It can be tough to keep tabs on what is going on in your office not to mention the global economy. Al Schuler, a research economist for the U.S. Forest Service, crunches numbers and looks for little trends so you can focus on your daily operations.
In a recent Pallet Enterprise interview, Al explores the changes taking place in the forest products industry and ways that smart lumber and wood products companies can take advantage of these opportunities. From globalization to housing to macro economic concerns, Al highlights the things you might not have noticed.
Prior to joining the Forest Service, Al was the manager of economics and market planning for Norbord Industries and a market researcher for Forintek Canada Corporation.
This interview is being divided into two sections. The second section will run in the February issue of Pallet Enterprise.
Pallet Enterprise: Given all the tough challenges over the last year, especially with the downfall of the housing market, what upside is there for the U.S. lumber and forest products market?
Schuler: The reason it sounds kind of bleak is that both the hardwood and softwood industry in this country is focused on residential construction. And as you know, the residential construction market is not doing well right now. It is down 35% from the peak in 2005.
When housing turns around, then that is when the wooden products industry will make a recovery. Seventy five percent of the demand for structural wood products, which is mostly softwood, goes for residential construction. More and more of our hardwood products are going to the remodeling market – flooring, molding, millwork, furniture.
Both the hardwood and softwood markets are trying to export more material. But that is asking an awful lot to have increased exports fill the gap.
Pallet Enterprise: What kind of impact has the housing downturn had on Canada?
Schuler: It is a big problem, particularly for softwoods. About 35% of our softwood lumber comes from Canada. Right now the Canadians are getting hit twice. The Canadian dollar is up to par now with the U.S. dollar. Eight years ago, the Canadian dollar was worth 65 cents. Today, it is one for one. The other problem is the softwood lumber duty. The governments recently eliminated the duty. However, the new agreement has a clause that reinstates a duty when lumber prices in the U.S. fall below a threshold level – today, we are substantially below that level.
In my opinion, the Canadians are hurting more than the American mills. More and more of them are shutting down or taking extended downtime. Of course, many mills on this side of the border are hurting too. The current FLC price ( average through October 2007 ) is $291/M — this is down $133/M or 28% from the peak year for the current housing cycle reached in 2004.
Pallet Enterprise: You predicted in a recent speech that the housing market would eventually recover, probably in 2009. Please explain why the market dropped and what it will take to recover.
Schuler: The main problem in the U.S. housing market is the inventory. It is at an all-time high. We have close to a ten month inventory. What I mean by inventory is how long it takes to sell the existing number of homes on the market at the existing sales rate. Traditionally, it is five to six months at the very most. That inventory has to come down. That happens when the price of homes comes down, which is starting to take place at an accelerating rate.
There are in excess of half a million new homes on the market. Builders have incurred the cost of building these homes. There is a big inventory carrying charge for them. Until some of these homes sell, builders don’t want to build any new ones, which has translated into lower housing starts.
At any one time, a big builder could have over a billion dollars in inventory. It’s just a huge cost. Nobody can accurately predict exactly what the market will do. But most of the reports that I have seen suggest that the market will bottom out in the middle of 2008. Beginning in the third and fourth quarter of 2008, it will start to get better. By late 2009, we should be in decent shape.
In addition to the inventories, we have this sub prime mess. We have a potential freezing up of credit. The FED has stepped in to lower interest rates. That is going to help some, but it is not going to bring mortgage rates down to the point where most buyers will jump back in the market. Additionally, the recently brokered deal between the current administration and the lending industry offers some hope to help some American hold onto their homes. Time will tell whether this action will make any significant inroads into ameliorating the growing inventory problem.
The reason that prices got up so high was that credit was really cheap. It was easy to borrow money. Many lenders were not looking at the credit record of potential borrowers. These are the sub prime loans.
A few years ago, speculators were about a third of the market. They are gone now. They have even disappeared completely from some regional markets. Cheap money and fairly lax lending standards created a big demand for housing – more than the underlying fundamentals ( i.e., demographics) could sustain. Then, when interest rates reversed course and lenders started to more accurately assess the trade-off between risk and return, housing demand slowed abruptly. This left builders with huge inventories.
If you look at all the economic fundamentals for the housing market, they are reasonably sound. The GDP is slowing but still solid. Interest rates are still quite low by historical standards. The main economic pillars of housing are the economy, interest rates, employment situation, and inflation – all things that impact affordability. Most of the residential pillars are doing well. In addition, the non residential construction market, which is actually larger than the residential market in terms of dollars of investment, is doing well. The pillar of factor that is out of sync the most is the prices for both existing homes and new homes.
If you look at the underlining demand for shelter, which is household formation, net immigration, replacement of homes past their economic life, all those factors are very positive. Those fundamentals look even better over the next ten years than the last ten years. A big part of that is immigration. More than one million people come into this country every year. People come here for a better quality of life. One of the major components of that life is having a nice home. They want the same things that you and I do.
The Joint Center for Housing Studies at Harvard University recently released their long term outlook for housing (http://www.jchs.harvard.edu/publications/markets/w07-7.pdf ). They are projecting 1.95 million housing demand each year during the period 2005 – 2014. That demand includes 1.46 million annually from household growth (demographics plus net immigration); 150,000 annually from 2nd homes demand; and 330,000 annually from net removals (replacing homes past their economic life).
Immigrant’s home ownership rate is actually becoming higher than the home ownership rate for native-born Americans. It is hard to get real accurate numbers. But the estimates that I have seen indicate that close to 20% of home sales over the past decade has been to people who were not born in the United States. You can imagine what the demand for housing would be in this country if we didn’t have strong immigration.
Some countries, however, like Japan, don’t encourage immigration to the same extent as we do here in North America. With its aging population, Japan has been experiencing economic troubles for the last 15 years.
When you look at replacement homes that are beyond their economic life, there are about 125 million housing units out there with an average age of about 35 years. That means there are a lot of those houses that are 50-70 years old. After a certain amount of time, it doesn’t pay to maintain the house any more. That is going to become a bigger component of the demand for shelter in the future, and it will keep growing.
Older homes are where we see a lot of the remodeling taking place. Remodeling is almost as important as new housing to the economy. These numbers will become equal over the next ten years.
The key is to get through this mess we are in right now, which was caused by over building in response to “cheap money” and lax lending standards.
Pallet Enterprise: If most of the fundamentals are good and only one is out of kilter, yet the forest product industry is experiencing major problems, what does this say about the long-term viability of the industry? Are we entering a period where the glory days are over? Will the future be just a series of busts as different fundamentals go through market corrections?
Schuler: It demonstrates that we probably are over-focused on residential construction. We have put most of our eggs into just one basket. We have gone through these boom/bust periods for at least the last 50 years. Most of our wood products industries produce primarily commodities. You have to make money when the prices are good and lose as little money as possible when prices are bad. It is difficult to get away from these boom/bust periods. You have to plan for them.
If you are in a commodity market, the main objective is to be the low cost producer. That way you make more money when times are good and lose less when times are bad. There is going to a lot of producers in this down turn that will go out of business. The companies with deep pockets and low cost producers will be around when things change. That is how it has always been. It’s a little bit worse this time when you throw the globalization pressures on top of a severe housing mess.
This is forcing companies to ask how they can diversify and protect against globalization. There are ways to fight these guys. That means getting closer to your key customers. You have to figure out how you can help customers solve some of their problems. It’s not just producing products any more. Some how you are going to have to add some services to those customized or semi-customized products.
That is where you do things for your customers that someone who is ten thousand miles away can’t do as well. I spent ten years working with private industry. Our customers were sold primarily through distributors with most of the product going to builders and professional re-modelers. In my opinion, we didn’t talk with them as much as we should have. And I don’t think that we were atypical. That will have to change.
The key customer is not The Home Depot or Lowes. The key customers are the people who from a home improvement store or the professional builder and re-modeler who buys from the lumber yard. You can’t always assume that the distributor knows what the end customer wants. I am not sure that they do. But, then, this is the way we sell most commodities – through mass distributors to take advantage of scale economies.
Pallet Enterprise: Isn’t this kind of what we have seen with Red Oak?
Schuler: When you are talking about hardwoods, the species come in and out of favor. This creates problems. Red Oak is not in favor right now. You go out and try to create a demand for Red Oak. But that is easier said than done.
Pallet Enterprise: You talked about diversifying away from the residential market. Are there some emerging markets that you see might offer some good business opportunities?
Schuler: In the wood products business, you have to diversify geographically and product wise. There are some markets off shore with growth potential. China may not be a big market right now. As you look in to the future, there is opportunity. China is no where near self sufficient when it comes to wood products. China imports a high percentage of wood products from Russia and SE Asia with some coming from the USA.
There are untapped customers here at home. You have to go out and find them. You have to find what they want that they can’t get from their existing suppliers.
A few years ago, we did a survey of the Appalachian Hardwood Association’s members. Almost every one of those members said that they are paying more attention to what the end customers want. The closer they get to the customer, the better they are able to insulate themselves from cheap supply from other places.
The companies will do special proprietary grading for customers. They have bought specialized grading, lumber sorting and breakdown equipment that allows them to produce specialized products for customers. You may have to deliver smaller packages to customers instead of just selling truckload quantities. A lot of it seems to be proprietary grades, smaller loads, specialized colors, special lengths, mixed loads – there is no one thing that will give you all of the business.
Pallet Enterprise: Where does the United States stand as far as forest resources and competitiveness in this new global economy as more countries with timber resources enter the market? How competitive can the U.S. industry be in the future? What are our limitations?
Schuler: When you look at demand in the world for high quality logs that is where the United States is always going to have a competitive advantage. This includes higher valued furniture, flooring, veneer, and panel products. The United States has an advantage based on the way we grow these trees. When the trees grow slower, you get more rings per inch. It is generally a better quality whether it is hardwood or softwood.
When you look at fast growing plantations and products where quality is not a concern, other areas of the world have an advantage. Examples of these products include medium density fiberboard, particleboard, and commodity pulp and paper goods. Many of those products can be made cheaper elsewhere because either the trees grow faster, there is cheaper labor, or fewer regulations.
As the standard of living increases around the world, there is going to be an increase in the demand for high quality lumber and wood products. We also have an advantage in some species, such as cherry and walnut. Those species don’t grow all over the world. The biggest and best cherry stands in the world are in Pennsylvania.
Russia has some hardwood. But it doesn’t have real high quality hardwoods that we have here in the USA. Russia has mostly poplar, birch, material that is sold for pulp wood to Scandinavians. The only other place that you see beech and oak in fairly large volumes is Eastern Europe.
On a quality basis, the United States is always going to have an advantage, particularly for hardwoods.
