WY - The WOOD ETF Provides Exposure To Lumber Prices

2023-06-02 12:15:37 ET

Summary

• Lumber prices have experienced extreme volatility in recent years due to low liquidity and macroeconomic factors.
• The Chicago Mercantile Exchange introduced a new physical lumber futures contract to improve liquidity, but it remains low.
• The iShares Global Timber & Forestry ETF tends to move with lumber futures prices and could be a suitable investment for those looking to position for a recovery in the lumber market.

Lumber is an industrial commodity, like crude oil and copper. Lumber prices are highly sensitive to changes in the U.S. and global economy. In its most recent mid-May quarterly earnings report, The Home Depot, Inc. ( HD ) reported disappointing first-quarter results, with sales declining 4.2%. CEO Ted Decker said:

“ Our sales for the quarter were below our expectations, primarily driven by lumber deflation and unfavorable weather, particularly in our Western division, as extreme weather in California disproportionately impacted our results.”

The CEO blamed falling lumber prices for weak earnings.

After trading to record highs at well over $1,000 per 1,000 board feet over the past years, lumber prices are sitting at the $500 level. Lumber trades in the futures market, but the contracts are highly illiquid, leading to excessive price variance.

Home Depot expressed its exposure to lumber prices, and many companies have a high sensitivity to wood prices. The iShares Global Timber & Forestry ETF ( WOOD ) owns a portfolio of lumber-related companies and tends to move higher and lower with lumber futures prices.

Lumber prices can be wild

Over the past years, lumber futures prices have been explosive and implosive.

The quarterly chart dating back to the early 1970s shows that before 2017, lumber futures’ all-time high was in 1993 at $493.50 per 1,000 board feet. The rally that began in 2017 took lumber to a series of new record highs with extreme volatility gripping the wood market:

• In late 2017, nearby random-length lumber futures rose to a marginal new high at $500 per 1,000 board feet.
• The rally continued, taking lumber futures to $659 in April 2018 before correcting to $251.50 per 1,000 board feet in early 2020 as the global pandemic gripped markets across all asset classes.
• The early 2020 low led to an explosive move to a record $1,711.20 high in April 2021, where lumber futures ran out of upside steam and fell to $448 in mid-2021.
• Lumber rallied to a lower high at $1,477.40 in early 2022 before turning lower and falling to just above the $325 level in 2023.

Only cryptocurrencies and natural gas futures have been more volatile than lumber futures prices over the past years.

The new CME contract aims to improve liquidity

Lumber futures are volatile because they suffer from low liquidity. Daily volume and open interest, the total number of open long and short positions in a futures market, are very limited in the lumber futures arena. Low liquidity causes sellers to disappear during rallies and buying to evaporate when prices fall, causing price gaps and extreme price variance.

The Chicago Mercantile Exchange abandoned the old random-length lumber futures contract earlier this year. The old contract contained 110,000 board feet with very limited and specific delivery specifications. Each new physical lumber futures contract contains 27,500 board feet and has broader delivery options. Over the past weeks, the open interest in the new physical contract has been rising.

The chart shows a steady rise in the total number of open long and short positions to 6,908 contracts as of June 1. The CME hopes that the metric will continue to rise, allowing hedgers, traders, and other market participants to participate in the lumber futures arena comfortably. Increased liquidity should dampen the wild price swings witnessed over the past years.

The reasons for wood’s explosive and implosive price action

Over the past years, lumber’s wild price action a function of macroeconomic and political events. The factors contributing to price increases and the 2020 and 2021 highs were:

• Low mortgage rates: At the end of 2021, U.S. conventional fixed-rate mortgages were under 3%, with the Fed Funds Rate at 0.125%. Low mortgage rates encouraged new home buyers, igniting significant home price appreciation, a shortage of new homes, and a building boom that required more lumber.
• Supply chain issues: Pandemic-inspired supply chain roadblocks decreased supplies. Weather issues also caused lumber inventories to decline.
• Illiquidity: The low open interest and volume in the lumber futures market exacerbated price rises, driving prices to record highs.

The issues that caused lumber prices to plunge were:

• Monetary policy shifts: Rising inflation caused the U.S. central bank to increase the Fed Funds Rate to over 5% from March 2022 through May 2023. Meanwhile, quantitative tightening caused rates to rise further along the yield curve.
• Increases in mortgage rates: Thirty-year conventional mortgage rates rose to over 7%, causing the demand for new homes to decline. Tightening credit standards precluded some potential new home buyers from the market.
• Economic concerns: Recession fears caused by higher interest rates and bank failures caused real estate investors and home buyers to delay or cancel purchases.
• Inflationary pressures: Inflation at the highest level in four decades caused home prices to skyrocket, putting prices out of reach for many potential new home buyers.
• Illiquidity: Low open interest and volume in the lumber futures market caused bids to evaporate as lumber prices fell, causing them to plunge in an environment with few buyers.

While open interest is rising in the new physical lumber futures market, the contract is one-quarter the size of the old random-length contract. Therefore, 6,908 open interest on June 1 translates to 1,727 contracts, which is still below the low metric level in the old random-length contract. So far, lumber has not become a more liquid market.

Lumber could be in the buy zone

The new physical lumber contract is trading not far below the pre-2017 $493.50 record peak.

The chart illustrates at $484.50 per 1,000 board feet, nearby physical lumber futures are only $9 below the 1993 high. The following factors could encourage buying in 2024:

• Rate stability : The Fed Funds rate at 5.125% has reached the central bank’s 2023 target. While the Fed could increase rates by another 25 basis points, a pause is more likely as it takes time for the tightening to filter through the economy. Moreover, the recent bank failures and signs of a slowdown could curb the Fed’s enthusiasm for more rate increases. Interest rate stability could bring buyers back to the housing market as they become more accustomed to the current environment. Moreover, the rate increases have caused home prices to fall from last year’s highs.
• Inflation : The most recent consumer and producer price index data has indicated inflation is declining. While inflation is nowhere near the central bank’s 2% target level, the decline precludes the need for future rate increases, keeping mortgage rates stable or causing them to decline.
• Migration : With many people moving from high to low tax states in the U.S., the demand for new homes in low tax regions could increase over the coming months.

Lumber prices are less than one-third the level at the 2020 record high and are searching for a bottom around the $500 level. While the bearish trend continues, lumber futures have been consolidating around the $500 per 1,000 board feet level.

The WOOD ETF tends to move with lumber futures prices

The low liquidity still precludes any investment or trading position in the CME physical lumber futures. However, the iShares Global Timber & Forestry ETF product tends to follow lumber prices higher and lower.

WOOD’s top holdings include companies with exposure to lumber:

WOOD’s second leading holding, Weyerhaeuser Company (WY), operates as a real estate investment trust ("REIT") with holdings in timber-producing properties owned or leased in the U.S. and Canada. Higher lumber prices are bullish for WY and WOOD’s other holdings.

At $71.61 per share on June 2, WOOD had $201.31 million in assets under management. WOOD trades an average of 12,525 shares daily and charges a 0.40% management fee. The $1.64 annual dividend equates to a 2.29% yield. The dividend covers the expense ratio in under one quarterly reporting period.

The chart highlights iShares Global Timber & Forestry ETF’s correlation with lumber futures prices, with the March 2020 low and May 2021 high. iShares Global Timber & Forestry ETF thus is a liquid ETF that investors and traders can use to position for a recovery in the lumber futures market in 2024.

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