There are prices we accept in life as absolutes. We accept
that gold is more expensive than silver or that a Mercedes is more than a
Chevrolet. Sometimes, things change. Remember when diesel fuel was cheaper than
gasoline? Not only is diesel more expensive, it has maintained its premium for
more than ten years now. Recently, another market relationship has been called
into question – the relationship between corn and wheat.
Historically, wheat futures trade at a premium to corn
futures. In fact, over the last 40 years, there are only about ten periods
where corn closed at a higher price than wheat. Going through 15,000 days worth
of data, I found that there were a total of 56 trading sessions that corn
closed at a higher price than wheat. This is .0037% of the time. Nineteen of
these closes have occurred this year and fifteen came in 1984. There have been
no instances of this for more than 25 years.
The typical eyeball range for the spread is around $1.50.
Wheat is normally worth about $1.50 more per bushel than corn. The widest this
spread has been is $7.15 in March of 2008. The recent peak was in August of
last year at $3.82. Conversely, when this spread has gone the other way, as it
is currently sitting, the widest we’ve seen it was corn trading $.40 cents over
wheat last month.
I went back through the USDA Acreage and Crop Production
reports from the periods when this spread went negative and found some
similarities between 1984 and 2011. The carry out stocks for the new crop years
were exceptionally tight in both cases. The carry out stocks at the end of the
1983 crop year were lower due to two factors. First of all, fewer acres were
planted in 1983 due to governmentally implemented acreage reduction programs
following record production in 1982. Secondly, crops in 1984 experienced severe
drought conditions, which led to the second smallest harvest in history. In
fact, the 1984 harvest ended up being 49% lower than 1983’s.
We started 2011 back at the same record low stocks to usage
ratio we were at 25 years ago. This year, the governmentally sponsored ethanol
production intends to take 40% of the 2011 crop off of the market and we have
had lousy planting weather on top of that. Combining governmentally driven
demand and lousy weather we begin to see the similarities between the 1984 and
2011 crop years.
The corn and wheat contracts for September delivery are still
trading back and forth of even money. The trading idea is to sell corn at a
higher price than we buy wheat. This strategy will profit as these two markets
return to a more normal trading relationship and wheat begins to rebuild its
premium over corn. This spread has recently traded as far as $.33 cents towards
corn over wheat at the end of June. The highest it has been is $.40.
Calculating the trade on a cash basis, we can determine our
trading parameters. Forty cents is equal to $2,000 per spread position in risk
to a trading account’s value. Conversely, a quick reversion to the spread’s
normal range of $1.00 to $1.50 in wheat over corn would equal a cash value of
$5,000 to $7,500 in trading account profits per spread position. However, as
with the diesel fuel to regular unleaded example, it’s possible that these
market relationships can shift from anomaly to a new normal. Therefore, risk
must always be the first consideration when deciding whether or not a trade is
suitable for your account.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.