bensprague.substack.com
In the past year, lumber prices have skyrocketed. Robust consumer demand for home renovation projects and new home construction combined with tightened supply due to COVID-related supply-chain issues and other factors have pushed lumber prices up over 250% in the past year. But there may be hope for consumers and developers who have been waiting out the feverish rise in prices: as shown in the chart below, lumber futures have tumbled over 20% in the past three weeks. Why is this happening and what does it mean? Let’s dig in. The futures market (also known as simply “futures”) exists to enable businesses, farmers, and other investors to hedge their bets and guard against certain risks. There is an actual functional purpose to the futures market; it is not merely speculative or predictive. If you are a farmer with one crop, soybeans for example, you might use futures contracts to guard against an unexpected drop in prices due to drought or pests. Some types of futures contracts are merely financial in that there is no actual exchange of products, but other futures contracts actually lock the contract holder into delivering or buying a certain amount of a product on a specified date at an agreed-upon price. That contract provides certainty to the soybean farmer, for example, in that he or she knows they will be able to sell their soybeans for that price. One risk to the farmer is that he or she could predict the market incorrectly and they could have actually sold their soybeans at a much higher price, but the futures contract acts a bit like an insurance policy and the lost surplus revenue is like an insurance premium for guarding against the downside risk, which if particularly significant could ruin a farmer’s season or maybe even lead to bankruptcy.
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