Corn's fundamental foundation

The performance of July soybean meal futures these past two months has been truly epic. The agricultural markets have had significant rallies in the past, but rarely has a single month of a single commodity staged such a significant solo performance. From early April until late May, July meal rallied $151.30/short ton, or 56%. It left July soybeans so far behind that board margins tripled from 57 cents to $1.71/bushel. Even December soybean meal lagged badly as the spread between those two months went from a six dollar carry to a $44 inverse.

There is no shortage of theories as to what caused such an exceptional move. The tendency is to focus on the dramatic, with stories of nine-figure losses at financial firms getting the most attention. Certainly some financial players and some hedge funds were set the wrong way or shorted July Soybean Meal futures too soon, but there is more to the story than that. The fact that all of the long-only index funds still have all of their length in this contract has also helped create a shortage of nearby futures.

However, I think there was more of a fundamental foundation for this move than many of us appreciated at the start. Global protein demand is exceeding all but the most optimistic projections for this year. Lower energy prices are creating more disposable income, allowing many emerging and developing countries to see meaningful improvements in their diets. Also, as we learned in the fall of 2014, there is little slack in crush capacity in the Americas and any disruption can cause far reaching price changes.

Brazil and Argentina had put together a string of monthly crush and export records in late 2015 and early 2016. Then record April rains in Argentina caused harvest and transportation problems. The Argentine crush rate that month was equal to the slowest April in six years and was 700K MT below last year. The impact of that slow down was felt in Europe in May. Europe’s cash market spread from May to December went from even money to a $21 inverse in ten days.

Further evidence of the capacity limitations was found in the United States where the domestic and export basis levels were surprisingly steady throughout the $1.14/bushel rally in board crush. If the move in the futures market was completely artificial, cash market weakness would have been quick to appear. End We Know Agriculture users have been the biggest shorts in the meal market and they have started to buy futures on this break.

The feature in the corn market during May was the tightness of the cash markets in both Brazil and Argentina. Brazil exported too much corn early in the crop year and a drought has now reduced their safrinha crop by 5-7 million metric tons (MMT). There are reports of animals starving, their domestic market is above that of the United States, and they have been forced to import corn, primarily from Argentina.

Argentina has also suffered weather problems and appears to have over-committed as well. Their April rains have forced farmers to prioritize soybean harvest and trucks of corn for export have traded at the equivalent of 160 over July. It appears likely that they too will be importing corn before their crop year is over.

As a result, the U.S. export window has grown from a few months to all of 2016. Only new crop corn from the Black Sea has a chance to displace the United States as the cheapest seller. With the U.S. corn crop off to an excellent start it is shaping up to be a year where a large supply will be met by excellent demand. Feed wheat, which is now well priced in the Plains, Europe and Asia, will help keep a lid on prices.

Virtually every major wheat crop in the northern hemisphere is on track for trend or better yields. The only risks for the wheat market are the rainy patterns in the United States and France. Fortunately, both are forecast to dry out in time for the main harvest. The United States is producing a bigger crop than last year on five million fewer acres. As a result, both HRW and SRW spreads have widened considerably to make storing those crops attractive. HRW has also done a good job of making itself competitive with corn as a feed ingredient for cattle. Not only has the KWNCN, (Kansas City wheat versus Chicago corn), spread gone from 132 to 42 in two months, the HRW basis is also historically cheap. On a per pound basis local wheat is priced at 90-95% of rail corn.

Looking ahead we see a multi-year impact from the current South American corn situation. Because of the Brazilian cash market and the Argentine tax structure, farmers in those countries are looking at a soybean:corn ratio of 1.5:1, not the 2.5:1 seen in the futures market. If these economics persist through fall planting we’ll we know agriculture see a major acreage shift in favor of corn. We feel the futures market has a job to do to prevent a shortage of soybean acres in the Americas next fall and spring. We anticipate this theme to play a prominent role in how we manage our client’s investments over the next six to nine months.