The following article, authored by ERA Senior Analyst, David Elstone, is reprinted with permission from the April 2014 Quarterly issue of Canadian Hedge Watch. To access the full publication, visit: http://canadianhedgewatch.com/reports/CHW_Vol14_Issue04.pdf
Pssst, have you heard there is going to be a recovery in the U.S. housing market, and Canadian lumber producers (Canfor, West Fraser, Interfor, etc.) will benefit directly as a housing recovery fuels lumber demand? Indeed, U.S. lumber demand collapsed following the implosion of the U.S. housing market, and there have been high expectations ever since for a recovery and its influence on the forest products companies that supply the products to build new houses. Add pending supply constraints and growing new markets for lumber in Asia, and you have the ingredients for a very compelling investment pitch. Unfortunately, this opportunity has been one of those worst kept secrets, with many investors having already staked out positions well ahead improvements in the U.S. housing sector. Early movers have benefited hugely, leaving those late to game to wonder what to expect going forward. While the easy gains may have past, the short-term outlook remains volatile,which should create new entry points for investors as the long-term lumber story remains intact.
While the S&P/TSX Composite was up 4% and 10%,respectively, over the past two years, West Fraser, Canfor and Interfor generated annual returns of 60%+ for two consecutive years.
Buying Canadian lumber producers (see table below) back in 2012 and 2013 would have rewarded your portfolio handsomely. While the S&P/TSX Composite was up 4% and 10%,respectively, over the past two years, West Fraser, Canfor and Interfor generated annual returns of 60%+ for two consecutive years. Canadian forest product companies represent just 1% of the S&P/TSX Composite, but four out of the five largest North American lumber producers are Canadian domiciled. These lumber equities were making spectacular gains even while U.S. housing starts (the primary driver of U.S. lumber demand) remained at trough levels. The U.S. housing recovery appears to have stalled a rate of below one million housing starts, but lumber prices and producers’earnings have returned to near-peak levels, and lumber stock prices have skyrocketed.
Those following the U.S. market know that housing construction has stumbled over the last couple of quarters, with particularly harsh winter weather playing a role in slowing demand. Other issues,such as lack of creation in quality U.S. jobs (not just any job) and stringent mortgage lending standards, are holding back a recovery. Because of these headwinds, ERA has been less bullish than many on a U.S. housing start forecast (1.05 million units in 2014). Furthermore, understanding the direction of lumber prices is sometimes more to do with psychology than operating rates.
The forest products sector has many moving variables that tend to make following the sector far from straightforward. One of the big variables includes a shrinking timber supply in the BC Interior due to a massive bark-beetle infestation that has killed over 50% of the region’s pine forests, thus reducing the timber available for lumber production in this region. The BC Interior has typically represented well over 50% of Canadian lumber supply to the U.S. market. Another huge factor is that China now takes one-third of BC lumber production. This is immensely significant because at the height of U.S. lumber demand in 2005, Chinese demand for North American lumber essentially did not exist. Canadian lumber exports to China now represent roughly the equivalent of 300,000 U.S. housing starts, which goes a long way to explain why lumber producers have made gains even at trough levels in U.S. residential construction. The emergence of Chinese demand, coupled with the promise of U.S. housing returning to more average levels justifies the excitement surrounding the lumber industry.
However, lumber markets have suffered in early 2014 and are expected to be challenged for the remainder of the year. Sawmills are restarting and new sawmills are being built across the continent, putting a damper on prospects for lumber prices for 2014. Regardless, there has been no lack of exciting developments on the M&A side, as Canadian lumber producers follow through on plans to diversify away from dwindling (and increasingly costly) timber supply in the BC Interior. Canadian producers have focused on acquiring sawmills in the U.S. South. In fact, over the past year and half, Interfor has rapidly gone from owning no sawmills in the U.S. South, to now having a majority of its capacity there. The U.S. South has an expanding wood basket and the region’s lumber industry is highly fragmented, affording opportunity to consolidate. There is also access to abundant (and currently inexpensive) timber. Acquisitions in the U.S. South allows these Canadian lumber producers to participate in the housing up-side, even while their historical production base in the BC Interior transitions to a shrinking post-beetle timber supply (e.g., there have been sawmill closures and more are expected).
There is plenty of opportunity ahead for investors to partake in volatility and long-term upward growth in U.S. housing recovery.
Year–to-date share-price returns for lumber producers have been negative, although the earlier part of the year saw gains driven by a weakening dollar. Uncertainty will dominate much of the remainder of the year as expectations are reset to accommodate for the slowly improving U.S. housing market. We view this as an opportunity to invest in these names. Interestingly, in lumber stocks, it has been historically possible to generate returns on a seasonal basis, with Q2 and Q3 often proving to be periods of declining values, followed by a higher returns generated from investments made late in Q3 into or early Q4 and sold in late Q1 of the following year (yes – this is a market inefficiency that surprisingly has persisted for many years). Even as current valuations of the lumber producers are coming back down to earth for the time being, the longer term story persists: demand pressure from the recovering U.S. market and ongoing Chinese presence will run head-long into supply constraints, pushing lumber prices to new highs. This situation will unfold in 2015 and more so into 2016. Investors will have time to buy into this developing story during Q2/Q3 of this year.
Lumber is just one of the commodities levered to the U.S. housing recovery story. OSB as well as timberland names will gain as well (look to U.S. equities for exposure as well). That’s where ERA Forest Products Research can offer value, helping investors to understand the intricacies of the forest products sector. ERA is an independent financial research firm that focuses exclusively on the global forest products sector, and has been serving investors through offering market updates, forecasts and investment ideas for the past 20 years. There is plenty of opportunity ahead for investors to partake in volatility and long-term upward growth in U.S. housing recovery.