By: James Cordier, Michael Gross, OptionSellers.com
March 13, 2009
Regular readers of our client newsletter may have to rub their eyes to be sure they are reading the title of the article correctly. You are. We finally may have a commodity that has run out of reasons to go down.
For the majority of our articles over the past several months (with the exceptions of Gold and gasoline), we have recommended selling CALLS on a variety of commodities based on slowing global economies and plunging demand.
While this bigger picture is not going to change overnight (despite a few pinholes of light as of late), there are some commodities that may have already priced in worst case demand scenarios for 2009 and will need something to change radically in order to push substantially lower from their already depressed price levels.
While demand for industrial commodities like oil and copper have dropped substantially during the global recession, “necessities” such as foodstuffs are partially insulated as food is one of the last things people cut back on in slowing economies.
Granted, as we pointed out in our January 5th soybean article (See Option Seller Newsletter), a dip in demand for meats such as beef and pork (especially prime cuts) has hurt soybean demand over the last 8 months. With the market trading over $10 per bushel at that time, prices still looked inflated. Call sales made sense.
But prices have fallen nearly $2.00 per bushel since January. Markets appear to have priced the slackened demand. And soybeans may not only find themselves at a value level, but some good reasons why prices should begin inching higher.
And here is the good news. You may not need to “wait for the recovery” in order to profit in soybeans.
You may not because as an option seller, you do not necessarily need a price move in order to be successful. More about that later.
Unlike in equities, commodities prices tend to reflect the core supply/demand fundamentals at any given time. While fear, media, and perceptions can drive equities for months, commodities “trading related” price moves, while still present, tend to be held in check by the fundamentals of that particular market.
You see, somewhere at some price, somebody needs to have your soybeans, your cattle, your copper. Nobody really needs your shares of Microsoft. Somebody may want them. But nobody actually needs them. In other words, a soybean processor in China that needs to secure soybeans for his plant next week will still need to buy them, regardless of what Wall Street thinks. That is why knowing the fundamentals in commodities is so important.
Again, to steal a line from our January 5th article, we state “Nice quiet, steady premium collection will suit us just fine and early 2009 could provide these types of conditions, at least in a handful of sectors. This brings us to the soybean market.”
It just so happens that we feel the same way as the first quarter of 2009 draws to a close. While we still do not see the potential for any spectacular price moves in the near term, we just happen to feel that the better opportunity for nice, quiet, steady premium collection is now on the put side of soybeans.
Soybean Fundamentals
As we have discussed in past articles, two of the most important figures for soybean fundamentalists are ending stocks and the stocks to usage ratio.
Ending stocks are the amount of soybeans “left over” at the end of the previous crop marketing year (September 1st) after all demand has been met. In other words, its the amount of soybeans still left over in the barn when they start bringing in this year’s soybean harvest.
Stocks to Usage ratio is this ending stocks figure divided by the previous year’s total consumption. Stocks to usage is expressed as a percentage and it is supposed to show how much total demand could be met if no soybeans were harvested this year. In other words, if stocks to usage ratio was 10% on September 1, 2009, the soybean stocks in the barn would be able to meet 10% of next year’s demand before we ran out of beans. (This figure assumes that demand in 09/10 will be the same as it was in 08/09, which is rarely the case. However, it is a useful measure of supply and demand nonetheless).
In February, projected 09 US ending stocks were raised to 210 million bushels by the USDA. While this is not large by historical standards (06-07 US ending stocks were 574 million bushels) it was higher than January’s figure and led the trade to believe that declining demand would lead to further stock builds. This was a major contributor to soybean’s near 18% price decline since January.
On March 11th, however, the USDA released this month’s Supply and Demand Report showing US Soybean ending stocks are now expected to be only 185 million bushels. This is a full 25 million bushel drop from last month’s figure and is due mainly to a 35 million bushel increase in projected exports. (Note: The Chinese are coming back to the table and may not be as bad off as we thought).
This would give 2009 the lowest US ending stocks figure in five years.
Additionally, 08/09 US stocks to usage ratio dropped to 6.2% - also the lowest since 03/04.
The Season of Supply . . . and Anxiety
Brazil, the world’s largest producer of soybeans, has began harvesting their 2008/09 crop this month. While not always the case, it is not uncommon for prices to experience a price decline ahead of harvest in anticipation of this wave of new supply hitting the market. This tendency has become prevalent enough that it has been labeled the “February Break” by many in the trade. While we don’t see it as reliable enough to actually trade from, the market’s pricing of these new Brazilian beans almost certainly played a role in January and February’s price weakness in soybeans.
By March, however, the market tends to begin focusing on the upcoming US planting season (initial indications are that the US will plant 5 million less acres of soybeans than last year – but this could change). This is especially true of contracts traded in Chicago at the CBOT.
Spring can be a time of anxiety for US soybean farmers as rain, lack of rain, mud, or cold can all appear at any time to stall or delay planting efforts. This uncertainty about the upcoming crop tends to manifest itself in springtime prices. Seasonally (while past performance is not indicative of future results), soybean prices will often firm into May or June, at least until the crop is safely in the ground. Our gut feel is that this year will be no different.
The Strategy
All that being said, we are not predicting any runaway bull markets. In fact, we don’t know what prices are going to do (Yes, you heard an analyst admit it). Fortunately, as an option seller, you don’t have to know what prices are going to do. You only have to compose a fairly good idea of what you think prices aren’t going to do.
And it is our opinion that at today’s prices, soybeans will have difficulty attracting heavy short positions in the face of the revised US ending stocks number, the lowest US stocks to usage in 5 years, and heading into a time period that has traditionally supported soybean prices. (A revived US stock market, should it come to pass, would probably add some extra upside support to the soy complex.)
Rather than invest for an upward move in prices – which we do not know will happen, you can simply invest against a substantially lower move in prices. For example, September soybeans are near 8.60 per bushel. If you think it will stay above 6.00, you could sell a 6.00 put, and keep the premium as long as it stays above 6.00 through expiration. In other words, you are simply “betting”, for lack of a better word, against a 30% decline in soybean prices over the next 90-120 days.
That is option selling. In particular, that is option selling using fundamentals.
There are of course, those who believe that soybeans will remain a friend of the bears. After all, global ending stocks remain adequate near 50 million tones. Chinese buying could slow in the near term as the nation’s effort to rebuild reserve stocks has reportedly reached completion. And global production for the 2009/10 crop year could top this year’s figures.
In our opinion, however, none of these factors will be enough to drive prices 25-30% lower over the next few months (we like the August and September contracts as they still represent “old crop” soybeans.)
The bears are entitled to their opinion, however, so let them have it. That’s what makes the market work.
Besides, we’re going to need somebody to buy all of our puts.
