Right now, the United States is in the midst of the worst construction bust since 1991... and that's really bad news for Canadian lumber producers.

The statisticians record a "housing start" every time contractors break ground on a new private residence in the U.S. Look at this chart. It shows the number of housing starts per year since 1970.

Lumber is a vital component in the homebuilding and remodeling industries. During construction booms, efficiency doesn't matter in the lumber business. Lumber prices rise so high, even the highest-cost producers generate profits.

When the bust comes, competitive advantage means everything. The highest cost producers go bankrupt – one at a time – until only the leanest producers are still in business.

As you can see, housing starts have fallen off a cliff. Demand for lumber has followed. The bust is crushing the Canadian lumber mills. The Canadian dollar is so high relative to the U.S. dollar that Canadian lumber simply can't compete:

• Two weeks ago, Pope & Talbot – an American company with all its assets in Canada – filed for bankruptcy.

• Tembec, a huge diversified forestry company from eastern Canada, is losing $450 million a year. Judging by its cash in the bank and the speed it's selling off assets, Tembec looks like it will be the next bankruptcy. Its stock price is down 98% since 2002, and I doubt it will make it past the first quarter of 2008.

• Fraser Papers will follow Tembec into bankruptcy. Frasers' stock price has lost 95% of its value since 2004. It lost $160 million last year. I expect it will fail within the next nine months.

Or look at Canada's two largest integrated forest companies:

Canfor's stock is down 41% since March 2005. The company lost $43 million last quarter. West Fraser's stock is down 47%, and it lost $12 million last quarter. I doubt these giants will go bankrupt – but I bet their stocks keep falling.

The bust is also hurting the small mills. You already know about the problems at Sechelt Lumber and Milling. I wrote about them in last Friday's column. I met with the owners of a small sawmill in Merritt, British Columbia, the following day. They'd recently cut a shift and laid off nine employees.

Considering the dire state of the market, you'd think more mills would have closed to bring supply and demand back into balance. The problem is, the lumber company bosses are doing what businessmen always do in these situations: They are cranking out product at a loss, hoping they'll make it through the storm.

According to the Canadian forestry blog, Forest Talk, Canadian sawmills spend about C$265 to produce 1,000 board-feet (mbf) of lumber. At current prices, the market pays only C$204 for that lumber. And that's before you add in the 15% import tax. This reduces the Canadian sawmills revenue by another C$30.

The bottom line is, an average Canadian sawmill loses about C$90 for every mbf of lumber it sells.

"Recent calls for more curtailments and cuts in production go unheeded," writes Keta Kosman. Keta is the expert I hired to show me around BC's sawmill industry last week. She writes a blog about the Canadian forestry industry.

Production is always slow to react to price. It takes time to close down mills and lay off workers. These are hard decisions, and the natural human instinct is to delay them for as long as possible.

Because of this, instead of cutting costs and preserving capital, the companies are flooding the market with product and pushing lumber prices even lower. That makes the problem worse for everyone.

This reaction is a classic symptom of an industry in the throes of death. In essence, Canadian lumber producers are having a race to the bottom. These desperate tactics ensure Canadian lumber capacity will all but disappear over the next 18 months.

You can take advantage of this crisis. Simply buy the stock of American lumber producers and wait for the massive supply crunch that will result when all the Canadian mills go out of business and the U.S. housing market rebounds.

Good investing,

Tom