Ferocious Beetles Destroy Forests and Hurt Homebuilders

A little over two years ago, the timber industry witnessed a boxing match between two international market leaders. In one corner was the champion of cheap construction, questionable lending practices, and overabundance of housing: Uncle Sam. In the opposite corner was, well, whoever represents Canada. In the international lawsuit, the United States accused its neighbor to the north of selling good-quality timber at low-grade prices, allegedly taking advantage of a nationwide infestation of mountain pine beetles (link opens a PDF) to undercut the American timber market.

Be careful what you wish for.

Now, those same ferocious beetles are devastating woodlands at a historic pace -- lifting timber prices to near their housing-bubble peak despite on lower demand.

Source: National Association of Homebuilders, Data through April 12, 2013.

Russell Taylor, the president of the International Wood Markets Group, called the developing crisis "one of the largest natural disasters we can think of, of all time." That may not be as sensational as it sounds. The government of British Columbia recently stated that mountain pine beetles have laid waste to an astounding 32% of the province's market-grade timber. Combine soaring prices from a severe lack of demand with the suddenly roaring housing market in the United States, and you come to some stark conclusions.    

Buyer beware
The mountain pine beetle epidemic is particularly troublesome for the simple fact that houses are framed with pine wood. Although soaring prices threaten the momentum behind the housing market, data released this week showed that housing starts in March leapt to watermarks last achieved in 2008. Progress at homebuilder D.R. Horton (DHI 3.75%) has shown no signs of slowing. In fact, operating income has increased in nearly every quarter since bottoming out in 2008, with Q4 2012 operating margins touching a new multiyear high of 8.5%.

Be careful with drawing conclusions from that. Housing starts have gradually improved in the past several years, but it's important to note that average lumber prices in 2013 are much higher than in preceding years:

Source: National Association of Homebuilders. Data through April 12, 2013.

It may only be a matter of time before the rise in prices catches up with and cancels out the enthusiasm for new home construction. Housing starts averaged about 1.5 million per year from 1959 through 2000, but annualized March starts stand at just 1.036 million. That means there's (potentially) a lot of room to run, which means demand is bound to increase.

D.R. Horton could face significant headwinds later this year. The disastrous Beazer Homes (BZH 4.44%) could be in for some real trouble. Larger quarterly revenues have been met with larger losses. Can the mountain pine beetles push Beazer into bankruptcy? Can beetles be brought to court?  

Homebuilders aren't the only one affected by these pests. As you can imagine, forestry companies are directly affected. Who's in worse shape?

Timmm-berrr!
Will the rise in prices offset the loss of assets for forest products' companies? It depends on location. Or it should, at least. Resolute Forest Products (RFP) is one of the largest softwood lumber producers in North America and has the bulk of its operations in Canada. Weyerhaeuser (WY 1.24%), meanwhile, is the largest softwood lumber producer in the United States. Shares of both companies -- and many other forestry companies -- have risen over the past year. If the market has a shortage of pine, how can the industry go unscathed?

Diversity is one major factor. And while I wouldn't rule out some rough patches ahead for the forestry industry (the mountain pine beetle infestation is expected to peak in 2014 and 2015), it has been faced with this problem for several years now. That has allowed time for alternatives. Not all affected pine can be salvaged, and there are still a limited number of outlets for sales, but more and more builders are beginning to find markets for damaged wood at reduced prices. If done right, as shown here, salvaged timber can be put to use while still maintaining its aesthetically pleasing appeal.

Image courtesy of Great Divide Builders located in Colorado.   

This won't be enough to effectively combat shortages or prices, but it could represent an important source of revenue on wood that was widely considered useless just a few years ago.

Foolish bottom line
You may not agree with the warnings I've outlined here, but I find it unlikely that investors will continue to dodge the consequences of this natural disaster. If it isn't happening already, lumber prices will eventually push back against any enthusiasm for new home construction. That could affect share prices of homebuilders and forestry companies alike, which have largely ignored the beetles threatening their top and bottom lines. It may be time to quarantine your portfolio and steer clear of these industries.