The debt crisis in the Eurozone has spooked investors, creating downdrafts in many commodity markets including lumber. Fears of a global double-dip recession are damaging the market, and CME lumber futures fell their trading price limit of $10 two days in a row, settling at $225 per thousand board feet on Wednesday, May 26.  However, there are some longer-term bullish fundamentals for this market for traders with a bit of patience.

During the past ten years, you can see the range for lumber has been $150 – $4.50 per thousand board feet. Overall, this market is at fairly depressed levels compared to historical levels, and relative to other commodities facing similar fundamentals.

Lumber Futures, Weekly Chart

The lumber/forestry industry has greatly eroded in North America over the past decade, and the productive capacity has also diminished. When a global economic expansion takes hold, and home building picks up, there will be a shortage of forestry products. Let’s take a look at some of the bullish long-term fundamental factors supporting this market.

Softwood Lumber Trade Dispute
The softwood lumber trade dispute has encompassed more than two decades, and while it has more or less now been resolved, it has caused a lot of businesses to exit the forestry industry.

The main cause of the dispute was between the way the U.S. and Canadian forestry industries operate. In the U.S., forestry typically occurs on private lands that are auctioned off to companies at market rates.

In Canada, almost all land that is forested is owned by provincial governments. The government sets the price charged to harvest timber (known as the “stumpage fee”) taken from public lands. The dispute centered around the amount of that stumpage fee. The U.S. administration felt this system amounted to a subsidy for the Canadian forestry industry, claiming it resulted in below-market prices for Canadian timber. Under U.S. law, foreign goods benefiting from subsidies can be subject to a tariff, and in 2002, it imposed a 27 percent tariff on Canadian softwood lumber.

The World Trade Organization and NAFTA got involved, and after a number of rulings, the dispute was essentially settled. However, the tariff resulted in the bankruptcy of many forestry companies in Canada which are unlikely to return to the industry anytime soon. This dispute has had huge implications for Canadian forestry, and that lost capacity will take time to rebuild.

The Mountain Pine Beetle Infestation
This pine beetle impacts both Canadian and U.S. forestry along the West Coast and Rockies of both nations. The pine beetle kills large pine trees and the dried, dead trees contribute to increased risk of forest fires. Because so many of these trees have died, there has been a major push to harvest this pine before it loses its commercial value. Large areas of pine forest that would otherwise have been left to grow have been rushed to market. The lifecycle of the pine beetle has been shortened due to warmer winters, exacerbating the problem. A very cold winter is needed to kill off the pine beetle and halt infestations, and we haven’t had the necessary low temperatures to do so during the past few years.

As this lumber has flooded the market, it has created a surplus. But in about five or six years’ time, it will result in a deficit as the lost trees will take many decades to replace. Large swaths of forestry will no longer be available for production until the forest can regenerate itself.

The U.S. Housing Crisis
A decade of low interest rates in the U.S. made it easy to get credit to buy a home, and builders were in overdrive to meet demand. Many people who probably could not afford a home or should not have been qualified bought one, which contributed to a housing crisis in 2009. Many of these homes faced foreclosures, and as the U.S. moved into a period of tighter credit, these houses have flooded the market without enough buyers to sop up the supply.

There will probably be cheap housing available in the U.S. for some time, and that will make it difficult for U.S. builders to survive. All markets go through cycles of boom and bust, and eventually, the glut will start to be absorbed. It’s likely we’ll see a surplus of housing for quite a while longer, but traders should watch for signs the U.S. housing market is waking up, which will put pressure on lumber prices.

Canadian Lumber Production
In the past four - five years, Canadian lumber production has been cut in half, moving from more than 82 million cubic meters to 45 million cubic meters, as shown in the table below. This trend is probably going to reach a bottom at some stage, but unfortunately, those who have left the industry due to adverse conditions are not likely to come back until they see substantially higher prices. The forestry industry is not one you can jump into quickly; plans, mills, and specialized equipment are required. Given barriers to entry, it takes some time from that initial decision point to the production stage.  It would take some time for production to reach the levels from 2005.

Canadian Boreal Forest Agreement
The Canadian Boreal Forest Agreement is an interesting development which was the result of many years of negotiation between the forestry companies and five major environment groups in Canada. These environmental groups had been campaigning to reduce or eliminate timber harvesting in areas that encompass the range of the woodland caribou, which are severely threatened.

The agreement ends a longstanding battle over logging in Canada’s massive boreal forest, covering approximately 170 million acres (690,000 square km). Forestry companies agreed to stop logging and restrict road building over some 75 million acres to protect caribou herds facing a loss of habitat. The two sides will then spend three years working out which restrictions to impose on logging in the remaining 95 million acres.

In return, environmental groups will end their campaigns against purchasing Canadian lumber and stop lobbying the government. The light green areas  in the map below are those that had been scheduled for harvest, but have now been deemed off-limits. While protecting the caribou is a good thing, it will have implications for the lumber market as supplies are restricted. This agreement is retroactive, spanning Apri1 1, 2009 to March 21, 2012. After 2012, I’m not sure what will happen, but harvesting will be delayed until then.

Shanghai Building Code
This was a huge win for the industry. In Asia, homes were not typically built with wood. The forestry industry has been lobbying the Chinese government to allow for more wood frame construction, and China recently changed its building code to allow for wood frame building in Shanghai. It’s expected other cities may follow suit. It may take time to adopt new building practices, but allowing alternative building materials will also allow greater expansion to offset price inflation impacting steel, concrete or other materials used in building.

Traders: Buy Big Corrections
As mentioned, right now, lumber is still in a state of decline. It’s difficult to pinpoint exactly when this cycle will change, but at some point in time, it will. Prior to the unfolding of the crisis in Europe, lumber had traded up to $320, so it has seen a tremendous drop in a short time. I think lumber is a good very long-term play, and traders might consider buying dips on big corrections such as we’ve seen recently. I think it’s a commodity worth considering in a diversified portfolio.

Lumber Contract Specs
Contract Size: 110,000 board feet (260 cubic meters)
Product Description: 2-inch by 4-inch lumber, 8-20 feet long
Pricing Unit: dollars per 1,000 board feet (mbf)
Tick Size: $0.10 per mbf ($11 per contract)
Daily price limits: $10 per mbf above or below previous day’s settlement price; expandable to $15 per mbf.

Please feel free to contact me with any questions you might have on this or other markets.

Aaron Fennell is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at afennell@lind-waldock.com.

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