The U.S. protectionist and America-first mentality have undoubtedly been re-invigorated by Donald Trump’s election. The Softwood Lumber Agreement (SLA) between Canada and the U.S. is being renegotiated and Trump continues to threaten to rip up NAFTA, including Chapter 19, the dispute resolution mechanism under which Canada ultimately won previous softwood lumber disputes.
The original softwood lumber discussions – “Lumber I” – began in 1982 under the accusation by the U.S. Coalition for Fair Lumber Imports (CFLI), a consortium of U.S. softwood lumber producers, that Canadian lumber producers were being unfairly subsidized by the Provincial governments. This began 35 years of managed trade or litigation in the Canadian lumber industry. It’s worth noting there have only been 33 months of truly free trade in the last 35 years in the Canada/U.S. lumber industry.
Approximately 90% of Canadian timberland is owned by the Crown (Provinces) and licensed to Canadian lumber producers under long-term harvesting arrangements. Under this system, Canadian lumber producers are charged a government determined “stumpage fee” per unit of volume. This stumpage fee is subject to periodic adjustments based on current lumber prices and other factors including terrain and distance from mills. Timber quality also has an effect on stumpage fees. As an example, much of the timber damaged by the Mountain Pine Beetle infestation was harvested at minimum stumpage. This compares to the U.S. marketplace, where the vast majority of timberland is privately owned and a competitive market based system ultimately determines the price paid per log.
The U.S. claims the disparity between these systems creates an unfair subsidy to Canadian lumber producers, who should be levied with Countervailing Duties (CVD) to bring log prices back up to competitive market rates.
In addition to the CVD, the U.S. has also intermittently argued that Canadian producers sell lumber in the U.S. below their production cost, which have brought rise to Anti-Dumping (ADD) claims.
Over the past decade all key Canadian provinces have amended stumpage calculations to factor in market bidding for a portion of Crown volume to appease the U.S. argument that the Canadian system doesn’t approximate a competitive structure.
Amidst the U.S.’ insistence on moving the goalposts to find other ways to impose duties on Canadian lumber, we have seen multiple Softwood Lumber Agreements (SLA) put into place since Lumber I.
The table below provides a historical timeline:
|1982||Lumber I||Canadian legal victory|
|1986||Lumber II||Negotiated settlement (MOU) – 1986-1991|
|1991-1996||Lumber III||Canadian legal victory, but agreement to SLA I (volume deal) – 1996-2001|
|2001-2006||Lumber IV||Canadian legal victory, but agreement to SLA II (volume + taxes) – 2006-2015|
|2016-??||Lumber V||Litigation underway; preliminary CVD announced; awaiting ADD in late-June|
HOW DOES THE FUTURE LOOK?
From the timeline above, two things become clear: 1.) this dispute is not going away and 2.) negotiations have become more punitive to Canadian producers over time. As a result, we have seen Canadian producers such as Interfor, West Fraser and Canfor diversify production away from Canada by acquiring mills opportunistically in the U.S. South. Today, Interfor, West Fraser and Canfor have 65%, 35% and 28% of their respective lumber production in the U.S. In addition to mitigating lumber trade file exposure, the U.S. South is attractive given its outstanding fibre resource (growing timber inventory and low timber pricing), as well as its proximity to the largest and fastest recovering segment within the U.S. housing market. Despite the diversity of their production base, Canadian producers continue to argue in favour of managed trade to reduce the ultimate volatility in lumber prices.
U.S. producers justify Canadian investment in the U.S. South (Canadian producers now own about 20% of U.S. South lumber capacity), by claiming Canadian companies have generated extraordinary profits because of a “biased” Canadian system and the need to deploy their profits outside of Canada. The irony of the U.S. position is that within months of integrating various U.S. mills into their respective operations, Canadian companies have been able to reduce costs materially, while most U.S. producers have historically struggled with this same exercise.
WHAT IS THE ULTIMATE GOAL OF THE U.S. COALITION?
The ultimate goal of current negotiations from the perspective of U.S. producers is to impose a hard-capped quota on Canadian lumber imports into the U.S. The U.S. producers were not happy with the 1996 SLA quota structure and believe the 2006 mix of quota and tax rates that followed didn’t satisfy their desired outcome either. For reference, during the 2006-2015 time frame, the U.S. industry ultimately levied $500 million in duties against Canadian producers plus an additional $500 million to promote North American wood use. It is also worth noting that U.S. producers don’t pay their own legal costs, the government funds them, so they ultimately have nothing to lose from long and repeated disputes. The latest U.S. proposal discussed under the Trump Administration is to limit Canadian imports to ~25% of U.S. consumption (Canada believes this should be closer to recent market share levels). The historical % is illustrated in the chart below and in 2016 sits at approximately 32%.
STRATEGIC GOAL OF U.S. PRODUCERS?
By implementing a hard-capped quota on Canadian producers, U.S. producers hope to increase domestic log prices. Log prices have been flat in the U.S. South for the past four years due to significant oversupply – so certain members of the coalition would like to increase lumber prices, which should encourage increased domestic log consumption and therefore log pricing. In order to do this, unlike a tax-based model that imposes lesser taxes when lumber prices rise, the U.S. hard-capped quota will impose Canadian import restrictions in both good and bad markets, in hopes of driving domestic log prices higher.
The confusing part of this trade dispute is that the U.S. cannot satisfy their own lumber requirements with domestic production alone. Canada currently supplies over 1/3 of U.S. lumber consumption and if the current rate of growth in housing starts continues, the U.S. will need to increasingly rely on higher-priced imported lumber from outside of North America to fulfill their needs if they impose a quota restriction on Canadian lumber. In addition, higher lumber prices will lead to substitution towards steel, engineered wood products and concrete in some construction applications. Ultimately, it is the U.S. consumer that will bear the increased cost of imports.
TIMELINE OF CURRENT DISCUSSIONS
Under the current timeline – we saw a preliminary determination of CVD duties just 2 weeks ago, which outlined an average duty of ~20% and required cash deposits effective May 1, 2017. While four investigated companies, namely West Fraser, Canfor, Tolko and Resolute have avoided being charged retroactively, the remainder of Canadian producers (~60% of Canadian production) did not and they will be charged CVD duties back to early February 2017. The next critical date will be on June 23rd, when preliminary ADD duties will be announced. We expect these to range from ~2-15% on a company-specific basis. Retroactive determination applies to the ADD’s as well, so the majority of Canadian producers (~60% of 2016 production) will be assessed the ADD from early April (90 days prior to July 1st).
WHERE DOES THIS LEAVE US AS CANADIAN INVESTORS
With this information in hand, we are now able to more accurately assess the potential earnings impact of duties on Canadian lumber producers from the CVD duties announced in April. Spot lumber prices had appreciated significantly (~+25%) in anticipation of these duties since the beginning of 2017, but have subsided since the preliminary CVD announcement, suggesting that perhaps headline duties weren’t as punitive as the market was expecting. As we head into the warmer summer months, we would expect to see further seasonal weakening in lumber prices, but ADD duties remain the wildcard in the pricing outlook.
From a company perspective, we continue to monitor the Canadian lumber sector for attractive investment opportunities, with a focus on strong balance sheets, low-cost profiles and diversified geographic exposure. We will continue to monitor developments around the softwood lumber dispute and provide updates accordingly.
Editor: Michael Schaab, CFA, Vice President, Portfolio Manager
This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The info provided in this article is compiled from our own research and is based on assumptions that we believe to be reasonable, accurate at the time the report was written, but, is subject to change without notice.