The news media has been offering up a number of reports, facts and figures regarding increasing food costs. "Food inflation" has become a hot topic among the pundits.
We would like to present to you some of the real numbers behind the story. When you peel back the glossy media cover, there actually is some substance to this theme as arguably much of the geopolitical unrest we are seeing can be attributed to food inflation. Food inflation is here, and it is real; so traders should be prepared and position themselves to profit from it.
Corn prices have benefited from what is expected to be the tightest stocks-to-usage ratio in history this year (5%). Stocks-to-usage measures the amount of corn supply on hand at the end of the crop year (September 2010) vs. the expected demand for the coming year (see "Dibs on corn").
The U.S. ending stocks-to-usage ratio for 2010 is expected to be the lowest in history. The March 31 USDA quarterly grain stocks report suggested this number could drop even further.
This shocked corn traders and led to a limit up move and a two-day rally of 75¢. The report pegged U.S. stocks on hand at 6.523 billion bushels, about 165 billion bushels short of trade expectations. What it means, in short, is that despite higher prices, we are using more corn than most anyone had expected. When one considers that nearly 35% of last year’s U.S. corn crop went into ethanol production, there is that much less corn on the market to meet the world’s growing demand for feed grains. Feed grain demand has become especially acute in developing economies such as China, Brazil and India, where newly affluent middle classes are developing appetites for meat.
Historically tight stocks mean that corn prices should remain acutely sensitive to weather during the U.S. planting and growing seasons.
The lower stocks report paves the way for the USDA to adjust ending stocks (and thus stocks-to-usage) even lower in next month’s report. This is bullish for near-month corn contracts such as May and July.
However, as we recommend here, option sellers that want to sell deep, deep out-of-the-money strikes should look to go further out in time. This means looking at September–December contracts. This is referred to as new-crop corn, as these contracts will be satisfied with the 2011 corn harvest rather than the stocks already on hand.
Some in the trade have suggested that higher prices will result in more corn acres being planted in the United States this spring. This would in turn "alleviate" the bull market conditions that have persisted for the past nine months. These traders may want to consider the following.
Corn’s planted acreage was bumped slightly higher in the March 31 report to 92.178 million acres from the previous month’s 92.0 million. However, even if you assume an abundant yield of 162 bushels per acre (152.8 in 2010), it still leaves the United States with 2012 ending stocks/usage figure of 6.9%. Higher yes, but still the third lowest in history. This is with acreage intentions fulfilled and near-ideal growing conditions.
Tight ending stocks for 2010 puts the corn market in a situation where it needs nearly perfect weather in 2011 to avoid a continued surge in prices in 2012. Hence, prices should be extremely sensitive to any planting delays over the next 60 days and any less-than-perfect weather during this summer’s growing season.
While corrections will occur along the way, it is hard to envision corn prices trading substantially lower through this year’s planting and growing seasons unless the global recovery becomes suddenly and drastically derailed.
We suggest selling put premiums ahead of the U.S. planting season as a high probability strategy for profiting from steady-to-higher corn prices this spring.
We will be working closely with managed accounts in the coming weeks to determine appropriate strikes and premiums in the corn market.
More aggressive traders may consider adding some call premiums in the late May-June time period, turning the trade into a strangle. This approach would seek to take advantage of a potential period of profit taking once the crop is in the ground.
James Cordier is the founder of investment firm Liberty Trading Group/OptionSellers.com.
Michael Gross is an analyst with Liberty Trading Group. They are the authors of "The Complete Guide to Option Selling," 2nd Edition (McGraw-Hill 2009). For more information on selling options, visit their website at www.OptionSellers.com.
