Relative Value Investigation: Day 1

How cheap is wheat? As I looked at the physical market in a couple of locations, it seems that wheat is still 5-15% above the price levels where US livestock producers will have to take a serious look at substituting wheat for corn. Certainly growers are motivated to maximize plantings of other grains than wheat at these levels. The only news reports on substitution concerned a few non-US markets, like the Philippines, with local corn production problems that were importing European wheat for animal feed.

But one news item really caught my eye: it was in the World's Best Rail Journal, featured on a link on this very website. Motiva, a joint venture of Shell and Saudi Aramco, has an ethanol terminal in Providence, RI, and it is exporting ethanol to Europe. Since ethanol has often been vilified as over-priced and generally useless, I was surprised. CME May ethanol is down to 70% of the New York Harbor gasoline contract. Even without a subsidy, ethanol is economically competitive at these levels; this is very cheap ethanol. Further, even with sugar back down below 18 cents/pound, US ethanol is priced competitively with Brazilian ethanol--thus explaining European imports from the US arranged while sugar was north of 20 cents.

So the gist of my thinking is that wheat doesn't have a lot of downside vs corn, but perhaps some. Ethanol production margins could grow, but higher gasoline will eventually start to drive corn. All in all, both wheat and corn are close to the bottom of their potential values vs gasoline. These relationships are too loose for making large leveraged bets where timing is key. However, we should bear in mind that the wheat market is at current levels only because of very high short positions maintained by trend-followers that are accommodating the commodity index longs.

Over the next few months it's very likely we will see grains improve versus gasoline. Whether it is due to short-covering in grains or a sell-off in oil is hard to say.