The grain complex has been pretty boring since the huge moves of 2008 as prices have steadily declined further after tanking from the mid-2008 peak. Anyone nostalgic for those glory days of beans in the teens is probably going to have to wait a while longer as slower demand and a near perfect spring planting season has bulls on the run.
If these fundamentals follow through, we can see prices of corn, wheat and soybeans at levels not seen since 2006.
What’s next for soybeans
Soybean futures reflected a significant speculative price premium throughout the spring. Traders argued an Argentine/Chinese trade dispute as a bullish reason to think China would buy more U.S. beans and force U.S. stocks into shortage status. Additionally, talk of early corn planting pulling acres from beans supported new crop prices with talk of potential tight supplies in 2010/11. However, the Allendale research staff was finding nearly the opposite to be true in every study completed and viewed the rally as a selling opportunity. China actually was canceling old crop purchases as rumors circulated of them buying. Based on the current pace of sales, we expect a 27 million bushel decline in export demand (see “Exports lagging”). However, offsetting a slowing export pace is the strong domestic soybean crush that is exceeding USDA’s forecast by 48 million bushels (see “Crushing last year’s pace”). Thus old crop soybean demand likely will be revised up, not by the bullish 50-75 million bushels that some were saying but only by 21 million bushels. This will equate to a stocks decline from 190 to 170 million bushels. Although this is a little tighter than thought, it is not a shortage and does not justify beans at $10.
New crop bean fundamentals are much more bearish as stocks will increase significantly. Historically, when farmers get planting done early, they have a tendency to plant 100,000 more acres of beans, even in years when corn acres increase. Additionally, yields have a tendency to exceed “trend” in early planted years. Thus, the good spring might have shifted the supply curve up a notch if summer weather complies. Demand for new crop is currently exceeding early projections. In fact, China has been buying new crop beans at a pace that is 60% better than last year. This statistic inspired November beans to trade as high as $9.87 recently. However, even if China bought 50 million bushels more than last year, the potential larger crop far exceeds the increase in demand. The end result is that 2010 stocks are projected near 320 million bushels vs. last year’s 170-190 million bushels. This 68% projected increase in stocks is similar to the 2004 and 2005 increases in stocks that drove the market to a seasonal average price of $5.74 and $5.66 respectively.
World stocks are hitting record levels as Argentina’s production hits 53 mmt, a 65% increase from last year. This jumped world stocks 40% and prospects for 2010 suggest an additional 20% increase is possible. The only time in history there have been two large back-to-back increases in stocks was 1984 and 1985 when prices averaged $5.84 and $5.05 respectively.
Traditional economic models suggest prices could trade in the $6.50 area, given the large supplies around the world. However, speculative premium from massive fund buying seems to be building in an inflation factor that must be recognized. If we use 1984-85 analog price levels as a base price, today’s inflated values equate to $10.90. Although the fundamentals are very bearish, we must assume funds will continue to hold inflation-based long positions and we must inflate the forecasted low price range to the $8-$9 area. With prices currently above $10, we believe shorting soybeans offers a reasonable commodity trade in the grain/oilseed sector.
Playing beans
Selling futures is always the least costly position to hold. However, a short call- long put position may be the best play. This position has reduced exposure to market volatility without sacrificing profit potential. Buying $10 puts assures traders will be short if the assumed fundamentals come to fruition and retains unlimited profit potential. Selling the $10.40 calls commits traders to the short side of the market at the higher forecasted price levels our models generate. Thus, we estimate the probability of time and price risk is very low against this position. By selling this call, traders collect enough premium to reduce the cost of the $10 puts to a mere 10¢ or $500 per contract. Bottom line, you are either short at $10 if the market is going down, or are committed to the short side at $10.40 if the market is going up. Our equity exposure is limited to 10¢ or $500 unless the market is above $10.40 at expiration, in which case the equity loss is the difference between the market and the $10.40 short plus the 10¢ position cost. There are margin requirements with this position in an up market.
Corn growing
The corn industry continues to grow in three distinct areas. Strong demand for corn ethanol continues to grow at a 17% pace this year and we expect another 4% growth next year as we near the U.S. mandated capacity. Future growth in ethanol will depend on the EPA’s decision (expected in June-August) regarding expanding the mandated 10% blend (E10) to a proposed 15% blend (E15). Without a decision to raise the blend, the ethanol industry will hit the “blender’s wall” by September 2012 as very little volunteer blend (blending outside of the government subsidy) takes place. The second growth area is in U.S. distillers’ dried grain (DDGs), a feed byproduct of ethanol. This product has become a big export market with China showing great interest. China started buying U.S. DDGs in 2005 and by 2010, they are expected to buy two mmt, or a corn equivalent of 79 million bushels. Finally, U.S. exports, which have been running below the five-year average for two years, seem to have found some light as a sale of 115,000 tonnes of U.S. GMO corn was sold on April 28 to China. This was the first significant sale of U.S. corn to China in 14 years. Industry contacts suggest that signs of another poor crop would cause China to buy as much as four mmt, or 160 million bushels, of U.S. corn if their government will grant import licenses for GMO corn and approve deliverable quality. At the time of this writing, their planting season is going poorly as they faced a cold wet spring very similar to the United States last year. Overall, the strong demand curve is providing economic value to the market and requires that the United States produce a 13.3 billion bushel crop to maintain stocks.
U.S. farmers have responded to strong demand, high prices and good weather. Unlike last year when corn was one of the slowest crops to be planted, the 2010 crop planting set a record pace (see “Getting it in early”). Historically, there have been 15 years when crops were planted earlier than normal. Yields exceeded trend in 14 of those 15 years and planted acres were revised upward in 10 of 15 years. This implies that we can expect the USDA to revise acres up about 400,000 and for yields to exceed trend by 15 bpa. If we make a 400,000 acreage change and raise yield to a conservative 167 v 160.4 trend, the United States would produce a 13.645 billion bushel crop versus the earlier expectations for a 13.048 billion bushel crop. USDA’s June 30 acreage report and good weather will be important because this minor acreage revision would be a major shift in the supply curve as it is the difference between a crop that exceeds demand and stocks build vs. a crop that does not meet demand and stocks draw down.
Fund buying continues to be a major influence on prices and we must respect this. Their long position has caused prices to exceed traditional economic pricing models. With demand strong and somewhat unknown as China buys, we can justify price strength but it is difficult to economically model any values above $4. Even when we quantify an extreme 4.0 mmt record export program to China, comfortable U.S. stocks can be maintained with good weather. Given these scenarios, we can expect a sideways price range with $4.20 offering good selling opportunity for a long-term position and the $3.20 area offering end users and speculators a good opportunity to lock in long-term ownership.
With a large trading range expected in corn, employing sideways technical programs might pay off. Stochastic and RSI tools would provide contrarian signals when the market is overbought or oversold.
Watching for spikes in volatility also would offer opportunities to take advantage of option premiums by selling $5 calls when the market is overbought on bullish news, or selling $3 puts when the market is oversold on bearish news.
Wheat supplies high
The last time U.S. ending stocks were over 950 million bushels was 1999, when prices averaged the year at $2.48 (see “Cupboards are full”) . The last time world stocks of wheat were 195 mmt (7.164 billion bushels) was 2001, when prices averaged $2.78. Current July futures are trading at $5.03 and thus the initial reaction is to “sell with both hands.”
Allendale’s research has projected world stocks in the 2010-2011 will decline 5.8% to 184 mmt but these are still very large stocks and exceed the five-year average stocks of 152 mmt (USDA will not release this information until May). World stocks to use ratio is projected at 23.6% for an 86 day supply of wheat in storage or about 12 more days than normal. Thus even with Allendale’s forecast for tightening stocks in 2010/11, the supply overwhelms demand.
Simply put, unless there is a major change in the fundamentals, there is no reason for end users to chase prices higher. That leaves market strength subject to the ability of fund and speculative traders to hold long positions. Index funds, long 179,000 contracts, are the only group identified by the Commodity Futures Trading Commission as a net long position. This group is largely made up of long-only funds or exchange-traded funds (ETFs). Money has been flowing into this sector to diversify an equity portfolio and to build in an inflation hedge.
This seems like a logical argument, but if you use the 2001 analog year’s $2.78 average price as a base and inflate it to today’s values, you get an average inflated price of $3.42, not the current $5 price. Thus the “inflation hedge” has already priced in a 46% rate of inflation for the coming 12 months, not a high probability bet. This does not imply that funds will start to sell out of positions, because the nature of these positions is diversification. But the current $5 price of wheat cannot be sustained in a true economic sense.
Wheat futures are overpriced. Selling futures, a box/collar or three-way option position can provide an outright short position that will prosper if the index and ETF money decides to liquidate some length. If the market continues to move higher, the futures would incur the most equity loss. All of the positions would prosper if the market made any attempt to narrow the current market to the economic value spread and some of the options would make money if the market simply remained sideways.
Bill Biedermann is senior vice president at Allendale. Reach him at bbiedermann@allendale-inc.com or through www.allendale-inc.com .
