As we enter 2011, China is becoming the obvious global economic heavyweight, holding over $1 trillion in US debt alone. Typical industry and economic forecasts are that the current Chinese consumption of commodities and other raw materials will continue to grow at an increasing rate. They point to China's skyrocketing GDP as the beginning of a burgeoning middle class in the country.
But China's stock market has been weak over the past year, down 18% while our own stock market was up by about that same amount. This could be because our companies are consolidating debt and increasing cash reserves, while Chinese companies are actively leveraging their financial resources to increase production at the urgent prompting of their government.
So China as a country continues to consume a lion's share of the world's raw materials. At a rate of more than double the previous year's record level of lumber imports, China is driving the world-wide lumber market. Why? The Chinese economy is still one of the world's strongest, but it is being driven by massive Government investment in commodities and energy development. And something you probably won't believe…ghost cities.
The China State Grid Corporation published this year that within 660 cities in China, about 65,400,000 households have zero electricity consumption for at least six continuous months. 65 million houses can provide enough space for 200 million people, about 15% of China's population…but nobody can afford them. These ghost cities are part of what are called in the financial jargon "Asset Bubbles", and a major reason Chinese government-calculated GDP has been able to soar…and many international financial experts are worried that runaway inflation in China will cause these asset bubbles to pop, and to send the world's economy into another major shock. Chinese officials are doing what they can to avoid this.
As China takes steps to control its inflation problem, such as they did when they increased interest rates again on Christmas day 2010, it tends to slow its economy and its imports. If they are forced to continue to increase interest rates, Chinese purchases of all commodities, including lumber, will slow. Announcements on Chinese interest rates will foreshadow Chinese demand for North American lumber…higher rates will mean less demand, and lower lumber prices in the U.S. This process began in October 2010 and is now in motion.
Another global economic factor as we enter 2011 is that the US Treasury is inflating the dollar by printing money, causing inflation in oil and food prices…and has announced it will borrow another $1.4 trillion from other countries this year. This "cheapening" of the US dollar and its debt is perhaps the primary reason the Chinese are buying commodities from all over the world, and building cities before their people can afford to live in them…because they are afraid that all those US dollars they hold today will be worth less tomorrow.
Our government's actions are also leading us into an inflationary economy, which we are already beginning to see in food, mineral, and oil prices. However, because lumber is a commodity that most people will use less of when times get tough (by refusing to buy or remodel homes), inflation will not drive lumber prices as strongly as other essential commodities. Lumber companies are in tough times, and most are cutting back production. This fact has kept lumber prices firm in recent months. However, lumber companies have traditionally been quick to ramp up, and slow to cut production. The current excitement about potential Chinese demand growth has mills gearing up. If Chinese demand flattens, they will be slow to cut back, and 2011 might become a year of lumber oversupply as struggling corporations seek to generate cash.
A third global economic factor is that our housing market has crashed to historic lows and shows no real sign of recovering any time soon. But despite a lot of evidence to the contrary, the official line is still optimistic. National Association of Home Builders projections at this time foresee housing starts climbing to 739,000 in 2011. But our housing market may continue to be flat, despite optimistic predictions. As a continued defensive response, our timber industry lobbyists continue to pressure the government for "protection" against market pressure from Canada, which they see as subsidized by the Canadian government through cheap stumpage prices of timber from Crown lands. So the Canadians are beginning to choose to switch, rather than fight. They're looking for greener pastures in China.
The Chinese lumber market is somewhat different than ours. Structural lumber is typically used for concrete forming, not framing, and economy grades are used widely. Due to the huge manufacturing base, the Chinese utilize all grades nearly evenly, averaging slightly lower quality than the U.S. market. But they pay slightly higher prices for the lumber on average, so the Chinese lumber market is a higher-margin market over the U.S. market. This means that North and South American producers will send as much production as possible to China, thereby driving up U.S. prices as long as Chinese demand remains strong. However, as China captures more market share, and supply chains firm up, China will exert more leverage to reduce its lumber cost, especially if Russia eases up its current tariff on log and lumber exports.
The final point I'll make about the global economy is that oil impacts everything, and it is on the rise again.
Traditionally, oil has not been a primary driver of lumber prices. But the bursting of the housing bubble has established a new "low demand" norm for lumber, and since then lumber prices have tracked pretty closely with oil prices. Fuel prices are a significant cost component in timber harvesting, lumber manufacturing, and distribution, and absent other major price drivers, trends in the oil market are preceding inflections in lumber prices pretty closely.
So let's get to the crux of the matter, and what you really want to know. What are lumber prices going to do in 2011?
While there are an infinite number of scenarios that could arise out of the variables discussed here, I'll present you with three scenarios I consider close to "most likely". In the first scenario, we'll model a relatively stable global scenario with status quo government policies around the world and use a moderate level of oil inflation as a baseline for the forecast.
Under the assumptions that oil goes to $110 a barrel by 2012, that housing gets back on the "Moderate" track forecasted by NAHB, and that the Chinese economy and lumber purchases stay strong, we should see the US structural lumber composite go to around $500 by the end of the year, and West Coast 2 by 4 move up into the $220-$230 range.
Now let's assume that the housing starts continue at the "worst case" rate.
Under this scenario, which is different from the first only in assumptions on the housing market, we believe that early-year optimism and increased levels of lumber production will result in another mid-year slump in lumber prices as lumber inventories build in the face of flat demand here in the U.S. Here we see the structural composite index returning to depressed levels around $270, and West Coast 2 by 4s hanging steady around $200.
Now we'll combine this worst case US housing market with a slowing in the Chinese economy caused by government actions to control inflation.
Under this scenario, our models show a rapid increase in oil and lumber prices as China continues on an inflationary path in the first part of the year, followed by a quick drop-off in both as the Chinese government takes some drastic economic measures to prevent inflation from getting out of control. Under this more volatile scenario, the structural lumber composite index could soar to $550 or above by mid-year before plummeting back to record level lows around $200. West Coast 2 by 4's will also rise and plummet, with prices returning to around $150 to $160 per thousand board feet.
In addition to these baseline forecasts, we should add the impact of any additional circumstances that arise. For instance, if there is a military action in the Middle East that suppresses oil supply in any way, then oil prices will shoot up and carry most commodity prices, including lumber, with it. If the US-Canada softwood lumber trade war heats up, then U.S. lumber prices will shoot up until a new compromise is established. If the US government comes up with another program to spur on the depressed housing market, then lumber will once again follow the boom-bust cycle demonstrated with the 2010 home buyer tax credit program. And should Russia need to spur its exporting economy by relaxing its lumber tariffs, US lumber prices will be pushed down as China negotiates new tough low prices on the world's lumber markets.
To conclude, we will see China increasingly dictate world lumber prices, and that may be either way up, or way down. The American housing industry is likely to underperform for a decade, and will exert less influence over US lumber prices as producers strengthen their export supply chains. Oil is becoming a better predictor of lumber prices, and we should monitor oil price fluctuations as well as American, Chinese, and Russian government actions for potential inflection points.