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Tuesday, March 21, 2023

Lumber Makes A Comeback

This article was written exclusively for Investing.com.

A wild ride in wood futures in 2021
Never trade or invest in lumber futures, but watch them like a hawk
Lumber found a bottom
The upside could be dramatic
Weyerhaeuser follows lumber, provides liquidity, but cut down on the volatility

The lumber price reflects the demand for new homes and new construction. During economic expansion, wood’s price tends to rise, and vice versa during periods of contraction. Lumber is highly sensitive to interest rates as rising mortgage rates cause new home demand to decline, and lower rates increase demand and construction.

Lumber is a highly illiquid futures market with low levels of open interest and volume. Open interest is the total number of open long and short positions in a futures market. Volume is the number of contracts that change hands between buyers and sellers. Illiquid markets suffer from price gaps and incredible volatility when bids or offers evaporate during substantial price appreciation or depreciation.

The lumber futures arena is a boom or bust market. After trading to a low of $251.50 per 1,000 board feet during the first quarter of 2020, the price moved over 6.8 times higher over the next fourteen months, reaching a record high at $1711.20 per 1,000 board feet in May 2021. Low interest rates, the demand for new homes, supply chain bottlenecks, and slowdowns and shutdowns at lumber mills during the pandemic pushed the price higher in a parabolic move. The parabolic rally turned into a falling knife from May 2021 through August 2021.

Lumber is a market to stay far away from as the volatility is downright dangerous. However, Weyerhaeuser (NYSE:WY) operates as a real estate investment trust in the timber industry. The shares tend to track lumber’s price. WY offers far more liquidity than the lumber futures. The shares tend to underperform lumber on the upside and outperform when the price becomes a falling knife. Meanwhile, WY pays shareholders an attractive dividend.

A wild ride in wood futures in 2021

Lumber futures had a head-spinning 2021, and the year is not over.

Lumber Makes A ComebackLumber Weekly
Source: CQG

The weekly chart shows the parabolic move from just over $650 in January to a record high of $1,711.20 per 1,000 board feet in May. Lumber had never traded above the $493.50 level, the 1993 high, before 2017.

Lumber ran out of buying in May, and the explosive rally turned into a falling knife, shredding anyone buying the initial selloff. Three months later, in August 2021, the price found a bottom at $448 per 1,000 board feet, less than one-third the price at the May high. 

Never trade or invest in lumber futures, but watch them like a hawk

I have been trading commodities since the early 1980s and have bought and sold futures contracts in almost all of the markets in the US and UK. Meanwhile, I have never traded one contract of lumber futures.

Since 2020, open interest or the total number of open long and short positions in the lumber futures arena has never been over the 5,000-contract level. The metric stood at 2,039 lonely contracts as of Oct. 19. The last time 1,000 contracts changed hands on a trading day was June 28, when the volume was 1,036. On Oct. 20, only 308 lumber contracts were traded.

Lumber is a highly volatile commodity, but the open interest and volume make it highly illiquid. Liquidity is critical as it allows market participants to buy and sell on a tight bid-offer spread. Lumber is like a roach motel; it is easy to get into a risk position when it is on the wrong side of the market but closing that position without a devastating loss can be another story.

I may not trade lumber futures, but I watch them like a hawk. I consider lumber a critical industrial raw material, much as crude oil and copper. Lumber is highly sensitive to US interest rates and construction. The price tends to move higher during periods when the economy is expanding and lower when it contracts. Moreover, lumber is a bellwether market that often leads other raw material markets. I view lumber as a barometer but will never participate in the futures arena unless there is a stunning shift in the volume and open interest metrics.

Lumber found a bottom

In mid-August, the continuous lumber futures contract found a bottom at $448 per 1,000 board feet.

Lumber Makes A ComebackLumber Daily

Source: CQG

The daily chart illustrates active month November futures reached a low of $462 on Aug. 20. Since then, lumber has made higher lows and higher highs, rising to $789.90 on Oct. 12. On Oct. 20, the price was above the $675 level as lumber corrected from the most recent high.

The upside could be dramatic

In 2021 the lumber trend shifted from bullish to bearish and back to bullish again. The following factors support lumber as we move into 2022:

Inflation – The Federal Reserve continues to call inflationary pressures “transitory.” The latest CPI data came in hot and higher than the market’s expectations. The Fed will start to taper QE, but tapering is not tightening credit. Moreover, funding the $30 trillion US debt is likely to keep a low cap on interest rates. Each 25-basis point hike will cost $75 billion in debt servicing costs. The central bank has few attractive monetary policy options. A continuation of low interest rates is bullish for lumber.
New home demand-  There is a shortage of new homes in the US. The price action in the real estate market has been explosive. While the need for new construction is likely to calm over the coming months, it looks set to come back with a vengeance after the winter season. Building new homes required lots of lumber.
Infrastructure rebuilding – The US government will eventually approve a $1 trillion infrastructure package. Rebuilding roads, bridges, tunnels, airports, schools, and government buildings will only increase lumber demand as it is a critical construction input.
Supply chain bottlenecks – Bringing goods to market has been more than a challenge for all raw materials and finished products. Lumber travels from timberlands to mills and then to the ultimate consumers. The kinks in the supply chain continue to create shortages, and lumber is likely to suffer along with other goods.
Rising energy prices- Traditional energy commodities have risen to multi-year highs. The cost of processing timber into construction-grade lumber has skyrocketed. As the cost of goods sold rises, lumber prices will need to move to the upside.
The trend- The trend is always your best friend in markets. Since the August low, the path of least resistance of lumber prices has been higher.

Above the recent peak at the $790 level, the first upside target in the lumber futures arena stands at technical resistance at the late June high, around $850 per 1,000 board feet. Above there, $1000 is the next target.

Weyerhaeuser follows lumber, provides liquidity, but cut down on the volatility

Weyerhaeuser tends to move higher and lower with lumber futures, but the stock that is a real estate investment trust with exposure to timberlands offers market participants liquidity. WY tends to underperform lumber futures on the upside, but it outperforms on a percentage basis when the price falls. WY is not a roach motel as the stock trades on a tight bid-offer spread and rarely gaps higher or lower, which is commonplace in the lumber futures arena.

At $37.31 per share on Oct. 20, WY’s market cap stood at the $27.57 billion level. An average of nearly 3.7 million shares changes hands each day. Moreover, as a REIT, WY pays shareholders a $0.68 dividend, equating to a 1.82% yield.

Lumber futures rose from a low of $251.50 in March 2020 to a high of $1,711.20 in May 2021. Wood moved over 6.8 times higher. The price then fell 73.8% to a low of $448 before recovering to the $789.60 level on Oct. 12, a rise of 76.3% from the August low.  

Source: Investing.com

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