By Larry Martin and Derek Albrecht
After months of steady decline, Chicago grain futures recently rallied to meet or exceed USDA forecasts in its November grain report. USDA forecast carryover of soybeans at the end of the 2014/15 crop year at 12.5 per cent of use, with a price forecast at around $10. This compares to 4% and $13 last crop year. The current rally gives an opportunity to sell for modest cash prices, but risks pricing too low if the rally continues.
How do you make the call on downside risk? The risk can be substantial, specially for highly leveraged farm operations.
For those who have been following markets for years, it’s important to note the relationship between the stocks/use ratios and prices changed after 2006/07. Below we explain the change in pricing relationships, provide perspective on the risk, and offer suggestions on managing it.
Changes in the Pricing Relationships
(Editor’s note: Click on the graphs to see them larger. Click the back button to return to this post). Figure 1, above, contains year-end stocks/use ratios for wheat, corn and soybeans since 1995/96 plotted against annual average prices.
Changes in the relationships since 2006/07 are quite clear in the graphs. We estimated linear trend lines for each grain and time period. The trend lines are “higher” for all three after 2006/07– i.e. annual prices were higher at any given stocks/use ratio. For corn and soybeans, the post–2006/07 trend lines are also steeper, indicating that prices change more with relatively small changes in the stocks/use ratio.
A possible cause of the changes is that the US dollar began to devalue during this period. Foreign buyers had an advantage in buying US grain in their own currency, driving prices up in US currency. Second, it corresponds with the period when Asian, particularly Chinese, imports of soybeans and corn began to rise substantially, thereby shifting demand for these products.
Implications for Pricing and Risk Management in 2014/15
Figure 2 also contains USDA’s forecasts of stocks/use and prices for the end of 2014/15 (triangles). Nearby futures rallied above the USDA forecasts; corn and soybeans rallied to an approximate 38.2 per cent Fibonacci retracement. The Fibonacci number series is a common way to measure countertrends within major trends. Significant chart points like this are good places to assess why it got here and the risks of the market moving unfavorably.
The rally to date has several components:
- Late US harvest caused uncertainty of supply, especially for soybean meal.
- This was magnified by dry weather in Brazil, causing delays in planting the first crop, and causing doubts about the safrinha second crop.
- Grain exports, especially soybeans, were ahead of expectations for several weeks, suggesting strong demand.
- These factors drove December soybean meal prices from $295 to $410 between early October and early November. This was largely because of a near shortage of meal toward the end of 2013/14.
- These fundamental factors started the rally, which fed on itself with technical buying by managed funds.
All three of wheat, corn and soybeans rallied to significant technical resistance even after USDA’s November report surprised the market with less corn production than expected. USDA forecast stocks/use for wheat, corn and soybeans at 30.1 per cent, 14.7 per cent, and 12.5 per cent, all significantly higher than the past two years.
What are the risks now? Fundamentally, several factors could cause markets to test October lows:
- Exports may move back down to expectations, especially with relatively large international crops.
- US harvest is back on track, and supplies appear to be plentiful.
- The South American soybean crop is now being sown and many expect a record.
- The US dollar is appreciating against most currencies.
We are particularly concerned about soybeans. The soybean graph in Figure 3 shows that the USDA forecast is $10/bu, but the new trend line would put price closer to $8 if the stocks/use ratio is to be near 12.5 per cent, and the rally in meal could drop as fast as it rose.
With relatively strong basis, this appears to be a good place for producers to do some pricing, especially those that have a large debt load. Pricing product now delivers the relatively high futures price, strong basis and the weak Canadian dollar. But this is difficult to do in a rising market – what if the positive fundamentals take over, or what if there is a currently unanticipated problem with production somewhere in the world before next year’s harvest?
To protect against a rising market, producers can also buy out-of-the-money Calls on the May or July futures contracts. This locks in the current price and gives the opportunity to profit on the Calls if fundamentals change positively. Our experience is that Calls with premiums at or less than three per cent of their strike price are often excellent insurance.
Pricing physical product now and using options to manage the risk of pricing too low may be worth considering for those with significant financial risk.
— Larry Martin and Derek Albrecht are with Agri-Food Management Excellence. AME is hosting an Introduction to Risk Management course Jan. 27-29 in Guelph