Collapse in spread the right medicine

The wheat market is sick. At the end of this year, the wheat stocks to use ratio is forecast to be around 30%. In the old days, the stocks to use rule of thumb was that anything under 20% was considered bullish for prices and anything over 30% was considered bearish. In reality, with improvements in global trade and logistics, this peg has probably moved down a few percentage points.

Anyway you look at it, the wheat market is sick and needs some quick medicine to get it better. Last week, traders prescribed some medicine, slashing global wheat values by 30USc/bu or around 6%. The aim being to make wheat more competitive with corn and encourage increased wheat demand (as feeders witch from corn to wheat).

Another way for wheat to become more competitive - from a feeding perspective - is for corn prices to rise. China announced further purchases of US corn last week to bring the total of reported sales so far this year to nearly 500,000t. The threat of imports has so far failed to bring down Chinese corn prices. Analysts are now forecasting that Chinese corn imports from the US could be between 1-6mmt this year.

The impact of Chinese corn imports is two-fold. The first is psychological. Anyone short of corn (from end users to funds who expect prices to continue decreasing) start to become nervous, question their market view and possibly reverse their positions. Secondly, Chinese corn imports will tighten the corn balance sheet (currently 2010/11 end stocks to use are forecast at around 18%), reduce the margin of error for 2010/11 crops. Corn prices held last week, despite heavy pressure from outside markets (stronger $US, lower crude oil prices and global growth concerns).

Our thinking is that with strong prospects for another massive US corn crop, corn fundamentals alone will not be enough to sustain higher corn values, notwithstanding larger than expected Chinese corn imports. If Chinese coarse grain buying changes grain market psychology, and leads grain prices spiking higher, we will take this opportunity to commence hedging.

Last week’s action has dramatically altered the wheat/corn spread. The Chicago Board of Trade (CBOT) futures spread collapsed by 22% in just the one week and is now threatening long-term support just above 100USc/bu. In parts of the US (Texas/Oklahoma) wheat is now trading on a par with corn in physical cash grain markets. The narrowing in this spread is the market trying to heal the wheat supply imbalance. The medicine may not taste to good, but should lead to a quick and full recovery.

Better week for grains

While most eyes in WA remain firmly focussed on the skies, the grain market has made a few tentative steps forward over the past fortnight. Since bottoming in early April, wheat swaps (our preferred hedging instrument) have recovered $20/t to around $226/t.

The recovery was sparked by news that China was buying US corn. Reports continue of corn sales out of Government stocks to key corn production areas. If the Chinese Government runs out of corn this could lead to further buying out of the US – this would be a huge fundamental boost for the market.

The biggest catalyst however was the divergence in movements in the $A from those of the grains market. For the past couple of years movements in $A have essentially mirrored grain price movements. Last week though, as global equity markets got the jitters, the $A came under pressure and money began to flow of out equities and into wheat and corn.

All we need now is for some sort of production issue to spark the market to a higher level. It is unlikely that the cold weather forecast for the US this week while cause much damage and rain across Europe seems to have alleviated concerns about spring crops. Dryness in WA doesn’t seem to have hit the radar screens of international grain traders yet, but if it extends into June it will.

There are two important reports scheduled for release this week; Canadian 31st March grain stocks and the USDA’s first attempt at forecasting 2010/11 crops. It is unlikely these reports will bring much joy. However, if the market can withstand these and then find a production issue or two and some ongoing Chinese demand for corn, wheat swaps might be a chance of advancing from current levels.

Those in safe production areas, should consider hedging wheat at swap levels better than $230/t. Average yields this year will see grain stocks again increase. Combined with a large carryover from last year, this means that we need to be defensive with our 2010 hedging programs. With swaps in place we can wait for the market to find better basis levels to enhance our returns.

Facing the harsh reality

With wheat stocks bulging and another large crop on the way, it looks like it is going to take something from outside the wheat complex to turn the weaker price trend around. The usual suspects would appear to be (in no particular order): corn, oilseeds, the $A or renewed fund buying. So what is the prospect of any of the usual suspects coming to the rescue of wheat this year?

Corn is often watched for its impact on wheat. Once wheat falls to within about 60USc/bu of corn, it is economic to substitute wheat for corn in feeding rations. The amount of corn fed to livestock globally is enormous and a moderate amount of substitution can dramatically alter the wheat demand landscape. However, currently the wheat/corn spread is +130USc/bu so something would have to alter dramatically with either wheat or corn prices to bring this into play.

Talk of China buying US corn has raised the possibility of an upside breakout in corn values. However, working against this is the rapid pace of US corn plantings and the mounting prospects of larger than anticipated plantings (normally US growers will keep planting corn until the optimal planting window closes) and record yields – put bluntly we are facing another monster corn crop squarely in the face.

There are also question marks about whether China will actually go through with US corn imports. US ProFarmer believes they are using the threat of US corn imports to ratchet down local corn prices and make Government held corn stocks look more attractive. Also with lower numbers of livestock on feed, the prospect of a medium term surge in demand from the livestock feeding sector appears unlikely.

The oilseed complex could be another source of market support for wheat. Strong demand from China and rising demand for oilseeds to crush for bio-diesel have helped the oilseed complex cope with rising supplies. Higher oilseed prices relative to cereals in 2010 is sending the market a signal to maintain supply growth to meet rising demand. This should prevent any large scale planting losses to corn. Any losses may be offset by increased oilseed plantings in Canada, Australia and Sth America. The early plant in the US is also boosting yield prospects.

Ironically, another downturn in the global economy could be a left field supporting factor. This would place downward pressure on the $A and may see investment funds again find relative value in soft commodities (as they seek a safe haven refuge from equity markets). But most bets are that the global economy will gradually overcome obstacles such as debt problems in Euro-zone economies and continue to improve on the back of a solid recovery in growth outside of Europe.

So, what does this all mean? In our view any sort of significant rally in wheat prices ($20/t from here) should be viewed as a selling opportunity. Even in a flat price environment, it would be very unusual for the market not to throw up this sort of opportunity in the period prior to our harvest. But be warned, opportunities may be fleeting as global producers view these spikes as an opportunity to offload their long stocks position.