Where can lumber markets go from here?

After hitting their lowest level in nearly 25 years (adjusted for inflation) late in the first quarter and early in the second quarter of 2007, lumber prices rallied into the third quarter. However, this rally could almost be described as trivial: at a peak of $307, the Crow’s Framing Lumber Composite Index was just 15 percent above its first- and second-quarter lows and a full 20 percent below the 2006 peak. Moreover, lumber markets have given back much of this gain in recent weeks. Since peaking around the Fourth of July, the Crow’s Composite Index has fallen nearly 10 percent. Where do lumber markets go from here?

Lumber consumption is highly correlated with construction activity, as the two main end-use markets for lumber are new home construction and repair and remodeling.

As anyone following recent developments in mortgage markets can attest, the outlook for housing is at best stormy. The bad news isn’t all on the financing side either. Inventories of unsold new homes in May, expressed as months of sales at the current sales pace, were at 7.8 months, up 22 percent over a year ago. For existing homes, an 8.8 months inventory in June represents a huge 28 percent year-over-year increase. This is worrisome for new-home builders, as a large unsold inventory of existing homes could hold up those existing-home sellers trying to upgrade by buying and moving into a new home.

While there are few reasons to hold out hope that recovery in U.S. housing markets will occur any time soon, a further substantial erosion in starts is also unlikely. Solid employment and income growth, falling existing-home prices and flat new home prices have all improved housing affordability. Moreover, U.S. housing starts seem to have found a market bottom.

The second largest end-use market for lumber, repair and remodeling remained stronger than new housing construction in 2006 (data on repair and remodeling expenditures lags that of housing starts). This is in part because of the tremendous amount of cash pulled out of home equity in recent years: cash-out exceeded $300 billion in 2006, 16 percent above 2005 levels and many times the $30 billion average of the 1990s. Some of this influx of cash to homeowners was spent on their homes for remodeling and upgrading (estimates of cash-out that goes back into the home range as high as 30 percent). Moreover, 6.8 million existing homes were sold in 2004, and 7.1 million homes were sold in 2005. Since the majority of repair and remodeling activity occurs within the first several years of a home purchase, that record pace of home sales translated into robust expenditures in 2006.

Higher home equity rates and slowing cash-out refinancing as home prices drop are limiting homeowners’ financing options. In addition, some of the record expenditures in 2004 to 2006 were borrowed from the future. In other words, the very low interest rates and the ease with which homeowners could tap into their home equity encouraged many of those considering a major addition, alteration or improvement project to undertake it in 2004 to 2006 rather than to wait. This recent strength will consequently be followed by a downswing when affordability deteriorates as it has in late 2006 to 2007.

We have already begun to see the beginnings of this downturn. Repair and remodeling expenditures dropped an average 10 percent (SAAR) in the fourth quarter of 2006 and the first quarter of 2007. Expect these markets to continue to slip through much of 2008.

Weakness in residential construction markets will drive lumber consumption lower over the next several quarters. And when construction activity picks up in mid-2008, it will do so at a tepid pace. This goes a long way toward answering our initial question: Where do lumber markets go from here? Most likely lower.

Recent buying, while driving up prices, has also left dealer inventories flush. Lumber prices began falling in mid-July, and this downward trend will continue (albeit perhaps with a short-lived reversal in September) into the fourth quarter. This decline will result from several factors, including the cyclically and seasonally falling consumption detailed above, sufficient dealer inventories, little perceived (by the dealers) upside risk to prices and over-production as prices were above costs through July. Consequently, expect lumber prices to retreat back near their lows for the year and the cycle in September to October.

Early 2008 will provide a bit of a break from the extremely weak pricing and profitability of 2007. The decline in consumption will have slowed, and dealers will be anticipating increased end-use consumption by mid-year. This, combined with extremely low prices and therefore limited downside risk, will encourage dealers to step up buying in the first quarter, driving up prices.

While prices should rebound somewhat in early 2008, the upside potential will be limited by weak (cyclically flat) first-quarter end-use consumption and operating rates that are only slightly above early 2007 levels. Moreover, higher prices toward the end of the first quarter will stimulate increased production. At the same time, dealers will have built sufficient stocks to carry them through the slowly rising consumption of the second quarter and will therefore limit buying. Consequently, lumber prices are again expected to fall in the second quarter of 2008.

The seasonal increase in consumption will bolster prices by the third quarter of 2008. And with cyclical growth in demand edging higher, expect them to continue to rise toward the end of the year. While there may be better pricing in 2008, it will not be significantly better: Lumber prices for the major species/products are forecast to increase around 5 percent from their 2007 levels.