Grain Marketing 101 for 2010

Following record wheat prices in 2008, world wheat stocks have been rebuilt to relatively comfortable levels. Another above average crop this year, would see stocks rise again to what could be considered relatively burdensome levels.

This situation is very similar to the late 1990’s when Chicago Board of Trade (CBOT) wheat futures made major highs in early 1996 and growers around the world responded by increasing production and creating a stocks hangover for the period through to early 2002.
In 1996 prices fell rapidly from their peak. A period of relative volatility followed for the next 1-2yrs until prices settled into a trading range of less than $1/bu until the next major rally in 2002.

Thus far, in the recent phase the market topped out in February 2008 and fell rapidly before rallying again in August 2008 before easing and making new lows in December 2008. Since there has been a series of failed rallies after which prices again fell to test the lows of the current price cycle. Lots of coincidence?

We are not saying that the market is going to flat-line for the next 5yrs - in many ways the market has changed significantly since the late 1990s.

The lesson learnt in the 1990s was that hedging using futures early in the year proved the most effective marketing method in a comfortable stocks environment. While prices early in the year were not stellar, they proved to be better than those later in the year.

If we repeat history for at least this year (flat prices as a result of heavy carryover stocks) then the forward carry currently embedded in CBOT December futures will eventually evaporate. Currently CBOT December 2010 swaps are trading at A$230/t vs March 2010 CBOT swaps at A$198/t.

Although it may seem defensive, we suspect hedging on early rallies (prior to Mid April) will be a winner this year. In a flat price scenario, this strategy will allow you to; capture the futures carry, pick-up the forward points in the currency and hopefully capture stronger basis later in the marketing year.

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Analysis doesn’t support conclusions

We read with note an article recently in the Rural Press entitled “Argument over the Single Desk”. If we are correct, the article draws the conclusion that, to date at least, “growers are not getting the same value for their wheat as they did under the single desk system”.

The analysis took the historical AWB net pool returns for Port Adelaide and then compared this to the $A value of Chicago Board of Trade (CBOT) wheat futures in late November each year. From 1994 to 2008 (dropping out the drought years of 2002 and 2006) the analysis contented that the difference between the net AWB pool returns and the $A value of CBOT wheat futures late in November each year was A$9.50/t in favour of the pool. For 2008 it suggested instead of a premium – on average of $9.50/t – a deficit of A$23.50/t resulted and for 2009 (to date at least) a deficit of A$22.50/t is showing. Using this “crude measure” the conclusion drawn is that in a deregulated market Australian wheat is averaging close to $32/t under the AWB single desk system.

It is simply erroneous to draw any conclusion about deregulation from this analysis. The fact is that physical wheat values in the past few years have not kept their usual relationships (historical basis relationships) with CBOT wheat futures.

A comparison of a range of international wheat cash prices and CBOT wheat futures shows that in recent years there has been a very noticeable divergence in the price of all international wheats vs CBOT.

This is nothing new to market watchers. The US Commodity Futures Trading Commission (CFTC) has held a number of recent enquiries into the lack of convergence between cash wheat prices and CBOT wheat futures. The operators of CBOT have gone to some lengths to change the futures contract specifications (such as variable storage charges and increased delivery locations/methods) in order to aid convergence.

The increase in investment flows, via index funds and other long only funds, are the major reasons for this divergence. At today’s prices, the investment in CBOT wheat futures by long-only type funds is a little over US$6 billion dollars or 33mmt. It is largely the presence of this capital washing around in the futures market that has caused the divergence between global cash wheat values and CBOT wheat futures.

Rather than making reckless claims about the impact of deregulation, we offer an alternative explanation that the divergence between cash wheat prices and CBOT wheat futures is a global phenomenon. The fact that Australian wheat prices have diverged from CBOT has little to do with deregulation of the Australian export wheat market. It has much more to do with the change in shape of the relationship between CBOT wheat futures and global cash wheat values.

What speed should we be doing?

I was out for a Sunday drive last week when I was flagged down for speeding. I have only been pinged for speeding a handful of times in my driving career and generally it is when I get confused about the speed limit.

Sunday was no exception. I smiled ruefully when the policeman showed me the radar recording at 63km/hr, thinking they were red hot, to my dismay he told me I was in a 50km/hr zone – I had absolutely no idea.

Since mid-way through last year I realised that the Chinese Government basically determines what speed it wants its economy to grow at. While it may not be as simple as tapping on the brakes of a car, the Chinese Government has a much greater capacity than most other economies to control its speed.On Friday, the Chinese surprised the market by again hiking the reserve requirement (the amount of money they must set-aside – this effectively limits lending capacity) for its banks. Stock and commodity markets knee-jerked lower in response.

But we now hear that the Chinese economy might have been expanding at even a faster rate than originally thought at near 11%, up from an 8.7% expansion last year. Rebounding exports, up for a second month in January, are now boosting the Chinese economy that relied on its own stimulus-fueled investment and consumption for growth last year. What we are seeing is prudent economic management - this should not pose a threat to global growth.

China supplanted Germany as the world’s biggest exporter last year and is poised to replace Japan as the No. 2 economy behind the US in 2010.

A strong China means a strong Aussie economy – it is no coincidence that both the Aussie and Chinese economy are outperforming growth expectations. As global investors recognise China’s ability to manage its economy, the Australian economy and the $A will again be sought after. The recent dip in the $A relates more to a lack of understanding about China’s capabilities than anything else.

Will the USDA back track on 2009 US corn production number?

Markets don’t like shocks, but that is exactly what they got in mid-January when the USDA increased the size of the 2009 US corn crop when most thought they would trim it. This effectively tipped grain markets over the edge; it was just too difficult to hold hard won gains, given the weight of market fundamental factors working against the market.
But the market chatter is that the USDA may be overestimating the size of the 2009 US corn crop. Even though this may not be a silver bullet for the grain market, it may be a factor in grains winning back some positive sentiment, or at least helping to neutralise current negative market sentiment.

The thrust of the doubters’ argument is that the USDA has not adequately taken into account the amount of ‘shrink’ attached to this year’s crop. This year’s rain interrupted, late harvest, saw higher-than-normal moisture levels in stored corn and this could explain why the USDA crop number was well beyond expectations.

Other elements of doubt cast over the 12 January survey results relate to: the low test weights of this year’s crop, and the large amount of corn that may be damaged due to it being stored under higher moisture. While the later may not have much impact on total production number, it will be interesting to see where this corn might find a home.
US ProFarmer warns that the January USDA survey asked growers to estimate yields adjusting for moisture and test weights, so the January survey should have accounted for survey noise associated with unusually high moisture and unusually low test weights.

It is likely that any changes that the USDA makes to its January estimates will have been more than made up for by an improvement in growing conditions in Sth America. While the Sth American situation will come as no surprise to most traders, the 9 March special USDA corn production update has the potential to surprise the market again.

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The worst type of regulation

My rant this week is about ineffective regulation. In most cases I favour letting the market work. Although this can be messy sometimes - capitalism has stood the test of time as an effective economic system. I understand that some regulation is necessary - like road rules for example.

It is counterproductive regulation that really annoys us. Through the advice provided in our newsletter, under financial services law we are said to be giving general advice on financial products (instruments such as grain futures, swaps and foreign exchange contracts) to retail clients. Because of this we are compelled to hold an Australian Financial Services License (AFSL).

Through our newsletter disclaimer, we warn our readers that the advice provided has been prepared without considering your individual financial position – in the disclaimer we compel readers to seek further advice before acting on our recommendations. We can’t do much more than this as we have in excess of 2,000 subscribers Australia-wide.

For the right to be able to write our newsletter, it costs $30,000-40,000 annually to comply with our AFSL - a good chunk of our annual profit. Under our license conditions we are not allowed to hold client monies or act on behalf of clients and do not receive any commissions from third parties that may affect the advice we provide.

Most of ASIC’s compliance regime is a form filling exercise. And the Financial services legislation has spawned a whole industry of form fillers and box tickers – which charge around $250/hour to help you understand ASIC’s labyrinth of regulation. Submit something to ASIC without the T’s crossed or I’s dotted and you are in trouble, but give shonky advice because someone is paying you a kick-back to make favourable recommendations, and…...

So imagine my dismay last year when I was told that ASIC was not considering any new license applications (for those providing advice on financial products such as derivatives) due to the Global Financial Crisis (GFC). The GFC exposed ASIC’s compliance regime as hopelessly ineffective - through its complaints process it was made aware of potential fraud and/or gross incompetence and they chose to ignore it. But worse still it was essentially using this same flawed regime to prevent new entrants. Go figure.

If we were to provide poor advice, then people would simply stop paying money to subscribe to our newsletter – this is what motivates us to ensure that the advice we provide is prepared to the best of our ability. All ASIC does for our business is deprive us of some profit that we could look at re-investing to provide an even better service. That’s what you call counterproductive regulation.

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