Commodity price changes are capturing headlines, but as those prices change, who are the winners and losers? Let’s explore the impact of lumber price changes on various business sectors. For example, home builders, real estate developers, wholesale and retail lumber sellers rely on access to lumber. Window, door, and furniture manufacturers use lumber as a production input. The timber producers and end-user consumers of lumber rely on the supply and demand equation to meet needs at a reasonable price. The cost of lumber has far reaching implications for the economy, and understanding the inflationary aspects of this commodity will be important.
This chart shows the lumber futures prices for the past five years. There was a price valley of $264.00 on March 30, 2020 and a spike to $1,670.50 on May 3, 2021. While prices have dropped to $932.50 as of June 21, 2021, this price level remains higher than the previous five year peak of $624.00 on May 14, 2018.
The National Association of Home Builders (“NAHB”) reports that the 300% increase in lumber from April 2020 to May 2021 caused the average price of a new single family home to increase $36,000. The NAHB also stated that the price of an average new multifamily home increased $12,966 which would translate to adding $119 per month to rent for new apartments.
According to the US Census Bureau and the US Department of Housing and Urban Development, the May 2021 housing starts were 1.5 million, which is 50.3% higher than the May 2020 level of 1.1 million, and compares to the May 2019 level of 1.3 million. The chart below shows the trends for building permits, housing starts and housing completions.
To measure the nonresidential construction market, the Architecture Billings Index (“ABI”) is used. This is a monthly economic indicator based on the American Institute of Architects (“AIA”) monthly Work-on-the-Boards survey which has been done for over 20 years. The ABI is reported as a single number, with a result above 50 indicating growth.
According to the AIA’s April 2021 report, the April score of 57.9 is the highest ABI score since the Great Recession. The report goes on to say that interest in new projects is strong with a 70.8 score and the value of a new signed design contract reached 61.7, which is the highest score for that index since the data began being reported in late 2010. This shows that architects are being asked about new projects and they are signing contracts to begin that work.
All the regions in the US are experiencing growth, with the South and Midwest leading the way.
The reported housing starts and the ABI indicate that construction companies and the companies that support them should be experiencing growth. This is good for the construction companies, as long as contracts allow for material price changes to be passed along. The spike in lumber prices that occurred in 2020 pushed many developers and contractors to float material prices against final invoices or index values, such as lumber futures. The spike in 2021 underscores the need for the consumers of lumber to mitigate their risk. According to the NAHB, 22% of builders are getting price guarantees from suppliers and 47% of builders have added price escalation clauses.
The lumber price increases are a result of a supply and demand imbalance. When the housing market cratered in 2008/2009 the US Forest Service reported that at least 30 large sawmills closed for good. Supply was also impacted by 2017 Canadian softwood tariffs and wildfires in the Pacific Northwest. When Covid-19 hit, sawmills closed or limited production, which pushed existing inventory through the system. Now labor shortages are impacting operating mills and are dampening desire to reopen mills. The truck driver shortage and higher fuel costs also impact supply. While the Canadian lumber tariff was lowered from 20% to 9% in December of 2020, Canada also has supply issues due to the impact of the mountain pine beetle on timber stands in British Columbia, Alberta and the Pacific Northwest.
Overall inventory levels of lumber are low at the wholesale and retail seller level. Sellers are attempting to increase inventory levels but the supply and demand dynamics are not allowing that to happen.
In summary,
Companies that rely on ready access to lumber are being negatively impacted by the supply / demand imbalance. Companies that rely on lumber and wood products in their manufacturing process, such as window and door manufacturers or furniture manufacturers, are experiencing supply chain disruption and cost increases. Companies that develop and build real estate projects are experiencing similar supply chain disruptions and cost increases. These impacts are further stressed by a company’s availability of labor and required skills.
Tracking the various indexes mentioned in this article will be critical in developing a sensitivity analysis for an individual company impacted by lumber prices. To produce an accurate sensitivity analysis, the topics of client and vendor relationships and working capital management need to be addressed. And, price volume variance needs to be tracked.
Companies must employ best practices in terms of managing their client relationships. This involves understanding:
Profitability by customer.
Profitability by product.
Profitability by location or division.
Without an understanding of profitability in this level of detail, a company is not able to make the changes necessary to continue to generate profitable operations and service its debt.
Contracts with vendors need to be evaluated for the potential to lock in input costs for a period of time, and for the potential that vendors will increase prices. Contracts with customers need to be evaluated for the potential to increase sales prices as a commodity price increases.
A successful company will be one that is clearly able to analyze profitability by customer, product and division, and make appropriate operating cost changes as needed, with the ability to pass along cost increases when contracts allow.
The second area to address is working capital management. This involves accounts receivable (“AR”), inventory, accounts payable (“AP”) and the line of credit.
Increasing commodity prices will result in companies experiencing pressure for extended payments from customers who are experiencing the same impacts of inflation, and pressure for faster payments to suppliers from vendors who are also having price increases. Just as Covid-19 impacts forced successful businesses to intensely manage their working capital in both directions, commodity price changes cause the same pressures.
Inventory levels may need to be increased to protect against unusual price swings or to allow better matching of costs to produce to revenues, or to deal with labor shortages and supply chain disruption.
The impacts on AR, inventory and AP put pressure on lines of credit. In some cases, while the working capital management is successful, the overall size of the line of credit may be limited by a borrowing cap which is below the collateral at the new price levels.
To address this, a company needs to be monitoring and reporting on price and volume variances. Companies need to be able to identify what amount of the change in revenues or the changes in costs are attributed to volume changes versus attributed to price increases. Without this level of analysis and understanding, a company will be unable to clearly articulate line of credit needs and the explanation for the changes required to continue to operate.
The large swings in lumber prices clearly show the impact of inflation and the impact of changing commodity prices on business profitability. Lumber is an important part of our overall economy, and directly impacts many businesses and industries. Awareness of the impact of commodity prices on a company’s performance is key to assessing financial performance risk.