Now it could be that this time is different, but Kansas City July wheat futures at 20 cents under Chicago looks very attractive.
Over the past 5 years, the period when commodity indexes have been very big, the July KC/CBOT spread has never been much below -20 cents (KC discount) and has gone off the board at prices between -20 cents and +100 cents with an average of 30-35 cents premium for KC--which is roughly what the protein premium is worth.
With July KC/CBOT 2011 trading at -20 cents now, what should we do? While the obvious move is to buy the cheap forward KC wheat, the catch is that while May 2010/July 2011 calendar spreads in KC are at (or close to) full carry, with the new VSR for CBOT, the CBOT May 2010/July 2011 could still widen significantly--up to 80 cents more in a worst case for storage fees. So with the front months at current levels, only the CBOT July 11 contract has room to move higher--meaning the spread could go significantly more negative between now and the July 11 delivery.
While I think that going long July 2011 KC at a 20 cent discount to CBOT is a good trade, the problem is that there might be some mark-to-market pain due to CBOT forward pricing going through the roof. The better way to execute on this idea is to maintain a long KC/short CBOT position in the nearby months and receive the pick-up on the carry: KC has the cheapest storage, CBOT will have, by far, the most expensive storage. To see the effect of the movement of the calendar spreads, contrast the May 2010 chart July 2011 chart.
Added to the long KC /short CBOT position today, but not much trading as there was a "back office" issue to sort out. Spreads were being split up with the buys going to one account and the sales to another--not on all of the spreads, but some of the TT executed legged spreads which are executed in a "block" account and then allocated by our clearing broker. They say they'll have it fixed today.
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The logic in avoiding the longer dated spreads is due to the expectation that the higher storage is built into a steeper contango from having it more greatly reflected in farther (further?) months, correct? But IF there continues to be a wide variation between the spot/physical market and the nearby month in CBOT shouldn't a good portion, if not all, the additional storage costs be reflected in the contract nearing delivery?
ReplyDeleteAdditionally, and I apologize if you covered this in a previous post, but is there some expectation that as the VSR begins to be reflected in CBOT that the KC and MGE wheat curves are forced into some "unnaturally" steep contangos to reflect some premium value to CBOT curve, making the implied carry more expensive than is really the case?
On the first point, Gordo, yes the additional storage costs could be reflected in the nearby CBOT contract--that effect should drive the nearby CBOT contract down vs. the distant months and vs. other cheaper-to-store KC and MGE wheat futures.
ReplyDeleteThe second point is interesting too. Since relatively little capital is devoted to trading back months in KC and MGE wheat, those futures could trade at contangos in line with the CBOT despite the different storage rates. I don't expect a huge opportunity here; there aren't limits that would stop commercial players from loading up on spreads that are too wide. While the CBOT has limited holders of "shipping certificates" (technical term for the warehouse receipts that CBOT delivers against futures) to 600 contracts, the other exchanges do not have such constraints. Cargill and ADM would just load up on carry trades on the KC and MGE when they could make 100-200 bp over their cost of financing.
That said, the KC and MGE might trade at levels that allow yields of around 5% for taking delivery and re-tendering for later months.