On Tariffs and Taxes – The Tariff on Canadian Softwood Lumber

The April 25, 2017 headline on The Wall Street Journal’s commentary (behind a paywall) said it all:

Trump’s New Housing Tax

A tariff on foreign lumber will raise the cost of U.S. homes.

Not might, may, or could raise the cost of U.S. homes. It “will.” Drop the mic.

The lead sentences of the WSJ commentary are unequivocal, and in our opinion, a bit snarky:

“Commerce Secretary Wilbur Ross announced Monday that the Trump Administration will raise the cost of new single family homes in the U.S. as part of its promise to ‘make America great again.

“Mr. Ross didn’t put it quite that way. He said the Administration will impose a 20% tariff on softwood lumber imports from Canada, which total about $5 billion a year. But that’s a lot of lumber and the tariff will add an additional $1 billion in new costs for U.S. construction. Most of those costs will be added to the price of new American housing, not counting the higher costs that will come as U.S. producers raise their prices to match the competition and pad their bottom lines.”

But then reality struck. The tariff announcement was made on April 24, and one might have expected the lumber futures market to shoot still higher in response to such news. This, per Dow Jones Newswire reporting on the tariff:

“Builders say lumber costs are already at the highest in a decade, even before the prospect of increased tariffs.… The prospect of U.S. duties on Canadian lumber imports has driven up prices this year, with lumber futures up more than 25% in the early months of 2017 and peaking at their highest point in over 12 years.”

Zerohedge’s comments on April 25 succinctly stated the case, and apprehensions, of many:

“And with lumber prices already at 13-year highs, one can only imagine what this will do to the price of houses in America.”

But somewhere amongst the rhetoric and theory, markets intervened (see last six months of lumber futures prices in the chart below). By 4/28, Friday of the week of the announcement, futures contract prices were down 1-2% compared to the average price for the prior week (4/17-4/21) rather than increasing as had been expected. By 5/12 the May 2017 contract was down by 4%; the decline by 5/12 for the more distant contracts ranged from 7 to 9% compared to the average price for the week 4/17-4/21. This response definitely ran counter to the expectation of many.

Click image for larger view

A close-up (see chart below) of the last month focuses on market responses in the aftermath of the announcement. Further, the convergence among the various contract terms is striking. In late January 2017 the gap between the May 2017 and March 2018 averaged over $46; the average between May 2017 and March 2018 contracts over the last two weeks (10 days) is just under $2. While it could be argued tariff impacts may not be seen in lumber prices for the next six months (e.g., the Nov 17 contract), the convergence of more distant contracts with current pricing belies, at least for the moment, an expected 20% explosion in lumber pricing as a result of tariffs.

Click image for larger view

The question is why would prices drop in the aftermath of the announcement rather than increase? We can think of four possible reasons; undoubtedly there are others but, to our way of thinking, these seem at the top of the list. A caution: the first and fourth reasons will take a bit of time to unpack.

1. There will be a downturn in U.S. housing starts due to higher lumber prices as a result of tariffs which futures traders are betting will take prices lower as demand retreats.

For this to be the case higher lumber prices would have to hike new home prices sufficiently to discourage marginal buyers. Some media reporting could certainly lead to that conclusion. For example, USA Today states, citing NAHB, “…[a price] increase in newly built homes is likely. The NAHB, which opposes the tariffs, says a 19.9% tariff would result in a 6.4% increase in prices paid by U.S. consumers. The price of a single-family home would increase by $1,236, it says. ‘This is going to increase the cost of construction of residential houses," said Jerry Howard, CEO of NAHB. "Producers will try to pass on the cost to consumers if they can.’“

Before proceeding, a bit more context is in order. The average 2016 home price was $372,500. So, combining this fact from the U.S. Census Bureau with USA Today reporting on the impact of the tariff, either the average home price is $1,236 divided by 6.4%, or $19,313 (which is only 5% of the U.S. Census Bureau’s reported average home price), or the expected increase is $372,500 multiplied by 6.4%, or $23,840. If the latter interpretation is correct then one can understand why housing starts might fall, driving demand lower and taking lumber prices with it. Regardless, it seems something was lost in translation from NAHB’s assessment to how the media reported it.
Dow Jones Newswires (DJN) reporting provides additional details that help to clear some of the fog. NAHB reports that based on 2016 analysis (“last year”) a builder spends an average of $15,413 for softwood lumber in a single-family home which represents about 7% of the total construction cost (i.e., not price) of a home. Those values translate into $15,413 divided by 7% for $220,186 construction cost of a new home. This interpretation of the NAHB data is consistent with an analysis by Moody’s Investment Service regarding the impact of the tariff on home builder margins
However, we’re not quite square yet. The $1,236 increase on the $15,413 of softwood lumber cost in a new home is an 8%, not 6.4%, increase. Why the difference?

The aforementioned DJN article notes that year-to-date (YTD) 2017 lumber futures prices are already up 25%; other reporting places YTD gains at 22% to 29%. The DJN article speculates the prospect of U.S. duties on Canadian lumber imports is responsible for lifting lumber prices YTD, and others (here, here, here, and here) concur with that assessment. This leads to estimates on the increased lumber costs already seen this year in a new home ranging from “an estimated $3,000” to “nearly $3,600.” Applying a YTD 22% softwood lumber increase to the $15,413 softwood lumber cost in new home construction yields an increase of $3,391 per home; applying a 25% increase yields an increase of $3,853 per home, and applying a 29% increase yields an increase of $4,470 per home. Averaging these three estimates provides a “middle-ground” value for the average softwood cost increase thus far this year of $19,318 ($15,413 + $3,905, a 25.3% increase) in a home being built using elevated YTD2017 lumber prices. Taking NAHB’s estimated increase of $1,236 per home due to Canadian tariffs divided by this new estimate of $19,318 yields an estimated increase of 6.4%.

Now that we understand what the reported “data” relate to we can use them more intelligently to infer market responses. But before doing that, let’s summarize

• The NAHB estimate of an additional $1,236 per home due to the tariffs is on top of a higher estimate of softwood lumber cost in a home incorporating a 22-29% YTD lumber increase.
• Further, most analysts believe a key driver for the YTD increase was in anticipation of tariffs being enacted.
• Thus, the $1,236 per home increase on the revised base of $19,318 in softwood lumber cost in a home rationalizes with NAHB’s estimated increase of 6.4%.

Our first observation is that the cited 6.4% increase applies to the cost of softwood lumber in the home, not the home price. That increase, using NAHB’s assumptions, is $1,236 per home -- or 0.3% based on the 2016’s average price of a new home; note this percentage would be lower still if compared to YTD2017 home prices since home prices have continued to increase. Our conclusion is that it seems unlikely a 0.3% increase in new home prices would cause a dramatic decline in housing starts.

Further, if YTD lumber prices already “priced in” the anticipated tariff, as many suspect, then the NAHB estimated increase would constitute double-counting by adding an additional impact on top of the increase in home prices due to higher lumber costs in 2017. Moody’s Investor Service and Fitch rating service both make their calculations of the tariffs impacts at 20% on top of the unadjusted softwood lumber cost in a home ($15,413), avoiding double-counting the effect (this is always a plus when doing analysis of any kind). Thus, it is arguable in light of the current run-up in lumber prices YTD the impact of the tariff on the number of homes sold may be negligible as that impact is already being priced into the market and houses continue to be built.

The conclusion from all of this is that it seems unlikely futures prices fell after the tariff announcement because traders are expecting a significant reduction in demand due to higher lumber prices.

2. Lumber markets had priced in a higher tariff than actually was announced and so the subsequent lumber price reduction reflects that new information.

Earlier we had quoted from a DJN piece:

“Builders say lumber costs are already at the highest in a decade, even before the prospect of increased tariffs.… The prospect of U.S. duties on Canadian lumber imports has driven up prices this year, with lumber futures up more than 25% in the early months of 2017 and peaking at their highest point in over 12 years.”

So which is it? Are lumber prices up and tariffs will add to them? Or are lumber prices up in anticipation of tariffs being enacted? You can’t have it both ways.

As already noted, the preponderance of opinion comes down on the side the lumber market was pricing in expectations of tariffs being enacted. The question was how high would they be? A Bloomberg article reports the countervailing duties (the more accurate term for the tariff being imposed) came in below some analysts’ expectations. For example, the article quotes Kevin Mason, managing director of ERA Forest Products Research: “I think a lot of people were bracing for a higher duty.” How much higher? The same Bloomberg piece cites CIBC’s Hamir Patel’s forecast that the combined countervailing (already announced) and anti-dumping (yet to be announced; decision expected in June) duties could reach 45 to 55%.

We’ve already cited several YTD increases ranging from 22 to 29% for a simple average of 25.3%. Between 4/24 and 5/12 prices have dropped by 4 to 9%, depending on the contract, for an average of a 7% drop across the May 2017 to Mar 2018 contracts. Subtracting the 7% declines from the average 25.3% reported increase yields 18.3%, roughly in line with the announced 20% average tariffs. Perhaps it’s coincidental, but this result might lend credence that even higher tariffs were already priced into the market, and once the tariff was announced the market recalibrated to the news by lumber prices declining.

3. Markets expect Canadian suppliers to ramp up production prior to actual enactment of the tariffs, expanding lumber supply and so dropping market prices.

This prospect seems unlikely for several reasons. First, except for Canfor, J.D. Irving, Resolute FP Canada, Tolko, and West Fraser, tariffs will be retroactive for 90 days from date the preliminary determination is published in the Federal Register (which was April 28, 2017). Thus, as of the date of this writing the preliminary duties are already in force for the five firms listed, with 90-day retroactive duties from April 28, 2017 being enforced for all others. Consequently, there is no “production window” incentive. Second, even if there had been such a window, it is unlikely Canadian production could have increased significantly given Canadian sawmills are already operating at high capacity utilization rates.

One additional comment: If reports by the Madison Lumber Reporter are correct, prices may increase -- not because of tariffs, but rather because of logistics breakdowns at Canadian/U.S. border crossings for Canadian lumber being imported into the U.S. (emphasis in the original):

“Operators are suffering total bewilderment as U.S. Customs and Border officials cannot provide clarity on vital details of application of the new softwood lumber duties to entry waybills and pro-forma invoices…"

“Wood destined for the U.S. from Canadian sawmills two weeks ago is literally trapped at the border right now because operators and agents do not know how to fill out the Customs forms.”

If this situation is true, widespread, and persistent the U.S. lumber market will be affected. Canadian imports represented 30% of U.S. softwood lumber consumption in 2016 per Western Wood Products Association (WWPA). However, we expect this is a momentary hiccup and there won’t be any extended lumber market impacts as a result of this supply chain breakdown at the border.

4. With a tariff on Canadian softwood lumber imports in place the competitiveness of Canadian softwood lumber imports is reduced, prompting U.S. sawmills to ramp up production, thereby expanding supply and taking prices lower.

An implicit assumption of much analysis is the U.S. market needs Canadian lumber production to meet U.S. consumption. Under this assumption, there is a lack of U.S. softwood lumber capacity and Canadian imports offer the lowest-cost means to fill this gap. This logic is reinforced by relatively high capacity utilization rates (per WWPA 2016’s rate was 86%, only 4% less than WWPA’s 90% capacity utilization estimate for Canadian manufacturers).

The corollary to this reasoning is the lead time to bring on more U.S. capacity is a minimum of two years. Paul Jannke of Forest Economic Advisors succinctly states this view:

“‘We won’t be able to meet new demand with the existing capacity base.’…
“According to Jannke, it takes two years from the time when a company decides to invest in a new mill until the time that mill is operational. ‘That means it would be 2019 before we would get any significant new capacity coming on line,’ he says. A few new mills have been announced, but their combined capacity won’t be enough to meet demand if we were to see 1.5 million to 1.7 million starts—and Metrostudy is predicting 1.52 million starts just next year.”

First, as an aside, we don’t see housing starts approaching 1.52 million starts next year so we discount the prospect of a significant near-term ramp-up in demand.

Unquestionably U.S. softwood sawmilling capacity declined sharply as a result of the Great Recession and has yet to recover to pre-Great Recession levels. But, beyond that, we believe there is another dynamic in play that is generally overlooked by most analysts. The U.S. Census Bureau, in conjunction with the Department of Defense, conducts periodic capacity utilization surveys of various industry sectors -- sawmills being one of them. The survey reports two estimates of capacity utilization: actual and emergency production levels.

What the Census Bureau reports as “actual capacity utilization” appears closely aligned with more conventional reports of capacity utilization, understanding that capacity utilization is a slippery term. For example, when WWPA reports on capacity utilization it inserts the adjective “practical” in front of capacity.

The second capacity utilization that is reported is production as a percentage of what manufacturers produced compared to what they could ramp up to produce rapidly for the period of one or more years. This is the “emergency” capacity utilization, and presumably it is why the Department of Defense is a co-funder of the quarterly survey.

It’s interesting to compare the differences between these two levels of capacity utilization (see chart below). To highlight the differences between the capacity metrics, two Census Bureau manufacturing categories are reported: (1) sawmills (includes hardwood and softwood) & wood preservation plants and (2) pulp mills. In addition, WWPA’s utilization of practical capacity for softwood sawmills is included for comparison.

Click image for larger view

While the capacity utilization rates are slightly different between WWPA and the Census Bureau’s actual rate for Sawmills and Wood Preservation the difference is easily rationalized; the WWPA utilization rate is for softwood sawmills only while the Census Bureau includes hardwood and wood preservation plants as well.

The key point is comparing the actual to emergency rates. Note that the difference between the Census Bureau’s sawmill actual and emergency capacity utilization is 18.9% while there is no difference between actual and emergency capacity for pulp mills. For pulp mills this is not surprising; the high fixed costs of pulp mills require mills to be run nearly continuously for any hope of profitability. For sawmills, however, fixed costs are relatively low and many are running only single shifts. As a result, if conditions warrant, such as a national emergency, production can ramp up rapidly as mills add a shift and/or extend shifts.

That latent capacity is available to increase lumber production not only under national emergency conditions but also if economic conditions, such as high lumber prices, provide opportunity for profitable domestic lumber manufacturing. The strong U.S. dollar against the Canadian dollar and no softwood lumber agreement between the U.S. and Canada have made U.S. mills cautious about ramping up production even while pricing has been strong. Most recently the strong U.S. dollar has placed U.S. mills at a competitive disadvantage of about 25%. However, with tariffs being applied to Canadian lumber imports the likelihood of U.S. production ramping up is higher as this competitive disadvantage due to exchange rates is either eliminated or at least reduced.

We believe this largely ignored “latent” capacity in the sawmill industry accounts for historical lumber price spikes but no ability to sustain peak pricing for an extended period of time. If the only means to bring on additional production was through new capacity investment peak pricing would be sustained for longer periods of time. However, as prices climb, in addition to new capacity coming online through investment, manufacturers produce more by increasing/extending shifts at mills that already exist. The production response due to increased and extended shifts is able to occur quite rapidly, thereby expanding lumber supply and so causing prices to crash.

While the mechanism described may not be well understood, the market reality of lumber price volatility is recognized. This is why we suspect that, in addition to futures prices retreating since the tariffs were announced, more distant contract prices have been converging (see table below).

Click image for larger view

On 1/17/2017 the March 2018 contract was $43.10 higher than the May 2017 contract. By 3/1/2017 the difference had shrunk to $29.00. Clearly this is due in part because lumber futures only rarely break above $400 (see chart below) and as the near-term contract climbed toward $400 traders recognized it was highly unlikely prices would be near that level roughly one year later. As we have explained, the reason for that occurring is because of the latent capacity that can be tapped into quickly when lumber prices are at high levels.

Click image for larger view

Since March that convergence has continued. On the date of the tariff announcement the spread between the highest contract and front contract dropped below $8.00. On May 12, the last date of trading for the May 2017 contract, the May contract was the highest of the six contract dates and the spread showed the lowest contract to be $19.10 below the May 2017 contract. This reaction runs totally contrary to the many pronouncements made shortly after the tariff announcement that prices were about explode higher still.

Instead we believe the combination of tariffs on Canadian lumber and high prices will stimulate more U.S. lumber production, causing lumber prices to decrease rather than climb higher. The latent capacity indicated by the difference between actual and emergency capacity utilization is indicative of that potential.

We realize some might argue one reason for sawmill capacity not growing rapidly back to pre-Great Recession levels in the U.S. is due to lack of adequate timber supply. An analysis of that type is beyond the scope of this blog post but suffice it to say -- based on other analyses the author has done -- there is adequate timber across most of the U.S. South and in pockets across the U.S. Pacific Northwest (PNW). The chart below provides a simplistic picture of current timber supply conditions.

Click image for larger view

The data are softwood sawlog inventories on private lands only. The South consists of the states of Alabama, Arkansas, Florida, Georgia, Louisiana, Mississippi, North Carolina, South Carolina, Tennessee, Texas, and Virginia. The PNW consists of the states California, Idaho, Montana, Oregon, and Washington. Only inventory in stands 25 years and older was included in the analysis as well as only inventory on slopes less than 30%. The condition of only stands over 25 years for the PNW is too low for rotation-aged inventory but it does at least knock out sawlog inventory “trapped” within younger-aged stands from the analysis. The 30% slope condition focuses this analysis only the more economically viable stands. As can be seen, inventories have been expanding both in the U.S. South as well as the U.S. West. This indicates additional softwood sawlog harvest could occur without jeopardizing the current level of timber inventory, and so timber supply does not currently present an impediment to U.S. sawmill capacity expansion.

Wrap-up
In summary, we think the recent lumber price declines in the aftermath of the announced softwood lumber tariffs on Canadian lumber can be explained by near-term lumber prices having overshot the size of tariffs announced on April 24. For more distant contracts the recognition the lumber market has not been able to sustain high pricing over an extended of time is contributing to convergence of those contracts at or below the levels seen on the May 2017 contract price. We suggest the reason lumber prices don’t sustain peak prices for extended periods can be explained by the latent capacity in the sawmill industry. A clue to the magnitude of this latent capacity can be detected by comparing the difference between actual and emergency capacity utilization rates. As a result, while tariffs will most certainly impact portions of the supply chain we don’t expect there to be significant increases in lumber prices or home prices, or significant reductions in housing starts.

Closing Thoughts

In closing, we want to underscore we are not arguing for or against the Canadian tariff on softwood lumber imports; rather, our goal is to accurately gauge the likely market response to such tariffs. There is a certain irony, however, that we can’t resist pointing out.

We started this post quoting the WSJ article proclaiming the Trump administration had just levied a tax on “new houses.” While we disagree the tariff will result in a meaningful “tax” on U.S. consumers in this case, we would be remiss to ignore the reverberations of the environmental-regulation “tax” levied on U.S. consumers. In fact, one could advance the argument this environmental regulation “tax” has paved the way for further market interventions such as the recently announced tariff.

Although perhaps well-intentioned when enacted, the implementation of environmental restrictions regarding the active management, including timber harvest, of Federal forest lands has precipitated profound changes in the U.S. forest products industry beginning in the 1990’s, with continuing impacts to this day. USFS harvest swooned (see chart below), causing raw material prices to initially skyrocket.

Click image for larger view

Then economic adaptation happened: mill closures, capacity shifts to other regions of the country (the impact of the environmental restrictions was greatest in the western U.S., see chart below), and increased imports. A new, but higher, equilibrium cost for timber emerged which, for the sawmill industry in North America, represents 55 to 75% of a mill’s manufacturing cost. Further, the regulations played a significant role in rendering the western U.S. forest products industry less competitive from a global perspective.

Click image for larger view

Rural communities across the U.S. West have paid -- and continue to pay -- the steepest price, but the U.S. consumer continues to be unwittingly “taxed” too as a result of these policy decisions and their implementation through increased timber costs. These increased costs, in turn, contribute to higher lumber prices to cover at least a portion of the cost of production.

Recall, too, the logic supporting the tariff against the Canadian industry is that the Canadian government subsidizes its industries by providing it with cheap timber. A cynic might ask, cheap compared to what? High-cost timber in the U.S. due in part to U.S. environmental policies? We know it’s more complicated than that, but we feel it should be pointed out the indirect impact U.S. environmental regulations might be playing in the cross-border tariff tiff.

In addition to these market affects, federal coffers are deprived the revenue from USFS timber sales as a result of these regulatory impacts. In our opinion perhaps even more impactful is the lack of forest management on federal land which has resulted in forests becoming too old and overcrowded. We believe that this is resulting in increased tree disease, insect infestation, tree mortality, and catastrophic wildfire.

We realize this topic should start a whole new post as these observed outcomes (increased disease, insect infestation, tree mortality, and catastrophic wildfire) are being attributed to other factors -- such as global climate change -- rather than lack of management, so we’ll leave addressing that topic for another day. We will leave it, however, by posing this question: If global climate change is the major factor driving this pestilence in western forests, why is the hammer falling demonstrably harder on federal forest lands rather than intermixed forest lands owned by other owners and under different management regimes?

While death and taxes are inevitable, it seems to us neither is specifically in play -- despite the rhetoric -- for the U.S. consumer in the case of the Canadian softwood lumber tariff; rather, we see only modest (at most) impacts. Instead, we see policy interventions such as the tariff as simply a Band-Aid on more impactful decisions made decades ago that continue to send ripples through both our economy and society today.