Wheat prices have traditionally commanded a premium over corn prices. Both grains can be used as a carbohydrate feed for livestock and fowl, but wheat is used primarily for human consumption. Wheat becomes animal feed only when wheat prices become competitive with corn prices. Chart 1 tracks this relationship going back to the early 1970s. Over the past few years, wheat supplies were abundant, while corn supplies were relatively scarce. Hence the wheat/corn spread fell to zero and beyond.
The supply/demand fundamentals that led to this anomalous relationship are fading, though, and the ratio should be drawn back into its normal ranges.
As we’ve discussed countless times in these pages, corn-based ethanol exploded from an insignificant, boutique fuel to a significant component of the US energy market. The federal government now mandates a minimum blend of ethanol in gasoline. In the span of a decade the US moved from using an inconsequential amount of corn for ethanol production to the current situation in which about 40% of all corn grown in the US is turned into ethanol.
US farmers attempted to meet the new demand, but their efforts have often been thwarted by weather, particularly in the 2011-12 crop year. Planted corn area increased by 4 million acres over the previous season, or by 4.2%, but the weather was so poor that yields sank precipitously, which ultimately resulted in a crop that was even smaller than 2010-11ouput.
Argentina is the world’s second-largest exporter. For a while, we believed that a huge expansion in Argentinean corn area was going to supplement disappointing US output, but that did not pan out. Drought in South America delayed the the Argentinean’s expansionary plans. At one point, when the crop was first being planted, estimates ran as high as 30 million tonnes, up from 22.5 million tonnes the previous year. After assessing the damage, some analysts pegged the crop to fall below 20 million tonnes.
We’ll have to wait another year to see if Argentina is capable of adding enough supplies to make an appreciable difference, but in the meantime, late rains for the late-planted portion of the crop propped up yields. Informa Economics estimates the crop at 22.5 million tonnes, no worse than the previous year.
The real bearish factor, however, is that the rate of growth in the percentage of US corn used to make ethanol is likely to have peaked just when US farmers are about to plant a monster crop. The US government has ended the era of incentives for producers by eliminating the direct subsidy to producers and the tariff on Brazilian imports. Acreage for the soon-to-be-planted 2012-13 crop will increase by about 2 million acres over this season’s acreage. With a return to normal yields, we could see a crop of between 13.5 and 14 billion bushels, which would be about 10% above last year’s output.
Getting back to the wheat/corn ratio, while bullish corn fundamentals have plateaued, wheat fundamentals are no longer as bearish as they’ve been. After a major recovery from a drought-stricken 2010-11 crop year, FSU production bounced back in 2011-12, leaving the world awash with feed-grade wheat.
Northern Hemisphere winter wheat crops will definitely not be as bountiful this year. A bitterly cold winter in Europe has compromised some 2012-13 EU winter wheat crops, but, in particular, has affected Ukrainian wheat regions. Some current estimates put the Ukrainian harvest as low as 13 to 14 million tonnes, compared with 22 million tonnes last year.
In the US the winter was exceptionally warm, which hastened the maturing of winter wheat crops, leaving the plants vulnerable to early spring frost.
There is neither a strong near-term bearish case for corn nor a strong bullish case for wheat. But the era of stark extremes in both has certainly ended, as illustrated, and we expect the price ratio to reflect this.
July wheat is currently trading at about 20¢ premium to July corn. Buy July wheat and sell July corn. Place initial stops at even money.