The North American lumber futures market: A primer
February 25, 2013
Given the strong performance of softwood lumber prices in the last year, there has been more press than usual about fluctuations in lumber futures prices – which can create confusion over just what is going on in this market, who the participants are, and what they are doing. A futures contract is a legal agreement to buy or sell an asset on a specific date. A futures contract is bought and sold through a futures exchange using an auction-like mechanism, and is standardized according to quality, quantity, delivery time, and place. In North America, the trade of softwood lumber futures occurs through the Chicago Mercantile Exchange (CME), primarily via an electronic platform. The futures contract traded is called the Random Length Lumber Futures (RLLF), and corresponds to the random lengths SPF (spruce-pine-fir) #2&Btr (and better) 2X4 price. One RLLF contract represents 110 000 board feet (bf) of lumber, priced in US$/MBF.
In terms of participants, hedgers want to trade in futures contracts in order to protect themselves against the risk that the price of an asset may fall (in the case of lumber producers) or rise (in the case of lumber buyers). Speculators, however, have no direct involvement in the production or consumption of lumber, they simply believe that they can anticipate the movements of lumber prices accurately enough to make profits based on the buying and selling of lumber futures.
In terms of the size of the market, this fluctuates considerably depending on the month of the contract under consideration. Open interest refers to the total number of contracts that have been entered into that have not yet been offset by a delivery. In 2012, for the front (or soonest to expire) contract, the average open interest was approximately 3,500 contracts, representing 385 million bf. Average monthly North American shipments in 2012 were approximately 4,265 million bf. This implies that approximately 9% of total shipments were being hedged in the futures market.
Do deliveries actually take place in the futures market? Not necessarily. The most common strategy for an individual trader in the futures market is to offset their position. For instance, a lumber company seeking to hedge against falling prices in the future would enter the market by selling an RLLF contract – in which case, they would be making a commitment to deliver lumber at a certain date in the future to a specified location for a given price. However, before the delivery date arrives, they could buy an RLLF contract. If prices have, indeed, fallen, they will make a net profit (selling a contract at a high price and buying one at a low price) while simultaneously cancelling out their commitment to deliver the lumber with their commitment to receive it. The profit generated by offsetting their position would in part compensate them for the falling prices at which they are selling their lumber into the open market. Even without offsetting their position, a seller can exchange futures for physicals, by which a seller can extinguish the contract through mutually agreed upon terms – eliminating the obligation to deliver the product. While detailed data on lumber delivery as a result of futures trades is not widely available, as a general rule only 2% of physically deliverable futures contracts ultimately end up being delivered.
So, in the end, what does the price of a lumber futures contract reveal? It represents the average expectations of a host of market participants: lumber producers, lumber consumers and investors of various types, as to what the SPF #2&Btr price will be on a given day in the future. It is thus fraught with uncertainty, though this uncertainty dissipates the closer the month specified in the contract approaches. Consider the following figure, that compares the history of the March 2013 RLLF price to the SPF #2&Btr price since January 2012. The bar-whisker format for the RLLF price shows the weekly opening price (left-ward tick) the weekly closing price (right-ward tick) and the high and low price (vertical bar) for each week’s data. As the contract approaches delivery, the open interest increases, which increases the range of perspectives on the future price.
March 2013 Random Lengths Lumber Futures contract price
When trading of the March 2013 futures contract began in January 2012, it was priced at US$275/MBF, noticeably higher than the #2&Btr price, indicating (correctly) that market participants expected the price to rise over the next year. Otherwise, the two prices have largely risen in sync, with a tendency for the futures price to slightly anticipate movements in the #2&Btr price. With 3 weeks of trading in the March 2013 contract remaining (the contract will close on March 15, 2013), the March 2013 RLLF is trading US$12.50/MBF below the SPF #2&Btr price – suggesting that once again the average market participant expects prices to fall over the next three weeks.