lumber futures contracts traded in Chicago offer mills the opportunity to
hedge against drops in lumber prices.
By Paul MacDonald
In what looks like a frenzied shouting match, a few hundred traders make direct decisions every business day in Chicago on where they think commodity prices—including SPF lumber—are going.
Most stock exchanges, like the Toronto Stock Exchange, are now trading electronically. Shares in corporations—including the publicly-traded Canadian forest companies like Abitibi-Consolidated and Canfor, for example—are bought and sold in a very orderly manner, using computers.
But commodity futures, in everything from Euro-currencies to lumber, is traded on the Chicago Mercantile Exchange or the “Merc” as its known. They conduct trades there the old fashioned way: using the open outcry method. This sees traders shouting bid/ask prices back and forth on lumber and other futures, exchanging hand signals furiously. Even though we live in a high tech age, when a deal is made, it is still written up on a piece of paper down in the trading pit in Chicago.
For the few hours of the day it operates, the Merc’s trading pit is action central. The futures and options contracts traded on the two trading floors cover agricultural commodities as well as a dizzying array of currencies, interest rates and stock indexes. Futures and options are available on more than 50 products.
Although not a huge amount of lumber is traded on the Merc—earlier this year there were 4,000 outstanding futures contracts representing about 440 million board feet of dimensional SPF lumber—the exchange is one of the clearest indicators of where the industry, and to some degree speculators, think the lumber market is headed. For example, if the cash or spot price for lumber is $225 and January futures contracts are trading at $250, then the betting is that lumber prices will be headed up.
And the information is easily available: most newspapers publish the lumber futures quotes in the business section every day. That, according to veteran commodities futures broker Graham Dallimore of Global Futures Corporation of Vancouver, is one of the beauties of the lumber futures market.
“It’s very open and transparent,” he says. “Prices are disseminated throughout the world instantaneously. The guy operating a mill in Burns Lake, BC has access to the same information as the guy in Chicago or New York. ” You don’t even have to wait until the next day’s newspaper to get the prices—they are available immediately on the exchange’s web site.
While a great deal of myth has been built up around the relatively small number of colourful hard core speculators and professional traders that populate the trading pit in Chicago, on a broader basis lumber futures trading serves a number of functions for the forest industry and its customers. “It’s important to dispel the notion that the Merc is a great big gambling casino where a bunch of crazies are just tossing the dice,” says Dallimore. “There are some traders like that in the pit. But it’s a very small number.
“One basic purpose is that it allows lumber users to buy/hedge their needs to protect themselves against any price spike in the market,” explains Dallimore. He has one client, a large house builder, who wants to lock in his raw material costs and routinely buys lumber futures contracts to ensure he will get the wood he needs to build homes at a set price at a set time one year out. This client may purchase contracts, for example, around and through the peak home construction times of spring and summer.
“A client like this is looking to hedge, or reduce his risk,” says Dallimore. A lumber user or buyer can be at risk if the cost of lumber advances and the quotes they have out for jobs are based on a lower lumber price. If the lumber market is hot, any profit could evaporate. “The buy side of the market might be manufacturers, homebuilders or wholesalers who are committed to delivering or using the lumber and they don’t want to see prices rising on them.”
Futures can also work well on the production side for the sawmills in that they can hedge and get a guaranteed price. At a time of high lumber prices, a mill can sell ahead into the market and lock in a higher price. If prices are $300 per thousand board feet in March and the mill believes they are going to decline following a spring spurt in house construction, they can sell a contract for July delivery at $300, if that is the going rate in the market. If lumber prices go down, the mill still receives its price. If prices go up, of course, the mill loses out on any gain because it has committed to deliver the lumber at $300.
The number of open contracts on the Merc earlier this year illustrates that although lumber futures contracts reflect current and anticipated future prices, the volume traded on the market is small compared to overall lumber production. The 4,000 contracts, timed through the next year, represents only 440 million board feet of lumber. Contrast that with the approximately 63 billion board feet of lumber produced in North America in 2000.
“Lumber futures are not used nearly as extensively as they could be,” says Dallimore, although he noted that British Columbia mills have been using contracts more in the past few years. When it comes to lumber, the cash or spot market, is still apparently king.
“But future contracts enable everyone to understand where the cash price is and where people think the market is going.”
The large lumber producers usually have their own marketing departments, as well as deals with big customers, through which their production is sold, often as close as possible to a just-in-time basis. The focus for these marketing departments is onselling lumber now, not nine months down the road.
A lumber futures contract is, basically, a BC contract. It is quoted based on a Prince George delivery, with freight, and more importantly with the expiry of the softwood lumber agreement, all tariffs or duties pre-paid by the mill. If a countervail duty is suddenly imposed on Canadian lumber, such as happened this year with wooddestined to the US, the mill then has to pay the duty.
Dallimore notes most of the BC mills have been involved in the market at one time or another. “Their use varies and it depends on market conditions and the style of the people doing the hedging. Some mills hesitate to hedge when prices are low, at $200 per thousand. Other will jump right into the market, as long as there is a premium there to the cash price. They don’t care whether the prices are $200 or $400, if there is a premium there, they will sell into the futures market.”
Dallimore says the market could be used much more on the mill side. “There’s no question about that. But the mill or lumber user obviously should use it only when it’s to their advantage.” That can be tricky when prices are unpredictable and it can come down to a judgment call.
But he noted there have also been what he terms “no brainer” deals out there in the futures market at times. “There have been huge premiums, as much as 10 per cent, from the spot to the front contract.” That would mean a front contract price—in May—of $242 when the cash price in March is $220. “What else will pay you 10 per cent in two months time?”
The trading is usually sedate, but there can be exceptions. “If there is a high degree of conformity, when traders think the price is about right, then trading dies right down,” he says. The busy—and interesting—times come when there are different viewpoints about where lumber prices are going, or should be going. (See sidebar story.)
Sometimes the professional traders in Chicago might see the market as being positive, or bullish, and the mill side does not see it that way. The result could be a very active trading day, with traders trying to buy contracts at the best price and the mills looking to sell.
As with stock markets, basic human elements and psychology are also at work in Chicago at the Merc. As Dallimore puts it, “two very supreme motivators for mankind are fear and greed”.
“The next step up from greed is fear and on some days there might be some people in the market who think they are too exposed on contracts and start to try to cover themselves.”
Even though Dallimore trades other commodities, he readily admits lumber futures are his favourite. This has to do with the fact that BC is essentially the home of the SPF lumber contract and that he has BC mills as his clients.
And, although the large lumber producers appear to be dealing on a more direct basis, selling directly to companies such as Home Depot, Dallimore says there is evidence that the lumber futures market has been used more in the last five years than in the early 1990s.
“It seems to be gaining,” he says. “I think part of this has to do with the leadership of some individuals in the forest industry who are showing the way and broadening the use of lumber futures.”
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last modified on Thursday, October 07, 2004