Why a buying opportunity is emerging in Canadian forestry stocks

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Why do investors need to wait for rising demand for forestry products when production cutbacks seem to be doing the trick?

Canada’s forestry sector has been curtailing production of lumber and oriented strand board (OSB) amid low commodity prices, and the cutbacks have been igniting share prices in recent weeks.

OSB maker Norbord Inc. announced on Monday that, starting in mid-November, it will curtail production at its mill in Cordele, Ga., indefinitely. The move will remove 440 million square feet of annual capacity, which is about 1.7 per cent of total OSB capacity in North America, according to CIBC World Markets.

Norbord’s share price has rallied 7.5 per cent this week. That brings the total rebound to more than 32 per cent since early August, shortly before the company announced reduced schedules at the same Cordele mill – which suggests that investors are responding to curtailments.

Norbord isn’t alone here. Georgia-Pacific LLC, a division of Koch Industries Inc., announced this month that it will cut production at its OSB mill in South Carolina, bringing the total industry-wide curtailments this year to 9 per cent of capacity, according to CIBC.

Lumber producers are also removing production capacity. Total lumber curtailments this year represent about 5 per cent of North American capacity, according to Raymond James.

The curtailments are a response to a difficult period. Canada’s forestry sector has been struggling with a challenging backdrop for more than a year, as lacklustre U.S. home-building, signs of weaker global economic activity and a trade war between the United States and China have weighed on forestry commodities.

Lumber prices are down 28.8 per cent year-over-year (in the case of western spruce, pine and fir). Prices for OSB, wood panels used in home construction, are down 41 per cent.

As commodity prices have fallen, so have stock prices. Before the recent rebound, Norbord shares fell 52 per cent from mid-2018 to August. West Fraser Timber Co. Ltd. shares fell 55 per cent over a similar period.

Now, though, some observers believe industry curtailments are a bullish development for the forestry sector and a big part of the reason for scooping up forestry stocks while they’re still well below their highs from a year ago.

“We have conviction that building materials commodity pricing will trend higher in coming quarters,” Daryl Swetlishoff, an analyst at Raymond James, said in a note this week.

Hamir Patel, an analyst at CIBC World Markets, acknowledged curtailments when he raised his target price on Norbord shares – or where he expects the stock price to be in 12 to 18 months – to $37 from $30, based on better supply-and-demand conditions and rising commodity prices.

In the third quarter, prices for lumber and OSB nudged higher from the second quarter.

That curtailments work at all is remarkable. A company that removes capacity voluntarily could simply encourage its competitors to maintain – or even increase – their capacity, rewarding these competitors with greater market share. This is what plagued airlines for decades, and contributed to frequent booms and busts.

But investors appear to be betting that the forestry sector is more disciplined in its approach to supply, and sector-wide curtailments support this view. What’s more, some observers expect that the demand side of the equation will likely pick up, as lower borrowing costs support home-building activity. Last year’s rising borrowing costs, driven by interest-rate hikes by the Federal Reserve, hurt the forestry sector.

In September, U.S. housing starts fell by 9.4 per cent year-over-year. But single-family starts, which are closely associated with demand for lumber and OSB, increased 0.3 per cent and extended the winning streak to four months.

“A solid demand backdrop, thanks to lower interest rates and an unemployment rate that sits at a 50-year low, along with a general shortage of inventory in the housing market, should continue to push starts higher,” Admir Kolaj, an economist at Toronto-Dominion Bank, said in a recent note.

Mr. Kolaj added that confidence among builders, which is reflected in the National Association of Home Builders Housing Market Index, has risen to a 20-month high.

This could be good news for Canadian forestry stocks. If industry curtailments have rewarded bargain hunters in recent weeks, then rising demand for lumber products will underpin the next long-term rally.