As you might expect, the U.S housing slump is reducing demand for finished lumber. Meanwhile, timber, pulpwood, and paper prices are rising worldwide – but curiously, profit margins are eroding.

What’s up with that?

The global commodity boom has created a supply/demand price imbalance between the four distinct industry sectors that rely on timber as a raw material. In fact, that imbalance is a huge mismatch. And savvy investors may be able to wring substantial returns from the winner.

You see, timber companies have shrewdly maintained monopoly-like control of raw materials to hold the line on prices, despite the economic downturn. They are doling out enough – and only enough – supply to maintain sufficient revenue streams to pay the bills. Meanwhile, their downstream relatives are suffering.

In a sense, timber owners are weathering the storm. And when the storm is over, their profits should explode.

It’s a complicated scenario being driven by a number of economic factors including the declining U.S. dollar, classic market demand/supply ratios, emerging markets growth, and even export quotas and tariffs.

Investors who tune in may catch lightning in a bottle. The end game could send timber company profits – and your portfolio – soaring in the next 12 months to two years.

Let’s take a look.

Housing Slump Wreaks Havoc on Lumber Mills

As lumber prices have swooned to a five-year low, wood has been piling up at lumber mills. Sawmills throughout the United States and Canada have been reeling since the second quarter of 2007, when lumber prices collapsed to below the cost of production.

Here’s what’s happening now:

* In the United States, single-family-housing starts dropped 1.7% in April to a seasonally adjusted annual rate of 692,000 units, the lowest monthly production rate since January 1991, and a jaw-dropping 42% below 2007.
* U.S lumber consumption is expected to drop, from 64 billion board feet to 43 billion board feet from 2006 to 2008. A drop of 21 billion board feet in the span of three years is simply staggering, equal to the total production of the Top 20 softwood lumber producers in the U.S. market for all of 2007.
* North American lumber at the Chicago Mercantile Exchange has fallen as low as $209 per thousand board feet, down a whopping 56% from its peak of $473 in 2004 – at the apex of the housing boom.
* Lumber companies in the Billion Board Foot Club, a measurement of the largest lumber companies in the world, was reduced from 22 to 15 in 2007. Six of the victims to be cut were in North America.

Particularly hard-hit are the big lumber mills in Canada, which ship much of their production to the United States. The key factor was the unprecedented run-up in the Canadian dollar. With sales denominated in U.S. dollars and costs accrued in Canadian dollars, a wide range of Canadian producers were running in the red and simply ran out of money.

In addition, Canada mills must pay a 15% duty to ship lumber into the United States. That puts the price at those mills at about $175 per thousand board feet, said Gerry Van Leeuwen, vice president at International Wood Markets Group, a Vancouver-based lumber consulting firm. “There is just no way anyone is making any money,” he added.

In the past, sawmills only needed to wait for interest rates to decline before ramping up production. Now, however, they will have to wait until the housing glut is over before lumber demand gets back to normal.

And that’s not likely until mid-2009 at the earliest. Our advice is not to bet the farm on lumber companies right now.
Global Growth Buoys Pulpwood and Paper Mills

Meanwhile, pulpwood and paper has been in a strong bull market for almost two years. Demand for paper and pulp remains strong – from overseas markets, in particular. And that demand doesn’t appear likely to ebb anytime, soon.’

Overall, world paper demand is moving ahead, buoyed by accelerating growth in Asia. The surge in paper demand in Asia is driving a huge appetite for both virgin pulp and recycled fiber. In 2006, alone, China’s imports of wood pulp jumped 150% to 7.5 million tons.

Increased exports have also helped pulpwood prices. The weak U.S. dollar makes it cheap enough for pulp and paper companies to purchase products in the United States and ship them overseas.

On top of that, demand from European utility companies for wood pellets should keep pulpwood prices elevated. Believe it or not, European utilities have turned to wood chips to produce power in order to lower their greenhouse gas emissions in accordance with the Kyoto protocol.

So you would think paper and pulpwood mills would be humming along, bringing in record profits.

Don’t make that bet.

The Big Squeeze

There is a huge fly in the ointment for pulpwood-and-paper mills.

Paper mills, of course, rely on pulpwood as raw material. Pulp mills, in turn, operate on small logs and wood chips – a byproduct of lumber production. And, as you might expect, the weak market has lumber mills cutting back on production. This is forcing pulpwood mills to rely on buying more logs or raw timber, says Daniel Stuber, of Forest2Market.com,. The lack of available chips has produced a big demand for small, lower quality logs.

The fact is, pulp mills are using twice as many logs as they normally would to satisfy production levels. And they’re getting hit right in the wallet.

“One of the bright spots for timberland owners is the demand from the pulp-and-paper industry,” Stuber said. “Land owners have been withholding stands with larger trees until saw-timber prices rebound, but they have been able to generate revenue through thinning practices and harvesting younger stands.”

You see, I’m planning to buy a lumber futures contract. The standard contract of lumber on the Chicago Mercantile Exchange is 110,000 board feet. This is the capacity of a standard lumber centerbeam railcar. (I traveled on top of a lumber car once… out of the BNSF Spokane yard… but that’s a story for another day.)

I’d love to have this wood in my front yard. But I don’t have a warehouse, and I don’t have a railroad spur to my door. That’s what’s great about the futures market. I can buy lumber now for delivery in the future.
A railcar of lumber sells for $20,000. A November delivery of lumber, however, costs about $27,000 today. I’m okay with the extra cost (the $7,000 over the current spot price). Lumber spoils. Storage is expensive. I’ll pay the premium for a future delivery.

And in fact, I won’t take delivery of my lumber. What would I do with 32 miles of lumber, anyway? I’ll sell it to someone else before the delivery date in November.

I want to buy this lumber because, in my opinion, it’s too cheap. As a long-time lumber broker and trader told me on the phone just now, prices are “economically unsustainable.”

Let me explain:

Even the largest, most efficient producers of lumber in North America cannot fill a railcar full of 2×4s for $20,000.

Take Canfor for example. Canfor is the largest producer of lumber in Canada. It made a profit in 2006 and a loss in 2007.

These numbers are very rough, buy they imply that for Canfor to break even, the company needs to sell a railcar of lumber for around $30,000. It’s nowhere near that now.

With the market price for a railcar of lumber at $20,000, every lumber producer in Canada is slowly going bankrupt, including Canfor. The Vancouver Sun did a survey. It found the Canadian logging industry shut down 34 lumber mills and fired 10,000 workers in 2007.

Lumber is down in part because the housing industry is in a slump – homebuilding and remodeling make up two-thirds of U.S. lumber consumption. Right now, the major Canadian producers are trying to raise cash and ward off bankruptcy, so they’re dumping their inventories on the market. That’s pushed lumber prices even lower. But soon, there’s going to be a shortage of lumber.

Contractors will notice how cheap lumber is and will decide to start building houses again. But they’ll find the forest industry has shuttered all the mills, fired all their workers, and sold all their lumber.

This will cause lumber prices to rise. I expect they will double within two years… to around $40,000 a railroad car. I plan to buy my lumber with 50% borrowed money, so I’ll double my money if I’m right. The risk is if prices stay low longer than I expect, I lose $7,000 in storage costs.

If you want to play this idea without using futures, consider buying stock in one of the large Canadian forest-products companies like Canfor (Toronto: CFP) or Western Forest products (Toronto: WEF). But there’s risk here, too. These companies have enormous debts and are at a high risk of bankruptcy…

So what’s holding me up right now? As much as I’d like to buy, lumber is still in a downtrend. I’m waiting for the price to turn around and prove my thesis. So before I buy my railcar of lumber, I’ll wait for a 10% rally in lumber prices.

More to come when I see that rally…