The Next Gold Will Be Yellow
by George Kleinman
Editor, Commodities Trends
March 6, 2006
First consider this: During the past decade, Chinese meat consumption has increased by nearly 100 percent, about 10 percent annually.
Now consider this: Today, US corn inventories are large--ending stocks are projected to be 2.4 billion bushels. As a result, corn prices are cheap. Additionally, bird flu is now spreading across the globe, affecting poultry feeding and thereby, to an extent, corn exports.
We are trading futures, however, so let's take a look ahead. For 2006-07, the US Dept of Agriculture is estimating corn production at 10.8 billion bushels. This assumes normal yields without any real weather problems. Projected usage is 11.5 billion bushels. For next year these numbers result in a usage-to-production deficit of 700 million bushels. In other words, next year's ending corn supplies will drop from today's 2.4 billion bushels to 1.7 billion. Though still a big number, US supply is headed lower.
However, these government numbers aren't addressing the real wild card in the corn picture. It's China--they are eating a lot more meat, which requires corn for feeding. Few people are talking about a potential sea change that is set to begin shortly.
News emerged last week from China that is potentially explosive for corn prices as we move into the new crop year and beyond. China just announced it's going to halt exports of corn sometime around the end of March due to high domestic prices (corn is trading at close to $4 per bushel in China). Corn exports won't resume out of China until they are assured of at least normal yields this year. The last time China turned from a corn exporter to an importer was in 1995.
Here's what's behind this announcement: For the last six years China has produced less corn than it uses (including exports). Above ground corn supplies in China are now at 30-year lows. China is the second-largest corn exporter in the world and the largest in Asia. For example, South Korea routinely buys 5 million metric tons of corn from China (but they just started switching to US corn).
History tells us a sea change of this nature can have a dramatic effect on corn prices. Similar to this past year, in 1994 the US produced a record corn crop; at the time some analysts said it would take four to five years to work through the excess supplies. However, the 1995-96 season saw a reduced US crop and this, combined with Chinese imports, resulted in corn prices exploding, peaking at nearly $5.50 per bushel during the summer of 1996.
Take a look at the spike in the long-term corn chart below. This had never happened before and hasn't happened since, but I predict it will happen again. The only question is timing.
And now there's another wild card: Ten years ago the ethanol industry was in its infancy.
Let's take a look at corn demand for ethanol production (something that didn't materially factor into the price spike of 1996). Ethanol is currently used in approximately 4 percent of the gasoline consumed in the US. This requires about 12 to 15 percent of the US corn crop, or 1.6 billion bushels in 2005. This number is projected to increase to 2 billion within a year as new plants come on stream.
What happens when this 4 percent becomes 10 percent in the coming three years? There will be additional 2 billion bushels of corn usage, more than 30 percent of the crop, a number equal to current US corn exports. What if there's a crop problem this year or next in either the US or China? Most traders are now focused on the shorter-term supply glut, but in the long run it's hard to be bearish corn.
The market is considered a bit overbought right now, and perhaps it has run up a little too fast as the bird flu news could keep a lid on any rallies. However, any breaks in price need to be viewed as buying opportunities for the 2006 crop year and beyond.
There are ways to buy corn for the long pull using options (see below) and/or futures.
Longer-Term Trade Ideas (Using Options) To Trade The Corn Bull
For those of you who understand the risks and rewards of option trading, I've worked out possible trade ideas using options, which will be profitable should corn prices move higher over time.
While these strategies may entail less risk than outright futures, you should be aware there's still risk involved here. These trades are not appropriate for all investors, and you should familiarize yourself with option trading prior to entering trades similar to the following (note the numbers are based on December corn trading at 265, and could change based on market conditions):
Sell the December 260 corn puts for about 22.5 cents, and buy the 300 corn calls for about 14 cents. This will result in a credit of about 8 cents, or equal to $400 per option spread (you pay 14 but receive the 22). If December corn is above 260 by Thanksgiving, you keep the 8 cents for a small profit. If, at that time, December corn is below 260, the put options will be exercised and you will own December corn at 260 (you still keep the 8 cents), so the potential loss is at approximately 252 and below.
With May corn trading at around 239, if corn prices go nowhere between now and end of the year, the December price will gravitate to this area; the risk under this scenario is about 15 cents, or $750 per option spread. The risk is higher if corn prices plummet, but this would mean a crop size larger than last year (which is, in my opinion, unlikely but possible).
If there's a weather problem and corn prices surge this year, because you own the $3 calls, the profit potential is unlimited above $3 corn. These $3 calls are 'free' in this case, because the sale of the 260 puts paid for them. If corn moves above $4 you could make more than $5,000 per option spread.
For those of you with an even longer-term view, looking ahead more than 600 days, December 2007 corn is trading at 271. At around $2.70 December 2007 corn futures, the December 2007 270 puts will be trading at about 30 cents. The December 2007 300 calls will be trading at about 22 cents. For the same 8-cent credit, you can work this same basic strategy for the very long term (with about 10 cents more risk). These options are thinly traded out at 2007, therefore, these options need to be legged on and it isn't the kind of position you can get out of easily without getting poor price fills, so think long term on this one.
© 2006 George Kleinman
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