Over the past 2 decades, a more interconnected and intertwined world have allowed capital to flow easily across borders, leading to rising correlations among asset classes that were once thought to be totally disconnected or unrelated to one another. One such area is the grain market, where the increasing usage of bio-fuels as well as investment products (think commodity ETFs) have led to intertwining relationships with trends in the energy industry and among Wall Street.
Agricultural commodities, also known as soft commodities “softs”, typically get less attention among financial and investment types. However, it is an area not to be ignored, particularly among savvy market observers or macro traders.
At this current juncture, the entire soft commodity space has been somewhat in its own bear market since the summer of 2012 when worse-than-expected weather conditions materialised in North America causing concerns over supplies and sending prices of many softs up (like corn and wheat). Many of their futures prices have declined quite substantially since then as supply caught up and inventories are worked through.
Here are the weekly price charts of generic corn, wheat and oats since 2011 respectively:
Just by looking at their technicals, the charts suggest that prices of these 3 softs could be turning the corner in 2017. All 3 display rounded-bottom / double bottom / triple bottom kind of patterns on higher time frames – a rather bullish signal that would capture the attention of speculators and Commodity Trading Advisors (CTAs) / Managed Futures managers. They also hover close to their 200 day moving averages, a key indicator that would attract the attention of technical/quantitative-based systematic investment programmes.
In terms of fundamental news, the outlook for crops like wheat was bleak as the US Department of Agriculture reported that the global wheat market is still suffering from oversupply and glut and that :
“2017 Winter Wheat Seedings Lowest in 108 Years
After consecutive years of low prices and sizable carryouts, U.S. farmers have opted to plant the second lowest number of winter wheat acres on record, and the smallest number in 108 years. Winter wheat sowings for the current marketing year (2016/17) were well below average and, at the time, the sixth lowest on record. With a 10 percent year-to-year decline, winter wheat sowing for 2017/18 are estimated at just 32.4 million acres. HRW plantings are reduced 3.3 million acres (12 percent) from 2016, to 23.3 million acres. Plantings in most HRW growing States are down and are record-low in Nebraska and Utah. Winter wheat plantings in Kansas alone are down 1.1 million acres. Other sizable year-to-year reductions in planted area are projected for Montana (down 350,000 acres), Oklahoma (down 500,000 acres) and Texas (down 500,000 acres). In the majority of reporting States, the wheat crop is reported to be in good to excellent condition at the end of December. However, in Kansas, a lack of moisture followed by a period of deep cold has reduced winter wheat condition ratings to below normal and far below last year. Just 44 percent of the winter wheat crop in the State is rated good (42 percent) to excellent (2 percent), in contrast to 96 percent rated similarly at the same time a year prior. Last year, the production-reduction effects of lower year-to-year HRW planted area were more than offset by record yields. Based on the conditions ratings to date, yields are not expected to repeat the same performance in 2017/18. ”
While US farmers are decreasing planting, wheat production in other countries are expected to increase.
If looking at supply and demand dynamics in order to figure out where prices may head to is tough, another way to size up the situation is to see how the market is positioned. A look at futures contracts and open interest data reported by the CFTC (in their COT report) will give us a better idea on what the market is thinking about this.
Generally, there are 2 major parties that utilise the futures market, producers/sellers and speculators. Producers are companies that typically use futures contracts to hedge their positions. For example, a wheat farmer normally knows when he is harvesting his crop and selling it, so in order to prevent the risk of prices in the future declining and hence lowering his potential profits, he approaches the futures market and sells at current prices for a future contract, effectively hedging his physical exposure. On the other hand, speculators are traders or investors who are utilising futures as a way to make money from price movements.
Because these 2 major parties approach the futures market for different reasons, their collective behaviours tend to diverge. The producers/hedgers tend to buy when they think prices are heading downwards because they need to hedge against future risk, whereas the speculators tend to follow the direction of prices, decreasing their buying or going net short when prices are declining. Conversely, the producers/hedgers tend to decrease their hedging (buying less) when they think prices will head up.
Below is the positioning of both the commercials/hedgers (blue) and the non-commercials/speculators (red) since 2010, courtesy of Bloomberg’s compilation. One could easily see the divergence between the positioning of both parties.
The following are for corn and oats respectively:
The commercials/hedgers typically understand the fundamentals of the respective agri-market that they deal with better than industry outsiders, thus, they can be viewed of as ‘smart-money’ if you take the opposite stance of them. Should the commercials/hedgers (blue) continue to decrease their positions on aggregate, a sustained and strong price recovery could come sooner than expected.
With this backdrop and since the news of oversupply and glut is already well-known, attention should be focused on events or developments that could reduce the current glut, affecting the perceptions and actions of players, and acting as the driver of prices going forward.
I’ll consider taking exposure to these 3 commodities and let price action guide me. In terms of risk exposure, I’m considering between 50 to 150 basis points of risk, and should the trades go well in my favour, I will systematically increase exposure (to a maximum of 400 basis points) depending on how other fundamental and macro factors develop. I’ll also be quick to cut and get out should price hit my risk limits.
Interestingly, rough rice prices also display the same patterns as described above. I’ll have to dig deeper in the rice market…
*image credits to http://agrodaily.com/ & http://weckerfarms.com/*