Tight Ethanol Markets

The Jan Ethanol futures continue to strengthen versus Feb, moving to a full 5 cent/gallon premium. This is a pretty steep backwardation for 1 month on the calendar, though we have seen this kind of action in ethanol for several months now. So far this "squeeze" hasn't been powerful enough to drive ethanol higher relative to corn, but it seems to me that we will likely see that eventually. For the past few months the corn market has been so strong that it is tough for any commodity to outpace it, but if (when) we see a pullback there, the ethanol market may finally outperform.

A similar kind of narrative may also describe the oats market. While oats are close to their highs, there hasn't been the speculative or institutional interest to drive oats to new highs in the way we have seen corn chased higher. With wheat, and especially Spring Wheat, much stronger along with corn and beans, it is hard to make a case for oats "winning" many acres at current prices. So with current stocks allowing Dec10 to trade up to a premium to March11, it seems that tightness will continue. As with ethanol, this should eventually lead to an improvement in the ratio against corn. (While corn inventories may be tight in 6 months, the nearby calendar spread shows little immediate concern.)

Another Bite at the Oats

A month ago I said that I liked long March Oats vs Corn and the ratio moved quickly in favor of the Oats...and then all the way back. So we are getting another chance to buy pretty cheap oats: Oats at or below 62.5% of corn. That's my somewhat arbitrary threshold for cheapness. Certainly, oats can get cheaper--maybe all the way down to 50% of corn. If we saw that the corn market was tight and the oats market well-supplied, perhaps I would wait for more attractive levels. But today we have March/May Oats at 45% of full carry while Corn is 65-70% of full carry. So the Oats market, where Dec futures traded up to 20 cents premium to March, is clearly tighter...

I didn't have a lot of patience with the long July MGEX/ short CBOT--dumped it at the lows below 55 cents premium MGEX. Ugly. Still keeping the long Dec11 MGEX/short KC which is now available at better levels. Also keeping the long ethanol (now Feb) vs short Corn.

MGEX Wheat Dips Vs. CBOT

Considering the smallish positions I have, I got nicked pretty good today. The Dec11 MGEX contract dropped 3-4 cents vs CBOT and nearer futures like July lost 6-7 cents. Ouch. The outright moves were not so large that the "tail hedge" was meaningful--MGEX was only up about a dime.

The ethanol market was a bit kinder to me. The ethanol/corn crush didn't move much my way but the front end on the ethanol market stayed very firm with Jan trading 1.5 cents premium to Feb. So I like how that's shaping up.

I Don't Trade Every Day

And if I'm pretty sure that I'm not going to trade, I don't really follow the markets that much. Right now I have my Long Dec11 MGEX/ Short KC intermarket position (not very large) and I have some long front/short back calendar spreads. Nothing to get excited about.

I also have the Long ethanol/ Short corn position, but that is smallish and meant to be long-term as well. Kind of disappointing that ethanol futures only traded about 300 lots today as the market made new highs, but hopefully that is mostly a holiday season effect.

Same Stuff as Yesterday

Adding Dec11 MGEX vs KC.

Have a good weekend.

Hard to Stay Away from Irresistible Hard Spring Wheat

As much as I would like to sit back and wait for bargains to throw themselves at me, I feel I am missing out if I don't have a trade that I like. In general, I like intermarket spreads in wheat where I short CBOT wheat; Soft Red Winter Wheat has usually traded at something like a 10% discount to Hard Red Spring Wheat due to its lower protein content, but nowadays, CBOT wheat also incurs much higher storage rates due to the exchange's VSR rules.

Right here, I feel that the market has pushed MGEX HRS wheat to a big enough premium so that it's risky to put on a position at the front of the market: March MGEX at 90 cents over CBOT isn't cheap in any obvious way to me--there's no "edge." But if we look out farther on the futures curve, and consider KC wheat, then I think there is a trade. Dec11 MGEX is less than 10 cents over KC. The KCBT has adopted new storage rules (higher rates, especially from July through November) that may well make KC less attractive to hold than MGEX. And 10 cents is below the historical norm anyway.

So, even though there may not be as much volatility farther out on the curve, I feel there is so much less downside that I prefer to be positioned there.

Ethanol Views

I have posted a bunch of comments over at a blog called The Baseline Scenario . The blog was started by former IMF economist Simon Johnson and a grad school partner, so it's not exactly a leftist political blog-- more a centrist economic blog. Anyway, ethanol was mentioned in passing and I posted some comments on the relative merits of ethanol use versus imported crude oil...turns out it's a hot-button issue on any blog.

My impression from the comments there, along with past opinion pieces by economists like Paul Krugman, is that most people see ethanol use as "burning food" and contributing to world hunger. That's about as bad an image as a commodity can get.

Conservatives say they hate ethanol subsidies and Liberals say they hate them just as much. That leaves the Center and the Center isn't too crazy about ethanol either. While the blender credit will be renewed this time around, it may not survive a big, sustained rally in corn.

This is the "wall of worry" that ethanol will climb. With relatively low margins and precious little glamor, the business of ethanol production will struggle to find investors. Production growth will be slow. Producers will cut back quickly if margins turn negative, so prices will, at worst, follow corn.

This is a situation where two commodities are fairly tightly linked, but one is far more popular than the other. I believe that, in general, investor will do better buying the market where there not 500,000 other longs.

Done for the Year?

The recent trend where MGEX has strengthened versus KC and Chicago seems to have ended. I don't any screaming bargains there. I do like buying the March/selling the May in KC and Minneapolis wheat futures. Considering that the outright price still reflects substantially lower inventory levels from a year ago as well as strong global demand and also a not-so-strong dollar, I think buying March KC at almost 9 cents under May is an attractive risk/reward proposition. The downside: a 3 cent loss.

Posting here is going to be spotty through the holidays--especially if these calendar spreads are my only position.

I do also have the small long ethanol/short corn position, so hopefully, I will think of something worthwhile to write about there.

Trades I've missed:

As I noted in a recent post, I've spotted some good trade entries, but left the trades before the party really got going. But I don't lose a lot of sleep over getting out of an intermarket wheat spread too soon. I do kick myself for not buying MGEX seats more aggressively. The idea of buying cheap MGEX seats has been in the slogan box on this blog page since March. Being cautious in a falling market is fine. But missing the last two trades at $95K and 105K was not good.

I guess it's still 110K offered so there's not much harm done; but that's 15% higher than a month ago when the broader equities markets haven't moved all that much...

Apparently No Capacity Here for Long-Term Positions

Back after a week and I have none of the "long-term" positions that I put on back on November 29. All were winners right from the start and none have really stopped. So why am I flat?

Fear, mostly. Two of the three positions involved being short corn. The third, long March MGEX wheat/ short KC Wheat has added about 20 cents in 5 sessions; so while it's looking great, if the premise of the trade was a limited downside from 10 cents premium MGEX, there is now a lot more risk. With a USDA report due out, I don't really want either the short corn exposures or the newly hefty MGEX premium exposures.

One new position added today, on the smallest scale: long Jan Ethanol/ short corn. Ethanol calendars spreads have been in backwardation for most of the last few months, so I think the current inventories would have to be described as fairly tight. And these are the lowest ethanol crush levels in months. With sugar in the stratosphere and gasoline going on the up elevator with crude, it seems like ethanol could perform very well with any positive news at all.

Small Positions for the Vacation

I am taking a one week break.

I will take just a long March MGEX/short KC position with me (with a bit of tail hedge to protect against a further wheat rally). And a bunch of long March/short May calendar spreads in wheat, corn and oats.

I did not hold any December Oats into the Notice period, which of course, I regret. But oats was not the only futures market to see a spike in futures rolling off--there were moves in copper, coffee, gold...very interesting. Once the financial longs have done their rolls, supplies start to look a lot tighter.

KCBT Changing Wheat Contract Specs Starting September 2011

In a move that is intended to narrow the cash/futures basis, the KCBT will raise the "storage" rate for shipping certificates beginning next September. Additionally, they added a protein content requirement and lowered allowable vomitoxin levels.

I don't think these measures are certain to succeed. Raising the storage rate to 9 cents/month from July through December will help (up to 6 cents Jan-June), but it's not enough to change the current dynamic. If grains continue to rally, and I think commodities generally will, there will be increased interest from financial participants that will tend to push the futures higher than the cash markets.

To solve the convergence problem, the exchanges need to have huge penalties for deferring delivery (the CBOT is getting there) or adopt the MGEX contracts for settlement to a cash index. When you can't force anyone to take delivery and don't penalize them for deferral, there will be a strong tendency to very wide cash/futures basis.