Crack! The next phase of the bullwhip effect begins

Many of the readers of Materials Risk will be familiar with the extreme price movements in the lumber market over the past year. Much like other markets the price of lumber initially fell sharply as coronavirus spread across North America. After all, who would want to even think about an extension in a pandemic after all? North American mills cut production in expectation of plunging demand. Lumber prices declined by 45% during March 2020 to around $250 per 1,000 board feet (mbf).

However, the mills didn’t count on a surge in home renovation projects and an exodus from the cities as urban dwellers pined for a country retreat. Lumber’s barn storming bull market had been set alight and prices barley missed a beat all the way up to a peak of over $1,700 per mbf on the 10th of May 2021.

The lumber market is perhaps the most visible example of the bullwhip effect inaction. To recap, the bullwhip effect is a phenomenon that can occur in supply chains in which irregular or unexpected orders by consumers reverberate up the supply chain. As participants in the chain react to the new information the impact is amplified, resulting in wild swings in inventories.

There are four sources of the bullwhip effect and each of which was evident in the lumber market over the past year: demand signal processing (the supply chain failed to anticipate the surge in demand), rationing game (over-ordering to ensure they go something), order batching (deliveries occur by truck on a rigid schedule) and price variations (each stage in the supply chain reacted to higher prices as a signal of scarcity).

The surge in lumber prices was so crazy it even got memed.


Lumber - meme

But of course the oscillations caused by the bullwhip effect eventually snap in the opposite direction as the market adjusts. A visit to a builders yard in the US during early May was all you needed to know that there no longer any shortage, rather that there was now too much material. High lumber prices and the construction delays it resulted in provoked a demand side response from home builders pushing back on a market that was no becoming unworkable. For example, there were numerous anecdotes of construction quotes being frequently revised higher both before and during construction.

From its peak in mid-May the price of lumber plummeted by 44% to around $970 mbf. Despite the rapid descent this only brings prices back to where they were less than two months ago in late April. Holders of lumber are still in the money compared to where longer term historical prices; up around 150% higher versus where they were in summer 2019.

One of the best ways of seeing the bullwhip in action is by rummaging through the economist toolkit and using demand-supply diagrams. This first diagram shows the initial reaction back in March 2020 as the pandemic hit. The mills cut supply and demand (initially) fell as households were forced retreat to their homes. The key point here is the slope of the supply curve. It doesn’t just shift to the left, it becomes steeper. In economics parlance the supply becomes price inelastic. When this occurs supply can’t respond as smoothly as in the past and so changes in demand result in significantly higher price volatility.

The second diagram illustrates subsequent events. Demand initially surges resulting in the record prices we saw in May. Supply responds to an extent, but the big impact on price is due to the decline in demand. It’s here that the inelastic supply curve results in the same price volatility seen during the bull market – but now to the downside.

There will be more oscillations from this example of the bullwhip effect before the lumber market settles down at a new equilibrium. But the lumber market is not the only market to be experiencing a bullwhip effect. Almost everything is experiencing the same phenomenon. The only real difference is that relative to other commodity markets, the North American lumber market is somewhat closed off from the rest of the world. Other commodity markets are typically much more global in nature. This also means that they are not being buffeted by a single shock, but multiple shocks, sometimes occurring in other markets that have knock-on impacts.

The other lesson from the lumber market experience is that commodity markets are opaque. This complicates the adjustment process however since each market participant knows little about how others are reacting, which in turn might prolong the bullwhip oscillations. While you and I might have been able to see lumber on the shelves at the builders merchant, its impossible for most of us to check out the supplies of copper, corn or some other commodity or component at each level of their supply chain. Remember, that during the first bull phase each market participant has an incentive to over purchase and hoard as much as they can. However, as the bottom drops out of the market in the next phase, the opposite is true. Holding too much inventory can be the death nail for a business.

Related article: The bullwhip effect

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