Agricultural commodities are changing and despite the fact that they trade in predominantly open-outcry pits, the changes are real. As historically domestic products become exports, suppliers such as Argentina and Brazil gain prominence and hedge funds enter the fray with elbows up. “Agricultural markets are entirely different now than they were a year ago,” says Richard A. Brock, president of Brock Associates in Milwaukee.
“Now that Brazil is the largest producer of soybeans, you’ve got two times of year where you’ve got to worry about droughts; two times a year you’ve got to worry about floods; two times of year you’ve got to worry about Asian Rust.” Doug E. Carper, president of DEC Capital, says, “The window of one crop season to the next seems to be narrowing all the time because there are so many outside influences and producers. The season seems to be never ending. We have two: ours and the South American growing season, which is exactly opposite our season here in America. Rather than a three or four month growing season to worry about, now there is twice that.”
Just a couple of years ago, ag traders could base their expectations on a look at the stock consumption ratio on the United States balance sheet, says David Bell, president of Bell Fundamental Futures in Memphis Tennessee. “South America just took whatever price it took to sell. And now with them as the dominant producer, much of that has changed. Now they set the price.”
INTERNATIONAL VS. DOMESTIC
The differences between domestic and international crops are important and multiply the number of fundamental variables influencing prices. And whereas the Argentina, Brazil and the United States are the largest growers and exporters of soybeans, corn is primarily a domestic crop.
“We are by far the largest producer of corn, and thus the value of the dollar and the price of corn has little or nothing to do with corn exports,” Brock says, adding that in the nongrowing season traders are looking at available supplies in the United States and the domestic stock-to-usage ratio. But in soybeans, the world numbers are extremely important. “You are not only looking at the free supplies in the U.S., you’re looking at crop progress in Argentina and Brazil and weather patterns in both of those countries. In corn, that’s not a factor at all.”
During the growing season the markets are preoccupied with supply, outside the growing season traders focus on demand. Supply and demand always determine price, but the variables influencing supply and demand change from season to season. Supply variables, such as weather, draught, disease and pests, have a large impact on price action for a short time, typically no more than a few months. But demand is determined year long, and volatility tends to be greater during the growing season.
If weather is the single most important supply variable, the timing of the weather is a very close second. “What I like to do is to scan the weather data looking for a change,” says Mark Hawkins, president of Commodity Capital Inc., adding that in the very early parts of the growing season, which may not be yield determinant, the market is still focused on weather. An example of this is the draught last June in Illinois and Ohio. “It was drier than the record draught in 1988 in lots of areas. That was June. And that typically is not a time where you determine corn and bean yields. But can the market just sit still and say, it’s really dry and hot, but I’m not going to rally, or is it more likely to extrapolate the current conditions into the growing period and rally accordingly? And that’s what it did,” Hawkins explains.
When the rains came in July, it took the market some time to get to grips with the change. “If you look at the 2005 weather data from the Midwest, the June-August period was essentially normal. And it didn’t feel normal to anybody in late June and early July. And what happened was the market saw unusually dry conditions in key area of the growing region. It rationally knew it didn’t really matter that it was hot and dry in June, but it projected that weather forward and rallied accordingly, and then we ended up with a record soybean yield. Did soybeans manage to shrug off the June weather? They rallied really hard,” Hawkins says.
There are also seasonal market phenomena. “In August, the speculators typically short the bean complex,” Bell says. “Farmers don’t want to sell any more until they’re sure about the size crop they have, and they have already sold at higher prices and don’t want to sell into the hole, so you kind of exhaust your selling. On the other side, the consumers say ‘these are pretty good prices, we don’t know how big that crop is,’ so they do a little bit of buying, and it sort of builds into a short covering rally.”
The key uncertainty is crop size, which can change dramatically during the season. But once the crops are out of the ground, traders turn their focus to the demand variables simply because there are fewer fundamental factors to consider.
Hawkins stresses the importance of adjusting position size in anticipation of the different levels of volatility in the supply versus demand seasons. “Your risk in any given position is dramatically greater, let’s say, if you are trading corn in July than if you are trading corn in December. The median range for corn futures in July is about 40¢ a bushel ($2,000 a contract). The median range for corn futures in December is about 17¢ or 18¢ a bushel, so your volatility is more than double. And, you don’t really know if that is going to happen in a gradual way and you can incrementally adjust, or whether it occurs over night. Your value-to-risk is going to increase substantially for a given contract position size in the growing season.”
Hawkins says he will watch the 20-day moving standard deviation for a particular market, and when he sees an increase he will factor that into position size. “You could have a relatively quiet planting season and the market [volatility] may not increase in May. And then it suddenly increases in June or July,” Hawkins says. If the volatility is relatively benign, Hawkins adjusts his position size down anyway, knowing at any stage it “could become explosive.” He also watches the implied volatility in the options market to help anticipate increases in volatility and the timing of potential increases. “Some people will look at the moving standard deviation of a daily market, some people look at the implied volatility of options, I tend to look at the historical median and mean ranges in a particular month. So I know that in July, my position size will probably have to be half what it is in December, maybe a third just based on the median ranges that I mentioned,” Hawkins says.
HERE COME THE FUNDS
In the past, large fund managers had to curtail their activity in the agricultural markets as their money under management grew because the position limits were too small. Most funds eliminate or severely limit grain positions once they surpass $1 billion under management but that may change as higher position limits went into effect Dec. 10, (see “Trading room,” below). The Chicago Board of Trade fought for limit increases as more of its business comes from funds.
“Take something like Eurodollars where there is no limit,” Brock says.
“They are going to concentrate on the markets where they can expand their position size to match the amount of money they have under management. For example, you take a John Henry or a Campbell, where they are trading in the billions of dollars, 45 million bushels is a pimple on an elephant’s back. If the market moved a dime, that would only be $4.5 million; when you have $5 billion under management, why waste your time?”
Carper too has noticed that the order flow and the composition of the order flow has changed dramatically. “The amount of hedging pales to what it was when I first started trading,” he says, adding that the grain companies were the dominant order flow, with locals playing the role of speculators. Now the CTAs and hedge fund operators are the dominant order flow. “The locals on the floor at the Board of Trade are a minor part of the scale volume that once existed.”
The new alternative investment managers don’t have a lot of experience, he says. “They are kind of like elephants in a china shop,” adding that fund participation occasionally drives ag markets beyond their capability for absorbing volume. “The drain is just a little too small to handle the water that needs to run through it from time to time,” Carper says.
That is particularly true with the newest entrant in the market: longonly funds benchmarked to indexes like the Goldman Sachs Commodity Index (GSCI). These funds take massive positions on hold the indefinitely (see “Dr. Strangefund,” September 2005).
Hawkins says the markets need to rebalance. “There appears a time when the index fund is by far the dominant force on the crop,” and prices will probably be higher for some time. “One of these days they’ll have their boat load and then the market will wait because there won’t be anyone other than the funds buying it.”
Large fund positions can distort markets but they also create opportunities. “My basic mode of trading is waiting for market disequilibrium, expecting it to move to equilibrium; and then to be there when it happens. And I believe the funds are pushing the market into greater disequilibrium,” Bell says.
ELECTRONIC VS. OPEN OUTCRY
One of the things that hasn’t changed in the ag markets is reliance on open-outcry trading. Ag markets are only electronically available after hours. Even orders that are sent electronically are executed on the trading floor.
“Electronic clerk? It’s a joke,” Carper says. “Nobody seriously thinks that’s an alternative. It’s kind of like clicking on your mouse to send an order into a pony express rider,” adding that open outcry adds to the expense of trading and is inefficient for handling large-scale volume.
It is also unlikely to change soon because floor traders, formerly members of the exchanges and now large shareholders in the exchange holding companies, benefit from brokerage fees and income from renting trading privileges and don’t want to see floor trading go away. “They are not the big players, they are facilitators. The percentage of volume that trades these markets is radically different than what it used to be. My contention is that floor traders are more irrelevant to the price discovery process than ever before, yet they represent an impediment to people who do want to trade,” Carper says.
“I don’t think floor trading as we know [it] is indispensable,” Bell says, adding that many of the functions that the floor performs could be done better electronically, “If the floor is providing a service that cannot be provided in an electronic format, then that would imply that the electronic format is inefficient. If the market creates inefficiencies, then it is also creating an opportunity and someone will figure out how to exploit that inefficiency.”
Proponents of open outcry say because the agricultural markets are dominated by spread trading, it is unlikely to go away, and that technology is not yet capable of handling the complexities of spread trading, a point Carper acknowledges. “It’s harder to make those kinds of trades electronically, but the underlying futures would be better served,” Carper says, adding that something has got to give. “Right now, we can’t run any faster, or grow our markets any larger.