The following editorial was published in Price Perceptions issue #1087 on December 7, 1996
Adjusting to a New Environment...
An unusual relationship occurred in wheat spreads this year. Although US and world production increased sharply, the July contract traded higher than September during the delivery month. Again, in September, the spot contract traded well above December. Now, the December contract is repeating the same pattern against March. In past years when all three contracts moved to inversion during the delivery month, it was a sign of shortage and a developing bull market... However, the wheat market experienced an historic bear market year!
Now that a huge corn crop has been harvested and the world is awash in grain, tradition and economics would dictate that December futures trade at a wide discount to March. The cost of storage, insurance, and interest makes holding an inventory of corn for three months worth at least 10 cents. However, December futures traded 3 cents premium to March this week, providing a loss of 13 cents per bushel for inventory holders.
Although soybean prices collapsed this fall as the USDA revealed a larger than expected crop, January futures traded 6 cents above March this week. Whats happening? Has it somehow become profitable to hold an inventory and see its value decline over successive months? Is there a change taking place that justifies this unusual market behavior?
The energy market has worked on a system of inverted markets for years. The oil market began to realize that production capacity was greater than demand in the early Eighties. Market structure changed and nearby futures began to trade at premiums to deferreds... After all, if demand for oil picks up, OPEC will be more than happy to turn on additional pumps and flood the world with oil. This market psyche has been ingrained in the energy structure for years.
Because energy markets reward the user by offering cheaper prices in the future, the industry learned to minimize inventory holdings. After all, who wants to build storage and tie up precious capital to own inventory that will depreciate in value. Management began to look at inventory practices during the mid-Eighties and found they could reduce costs and improve profits by utilizing on time inventory practices. Leading business schools began teaching on time inventory management and the practice has spread to nearly every major industry. It can create problems at times. The auto industry has been forced to shut down assembly lines because a parts maker went on strike. However, it appears that management places greater value on managing inventory than the risk of running out of raw materials.
This management practice has been working its way into grain markets for several years. In the past, grains were primarily a domestic commodity and supply could not be altered to any significant degree by foreign supply and demand. However, following adoption of NAFTA and the World Trade Organization, grain markets have moved into a world market environment. Now, that environment appears to be altering the fundamental makeup of US grain markets.
The value of grain has become much more dependent on future prospects for exports, foreign production, and foreign demand. Foreign soybean crushers now buy hand-to-mouth from the US in anticipation of lower prices next spring when South American crops are harvested. Therefore, while todays price may be high, the promise of cheaper supplies next spring has held down deferred futures.
World buyers were forced to pay higher prices for US wheat last summer, before European and Canadian crops became available. However, US farmers were willing sellers and now US millers are caught short of milling quality wheat. Although supplies are readily available at cheaper prices from Argentina, the fear of a farmer backlash has prevented millers from importing... to date.
Last year, the practice of on time inventory management caught the US feed industry off guard. They failed to see that supplies were going to run out before new crop became available. An unprecedented scramble ensued and corn prices were driven to record highs.
Although the marketplace is still in the process of adjusting to this new environment, the process will provide excellent profit opportunities. When inventories run low, as they have in the energy sector, markets will respond to a much greater degree than in the past.
Traders should maintain keen awareness of industry inventories. When they are low and demand surges unexpectedly, a much stronger advance will be offered than in past years. Also, spread traders will be provided outstanding opportunity through buying nearby and selling deferred contracts when supplies are viewed as burdensome.
The era of buying ahead to avoid future shortage is ending. It is being replaced by management principles that assume risk of future shortage. This will lead to greater volatility in commodity markets and much stronger, but shorter, bull markets. We expect this new era to provide greater opportunity for those who utilize and trade in the commodity arena.
TRADING IN COMMODITY FUTURES OR OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
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