Historically, when the commercials become net long futures contracts, a major bottom has formed. This occurred with corn in the second half of 2009 as commercials (farmers, elevators, and end users like Cargill) decided to go long, betting with their wallets and their operations that current corn prices are very cheap and that higher prices are likely in store in the months ahead.
Clearly the commercial entities do not share the current bearish outlook on corn prices widely embraced by the analyst community. For some reason, they see a bottom in prices where others do not. It has been a major mistake in the past to bet against the commercial players’ collective wisdom, as who knows these markets any better than the people who grow and use corn on a regular basis.
Could it be that the corn crop has not met record yield expectations? Could it be that China, given their terrible corn crop, is already buying corn through intermediaries in the United States that we will only find out about at a later date? Could it be that the ethanol plants are consuming far more corn and producing much more ethanol than current expectations? Or is it something totally different that is not readily identifiable at this moment in time?
No one knows the answer for sure, but for some reason the commercial operators have taken a very bullish stance that should not be ignored. Over the next several months the answer will become clear and by that time, corn prices may have already moved up substantially.
There is another reason to be bullish corn: seasonal price patterns. Historically, corn prices tend to reach harvest lows in the fourth quarter. Why would it be any different this time?
So not only are the commercials flashing buy signals with their futures activities, but they are doing so at a time of the year where most major bottoms in the corn market tend to form.
The July/Dec 2010 futures corn spread suggests that a major spike may be imminent as the end of the long-term wedge formation approaches (see “Popping corn”). The odds favor a bullish breakout of this formation given the commercial net long positions, favorable seasonal patterns and the likelihood of a reduction in U.S. corn yields in the January 2010 USDA report.
During past tight supply/demand markets, this spread had achieved levels near 40¢ per bushel. The 40-year historical lows have been near -20¢. In early December the spread stood at -12¢. This gives you a very attractive risk profile. If you go long at -12¢ and the spread reached 40¢, that is $2,500 per one lot. With a stop at -20¢, you risk a loss of $400 per spread. The margin requirement for this spread is around $210 per one lot.
Something likely will occur to provide the catalyst for a bullish breakout in corn prices and the bull spread. Possible catalysts include:
1) Disappointing actual corn yields coming off the combine in November/December, negating the current record yield expectations. The November USDA report downgraded yields to the 162 bu. per acre level from 165. Expect the January USDA report to drop yields to under 160.
2) Continued major downgrading of China’s corn crop by the USDA and the confirmation of large Chinese purchases of U.S. corn. Already the USDA has pared back production from the 165 million metric ton level to the 155 mmt level. Expect a decline below 150 mmt come January.
3) Greater domestic ethanol demand from current expectations given the improved economic rationalization of the industry against a very profitable ethanol refinery margin environment.
4) Drop in quality and other wildcards. Excessive wet weather that led to a near record late harvest could drop the quality of corn due to moisture-related damage. Also continued weakness in the dollar could send prices higher regardless of fundamentals.
The lows that are set for corn during this cycle when the final bottom is clear (so far that bottom stands at $3 in the spot price) likely will turn out to be multi-year lows, if not decade lows. This is an historic moment to buy corn.
Utilizing the bull futures spread strategy until a clear price breakout is established with supporting fundamental data is the safer way to exploit this bullish view. Once such signals become clear, the lifting of the short side of these spreads would be highly recommended for those more aggressive traders.
Shawn Hackett, commodities broker and author of the Hackett Money Flow Report newsletter (hackettadvisors.com), is a nationally recognized agricultural commodities expert with more than 15 years of money management experience.