Even rising lumber prices can't entice investors

Negative sentiment lingers from 2018

When it comes to investing in Canada's timber and lumber sector, it sometimes can be hard to tell the forest from the trees.

These days, lumber prices are soaring, having peaked in early September at nearly US$955 per thousand board feet, a record high and about 82 per cent above the previous peak in 2018, according to Random Lengths, which looks at a basket of different varieties across North America.

Analysts say the outlook for lumber remains bright, as low-interest rates and a surging housing market across North America ensure strong demand going into 2021. But even as high lumber prices translate into rich cash flow for lumber companies across Canada, investors remain skittish.

“We're bullish on all the companies, right now,” said Paul Quinn, an analyst at RBC Securities who covers the forestry sector. “Usually companies' (share prices) move in lockstep with commodity price … if you had prices at this level in 2018, the share prices would be double what they are right now, but they're not because investors are worried.”

But there are clouds on the horizon: lumber futures suggest that prices will decline back to around US$600 per thousand board feet by November, and fall throughout 2021.

Quinn said prices for lumber tend to decline at this time of year as the weather gets colder and construction slows down, and attributed much of the negative sentiment around the market outlook as a hangover from what happened in 2018.

That year, prices started off strong through most of the first two quarters, as both interest rates and housing starts looked to support high demand, he said. But by the end of the second quarter, persistent problems moving lumber to market because of congestion on Canadian rail lines, interfered with companies' operations.

Then rising interest rates ultimately fed into what Quinn described as “lacklustre” 2019 in which lumber prices and company's share prices both dropped.

For example, Vancouver-based Canfor Corp.'s stock price dropped from a high of $32 in mid-2018 to below $9 per share by mid2019. By this summer, the company's stock had surged back above $18 per share at one point; it closed Friday at $15.63.

“That drop in 2018 surprised a number of investors,” said Quinn. “They've been a lot more cautious about this run- up in pricing.”

By the end of 2019, with log prices low, lumber companies across British Columbia surveyed the landscape and considered the devastation wrought by the Mountain Pine Beetle, an invasive species. Since an outbreak started in 2005, the province estimates the tiny bug has destroyed an estimated 54 per cent of its merchantable pine.

As a result, companies around the province made a series of cuts and closures at mills that resulted in about a four per cent reduction to the production volume in North America, according to Quinn.

While that may have had a marginal effect on lumber prices, the market disruption caused by the coronavirus pandemic, exacerbated by ongoing wildfires in California and Oregon, have created new kinks in the timber market.

Mark Wilde, an analyst at BMO Capital Markets who covers the forestry sector, said that the pandemic caught everyone off-guard because overnight the economy shut down and lumber companies stopped receiving new orders from large buyers.

The effect was most pronounced in B.C., where in April, saw mills cut back to 39 per cent of operating capacity, while mills in the rest of Canada and the western U.S. operated around 69 per cent capacity, and mills in the southern U.S. operating at 86 per cent of their capacity, according to Wilde.

“At a time of year when ordinarily we're building inventory because we're going into spring and summer construction season, nobody wanted to be stuck carrying a lot of inventory,” he said.

But demand was actually stronger than normal because people were stuck in their homes, many had received stimulus cheques and decided to embark on renovation projects, said Wilde and other analysts.

An estimated 65 per cent of Canada's lumber ends up in the U.S., where it is used for housing and where the property market has experienced its strongest year in more than a decade, Wilde said.

“So all of a sudden we get this better-than-expected demand, and there's no inventory out there,” he said.

As a result of wildfires in the west, many mills are also shutting down or reducing operating levels as workers flee from danger, according to several analysts. That could help keep prices higher for several more weeks, although Wilde and other analysts all expect a decline in the coming months.

Still, Wilde predicted that the prices will remain elevated for now and that most lumber companies will report record quarters through 2020 and enter 2021 “with significantly improved balance sheets.”

“Most lumber equities have rallied sharply since March/April, but remain below our … targets,” Wilde wrote in mid-September.

His price target for Canfor is $29 per share. Interfor Corp.'s stock-price target is set at $22 per share, up from Friday's close of $15.57. West Fraser Timber Co. Ltd. is targeted at $82 per share, up from $61.58 on Friday.

Similarly, CIBC World Market Inc's Hamir Patel has picked West Fraser, Canfor and Interfor as outperformers.

In a note on Oct. 2, Patel wrote that wood product companies could see further pressure and volatility in their share price over the coming weeks, as lumber prices come off their peak.

Still, he wrote that the last time lumber prices exceeded US$600 per thousand board feet, Canfor traded at over $33 per share, Interfor at over $27 per share and West Fraser was over $96 per share.

Quinn, of RBC, said the stars are aligning for a strong run for the forestry sector.

“At some point, investors will say, `Wow, these lumber companies are looking good, and 2020 looks good,' and those share prices will come up,” he said.