. The recent market weakness brought forward that process.
On the demand side, conditions are improving. Homebuilders say that operations have normalised and that the transition from ‘move-up’ and luxury to entry-level is essentially complete. In addition, pent-up demand from April to July this year, when heavy rainfall postponed housing starts, has partially returned. August data shows US housing starts are at their highest level since 2007. A change in the direction of interest-rate expectations has also started to support new housing and home-improvement demand.
With a price recovery from US$300 to around US$375 per thousand board feet currently, the profitability of lumber producers has improved somewhat. But these prices still leave smaller, older and more marginal mills loss-making. Mill shutdowns have been announced in the US Pacific Northwest and Georgia, with curtailments in Quebec and Ontario in Canada, and in California and other US states. We expect this trend to continue. We also expect more curtailments and mill closures in British Columbia as fibre availability falls further.
Deficit market offers opportunity
Our view is that market fundamentals will continue to improve for lumber as the market moves into deficit next year. We are invested in several of the listed producers and have recently benefitted from the cash offer to privatise Canfor, at a ~85% premium to the pre-bid share price. Although more consolidation is possible in the sector, our investment case is based on the increasing earnings and cash flow that we expect to be generated in 2020 and beyond.