Demand or Supply Driven Markets

USDA's March 2, 2002 Supply and Demand Report decreased corn exports by 5 million bushels, increased soybean crush by 5 million bushels and reduced wheat use by 30 million bushels. These changes produced corresponding increases in corn and wheat projected ending stocks along with reducing estimated soybean ending-stocks. World supply and demand estimates raised corn ending-stocks by 23 million bushels and wheat by 72 million bushels, while World soybean carryout projections were lowered 6 million bushels.

Somewhat lower market prices were expected the morning following the report. Prices did open somewhat lower, but closed higher for the day-why? While higher price expectations are limited, some market analysts are beginning to believe that supply impact of last fall's large U.S. crops and the current large crop being harvested in South America is "in-the-market." These analysts are starting to credit a shift in market focus from large supplies to strong demand for recent market strength. If this is occurring, will strong demand bring any additional price strength in the coming months?

Demand driven markets typically are slow to develop. They begin as strong demand gradually "chews up" large supply and starts to bid up prices. Demand driven markets tend to be less volatile and move slowly. Progress is usually steady, but slow. Upward trending prices would be positive, however it would take considerable time to significantly improve prices. Strategies calling for patience in waiting for the market to develop usually produce better results in a demand driven market.

Weather problems could shift the focus back to supply and produce more rapid price changes. Corn ending stocks are expected to decline from last year and soybean supplies are not really burdensome. Weather problems that threaten reductions in production could tighten the supply/demand situation quickly-a situation that might produce a supply driven bull market. In contrast to the less volatile and slow moving demand driven market, a supply driven market can produce sharply higher prices in short time periods. Unfortunately, prices also can react more rapidly to the downside as weather conditions or forecasts improve. Supply driven markets generally require strategies to react quickly before profitable opportunities are missed.

Most analysts expect markets for the 2002 crops to be similar to the last few years. Increases in corn and/or soybean acreage are expected to provide large production and low prices again at harvest time. However, record demand continues to consume large supplies and continued growth could produce a demand driven market, eventually providing somewhat better prices. Strong demand has already kept stocks from becoming burdensome and weather problems could change the price situation quickly with sharp price reactions to supply concerns. A demand driven market situation and potential large crop production, calls for marketing strategies to follow market trends and avoid expected low prices at harvest. At the same time, flexibility to deal with unexpected weather problems and volatile prices of a supply driven bull market also should be in place. This is a challenging, but not impossible, marketing task.

Setting Sales Targets:

Most analysts expect a continuation of the low price pattern of recent years and, regardless of whether a supply or demand driven market develops, setting price targets is an important element of any marketing plan. Seasonal trends suggest that the best opportunities for pre-harvest sales usually occur between now and July 4. Historically, the best prices for corn often occur during April and for soybeans in May. However, higher and lower prices may occur at any time throughout the period depending upon supply and demand news. Setting price targets aimed at this time period is usually a good place to begin with marketing plans. These sales targets can be combined with other strategies to provide flexibility needed for changing markets.

Price Averaging: This can be accomplished by simply making regular sales throughout the period of seasonally higher prices. Some sales may occur at or near the high, others during price declines. However, sales made with this method prior to July 4th would be expected to be higher than the yearly average.

Price Targets: Setting a price target to trigger sales is a commonly used method. These targets can be established using a variety of methods. One simple method is to set a target near the upper end of USDA's expected price range. Knowing the cost-of-production and using price targets that generate positive returns also can be used. Another method is to use resistance prices from technical analysis that many marketing newsletters include in their outlook information. Since price rallies often stall out at resistance prices, they can serve as targets to capture prices at price peaks during the period.

Scale Up Selling: This strategy usually begins with making a sale of a portion of expected production at a price target, then making additional sales as prices move higher-"scaling up" the average net prices as long as prices move higher.

Trailing Stop: The objective of this strategy is to follow up trending prices, as long as they last, by selecting price targets (or stops) a few cents below the current price. If prices continue to move up, the stops are raised accordingly until a price break triggers a sale when prices fall through the stop price. This strategy won't trigger a sale at the high, but allows following an up trend until it breaks and may produce a higher average price than other strategies.

New Corn and Soybean Futures

On February 15, 2002, the Minnesota Grain Exchange (MGEX) began trading new corn and soybean futures contracts. The contracts are for every month of the year and are cash settled instead of physical delivery as with Chicago Board of Trade (CBOT) futures contracts. Corn and soybean cash price indexes represent approximately 1500 elevator cash bids, collected and computed through an agreement with Data Transmission Network (DTN). The settlement price for the National Corn Index (NCI) and National Soybean Index (NSI) futures is a 3-day average of the national indexes for last three business days of the contract month. The NCI and NSI contracts are intended to track cash prices from country elevators while CBOT contract prices are based on delivery in selected terminal elevators.

Understanding how basis impacts cash price will be important for effective use of the contracts. In general, the new MGEX futures are based on cash prices and should reflect an average country elevator basis. The following are some potential uses or advantages of the new contracts:

• Instead of a Forward Cash Contract. Cash contracts are a commonly used alternative to futures hedges for pre-harvest sales. Among the advantages of forward cash contracts is the ability to "lock-in" a favorable basis that cannot be captured with a CBOT futures hedge. The MGEX cash index futures should allow capturing basis in a futures contract hedge similar to a cash contract. However, the cash index futures contracts avoid the delivery commitment of a forward cash contract and that could make them an attractive alternative.
• Basis Hedge. The new futures contracts also may provide the opportunity to hedge basis by selling MGEX cash index futures and buying CBOT futures. The objective would be to hedge basis with results expected to be similar to a basis contract, again without the delivery commitment of a cash contract.
• Protect the LDP. Buying cash index futures might be used as a strategy to "protect the LDP" when very low prices occur prior to harvest and before the LDP can be claimed. In the past, some have tried to "protect the LDP" using CBOT futures, but MGEX cash index futures should be more effective because both the LDP and cash index futures are based upon cash prices.
• Re-owning grain sold at harvest. A disadvantage of a strategy to sell cash grain at harvest and re-own with CBOT futures is the inability to capture post-harvest basis gains (strengthening). Using cash index futures may allow a portion of post harvest basis recovery to be captured, since they are based on cash markets.

Cash index futures have some disadvantages too. Basis is more predictable than price. Changes in basis or anticipation of basis changes will affect cash index futures prices. CBOT futures strategies can be used to protect price levels while speculating on more predictable basis to capture gains in the cash market. Cash index futures may not perform as well in this situation.

• Post-harvest basis strengthening. Cash index futures may not perform satisfactorily if used as a short hedge to protect price level or lock-in market carry for stored grain. Selling them may "lock-in" the weaker basis and prevent capturing post-harvest basis strengthening. In recent years, capturing post-harvest basis gains represented a major portion of any storage returns.
• Risk of weaker basis. While long (buy) positions with cash index futures to re-own grain may enable capturing strengthening basis, they also carry the risk of lower prices if basis weakens.
• Local basis differences. The cash index represents an "average" basis for country elevators in several states. Local basis could be much different, depending upon local supply and demand situations. These differences might significantly affect the local cash price and the effectiveness of the cash index futures.

What about market liquidity? Another question, and it's a big one, is whether the volume of trade will be enough for cash index futures to be an effective marketing tool. A significant volume of trading is necessary to produce market liquidity-enough buyers and sellers so that contracts can be traded at all times during market hours (8:30 a.m.- 1:45 p.m. CT). MGEX and DTN are promoting the new contracts and expect them to be successful, but time will tell whether they catch on and are traded in sufficient volume to be useful in marketing strategies.