Spread trading in the grains seems to be gaining popularity these days and for good reason. With high volatility in grain markets spread trading may be a way to take on less risk and lower margin requirements.
However, when spread trading grains it is important to understand the difference between crop years and their relationship to each other. While new crop and old crop contracts certainly are related they do have different factors influencing prices, and sometimes very different fundamentals. So, what does the relationship between the new crop and old crop tell us?
In grains we refer to last year’s crop as old crop. This is the grain supply we grew last year and currently are using. New crop is the next crop supply that we expect to grow. This is the grain that we will be working hard to produce and that will be harvested in the fall. The marketing season for corn and soybeans begins when crops are harvested starting in September and ends when the new crop harvest begins. There is certainly a lot of overlap in fundamentals between any particular grain’s old crop and new crop.
For the most part we assume demand will be fairly consistent unless a big price fluctuation were to occur because demand is sensitive to prices. We know that there will be some old crop that we carry over into the new crop marketing season. How much or how little grain will be carried over from one year to the next sometimes dictates how correlated old crop and new crop prices will be. The biggest unknown factor for the next year is supply. Grain production can vary (sometimes dramatically) from one year to the next depending on how many acres are planted and how good or bad the weather is during the growing season.
Under normal market conditions there is usually a premium to the new crop contracts because we do not know how the next growing season will go. This production uncertainty keeps new crop prices higher. In a bear market this can be exaggerated as old crop prices can go lower to try to spur demand, while at the same time keeping a premium in new crop because we still have to grow it.
In a bull market this relationship can flip. A bull market generally means that demand is strong relative to supply. In this scenario many times old crop prices will be higher than new crop prices (see “A bean in the hand is worth” below). The idea is that the balance sheet is tight now but could be better next year if production is good. When old crop prices are higher than new crop prices this is generally a good indication of a bull market. Because of this relationship old crop and new crop prices do tend to go in the same direction but that direction is usually led by old crop.
So, in a bull market the old crop usually moves higher faster and farther then new crop, and in bear markets old crop usually moves lower faster and farther than the new crop.