prices are back near their fows for the year. fs there relief in sight?

By Paul Jannke RISI

A FfER hitting their lowest level in .Cl,nearly 25 years (adjusted for inflation) late in the first quarter and early in the second quarter of 2007, 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 l57a above its first/second quarter lows and a full 2oa/o 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 l0%o. 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 807o 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 22Vo from year-ago levels in the first half of 2006, and down 87o (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 22Vo over a year ago. For existing homes, an 8.8 months inventory in June represents a huge 287o 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 of any 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 2OO7 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 Iikely lower.

Recent buying, while driving up prices, has also left dealer inventories flush. Lumber prices began falling in mid-July and this downward trend will continue (albeit perhaps with a shortlived reversal in September) into the fourth quarter. This decline will 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 were above costs through July. Consequently, we expect lumber prices will retreat back near their lows for the year and the cycle in September-October.

Early 2008 will provide a bit of a break from the extremely weak pricing and profitability of 2007. The decline in consumption will have slowed, and dealers will be anticipating increased end-use consumption by mid-year. This, combined with extremely low prices and therefbre limited downside risk, will encourage dealers to step up buying in the first quarter, driving up prices.

While we expect prices to rebound somewhat in early 2008, the upside potential will be limited by weak (cyclically flat) first-quarter end-use consumption and operating rates that are only slightly above early 2007 lev- els. Moreover, higher prices toward the end of the first quarter will stimulate increased production. At the same time. dealers will have built sufficient stocks to carry them through the slowly rising consumption of the second quarter and will therefore limit buying. Consequently, lumber prices are again expected to fall in the second quarter of 2008.

The seasonal increase in consumption will bolster prices by the third quarter of 2008. And, with cyclical growth in demand edging higher, we cxpect them to continue to rise towards the end of the year. While we do expect better pricing in 2008, it will not be significantly better: lumber prices for the major species/products are forecast to increase around 57o from their 2007 levels.