Thursday, August 27, 2020

A surprise commodity demand shock - the case of lumber

Demand or supply shocks will have big price impacts in commodity markets given short-run inelastic demand and supply curves. In the case of lumber, prices have exploded to the upside based on a big producer mistake coupled with a huge change in home buyer sentiment. 

If I told you, we were going to have a recession from a pandemic, there are certain expected behaviors. Aggregate demand for durable goods would be expected to fall. While this is not the Great Financial Crisis, the general expectation in March was for weak housing demand given past behavior in a recession. Lower interest rates would soften the blow but not offset the decline.

Lumber mills cut production dramatically to get ahead of the expected fall-out from expected lower housing demand. Mills were also seeing labor problems from COVID-19 which affected production. This was just another shock to the lumber industry which has been facing sales declines from the higher China tariffs on US exports.  

The lumber industry got it wrong. Housing starts and permits have shot higher. More households are doing remodeling. Money not spend on other good is being used to adapt to a work from home outside the central city world. The current lumber market has a recipe for extraordinary price moves based on inelastic supply in the short-run with a surprise demand shock

Until order and equilibrium is restored the trend continues. Will it last? Unlikely. Production will respond to the higher prices. The building surge may normalize with time. The signal will be seen in a price reversal and a new trend. 

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