What If There Is an Actual Bull Market in Wheat?

We'll cross that bridge when we come to it. While the COT report from the CFTC will likely show a continued drop in managed-money shorts (and rise in commercial shorts), that is still just a bear-market rally. Right now, we are not going to fight the tape. We've closed out the intermarket wheat spreads that would be pressured by a rally.

Today I added exposure to "full carry" July10/July11 spreads on the KCBT by liquidating most of an offsetting July10/July11 spread on the MGE. Full carry for a year on the KCBT should be about 6 cents/bushel less than MGE due to lower exchange-defined storage charges- 4.5 cents/month on the KC vs 5 cents/months at MGE. The KCBT July10/July11 has been trading about 3-5 cents wider than MGE, so we have had a position in KC vs MGE on that spread, betting that the MGE would reach full carry and go out to a wider, steeper contango than KC. By taking off the MGE spreads today, we are left with just a long July10/short July11 KC spread. This is priced to yield around 3% on cash and should benefit from any perceived tightening of supply.

Not Exactly Warren Buffett

About 48 hours after peak conviction that MGE wheat and KC wheat would continue ever higher vs the CBOT, I ditched the entire position. Here's why: trend-followers still have more CBOT shorts to cover (likely if wheat trades up another 20 cents); Chinese buyers taking US corn; commodities generally behaving very positively (no significant reaction to Eurozone economic worries).

I ran through the reasons wheat would underperform other grains a few days ago. The major reason is that the strong USD would hurt exports, leaving piles of inventory. But recent exports numbers were OK. Corn and beans still have much tighter inventory situations, but wheat has drawn in the most short positions. Going to flat on intermarket wheat spreads may have been an over-reaction to today's China news in corn. But at our current scale of operations we have the ability to be nimble, so we may as well take advantage.

We did add some KC July/July11 wheat spreads at full carry. We can take delivery and earn 3% after fees for a year. Maybe 3.2% if I can get the broker to waive the delivery fees.

Out of Town

Missed all but the last couple minutes of trading. There wasn't anything compelling in those 120 seconds, though I did look at adding calendar spreads on the CBOT: short July11/ long Dec11.

Ed's World is a good blog that applies academic finance to actual farm situations to devise marketing and hedging strategies for grain producers. As you can see from the link, even Ed was not aware of the VSR regime and the impact it has on longer-dated futures. In an unGoldmanlike gesture, I posted a link to the CBOT's new rules in the comments.

You Can Feel the Open Interest Shrinking

Ok, maybe not feel it shrinking, but there were no signs of any new appetite for risk in the wheat futures today. The outright prices consolidated after yesterday's tumble. Calendar spreads were unchanged. Intermarket spreads pretty steady too.

We have sold out a quarter of our core hard wheat longs against soft wheat shorts as MGE July has rallied from last week's 28 cent premium to CBOT to around 38 cents premium today. I believe it has further to go, but the smaller position gives us flexibility to re-position on pull-backs and to add calendar spreads that will also perform better in down markets.

One particular area on the calendar that I am watching is July11/Dec11 CBOT wheat. Overall, the CBOT is priced for 1 bump up in VSR that will occur in July10 and no further increases at all--in fact, the CBOT is pricing a drop back to current storage rates from May11 through Dec11. The implication is that the current surplus will be significantly reduced over the next 12 months and that the commodity index longs will not cause a distortion to a fairly balanced market. Both assumptions are looking heroic at the moment.

Ethanol has been slowly appreciating against corn for a few days. The "ethanol crush" is still not good for producers and I still like our long ethanol/short corn position. There are some clouds on the horizon, though; gasoline's rally has fizzled and sugar has lost 10% since we put on our trade.

No CBOT Short Covering Today

Today's wheat market was a demonstration of what happens when there is no short-covering to drive the CBOT: Wheat heads toward 1.3:1 against Corn; CBOT drops a few cents more than MGE and KC; and the CBOT spreads go to steeper contangos.

The US must export a significant amount of its annual wheat crop and current US prices are not competitive on world markets. Wheat has the worst prospects of the major grain markets; soybeans are in backwardation July/November on tight supplies, and corn has good demand from ethanol and the potential for significant Chinese demand. I expect wheat futures to continue to underperform other commodities as US wheat inventories prove difficult to shift.

We're Back in the Front

As I indicated yesterday, the prospects for steeper CBOT contango in wheat has driven me back to the front end of the market in the intermarket wheat spreads. We want to be short CBOT wheat futures, and it's primarily because the deferred months are too high compared to MGE and KC deferred months. But that doesn't mean we need to have our position in the deferred months; we can pick up the benefit on the futures rolls as we go.

I still think the market is underestimating the impact of VSR on CBOT calendar spreads- the July10/July11 spread which has widened from 60 cents to $1 over the past 5 months could be on its way to $1.20-$1.40. We don't have a position in it, but I want to avoid being on the wrong side of it.

MGEX News

The Minneapolis Grain Exchange is going to have a vote in May on changing status from Minnesota non-profit to Delaware corporation. Initially this will allow for distributions to members, but more significantly, would greatly facilitate a sale/merger.

No significant position updates. We "earned" about 33-34 cents to roll our KC vs CBOT position forward from July10 to July11. With the flatter CBOT contango, that roll is only worth about 30 cents now. And while being out a year forward has reduced the volatility of our intermarket spread position, I am less comfortable with the forward CBOT short as that contango flattens. I think it is virtually certain that the VSR will push CBOT rolls for the period July10 to July11 to at least 17.5 cents more than KC and highly likely that the rolls end up costing at least 35 cents more on the CBOT than the KCBT. So I am going to roll that intermarket spread back to the front month around current levels.

Ouch!

The things we own fell, the things we're short rose.

The money-manager short CBOT positions peaked around the end of March--at the recent bottom of the wheat market. For the last three weeks, trend-followers have been covering their shorts in fits and starts and today was one of those days. MGE and KC were weighed down because fantastic growing conditions and a stronger USD will lead to a very large US wheat surplus. The CBOT wheat contract was more driven by rallies in other commodities: soybeans, corn, gold, oil...

The hard wheat/soft wheat intermarket spread got crunched in by the most we've seen in the last couple of months: July MGE/CBOT dropped by 5 cents and KC/CBOT by a good 3 cents. We were marginally less hurt because we are positioned out in July 11 and the CBOT contango flattened by a penny or so. We did not add to our strategic position because it's already big enough. We didn't daytrade because I wasn't aggressive enough trying to short the hard wheats against the CBOT early in the day.

It would be nice to say that this is the end of this move, but my estimate is that only 40-50% of the money-manager shorts have been covered. So there could well be more. While I haven't been particularly bearish on wheat while putting on our position, our performance is definitely better on down days in wheat. In the long run, I believe that the intermarket spread values will be driven by relative storage costs and relative value of the protein content whether wheat is $4/bushel or $6/bushel.

Let's Call It a "Day Off"

Due to a Trading Technologies upgrade, I had to manually reset a number of account settings, so I got off to a very late start.

As the wheat futures returned to pre-Goldman-sell-off levels, there was little movement in the intermarket wheat spreads--MGE and KC stayed relatively firm. This may indicate that there was no further liquidation by money-manager shorts. However, further rises may well force these players to cover their CBOT shorts and squeeze the MGE and KC premiums.

Formulating Strategery

We have the strategic positions we want: long hard wheat(MGE and KC) vs short soft wheat (CBOT). The levels are attractive on a historical basis and we have an upcoming event--the new Variable Storage Rate regime at the CBOT-- to help drive valuations in our favor.

In addition to intermarket wheat spreads, we will look to actively trade calendar spreads on MGE and KC on an intra-day basis. While the CBOT calendar spreads should continue to be quite volatile, the smaller exchanges still have their fixed storage rates and have traded out to full carry (or very close). So the July 10/ July 11 period in MGE and KC spreads offer a chance to bet on a tightening of supply with very little or no downside. This isn't my idea for a strategic position, but rather indicates that I will enter short term positions on the side with the more limited risk.

The Worst of All Possible Wheat Worlds--Continued

Liquidation across commodities means trend-followers have to buy wheat futures. As usual the CBOT ramps up more quickly than MGE or KC...compressing the hard wheat premiums.

No evidence anywhere of improvement in the actual market for wheat. In fact, the stronger USD will eventually pressure wheat futures here as US wheat is still not very competitive on world markets. Also, the KFC Double-Down could indicate a drop in wheat demand. Then again, maybe Wendy's will counter with a "bread bowl" for their chili...

We are up around 40 cents from the recent lows in wheat and that has squeezed the front month MGE premium down by about 8 cents and the KC premium down by about 6 cents. All in all, not too surprising on such a rally and the rally may not be finished. While I am very confident in our July 11 long hard wheat/ short soft wheat position, I don't see it moving in our favor anytime soon.

Not Enough Noise

When I started trading wheat futures in March, my plan was three pronged: 1) make money on storage and perhaps on trading around commodity index rolls; 2) make money on strategic positions-focused on situations where commodity index investment has caused distortions in intermarket wheat futures spreads; and 3) make money by "jobbing" or "scalping" spreads on the less liquid MGE and KC exchanges on a daily basis.

The #1 and #2 ideas still seem sound, but #3 has been a disappointment. There are a few challenges to making money from taking advantage of "noise": Fast market execution, correlation with overall market direction, and expense. I think there are adjustments I can make to limit the poor executions in fast markets. And the expenses are not prohibitive if we can be right; expenses are only 1 tick for a round turn on a spread (4 sides).

The major problem with trading intra-day has been that the intermarket spreads and the calendar spreads are behaving as straightforward bull or bear spreads. To be right on the spread, one has to be right on the overall direction of the market. There isn't enough trading range on the spreads to allow any wiggling out if the overall direction works against the spread position.

For now, I will continue to explore intra-day opportunities on the intermarket wheat spreads, but I am not going to force it--trade just for the sake trading something.

Bargain Basement Ethanol

Aside from buying hard wheat at a discount to soft in the July and Dec11 futures contracts, my next favorite trade over the last weeks has been buying ethanol vs gasoline. This hasn't worked out so far and I find I don't have the stomach for it. More technically, the correlation is very loose and the trade may have a more volatile downside than I can comfortably afford. You can't do it very small; each gasoline contract is worth about $100,000.
So I've switched the exposure to long ethanol/ short corn. This has a tighter, more highly correlated recent history and is also attractive on a relative value basis. That ethanol is one unloved commodity.

No new developments in wheat today.

The Worst of All Possible Wheat Worlds

Ok, maybe not that bad...
The thing is that wheat rallied--CBOT leading the way, squeezing the hard wheat premiums back down--but the CBOT contango didn't flatten. So the CBOT rally was felt all the way out through our deferred positions a year forward.

Exactly what I didn't want to happen. The talk on the farmers' websites is still about how to store all the wheat inventory and how wheat in storage will displace soybean and corn stocks because the wheat futures are paying so much more for the storage space. So while I hope the KC and MGE will regain their intermarket premiums to CBOT, I don't expect that the CBOT contango will flatten anytime soon.

Gravity Too Much for Wheat

With the USD lower this morning, wheat started the day up 2%, much as it did on Friday, but again, the market for wheat was pulled inexorably back toward unchanged. There was nothing notable about the intermarket wheat spreads--all stayed within recent ranges. The May/July CBOT wheat spread moved by about 3 ticks tighter (less contango) as speculative shorts and commercials raced to accommodate the "Goldman roll." More deferred calendar spreads did not react.

I decided to make a further bet on ethanol; this time against corn. While there isn't much protection long ethanol/ short gasoline--gasoline could always spike, there is a bottom on the ethanol/corn crush spread. We are within a few cents of the smallest premium for ethanol over corn in over a year. (CME defines the spread simply as Ethanol- (Corn/2.8) to reflect the 2.8 gallons of ethanol from a bushel of corn. Of course variations in energy prices can be important, but on the scale of about $1 move in nat gas= 10 cents/gallon on the ethanol production costs.)The margins are down where ethanol production isn't worth the trouble--yet ethanol remains very cheap vs gasoline.
I took delivery of April ethanol after buying it around 3 cents under May. I also bought May around 3 cents under June, but flipped the May back out today at 1.9 cents under June--so maybe the inventory situation in the ethanol market is tightening up a bit.

Recipe for Disaster

Let's say the cash wheat market rallies 20% in the next year. That would make all the index longs happy, right? Sadly, that may not be enough to put them in the black. The CBOT is pricing in a carry over the next year at well over 20% and it could end up in the 25-30% area. Ouch. The wheat market may move higher and non-commercials may cover at higher levels, but it's hard to see how this will work out well for the indexer's long wheat positions.

The problem they face is that they own futures covering approximately the entire current (large) inventory of wheat in the USA. Wheat usually costs 15-20% annually to store, but, with VSR, the CBOT has made it much harder to accommodate the index funds. The cost for storage is going to rise, but there are also new limits on inventory holdings at exchange warehouses. Market participants will be limited to 600 lots each in exchange warehouses; anything over must be "loaded out." This limit could put downward pressure on the delivery month, or push the spreads to wider contangos, or both.

The people who constructed commodity indexes have tried to mitigate this rollover problem by weighting commodities by liquidity (which makes no sense from an investment return point of view). But they have always kind of fudged the issue; wheat futures don't represent all wheat, they represent a particular variety and grade delivered to a particular place. Compared to the actual market for soft red winter wheat, the index positions are wildly disproportionate. I think we will see the effects by July.

Losing Patience

After a couple of days where wheat rallied and premiums for hard wheat slipped, wheat fell along with other grains and the premiums for hard wheat began to strengthen again. While I am still concerned about CBOT short-covering, as I short CBOT against KC and MGE, I think it is worth putting on at least some position in the deferred, July11 KC vs CBOT and MGE vs CBOT. I am a little more confident than I was last month on the behavior of the CBOT contango; while a CBOT rally may shrink the premiums for hard wheat, it may also shrink the CBOT contango, leaving the July11 intermarket wheat spreads relatively unaffected by this short-covering rally.
A big factor in this tactical shift is that buying nearby MGE at 32 over is fundamentally less attractive than last month's 12 over. Same with nearby KC at 17 over as opposed to 5-7 over. In contrast, the July11 MGE and KC are still at good discounts to CBOT.

Wheat Rallies with Typical Knock-On Effects

Price action in wheat continued higher today, this time led by the CBOT. The MGE and KC contracts have dropped from 38 and 20 cents premium just yesterday to 31.5 and 15.5, respectively. The contango for CBOT wheat flattened slightly: July10/July11 dropped to 101.50 from 103.50 .

We are still flat on the intermarket MGE and KC wheat vs CBOT wheat. I am really just looking for a place to re-establish a long hard (MGE or KC) vs short soft (CBOT) position. As wheat rallies, we should continue to see better opportunities.

Good Idea Meets Bad Execution

For the past few days I have been highlighting the growing possibility of a rally in grains, particularly wheat, driven by short-covering from trend-followers. And when that rally came today, we got run over. The market hit stops during the first hour that caught us and our Leg-O-Matic Spreader for something like 6-8 cents (24-32 ticks) on both intermarket KC vs. CBOT wheat futures and on calendar spread orders just on the CBOT wheat. Just awful really.

Another complicating aspect was the talk (which I haven't confirmed) that DB's Agriculture ETF would be re-weighting toward KC wheat and away from CBOT wheat due to the effect of the VSR (variable storage rates) pushing CBOT to ever-larger contangos. In the grand scheme of things, DB's move isn't so important--maybe 5,000 of the net 170,000 commodity index wheat longs moving to the KCBT contract; less than 1.5% of the CBOT open interest. But, of course, in the short term, that's big news. May KC wheat jumped to 20 cents over CBOT. And KC wheat outperformed on a day when we would expect the CBOT, which has a much bigger short interest from trend-followers, to have narrowed its discount to KC.

So we daytraded a bunch of intermarket spreads for a loss on a day when the volatility should have enabled us to make some decent margins. The only bright spot may have been that the distant calendar spreads (especially CBOT) continue to go to steeper contangos. We bought July10/ sold July 11 CBOT wheat at over 103 cents;with fully carry on the KC wheat inside of 70 cents, we would like to pick up about 35 cents rolling forward a July KC/ July CBOT intermarket spread. So, with July KC/ CBOT around 15-17 cents premium KC today, we could still develop a position a year forward with July KC at close to 20 cents under CBOT.

It's like an electronic farm: we plant the KC seeds at 20 cents under today, and we harvest them next year at 20 cents over...This is an attractive trade I have discussed previously, with the main concern being mark-to-market in the event that CBOT spreads continue toward super-contango.

General View on Grains

The CFTC COT report tells a story about the grains that is consistent with my previous ramble about the relative value of grains and energy. Over the past several weeks there has been little change in the positions of the commodity index investors. What has changed is how the markets have accommodated this interest.

As grain markets have moved lower, we see that commercials net bought over 30,000 corn contracts with speculators taking the other side. Similarly in wheat, where commercials and specs have both been short to accommodate the perma-long index positions, the weighting has shifted increasingly to the spec shorts.

By contrast, in energy we see that the commercial sellers have to accommodate both a large index long position and a large speculative long position. Prices have to be very high to induce this scale of selling (hedging) from energy producers. While it may seem obvious that energy companies should be happy to sell $75-85 oil, in fact, there is a lot of pressure from equity analysts and equity investors to minimize energy companies' hedging to the bare minimum ( 6-9 months of capex locked-in at most). Hedging profits are always seen as one-time gains, while hedging losses are criticized as "wrong-way bets."

So, in grains we see trend-followers selling to longer-term "investors," while in energy the trend-followers have piled in, buying at prices that even reluctant hedgers cannot resist. Could the managed-money crowd win on these trades? Sure: Middle East instability, Nigerian unrest, Russian assertiveness, Chinese demand-- all could push oil higher. Record crops, exports from India, a strong USD, and expensive storage-- all could push grains lower. The point is, at these prices, the markets are already pricing in very bullish news for oil and none at all for grains.

Anyway, that analysis is not only why we lost money on the long ethanol/short gasoline trade, but also why we've missed the last 5 cents on the Hard Wheat vs Soft Wheat spreads. As wheat has made new lows, the premium for May MGE reached 37 cents and KC hit about 18 cents. They could go higher. My fear is that when the spec shorts cover, primarily the Soft Wheat CBOT contract, the premiums will get crunched back down by 10-15 cents. We can wait.

On a somewhat different topic, I bought April/sold May Ethanol at 3 cents premium May. My calculation is that it will cost me about 2.4 cents to carry. Those are big ticks ($290/cent/contract) so hopefully I will pocket $174 for my trouble. That would be on a $44,100 investment: 39 basis points for a month, or 4.78 annualized--we'll see how it goes.

Next Update Easter Monday