Bull Market with Disappointing Wheat Prices

Complex supply/demand factors are creating a confusing situation in the wheat markets. USDA’s June supply/demand and crop production estimates contained considerable bullish news for wheat. Winter wheat production is expected to fall 16% from last year. U.S. 2006-07 wheat ending stocks are projected to decline from 547 million bushels (2005-06)to 416 million bushels, the lowest carryover in more than 30 years! World wheat supplies also are forecast to decline to the lowest levels (128.24 mmt) in 25 years. Tighter supplies suggest higher prices and USDA projects wheat prices to range from $3.60 to $4.20, compared with an average of $3.42 for the past year.

Severe drought in the southern Plains that continues to spread northward is reducing the hard red winter (HRW) wheat crop, which is projected to be down about 29% from last year’s production. Expectations for reduced production helped push Kansas City Board of Trade (KCBT) HRW wheat futures prices well above $5.00 in late May, reaching the highest price levels since the record price run-up in 1996. KCBT futures prices have since slipped 50 to 60 cents due to harvest pressure along with some weakness in other grains, energy and metals futures prices. In spite of the decline, HRW wheat futures prices remain at historically high levels and well above USDA’s projected wheat price range.

Spring wheat may not be able to compensate for the reduction in winter wheat production. USDA’s March 30 Prospective Plantings report indicated an expected 1% reduction in spring wheat acreage. Higher prices and favorable planting conditions have led market analysts to expect more spring wheat acres than were originally intended. However, spring wheat condition ratings are lower than year-ago ratings and declined again this week. If this condition rating trend continues, it raises additional production concerns.

The supply/demand situation for soft red winter (SRW) wheat is in sharp contrast to the situation for HRW and spring wheat. Planted acreage is up throughout the SRW wheat production areas of the Corn Belt with large increases Missouri, Illinois, and Indiana. With only a few exceptions (southwest Missouri for one), most of the SRW wheat crop is in good condition and production is expected to increase by 16% over last year! While some substitution with HRW wheat can occur, the milling qualities and primary uses are different. SRW wheat carryover supplies have been increasing in recent years and, with increased production, have the potential to increase even more this year. While the supplies of other wheat classes are tightening, SRW wheat supplies are likely to exceed the demand needs for this class of wheat.

In spite of less favorable supply/demand expectations, spillover from KCBT HRW wheat futures prices contributed to Chicago Board of Trade (CBT) SRW wheat futures prices moving above $4.00 in May. However, the spread between KCBT and CBT wheat futures prices, normally about 5 to 15 cents, has been about $1.00 per bushel, reflecting the much tighter supply situation for HRW wheat. Although CBT futures prices have declined nearly 70 cents per bushel since posting the May highs, SRW wheat prices remain relatively high when compared with recent price history. Current CBT wheat futures prices (more than $3.60) represent prices that have occurred less than 20% of the time in the last 5 years.

Expectations that SRW wheat supplies will exceed demand and increased transportation costs, along with competition by large soybean and corn carryovers for storage and transportation, are producing weak basis and disappointing cash price bids. Cash bids in Missouri range from 30 cents to more than 80 cents under the CBT July wheat futures price, resulting in cash prices well below USDA’s projected average price range for all wheat. Weak basis suggests weak cash demand and is a market signal to avoid cash sales.

Market carry in distant month CBT wheat futures prices also signals weak nearby demand in relation to available supplies. The December CBT wheat futures prices offer more than 30 cents carry or storage premium for December wheat delivery compared with the nearby July contract. Coupled with the weak basis market signal to avoid sales, market carry signals the possibility of storage returns. Should Missouri producers follow these market signals and plan to store wheat or should they just "bitethebullet"and sell?

Sell wheat? Although SRW wheat prices are disappointing, given the positive supply/demand factors for all wheat, current SRW futures prices are relatively good compared with the last few years and upside potential seems very limited. While basis may improve somewhat following harvest, the large carryovers of corn and soybeans coupled with the likely increase in SRW wheat supplies may continue to keep wheat basis relatively weak. There is plenty of risk involved in storing wheat and, although the market is currently offering storage returns, there are no guarantees that distant month futures prices will continue to provide those returns. In spite of market signals to store, with good wheat yields and historically decent (if not good) prices, going ahead and selling is an alternative to consider. If this alternative is chosen, it is a good idea to compare price bids at a variety of delivery points. While basis is weak, recently there has been considerable variation in the posted new crop wheat bids from location to location. These price variations may more than cover the truck bill to an alternative selling point.

Store wheat at harvest? The most common strategy to avoid low prices is storing the wheat to speculate on post-harvest price recoveries resulting from basis improvement and higher prices. Although weak basis and market carry represent market signals to do just that, it is still a risky alternative. Besides expecting stronger cash prices in a weak supply/demand situation, it depends upon continued concerns about HRW wheat supply/demand, unknown spring wheat fundamentals, and market risks associated with other commodities. Storing and speculating could offer some of the better returns, but it also could produce significant losses.

Store wheat with futures price protection? Forward cash contracting for later delivery might offer limited opportunities to gain from storage, but a variety of other marketing tools may offer better opportunities to protect price and capture basis gains on stored wheat. Hedging with futures (selling futures contracts) would lock-in the market carry and allow capturing any basis recovery. Remember, it is important that wheat quantities stored closely match futures contract sizes (5000 bushels) for a true hedge to exist. Buying a put option would eliminate the risk of margin requirements associated with futures hedges and also would allow capturing higher futures prices, as well as stronger basis, if prices recover significantly after harvest. However, the premium (cost) for a put option does offset much of the storage gains currently offered by the market carry. For those who understand and are comfortable using more complex strategies, an option "fence" (buying a put and selling an out-of-the-money call) could lock-in the market carry with minimum net premium cost. While it limits potential futures gains to the strike price of the call option, it results in a hedge at the call strike price should prices increase and the call be exercised. Although none of these strategies are "perfect," they may provide opportunities to reduce price risk and improve on disappointing SRW wheat cash prices in a complex marketing situation.

Weather Market for Corn and Soybeans?

USDA only adjusted 2006-07 beginning stocks in the June supply/demand estimates for 2006-07 corn and soybeans. All other new crop production, use, and price projections were not changed from the previous estimates. The markets will be awaiting the June 30 acreage report and the July 12 supply/demand estimates in anticipation of changes to new crop corn/soybean projections. Some private analysts are projecting more corn acres and fewer soybean acres than were planned in March. Although supplies are large, strong corn demand is expected to reduce carryover by about one-half and the potential for fewer soybean acres are factors that have provided price support in both markets.

In spite of large carryover and the potential for more acres planted to corn, poor weather resulting in below trendline yields would further reduce expected corn supplies and support the corn market. However, increased acres and better than trendline yields from a crop that appears to be off to a relatively good start could keep corn supplies at levels that are more than adequate and be negative to prices.

Although soybean carryovers are at record levels, if poor weather reduced production on fewer than planned acres, soybean supplies could begin to tighten somewhat. This, coupled with concerns about financial and production problems in Brazil, could provide additional support to soybean prices. However, with the soybean crop 94% planted and in a condition comparable to last year at this time, it is important to realize that good production will only add to record burdensome supplies and increase downside price risk.

New crop (December) corn and (November) soybean futures prices have slipped about 20 to 25 cents per bushel from their highs in May. This is not unusual at this time of year with favorable growing conditions. USDA’s first surveyed crop production estimate will not be available until the August production estimates. Until then weather conditions and forecasts are most likely to provide most of the production clues. While changes in expected use, fund speculation in all commodities, and other factors can impact prices, late June/early July weather scares are most likely to provide the price rallies that offer additional pre-harvest selling opportunities.