Puzzling over the Cash Basis Levels

I've been aware of the very weak Hard Winter Wheat cash price for a while. As people often do, I was content to ignore it--in part because it didn't fit my already-in-progress trading strategy. I'm still not sure how to interpret it.
The cash basis for Soft Winter Wheat was very weak for years (which is why the CBOT instituted the VSR regime), and it was primarily a signal that the futures had become unhinged from the cash market. In other words, the weak basis was the result of a futures market that was able to climb ever higher--the weak basis was not a signal to sell the related futures.
Now we have a situation where the KC wheat contract is the cheapest place to carry wheat inventory. The KC calendar spreads are at full carry for as far out as they are listed-several crop cycles. Is KC going to experience the same weak cash basis as the CBOT before VSR? The cash basis for Soft Winter Wheat is now about 57 cents under July CBOT, while cash Hard Winter Wheat is about $1.08 under July KC.
I don't think that's exactly what's going on. But this KC basis is creating some interesting situations. For example, the big discount for cash wheat means that cash Hard Winter Wheat is already down to 1.15X cash corn. There shouldn't be a whole lot of downside from there. The MGE has contracts for cash indexes on all the major wheat markets and corn and beans, but the only contract that trades is the index on Soft Winter Wheat (due to last year's big basis swings).
I'm continuing to investigate...

Leaving the Party ...Again

It is easy to get complacent sitting with a winning position. It's also easy to exit a good trade and fail to get back in....

Wheat rallied about 2% today; nothing special in the context of the sharper weaker USD and strong equities and commodities across the board. The hard wheat vs soft wheat premiums stayed close to the highest levels of the year and we took the opportunity to reduce risk. We closed out most of our calendar spreads and all the hard vs soft wheat spreads.

I rejiggered our intermarket exposure so that we have a long MGE/short KC position in July10. Recently, I have kept to MGE for long hard wheat exposure because I don't really understand why the cash basis for Hard Red Winter Wheat (KC) is so weak. The index of hard winter wheat (published by DTN) is over 20 cents below the cash soft winter wheat index and over $1 below the July KC futures. I'm not saying the cash basis is a leading indicator of intermarket futures spreads, but such a large basis has a very negative impact on hedgers and will attract some notice...

Wheat Still Pinned to the Floor

Outright July CBOT wheat edged up about a penny today, but lost ground against MGE wheat, KC wheat, corn and just about everything else in the commodities world. We cut back our risk on intermarket MGE vs CBOT because the levels are pretty good: July MGE is about 47+ cents over CBOT.
As we look out on the forward curve, July11 MGE vs CBOT is much less volatile than July10-and much cheaper. Since March 1, the July11 intermarket spread has rallied from -10 cents to today's high of +5 cents, while July10 has gone from +10 to +47. The difference is that July10/July11 calendar spreads on MGE haven't moved much from 65 prem July11, while CBOT July10/July 11 has gone from about 88 cents premium July11 to 112 premium.
While I think the long-term average premium for MGE over CBOT is not too far from current July10 47 cents levels, we can remain comfortably long MGE as long as forward MGE is very cheap (like close to even) compared to CBOT and, crucially, the CBOT contango can be relied upon to be firm. As July10/July11 CBOT steepens to 120 and beyond, we will have to get more cautious, since it will pay to move wheat out of CBOT elevators and into cheaper storage and the contango will no longer be a one-way trade.

No Miracle Close Here...

Strong USD, higher interest rates, good weather...nothing remotely bullish for wheat in today's news. After holding KC July10/July11 spreads for some time now at full carry (around 3-3.25% yield with delivery/re-tender), I pitched that position out. Too much risk of higher financing rates, too much much risk of a storage rate change, too long at the price to be considered a bargain.

I put on a new long ethanol/short corn spread. Ethanol margins are back close to 6 month lows--close to breakeven for most producers-so not much incentive to bring on new capacity. At he same time, the calendar spreads for ethanol indicate tighter inventories--the curve is almost flat from July to December. There is a possibility the blend wall (maximum ethanol mix) will be raised from 10% at some point this summer. Even with gasoline down almost 20% in a month, it is still very profitable to blend as much $1.60/gallon ethanol as possible into that gasoline. Since there is a lot of uncertainty around the likelihood and timing of a blend wall increase, I think it will have a very positive impact on ethanol prices should it come to pass. Even if the limit stays at 10%, US corn-based ethanol is still economic vs sugar-based Brazilian product, so exports should continue and imports will be almost nil.

Commercial Buying Here?

Most observers looking at wheat are commenting along the lines of "spec short-covering supports wheat..."--much as I have been. It was a surprise to see in the CFTC COT reportthat it was commercial buying, at least through last Tuesday, supporting the market. In wheat (and corn), speculators were indeed shorting the grains as the USD rose--but commercial interests were covering, reducing their shorts. Hmmm, worth thinking about.
Wheat does continue to slide vs corn; the ratio is down to 1.26:1. Usually substitution is considered economic around 1.15-1.10:1, but some of the corn inventory is very poor and there could be support a little before those levels.

While I am trying to stay open-minded to supporting factors to the CBOT wheat market, we added to our long July MGE/short CBOT position today. CBOT calendar spreads steepened back close to the widest levels yet and I believe that may be a harbinger of new highs on the MGE/CBOT spread.

Fresh Look at the Market

It actually looks a lot like the old market. So we'll start to put on the same sort of trades. Today we bought a little bit of July Minneapolis vs CBOT. We shifted the old Minneapolis vs CBOT to MGE vs KC. Warily, we are looking to get back in. Nothing new enticing in the calendar spreads.
We may get a further steepening of contango on the CBOT at the very front end over the next few weeks: non-commercial players no longer offset much of the index rolls. So the indexers will have to roll against the hard-ball playing commercial longs. Also, the VSR rules change included new limits on financial carries--carrying without "load out"--which may limit the appetite and ability for a relatively small number of commercials to accommodate the index rolls.

Leaving before the Party's Over

We took off 75% of our intermarket risk and 100% of our CBOT calendar spreads. We kept the KC July10/July11 calendar spread which is at full carry.

Unsurprisingly, the wheat market headed lower from the open with all the other commodities and equities...but it didn't go far, and soon enough we were back at unchanged. Buying was strongest in KC and MGE with those markets up 1 or 2 cents for most of the day. Though I try not to predict the unpredictable, i.e. turns in the market, fear (or caution) drove me to cover at attractive, not-at-all painful levels.

We'll take a fresh look at the market tomorrow.