From the June 01, 2010 issue of Futures Magazine • Subscribe!

Grains offer long opportunity by thinking short

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.


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