Streetwise Professor

April 30, 2021

If You Woke Up With Wood . . . You’re Rich!

Filed under: Commodities,CoronaCrisis,Derivatives,Economics — cpirrong @ 6:33 pm

Especially if it’s lumber. Not so much if it’s timber or logs.

Lumber prices have been on a tear recently. The CME lumber futures price has risen inexorably for weeks:

The softwood lumber PPI has increased 73 percent from April of last year, when Covid cratered all markets (including all commodity markets in particular) to March of this year. As the graph above shows, the price increase in the last month alone will add almost 100 precent to that. The plywood PPI is up 43 percent. The PPI for logs, timber, and pulpwood has not risen nearly as much over the April 2020-March 2021 period–only 7 percent.

So what’s going on? This podcast has a pretty good explanation, which comports with the analysis that follows. My main objection is that it repeatedly refers to the market as “broken.” No. A market is broken when it sends the wrong price signals. It is not broken if it sends the right signals, even if you don’t like them. That’s what’s going on here. Prices are signaling a major change in demand patterns that is straining a productive capacity oriented to the old patterns.

The podcast claims that log and timber prices are down. That’s not consistent with the PPI data, which does demonstrate some uptick in log/timber prices. I have also seen reports that timber/log prices are firm in western Canada. But it is obvious that the spread between lumber and timber has widened dramatically.

Which provides a perfect opportunity to apply what I teach in my commodities classes: Find the bottleneck. In a reasonably competitive market, the spread between two commodities, one that can be transformed into the other, equals the cost of that transformation. Sawmills transform logs into lumber, so if the spread between the prices of these things blows out, that shows you where the bottleneck is–at the mills.

The podcast largely confirms that. The sawmill sector has contracted and consolidated in recent years for a variety of reasons. The Covid-induced economic shock of last year also led to the idling of capacity. Now demand has come roaring back. There is a building boom, driven by an exodus from cities and a substitution of things for services. The turnaround has been so abrupt that sawmill capacity has not been able to adjust to keep up. It of course takes a long time to build new mills, and the decision to do that depends on expectations about long-term demand. It is quicker and more economical to restart idle mills, and to add shifts, and that is happening. But it can’t happen overnight.

A transportation bottleneck is exacerbating the problems. Shortages of railcars and trucks are limiting the ability of sawmills to satisfy demand. These shortages reflect in part a commodities boom generally. Chinese demand for US ag products (which has sent corn prices soaring) is contributing to that, but the transportation sector has been robust generally since its doldrums of a year ago. In that time the Dow Jones Transportation Average is up 128 percent off its Covid bottom, and is 40 percent above its pre-Covid collapse level.

Transportation bottlenecks tend to widen spreads at all levels of the value chain, from timber farm to mill, and from mill to lumber yard.

Lumber inventories are at barebones levels, as one would expect in such circumstances. When the supply-demand balance is tight today relative to what is expected in the future, the efficient thing to do is to draw down inventories and to consume everything that is being produced. This is leading, exactly as theory would predict, to a pronounced backwardation in lumber prices:

Note there’s an almost 30 percent backwardation going out six months. That’s very steep. Very Although I wouldn’t put too much weight in the distant deferred prices (given the absence of volume and open interest) one, it appears that the curve flattens out after the six month point.

So what’s going on is commodity economics 101. A surge in demand after a sharp fall (which led to reductions in transformation capacity) caused the lumber market to hit constraints–constraints in the amount of available inventory, and constraints in the capacity to transform a raw product (timber) into a consumable one (lumber). This in turn caused spreads (calendar spreads and the spread between finished and raw prices) to blow out. Market participants are responding to these price signals. The backwardation suggests that the constraints will ease by the end of the year. That of course is a forecast based on current information. Things could change.

So things ain’t broke. Indeed, what is happening in the lumber and timber markets is a symptom of a robust economic recovery, at least in the housing and goods sectors. It also reflects an apparent ongoing structural shift post-Covid (and post urban disturbances of the last year), namely, a desire to move out of cities driven by the recognition that more people can work remotely, and the declining amenities of cities (largely the result of lockdowns and their aftermath, and an upsurge in crime). Such an abrupt and seismic shift inevitably bumps up against constraints determined by past investments tailored to accommodate the old consumption patterns. That affects prices, and prices signal the need for new investments to alleviate the bottlenecks. This too shall pass, and within some months the bottlenecks will ease, as. participants all along the value change respond to the extraordinary price signals we see today.

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  1. You throw in a good vocabulary word from time to time, but backwardation has gotta be the tops. 🙂

    Meanwhile, I’m one of those home project guys for the past year driving the prices up. It’s been painful to my credit card.

    And agreed, no, the market is not broken. Sheesh.

    Comment by Howard Roark — April 30, 2021 @ 10:16 pm

  2. Initially, I thought the price squeeze was a result of soaring demand from people looking to board up their businesses in preparation for all those peaceful protests during the Summer of George, and the peaceful protests expected if the Democrats couldn’t rig the election enough to keep Trump out (again!). But this can’t account for the ongoing squeeze, so this explanation is more sound.

    Agreed about the economic recovery but I think the Fed and Treasury combining to shove raw cash into as many pockets as possible, at a faster rate than supply can grow, is the fundamental cause. And I don’t see this ending anytime soon! Tell me again, how does this usually end? I’m sure I’ve seen this film before.

    Revving up the wayback machine to a few posts ago: impressed to hear you could conquer the Battle of the Bulge. I’m engaged in the same battle now; Covid was disastrous in this respect. Now that the dojo has opened up again I’m finding my body is uncomfortable even during the initial warm-ups and stretches, which is a bad sign. So I’m heartened to know that you’re ‘living proof’ it can be done.

    Beefcake! Beefcaaake!

    Comment by Ex-Global Super-Regulator on Lunch Break — May 1, 2021 @ 4:53 am

  3. @Howard–“Backwardation” is part of my native language as a commodities economist. I’ve written a book about it :p. I use it almost without thinking. What, doesn’t everyone use this word daily???? Glad to expand your horizons!

    Comment by cpirrong — May 2, 2021 @ 3:53 pm

  4. @Ex-Global Super-Regulator on Lunch Break. Whether there is a recovery (in goods consumption and production, anyways), and the cause thereof are two different issues. Yes, I think all the fiscal and monetary dysentery has a lot to do with it. But it’s also a function of relative prices. Lockdowns have dramatically raised the prices of services relative to goods: when all restaurants are closed, the price of on-site dining is effectively infinite. So people have substituted towards goods and away from services. Goods are more commodity-intensive, so this has really jacked the demand for commodities.

    Good luck on your Battle of the Bulge. Yes, it can be done. For me the challenge was less in the losing, than in the keeping it off. I had to do a complete mental reboot in order to achieve that. I had lost but regained several times before. The biggest part was redefining the way I thought about food and being disciplined about that. What I eat. When I eat. How much I eat. To be conscious about all that. Before, I approached food consumption thoughtlessly.

    Comment by cpirrong — May 2, 2021 @ 4:01 pm

  5. rehabbed a cabin last year. Was tough to get stuff. Had to go to 5 different IKEA stores for cabinets in four different states. Thought there would be a good supply of labor but everyone busier than ever. Said customers were spending stimulus checks on home improvement. does cash lumber and said the bullwhip effect in lumber has been greater than ever. Plus, once you cut the logs, they have to dry in the kiln and age. There is no speeding the process and along with sawmill consolidation/no transport it makes for huge headaches. In Nevada there is a housing shortage, and many are choosing not to build new homes due to the cost of lumber. I am doing a big rehab on my home here that won’t have a lot of lumber in it; but the lumber price is double what it was a few months ago. Virtually all commodities are on a bull market tear in the last 70 days. Expectations of huge government spending are high-especially infrastructure spending which will only exacerbate the problems.

    Comment by Jeffrey Carter — May 2, 2021 @ 7:51 pm

  6. General Aviation (specifically: spare parts, overhauls and kit planes, but maybe others too) is experiencing a similar effect. Lots of people are using the pandemic-induced down-time to get cracking on with projects that may have been gathering dust in their garage for months or years.

    Also possibly interesting, we don’t seem to be seeing this effect in Europe. I guess because our houses typically use a lot less wood than in the US…

    Comment by HibernoFrog — May 3, 2021 @ 5:27 am

  7. The creeks and shores of Britain are littered with abandoned old boats, small, medium, and large. At some point it might presumably be economic to winch them ashore and break them up. Unless the inability to identify an owner gums up the works.

    Thinking about it, this is a fantasy, isn’t it? Pity – they are unsightly objects. I know: burn them in power stations as biomass. Then economic arguments are trumped by Being Green.

    Forgive my rabbiting on – it’s a public holiday here today.

    Comment by dearieme — May 3, 2021 @ 10:00 am

  8. SWP…
    1)You topped Howard Roark’s vocabulary with ‘backwardization’. I know what you are thinking: “I’ll drop a ‘contango’ on him!” Go for it!
    2) Lumberyards have been selling lumber _back_ to their suppliers. Since we have already used backwardization, what can we call that? Countersupplyification?
    3) Since the lows this time last year, lumber has been up 4X. Didn’t even do that in the real Barney Frank housing bubble back when.

    Comment by Richard Whitney — May 4, 2021 @ 9:27 am

  9. Wood hell! $15 beans and $7 corn!!

    Comment by Donald Wolfe — May 5, 2021 @ 7:01 am

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