US China trade wars - Blowout?

Wednesday 28 Aug 2019

 
(Canada) It is now clear that 2019 so far has been a blowout, with company results splattered with red ink from weak sales prices to key markets (especially the US and China). Wood products companies have been operating their sawmills at or below cash costs for strategic reasons for part of this year. “Burning cash,” especially for lengthy periods, is always a complicated decision, and companies analyze the pros and cons of it before considering curtailments.

Some of the objectives of not curtailing include maintaining (or even gaining) market share during weak markets (at the expense of higher-cost competitors); this in turn forces higher- cost or less capitalized companies to take downtime first. Also, during unsettled markets, companies want to hold on to their key employees, and perhaps even pick up some skilled workers from mills that do curtail or close. The same applies to contractors: losing a key partner can be problematic when it’s time to restart operations.

For some companies, cash-flow can be a requirement to meet commitments to financial institutions, so mills often continue operating at large losses long past when they should have curtailed. This is why the decision to do so can be a least-desired company strategy and will be delayed as long as possible — until, eventually, it simply needs to happen. When companies delay right-sizing their lumber output to balance overall market demand with supply, it puts more product in the market for longer, exacerbating oversupply.

This seems to be the pattern since 2018-Q4: lumber (and more recently OSB) markets have consistently been oversupplied, keeping prices at low and unsustainable levels. The resulting reduced prices (below breakeven or shut-down costs) eventually lead to capacity closures and longer-term curtailments. However, firms tend to delay these decisions until it is far too late, so low prices start to become semi-permanent.

Looking at the financial results of wood products companies in H1-2019, it is clear that business and market conditions have been a financial blowout thus far. Some companies in the lumber segment have reported losses, with most just barely in the black (on an EBITDA basis). Within any company, this means there are some regions/operations that are more profitable than others, so a below-breakeven situation requires reducing capacity in high-cost or negative- margin areas.

It is apparent from various public companies’ quarterly analyst calls, as well as transcripts and releases over the last four quarters, that some firms have been generally too bullish in their expectations for a U.S. market recovery — and, well, everywhere else. Hoped-for demand increases (in housing starts, repair and remodeling, industrial applications, export markets and even mass timber) have collectively failed to materialize due to a wide variety of unanticipated, uncontrollable factors that have stalled or slowed demand in 2019.

Business strategies that are more heavily weighted to a strategy of waiting for demand improvements can easily fail given that such factors as weather, global politics, etc., cannot be controlled. A dangerous herd mentality can emerge, and if too many producers remain overly optimistic in unsettled times, relatively few negative events are needed to topple market momentum. Furthermore, reacting to unplanned events takes time, so inventories tend to go up while prices drop. A low-cost production strategy works well when you are the highest-margin supplier (versus other mills or regions when markets are more balanced).

In North America, the US South has held this position (at least until recently), while other regions have faced skinny to negative lumber margins. As the FEA global sawmill cost benchmarking analysis shows (full report to be released in 2019-Q4), various European countries are now positioned as the second-lowest-cost lumber suppliers to the US South (after the South itself), while the highest-cost mills are mainly in the BC Interior. Until more capacity is removed, lumber operating rates will continue to drop until market demand improves; they are also being hampered by steadily rising offshore imports (also a factor in the US plywood market).

Expanding offshore exports can be another strategy to balance domestic markets, i.e., shipping incremental volumes away from the prime North America market to reduce domestic supply. However, exporters from Canada, Europe and Russia have oversupplied the China lumber market, and New Zealand has (almost singlehandedly) oversupplied China’s log market.

Like the industry in general, FEA (in both the US and Canada) remains mildly optimistic that Q4- 2019 and (especially) 2020 could surprise to the upside, but there is currently too much supply chasing oversaturated markets. More curtailments/closures are likely (and will eventually reduce the oversupply), but it is the last thing companies really want to do! So … onward the cycle goes.

Source: Russ Taylor, Managing Director, FEA Canada


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