Deciphering the opportunities that lie in the current futures spread.
Futures Trading 101 tell us a futures spread is the price difference between two futures contracts. A futures carry is when the deferred contract price is higher than the more nearby month. A futures inverse, or an inverted market, is when the nearby price is higher than a deferred price. Futures spreads can be bought or sold, and have a daily price limit equal to double the daily limit move of the underlying futures.
An important principle of futures spreads is that with storable commodities, there is a cap to how large of a futures carry the market will offer — a concept known as “financial full carry”, or FFC. FFC on grains is a function of the:
- price of the more nearby contract,
- the market interest rate, typically considered to be 3-month LIBOR + a small premium, often 2% (LIBOR + 2%),
- days from when a futures contract can first be received via delivery until delivery begins on the deferred contract, and
- the ‘per day’ storage rate as defined in the exchange’s rules.
Consider the December 2013/March 2014 corn spread: There are 91 days from Day 1 to Day 1 of the two contracts, LIBOR + 2% is about 2.27%, and the daily storage rate on corn is $.00165/bushel, or $.15 for 91 days. With Dec13 corn at $5, FFC on Dec/March is 17.88¢, the theoretical maximum March might trade above Dec13 futures. Dec13/March14 corn is trading at a 12¢ carry, equivalent to 67.1% of FFC.
Determining how close a spread might get to FFC is where "art" meets "science." Grain and soybean futures spreads in part reflect the market’s perception of available supplies relative to demand, over time. When supplies near delivery markets are readily available and basis is weak, a corn futures spread might trade to a high percentage of FFC — perhaps as high as 80% for Dec/March. In our example that would be 14.3¢.
But some years the dynamics turn on end — when demand outpaces supply and basis rises sharply. To reflect the need for supplies now rather than later, a futures spread could narrow or even invert. Corn and soybean basis hit record high levels in the summer of 2013, and in turn, July corn futures soared to a record inverse of $1.56 over September futures. This drives home the second principle of futures spreads:
- there is no ceiling to inverses
The charts shown here tell the story of five crop years, showing the transition Sept/Dec spread as well as the harvest Dec/March spread.
- The years shown include tight beginning stocks such as 1996 and 2013, as well as sizable stocks (’09).
- The years also represent both slow starts to harvest as well as a fast pace such as in 2004 and 2007.
- Each Sept/Dec chart shows the Sept 1 ‘carry-in’ corn stocks ratio, along with what percentage of corn harvested before October.
- In the right hand column, the subsequent Dec/March corn spread is shown, along with the ending stocks ratio for the following summer ("carry-out").
Sept/Dec corn spreads pose unique challenges. Some crop years the ending stocks (new-crop’s "carry-in") are extraordinarily tight. This happened in 1996 and again in 2013. When the summer coffers are nearly depleted, the value of September corn futures can invert to substantial premiums over December futures, which are pricing the coming crop. But as September nears, traders must analyze how much new-crop corn will be available by mid-September to cover consumption, and how this will affect the Sept/Dec spread.
If harvest is early, the supply tightness could disappear before the end of September. This occurred in the fall of 2007 when almost 1/3 of the corn crop was harvested before October, and to a lesser degree in the fall of 2004 when 16% of the corn was cut early. In both years the Sept/Dec corn inverse melted away during July and August, and widened to a respectable 10+¢ carry as Sept became a true new-crop month. Last year the 2012 corn harvest was a record high 54% complete by September 30; it was clear even by August that enough corn would soon enter the pipeline that the Sept12/Dec12 corn spread reversed from a 30¢ inverse to a 6-10¢ carry in August.
But in 2009, although the corn carry-in was a hefty 13.9% only a 20-year record low 6% of the corn crop was cut before October. The Sept09/Dec09 corn spread was a generous 13¢ carry carry in June, but narrowed to only 5¢ by August.
The past does not guarantee what will occur in the future, and it’s risky to draw conclusions from a handful of crop years. But some broad points about Sept/Dec spreads deserve mention:
- Sept corn futures are largely a new-crop month unless harvest comes slowly.
- Late planting or a slow start to harvest may have more impact on Sept/Dec than the size of the beginning stocks.
This summer the corn pipeline is nearly depleted, and late planting raises fears of another slow start to harvest. Sept ’13 corn futures are trading more like an old-crop month, at nearly a 40¢ inverse to Dec futures in mid-July. But in the end, any commercial that wants to take delivery of September futures in order to get physical corn likely won’t receive it until late September. This feature of the delivery system is why it’s common – but not guaranteed - for Sept futures to lose most of any premium over December futures during September.
But a more important corn spread to most merchandisers is the December/March spread. Fall is when firms typically own the largest volume of corn, and managers need a generous Dec/March carry to cover the cost of holding hedged inventory. There’s a strong seasonality (well beyond the few years shown here) for this spread to trade to its highest carry during the fall. As a result, merchandisers often wait to roll short hedges forward until October or November. But that strategy isn’t fool-proof and caution is warranted!
In 1996 the record tight carry-in plus prospects for tight ending stocks again in 1997, ran head-long into a harvest that was 20% behind average in October. And Dec 1996 futures had fallen steadily from spring to below $2.70 by fall - after farmers had seen $5+ old-crop futures just four months earlier. Farm marketings were below average that fall, which also contributed to the Dec’96/March ’97 carry narrowing during harvest and inverting by First Notice Day.
Much has changed since 1996; over 200 ethanol plants dot the landscape, using 4-5 billion bushels of corn each year. Close to two billion bushels of on-farm storage has been built since then. But there are also eerie similarities. The corn pipeline is running dry again, planting was slow this spring and the odds for an early harvest look dim. With record high basis and futures inverses, new-crop cash corn is worth nearly $2.50 less than summer ’13 values, and new-crop contracting is minimal in most regions. Recharging the ‘pipeline’ will take time and buyers will be competing aggressively for early bushels.
The Dec13/March14 corn spread is currently a fairly generous 69% of Financial Full Carry. You might get a little more by waiting to set this carry (80% would = 14¼¢). But this spread is an important part of the return for holding corn, and good opportunities can vanish. Perhaps this bird in the hand is worth two in the bush.