Lumber prices are back near their lows for the year. ls there refief in sight?

By Paul Jannke RISI

A trfER hitting their lowest level in la.nearly 25 years (adjusted for inflation) late in the first quarter and early in the second quarter of 2OO'7, lumber prices rallied into the third quarter.

However, this rally could almost be described as trivial: at a peak of $307, the Crows Framing Lumber Composite Index was just 157o above its first/second quarter lows and a full 20Vo 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 Crows Composite Index has fallen nearly l}Vo. Where do lumber markets go from here?

Lumber consumption is highly correlated with residential construction activity, as the main end-use markets for lumber is new home construction.

As anyone following recent developments in mortgage markets can attest, the outlook for housing is at best stormy. Over the last 12 months, foreclosure filings were up 507o. And the situation has worsened in recent months-filings were 8O7o above year-ago levels in the second quarter of 2OO7 (see chart below). The dramatic surge in defaults has caused several mortgage companies to close their doors, while those that remain in business are taking extreme actions. including raising interest rates, rationing credit, dropping programs for higher risk home buyers, and, in some cases, halting all new lending. The bad news isn't all on the financing side either. New home sales were off 227o from year-ago levels in the first half of 2006, and down 870 (through May) for existing homes. Inventories of unsold new homes in May, expressed as months of sales at the current sales pace, were at 7.8 months, up 227o over a year ago. For existing homes, an 8.8 months inventory in June represents a huge 28Vo 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.

Rising interest rates, tightening lending standards, and the increasing inventory of unsold homes have all dampened the likelihood and immediacy ofany recovery in housing.

However, while there are few reasons to hold out hope that recovery in U.S. housing markets will occur anytime 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 seemed to have found a market bottom.

Although none of the monthly housing reports in the first six months of 2001 have recorded a SAAR (seasonally adjusted annual rate) above 1.5 million, neither have they dropped below 1.4 million. Consequently, we expect housing starts will remain in the 1.4 to 1.5 million-unit range over the next two to three quarters. We project a slight upward bias in starts by mid-2008 with activity gathering momentum late in the year as excess inventories are worked off. This improvement will allow the underlying strength in housing fundamentals to kick into gear by 2009.

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 towards 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 downr.vard trend rvill continue (albeit perhaps with a shortlived reversal in September) into the fourth quarter. This decline lvill result from several factors, including the cyclically and seasonally falling consumption detailed above, sufficient dealer inventories. little perceived (by the dealers) up-side risk to prices, and over-production as prices rvere above costs through July. Consequently, r,ve expect lumber prices will retreat back near their lorvs for the year and the cycle in Septernber-October.

Early 2008 will provide a bit of a break from the extremely weak pricing and profitability of 2007. The decline in consumption rvill have slorved. and dealers r'vill be anticipating increased end-use consumption by mid-year. This, combined rvith extremely low prices and limited dorvnside risk, will encourage dealers to step up buying in the lirst quarter. driving up prices.

While rve expect prices to rebound somervhat in early 2008, the upside potential r,vill be limited by iveak (cyclically flat) first-quarter end-use consumption and operating rates only slightly above early '07 levels. More- over. higher prices tor,vard the end of first quarter rvill stimulate increased production. At the same tirr.re, dealers rvill have built sufficient stocks to carry them through the slowly rising consumption of the second quarter and rvill therefore limit buying. Consequently, lumber prices should fall again in second quarter 2008.

The seasonal increirse in consumption rvill bolster prices by third quarter

2008. And, with cyclical gror,vth in demand edging higher, we cxpect them to continuc to rise tor,vards the end of the year. While rve do expect better pricing in '0U. it rvill not be significantly better: lumber prices for the major species/products are fbrecast to increase around 5o/r, from 2007 levels.