I have been thinking about shorting agricultural commodities for some time. Last year, a combination of QE and La Nina pushed prices up and stocks/use ratios down, both to extreme levels. This year, with both QE and La Nina fading, it would be reasonable to expect a degree of mean-reversion in crop prices.

Corn ran up to new highs in April on the back of dry weather, mainly in the US and Europe, and on this year’s increase in the maximum ethanol content of motor fuel in the US (raised from 10% to 15%). Corn fell in the generalised commodity pullback in early May, but weather concerns have again pushed up the price to its April highs.

I think the main question here is: what is already in the price? The answer seems to be: strong ethanol demand, strong demand for traditional uses on the basis of projections for continued global growth, and a poor growing season. In other words, a perfect storm is priced in, and speculators are very long. What does not seem to be in the price is a mid-cycle slowdown in the US, economic disruption in Europe, a slowdown in China (which, unusually, imported corn last year), better growing conditions in the rest of the world and a tightening of liquidity conditions. With the price close to its recent maximum and, importantly, a USDA report on Monday that showed an unexpected jump in corn plantings (I don’t like to be short an uptrend unless the newsflow suggests there could be a turning point), this seems to be a good moment to bet that the storm will be less than perfect, with a wide-enough stop that I will have time to wait for some of the froth to come out of the market.

On the other hand, there are reasons to be cautious of corn. The ethanol story is real; stocks are indeed low; and there have been rumours of dryness in Russia, which is expected to return as a serious exporter this year. Also, significant backwardation in the futures curve makes holding a short position for a sustained period quite expensive. For these reasons, I have also opened a short position in soybeans.

The basic rationale for shorting soybeans is the same as that for corn: prices are high, poor weather and continued economic growth (especially in China, the major buyer) are priced in, and a deteriorating economic and liquidity picture is not. There are additional reasons to be pessimistic about soybeans: Chinese crushers are cancelling orders in response to government price controls on their end products in that country, farmers whose corn planting is delayed may well plant soybeans instead (so if I am wrong about corn, I may be right about soybeans), soybeans are more exposed to any general slowdown in China, and the futures curve, which also in backwardation, is considerably flatter.

Why not short soybeans alone, then? Partly because there is more froth in corn, and thus potentially further to fall. In addition, there may not be a slowdown in China, and Chinese buying could put a floor under the soybean market. Since the basic story that I am playing is mean-reversion and tightening liquidity, and that story should apply to both markets, it makes sense to be short both. I have therefore taken half a position in each market.

What could I be wrong about? First, there could be another disastrous growing season — the odds favour a return to normality, but that is not guaranteed. It would be tempting to wait for more data suggesting that growing conditions are at least reasonable, but that has to be balanced against an entry point that allows a stop beyond recent extremes and therefore the potential to be in a strong position if the downtrend that I expect is volatile. Such an entry point is available today, but may not be available tomorrow. Second, liquidity conditions may not be as tight as I expect. I think that the end of QE is a tightening, and that tightening in the rest of the world will combine with that to worsen liquidity conditions. If, in fact, zero interest rates in the US are enough to keep dollar-funded risk-asset carry trades going, these trades may not pay off.

Note: I have used the front-month future in both cases because that is what is available as a spread bet. I am disinclined to use my futures account unless I have to because of the trading costs and tax implications (and the danger I might forget to close the positions and take delivery!). I expect the factors I have mentioned to move the whole curve, hopefully enough to overcome the heavy backwardation in the corn market.

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