Chapter 16
The Bumpy Truth About Agricultural Markets
In This Chapter
Steering clear of bad trades
Cycling through seasonal crop fluctuations
Keeping track of grains and beans
Understanding other commodity softs
The agricultural markets have staged a resurgence over the last few years, as the use of corn for the manufacture of ethanol has led to price increases and political controversy over the grain’s role in global agriculture. As with most booms, there will eventually be a bust, and the heady gains of the recent past will meet with significant price declines. Still, good trading means that you go with the trend, and because what goes up must come down, when the boom busts, you are likely to get good opportunities to trade these markets on the short side.
During the first 70 years of futures trading, agriculture was dominant given its Japanese origin in the rice markets. However, in the 1980s and 1990s, as the stock market captured the public’s imagination, these markets became the province of insiders, such as grain producers, farmers, and professionals.
Obviously, things have changed as corn trading patterns have recently shown. There are some key factors that are likely to keep these markets near the headlines for a significant portion of the future:
Weather patterns and climate change continue to add volatility and intensity to the grain markets. and Politics center on environmental concerns as well as the use of crops for food or fuel, while are also an important influence.
Fossil-fuel prices are also increasingly influential as they raise the cost of grain production, transportation of grains to markets, and the choices consumers make in their food purchases.
For entry-level futures traders, the most important agricultural contracts are the corn and soybean contracts. They are the most actively traded and quoted agriculture contracts, so I devote much of this chapter to them.
After you gain a basic understanding of the concepts of seasonality and crop cycles and how external factors influence them, adapting to other contracts becomes relatively easy. In addition to the two major grain contracts, I also briefly touch on coffee, sugar, and lumbers futures in this chapter.
Staying Out of Trouble Down on the Farm
From a real-world economic standpoint, futures contracts in the agricultural markets are important. However, they’re not for the fainthearted because of their volatility, the thinness of trading that sometimes accompanies them, and the dependence of prices on the influence of the weather.
Indeed, trading grains and softs can be very challenging, especially during periods of volatile weather. If recent history is any indication, this will become a rule more than an exception, especially during hurricane season. Softs, by the way, is the name given to a group of commodities that includes cocoa, sugar, cotton, orange juice, and lumber. Here are some characteristics of trading grains and softs that you need to know to stay out of the doghouse and the poorhouse:
Thinly traded contracts: Grain contracts and softs are not traded as much as stock-index or financial contracts, which leaves traders open to the effects of decreased liquidity. Liquidity is an important term referring to the availability of money in the markets. Decreased liquidity, in turn, can lead to wide price swings in short periods of time, which make trading difficult. See Chapters 7 and 8 for information on technical analysis and details on trading gaps.
Low liquidity: A lack of cash in these markets can lead to lots of chart gaps and limit moves.
Before you trade any agricultural futures, you need a refined understanding of the fundamentals of the particular sector and market in which you’re trading. For example, at the very least, you need to know about growing and harvesting seasons, geopolitical risks in the growing area, and how the weather affects the crop. In other words, these contracts are better left for serious and experienced traders because they’re more adept at collecting information, putting it in the proper context, and managing risk. I’m not saying that you shouldn’t trade these markets. I’m just saying that they’re not the best ones to start with. As you gain more experience with the general aspects of futures trading, you’ll be able to do more in these areas.
Corn, soybeans, and other agricultural futures are excellent contracts to allow someone else to trade for you, either through a commodity fund that specializes in these markets or an advisor with a good record who knows what he’s doing.
Agriculture 101: Getting a Handle on the Crop Year
You need to know what the crop year is to be able to understand grain trading. The crop year is the time from one crop to the next. It starts with planting and ends with harvesting. During that time, crops are going through what the U.S. Department of Agriculture and Joint Agricultural Weather facility call the moisture- and temperature-dependent stages of development.
What happens between planting and harvest tends to affect the prices of the crops the most. For example, the weather is a major factor. Drought, flooding, and freezing are the major events. Other external events, such as shipping problems, can also affect delivery at key times, such as when Hurricane Katrina hit the port of New Orleans, from which much of the Midwest’s grain makes its way out of the United States.
Think of the supply of grain brought to market as a rationed situation. By that I mean that although grains are used year round, most of them are replenished only one time during the year. As a result, prices are affected by a combination of current supplies and future supply expectations. The way a grain market perceives future and current supplies and the way that traders predict the effect of internal and external factors on prices is a major set of variables to consider. In other words, in all markets there is a certain fudge factor, or an intangible influence on prices.
Think of it along these terms. In futures markets, as in all markets, perception is as much a part of pricing as reality. The markets are efficient, and that means they react to the information that they have available instantaneously, which leads to short-term price volatility. As with the hog and pig report I discuss in Chapter 15, data in a single quarterly report may be significantly off the mark as slaughter approaches, and thus the reality in any market, grains and softs included, can be different than the original report indicates. So you need to know that markets can retrace major moves as better information becomes available.
As with most other commodities, trading in corn and soybeans is all about supply.
Except during times of extraordinary circumstances, such as dietary fads or major external, political, climactic, or geological events, demand stays within a fairly predictable range. Under normal circumstances, demand fluctuates within certain bands based on the number of people and animals to be fed at any given time. Consequently, the market focuses on anything that affects how much grain will be available to feed them from year to year.
That doesn’t mean that demand isn’t important. For example, the markets are used to a certain amount of demand for soybeans from China every year; however, if China’s weather changes dramatically and its domestic crop suffers, global demand for soybeans will increase, thus having a direct effect on the markets. Assuming that U.S. supply remains stable in a year that China’s weather changes, you’re likely to have an increase in prices caused by the increased demand.
Likewise, if the supply of soybeans is decreased because of a crop plague in the United States — which supplies most of the world’s soybeans — and global demand remains the same, prices are likely to rise.
The situation is similar in virtually all markets; changes in supply tend to affect prices more strongly than changes in demand. See Chapter 13 for more details about how supply rules the markets.
Weathering the highs and lows of weather
Weather has the greatest influence on crops, and significant weather developments affect crop markets. Globally, weather is important in grain and seed markets. Some basic points to keep in mind about the weather include
Spring weather in the United States (or anywhere for that matter) affects planting season. Too much rain can delay planting.
Summer weather affects crop development. Crops need rain to develop appropriately. Droughts play havoc with crop development.
During the North American winter, agricultural market watchers and traders concentrate on the weather in South America because it’s summer there. Likewise, dormant winter wheat in North America needs enough snowfall to protect the crop from winterkill, or freezing because not enough snow is on the ground to insulate the crop.
A wet harvest can cause delays and decrease crop yields.
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Looking for Goldilocks: The key stages of grain development
Prices for grain and soybean futures can move significantly during three key time frames when seasonal and logistical expectations are the result of the cultivation and growing cycles. At these three times of year, weather conditions mustn’t be too hot, too cold, too dry, or too wet. Like Goldilocks and her porridge, conditions have to be “just right” during
Planting season: When it’s time to plant, rainfall is the major influence. Too much rain means a late planting season that can lead to smaller, lower-quality crops, which in turn can lead to higher prices. A wet planting season offers traders an opportunity to trade on the long side.
Pollination or growing season: Rain and heat are the keys when seeds are pollinating and growing. Too much heat and too little rain lead to lower levels of pollination, which again can lead to smaller crops. Cold temperatures and too much water can have the same effect.
Maturation and harvest season: When plants are maturing and harvest is near, too much heat and too much rain can mean poor crops from difficult field conditions and the spread of fungus among crops.
Cataloging Grains and Beans
The grain complex has multiple components, including soybeans, soybean meal, soybean oil, Canola, palm oil, corn, oats, and wheat. I concentrate on the soybean and corn markets because they’re the most heavily traded and offer the best opportunity for small accounts and beginning traders. However, you can apply what you find out about these grains and how these markets work to develop an understanding of other grain markets and to set up strategies.
One caveat is that individual markets have their own subtle sets of parameters, and you’ll have to figure them out as you expand your trading horizons.
The soybean complex
The soybean complex is made up of three separate futures contracts for delivery of soybeans, soybean meal, and soybean oil. Soybeans are legumes, not grains, but they’re traded and cataloged as part of the grain complex. Don’t let this weird stuff confuse you. Markets and traders are efficient, and they look for convenience. Besides, can you imagine somebody on TV talking about legume futures? Egads!
Until 2004, the United States was the largest soybean producer with about a 50 percent market share. Until 1980, the United States held an 80 percent share, but the Carter administration’s grain embargo, a political maneuver in 1980 that was designed to protest the Russian invasion of Afghanistan, cost the U.S. farming industry dearly.
Currently, South America produces most of the other half of the world’s soybeans, with China making up the rest.
Soybeans are the protein source used most by humans and animals around the world. The primary uses of soybeans are for meal for animal feed and oil for human consumption.
Soybean contracts
The soybean contract trades on the Chicago Board of Trade (CBOT). Here are the particulars of a soybean contract:
Contract: A contract is 5,000 bushels, and prices for soybeans are quoted in dollars and cents per bushel.
Valuation: A 1-cent move in the price of soybeans is worth $50 per contract, with daily price movements shifting as much as 50 cents per day.
Limits: Trading limits in soybeans are variable based on prevailing market conditions. As of April 2008, the limit was 50 cents per day ($2,500 per contract) with no limits in the spot month.
Margins: As of April 2008, the initial speculative margin requirement was $5,400 per contract, and the maintenance margin requirement was $4,000 per contract.
Soybean meal contracts
Soybean meal (what’s left after the extraction of oil from soybeans) can be fed to cattle, hogs, and poultry. A 60-pound bushel of soybeans yields 48 pounds of meal. Forty percent of U.S. meal production is exported. The rest is used domestically. Here are the particulars of the soybean meal contract:
Contract: A soybean meal contract is 100 short tons (200,000 pounds), with a (short) ton equal to 2,000 pounds. Prices are quoted in dollars and cents per ton.
Valuation: A $1 move in the per-ton price of soybean meal is worth $100 per contract.
Limits: Price movements are limited to $20 per day, which is also variable, again depending on market conditions. If the market closes at the limit, the limit is raised for the next three days to accommodate traders. Although this tactic may seem a bit strange, remember that the role of the futures markets, especially in key commodities such as grains, is to enable commerce to take place — capitalism at its finest. If market conditions are such that limits need to be expanded, the exchanges are more than happy to accommodate the markets.
Margins: As of April 2008, the initial margin requirement was $2,700, and the maintenance margin was $2,000.
Soybean oil contracts
Soybean oil is the third major soybean product for which futures contracts are bought and sold. A bushel of soybeans produces 11 pounds of oil, and soybean oil competes with olive oil and other edible oils. Soybean oil is extracted by a multistep process that involves steaming, pressing, and percolating (similar to brewing coffee) the beans. If you’re really into how soybean oil is extracted, plenty of background info can be found on the Internet. Have at it! Here are the basics of what you need to know:
Contract: A soybean oil contract is 60,000 pounds. Prices are quoted in cents per pounds.
Valuation: Be careful trading soybean oil. A 1-cent move is equal to 100 points, which is worth $600 per contract.
Limits: Trading limits are set at 1 cent, but they can be adjusted because soybean trading can be very volatile due to the weather and other external factors. Thus, trading limits are variable, meaning that they can be changed if prices continue to be very volatile over a period of time. See Chapter 3 for more about trading limits.
Margins: As of April 2008, the initial margin requirement was $2,025, and the maintenance margin requirement was $1,500.
Getting corny
Corn is the most active commodity among grain contracts, and it is the major crop grown in the United States. American farmers grow about 50 percent of the world’s corn supply, and 70 percent of U.S. production is consumed domestically.
Corn futures are known as feed corn, or corn that’s fed to livestock — not the same stuff that you and I eat at summer picnics or find behind the Jolly Green Giant label. Here are the particulars of corn futures:
Contract: A contract holds 5,000 bushels, and a 1/4-cent move is worth $12.50 per contract. Prices are quoted in cents and 1/4 cents.
Limits: The daily limit is 20 cents, or $1,000. There are no limits in the spot month.
Margins: As of April 2008, the initial margin requirement for speculators was $2,025 per contract, and the maintenance margin requirement was $1,500 per contract.
Culling Some Good Fundamental Data
Although charts are the most useful tools for trading futures, getting a grip on the fundamental expectations of price movements in the particular contract you’re trading is important. The fundamentals, of course, are background information, and you need to be aware that even the best guesses can be wrong. The key is to gauge what the expectations are for the market and then find out what prices actually do.
Getting a handle on the reports
You can find plenty of good fundamental information at the USDA’s Web site at www.usda.gov. Here is a good sequence of data and market factors to keep in mind for getting a handle on a market’s supply and demand:
Beginning stocks: The beginning stock is the amount of grain that’s left over from the previous year, as reported by the government.
Production:
Production is the estimated amount of a crop that will be harvested during the current year.
Weekly Weather and Crop Report: The USDA releases a weekly Crop Progress Report that updates the crop and weather conditions. This report usually is released on Wednesday. See the earlier section, “Weathering the highs and lows of weather,” for data included in this key report.
Import data: The United States is a grain exporter, so this data rarely is significant. If that ever changes — permanently or temporarily, the markets will let everyone know.
Total supply: The total supply is the sum of beginning stocks, production, and imports.
Crush: (No, I’m not talking about your favorite orange or grape soda — although a grape soda would taste great right about now.) Crush refers to the amount of demand being exhibited by crushers, or businesses that buy raw soybeans and make them into meal and oil.
Exports: Two export reports are released each week. They are
• Export inspections — released on Monday after the market closes
• Export sales — released on Thursday before the market opens
Currency trends: Trends in the currency markets, especially those of the dollar, can affect export reports.
Seeds and residual: Usually 3 to 4 percent of the crop is held for seeding the next year’s crop. Seeds are important because they’re the next season’s planting stock. Residuals are the portions of soybean oil that are not used in food-related processes. Soybean oil also is used as an additive in pesticides and has biochemical uses, including medications. It’s also used as grain spray to prevent dust from settling on stored crops.
Total demand:
Total demand is the sum of exports, seeds, crush, and the residual figure.
Ending carryover stock: Ending carryover stock is a big number that tends to move the markets. It’s the total supply minus total demand.
Don’t forget the Deliverable Stocks of Grain report
The Deliverable Stocks of Grain report is an interesting report that merits its own section. Every Tuesday the CBOT tallies the number of bushels of corn, wheat, soybeans, and oats stored in elevators that are licensed to deliver grains in relation to trades made on the CBOT.
This report is important because the information contained in it is a good way to determine whether enough grain is in storage for delivery. If not, the market experiences a short squeeze because traders with short positions don’t have any way to make good on their deliveries. They have to buy futures contracts to make good on their bets. A short squeeze happens when large numbers of traders have open short positions, or bets that the market will fall. If the market goes against those short positions, traders have to buy contracts to prevent their losses from getting worse. When large numbers of short positions must cover their positions at the same time, the market rallies.
Gauging Spring Crop Risks
The risk premium is the influence of future expectations of supply on current prices, and it’s the basis for price fluctuations in the futures markets. As mentioned in the section “Looking for Goldilocks: The key stages of grain development,” earlier in this chapter, crops are most vulnerable during planting, pollination, and harvesting. During these stages, the markets begin to apply a risk premium to prices. This kind of pricing can be an emotional rather than rational process, which is why prices can fluctuate wildly on weather reports, fires, and reports of diseases and insect infestations in the fields.
Corn and soybeans are planted in spring, so they tend to compete for acreage, which makes the price relationship between the two important. In other words, how much acreage farmers decide to devote to each crop is a significant influence on prices.
You need to realize that risk is around every corner during each stage of the crop year. Any external news event, such as flooding, drought, crop plagues, late freezes, or even the accidental introduction of a foreign beetle that flourishes as crops emerge, can shake the markets.
A perfect example of crop risk and its effect on the markets was associated with the rise of orange juice prices in October 2005. Aside from the damage to Florida orange orchards from Hurricane Wilma, an increase was reported in canker, a bacterial infection of citrus fruit trees that’s spread by wind. Any citrus tree within 1,900 feet of an infected tree had to be cut down.
As the market begins pricing in risk premiums, futures contracts in corn and soybeans tend to rise during the months of March and April because of the following:
Corn planting starts in late March and usually is completed by late May. March and April tend to be months during which corn tends to rally.
Soybeans usually are planted in mid-March through May. March and April can be good rally months for soybeans.
Pollination and harvest risks come into play as the year progresses:
Corn pollinates in late June or early July. June can be a strong month for corn.
Soybean pollination usually takes place in August. August beans can experience a small rally.
October and November are harvest months. Rallies during these months usually are not very profitable, because harvest usually takes place and, barring truly extraordinary circumstances, supply and demand find a balance.
During the summer of 1973, the Russians made large purchases of grains. Supply fear (the fear that planting, pollination, or harvesting won’t be successful) truly gripped the market, and the resulting rally was violent, but it didn’t last long. In the absence of major problems with planting, pollination, or harvesting, grain prices responded by falling back to their mainstream trend lines, which is rather simple technical analysis.
The bumps, rallies, and valleys of the grain markets are only tendencies. Before deciding to make a trade, be sure to
Find out from your charts whether the market actually is following seasonal patterns that have tended to happen in the past. In 2005, trading was difficult in the corn market, but it was easier in soybeans because the market tended to trend for longer periods.
Look for evidence that confirms what prices are telling you. In the case of corn in 2005, open interest started to rise in conjunction with prices, which is as good a confirmation of a rising trend as there is. Rising open interest means that more buyers are coming into the market. Compare the open interest in soybeans with that of corn, and you can see that the open interest rate for corn actually was flat. Corn contracts had no life in them at that time.
Agriculture 102: Getting Soft
Coffee, sugar, orange juice, and cocoa are known as the softs. Some call them the breakfast category of futures. They can deliver some profitable moves if you take the time to become familiar with the standard stuff that goes on in the softs markets.
In contrast to grains and beans, much of the action in softs goes on overseas and often in remote regions of the world, especially in places that from time to time are politically unstable. As a result, trading the softs can be more volatile.
Having coffee at the exchange
Coffee trades in the United States and in London, with the United States trading the largest amount. Coffee is the most active contract at the Intercontinental Exchange (ICE)/New York Board of Trade.
Coffee is all about supply, and the 2001 International Coffee Agreement (ICA), a product of the International Coffee Organization, is meant to provide guidelines with regard to managing the global coffee supply and to encourage consumption. Like all such agreements, the ICA isn’t foolproof. It can be circumvented and thus can create controversy in the markets.
Coffee is produced in two classes, Arabica and Robusta, and thus two coffee contracts are traded. These two classes of coffee can trend differently during short periods of time, but they tend to trade along the same long-term trend line.
Arabica
Arabica beans account for 60 percent of the world’s coffee supply. Arabica is a cool-temperature, high-altitude crop. Brazil and Columbia combined produce a third of the world’s Arabica coffee. Costa Rica, Mexico, Guatemala, Honduras, and El Salvador also are major producers of Arabica, and Indonesia, Uganda, and Vietnam produce the rest.
Robusta
Robusta is a less mild variety of coffee that comes from Africa and Asia. Robusta trades in London and is most often used as instant coffee because of its stronger flavor.
Trading coffee
Coffee trading is centered on the New York ICE/New York Board of Trade for Arabica and the Euronext for Robusta. Euronext consolidated the futures markets in Belgium, France, The Netherlands, and Portugal. Here are the particulars for coffee trading:
Contract: The contract size for coffee in New York is 37,500 pounds of Arabica, and it trades at the ICE/NYBOT. Robusta coffee futures trade at Euronext. A Robusta contract contains 5 tons of coffee.
Valuation: A 1-cent move is worth $375 per contract for Arabica. The minimum tick is $1 per ton for Robusta.
Limits: No limits are in place for Robusta.
Trading hours: - Trading hours in New York for Robusta as listed at ICE/NYBOT are “8:30 a.m. to 12:30 p.m.; pre-open commences at 8:20 a.m.; closing period commences at 12:28 p.m. (electronic trading hours: 1:30 a.m.–3:15 p.m. ET).”
Staying sweet with sugar
Sugar is another breakfast commodity, and it’s another volatile commodity that is best left for more experienced traders. As with all commodities, you have to understand the basics of the industry, the key reports that move the market, and how to apply technical analysis to trading. Unlike coffee, most sugar-producing countries produce much of the sugar that they use and then export the rest.
Cuba, India, Thailand, and Brazil are major sugar cane producers. Russia and the European Union are the major sugar beet producers. Russia, Europe, the United States, China, and Japan are the biggest importers, and Cuba, Australia, Thailand, and Brazil are the biggest exporters.
The two sugar contracts are
#14, which has subsidy-supported sugar.
#11, which has free-market sugar. The free-market sugar contract is the one to trade. A contract is for 112,000 pounds, and a 1-cent move is worth $1,120.
Traders also watch for candy sales and the price of corn because of competition from high-fructose corn syrup, which competes with sugar as a commercial sweetener.
Building a rapport with lumber
Lumber is another so-called soft. Why that is, I can’t tell you. Some traders think that it’s lumped in with the rest of the softs because another place can’t be found for it.
Lumber is used in homebuilding, and the price can be volatile. In some cases, lumber prices peak or trough before housing busts or booms, respectively. Several months can elapse before a glut or a major shortage finds its way from the futures markets to the housing industry.
The lumber contract calls for 80,000 board feet (construction grade two by fours) manufactured in the Pacific Northwest or Canada. Prices are quoted in dollars and cents per board foot. A $1 movement in price equals $80 in the contract. Lumber is another thinly traded contract that you can work your way toward trading as you gain more experience.