June 16, 2016 | Diana Klemme
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Wheat Waiting Game

Time to define your strategy, set futures carries, then watch for opportunities to develop

Wheat Waiting Game

Wheat exports from the Former Soviet Union totaled 172 million bushels in 2000; this year their exports will hit 1.5 billion bushels, a ninefold increase. U.S. exports of all wheat in 2000 were 1.03 billion bushels; this year they’re down to 774 million.

The export picture is equally dismal for the U.S. hard red winter wheat subclass, with 2015 crop exports forecast at a record low 220 million bushels.

Prospects don’t look any better for ’16 crop. Food and seed usage of HRW varies little year to year — about 390 to 440 million bushels — and wheat feeding hasn’t topped 190 million bushels since the ’90s. With exports declining and domestic usage stable, U.S. wheat carryovers are building.

HRW stocks on June 1, 2016 will be around 430 million bushels, 61+% of usage and the highest cushion in days of usage since the CCC days back in the mid 1980s.

Elevator managers are already looking ahead to the coming 2016 wheat crop and wondering whether they can sell and ship the wheat they already own before new-crop bushels arrive. The simple answer is “probably not.” Somebody here in the U.S. has to own the carryover on June 1. Farmers tend to have about 15% to 20% of the wheat carryover stored in farm bins, but commercial firms will hold and/or own the 80% to 85% balance.

Others wonder whether holding onto old-crop bushels means elevators may not have enough space to handle 2016 crop HRW.

The general answer is that overall, space should be sufficient:

6/1/15 HRW stocks + ’15 production

= 1.12B bushels

6/1/16 HRW est. stocks + ’16 est. production

= 1.1B bushels

HRW acres are down 2.4M for ’16 crop, offset by higher beginning stocks, so the volumes balance out. There will certainly be localized or even regional space problems this summer, and some elevators will have no choice but to move wheat at harvest at whatever value they can get. But just five years ago the HRW carry-in plus production was nearly 1.4B bushels; U.S. elevators have dealt with this challenge before.

But can elevators make money carrying HRW into new-crop? In areas in the Plains where storage space is plentiful, big futures carries give elevators and terminals a sizable backstop/incentive to hold HRW basis ownership well into 2017 or perhaps beyond. The drawback is that doing so will tie up capital both in owning the cash wheat and in margining short hedges for many months.

Assuming money and space are sufficient, the strategy of carrying company-owned hedged HRW looks attractive. The financial risk is that increasing stockpiles will weigh even further on basis down the road. But how does an elevator make this work? Ideas don’t put money in the bank.

Carrying company-owned hedged wheat profitably involves two parts: Protecting the wide futures carry(ies), and capturing gains (if any) in the basis. Or as we learned when we were young, “Don’t count your chickens until they’re hatched.”

KC wheat futures spreads have been generous through ’15 crop, and remain so well into 2017. Rolling short KC wheat futures forward one month at a time (around First Notice Day) since July 2015 would have earned 50¢ in total futures carries by March 1. The remaining KC March/July futures spread for this crop year at 20¢ carry (current value) would bring the 12-month futures carry to 70¢ total (less commissions/fees). An elevator might pay 20¢ to 25¢ in interest to hold HRW for a year, which would leave nearly 50¢ return, plus or minus any change in basis values.

Ex. Buy HRW in July 2015 at a basis of -15 July(15) Roll short futures consecutively at a total carry of 70¢

= Adjusted basis ownership

at -85 July(16)

Sell basis in July 2016 at a

basis of +10 July

= Gross merchandising gain of 95¢

(70¢ from futures carries + 15¢ higher basis) Minus estimated

interest cost of 25¢

= Estd merchandising gain

of 70¢ for 12 mo.

The merchandising gains are substantial in this example, but there’s always a risk that basis weakens over time rather than moves higher. Your backstop is that as long as the futures carry(ies) exceed your interest cost, you can wait for better basis values to develop. But that assumes you set the futures carry(ies) at wide enough levels. Waiting and accepting whatever futures spread develops down the road could jeopardize your projected returns!

One of the takeaways from my presentation on “Capturing A Carry” at the NGFA Country Elevator Conference in December was that the best futures spread opportunities don’t always come simultaneously with your cash market actions. I noted, for example, that the widest carry in the July15/Dec15 CBOT (SRW) spread occurred 11 months before harvest!

Looking ahead, the 12-month March16/March17 KC wheat spread was trading in mid-February at almost 69¢ carry, 5.7¢/month, and a generous 75% of Financial Full Carry, four months before the ’16 harvest. KC July16/July17 has been trading around 61¢ to 62¢, or 5.2¢/month. Extending another year out to July 2018, the July17/July18 KC wheat spread already shows a 40¢ futures carry.

Will exports increase?

USDA economists anticipate U.S. wheat exports will rise in the years ahead as global usage expands in developing countries. The U.S. share of global exports is not expected to rise much, however, as FSU production is forecast to continue to expand. U.S. wheat acreage, on the other hand, is projected to remain flat for some years, which will reduce U.S. surpluses.

Holding takes money

Elevators that hesitate to tie up capital holding HRW for what might turn out to be one to two years could look at a “Basis Repo”. This financing tool, widely used a few years ago when prices were higher, allows an elevator to sell their inventory to a financial entity and exchange futures, with a predetermined buy-back basis set in the contract. The cash sale generates operating money and eliminates any margin calls. The pre-agreed upon buy-back value would be a forward value that equates to about the cost of money. When the second part is executed, the elevator would retake ownership of the wheat (in-store) and again be short futures against it. Typically the buy-back timing is set to coincide with when the elevator may intend to liquidate the ownership to its final market, whether that’s for export or domestic consumption. Cash flow needs have been relatively low for elevators this year due to lower prices and light farm selling, but it’s smart to have a plan in case financing needs rise.

Soft red wheat carries

A few years ago it was the CBOT wheat spreads that traded to extremely wide carries, courtesy of the CBOT’s Variable Storage Rate program for futures spreads. VSR allows some of what would have been a cash market basis carry to shift instead to a wider futures carry. In May 2011, for example, the July11/July12 CBT wheat carry soared to $1.60/bushel! Those wide futures carries did the job: Elevators built bins and carried hedged wheat ownership for one to two years in some cases.

This season the CBT wheat carries aren’t as wide as KC spreads but are still reasonably generous. An elevator could have locked in the July15/July16 CBT wheat carry near 60¢ last May. Rolling short hedges forward month to month, instead of around each First Notice Day, would have “earned” closer to only 24¢, and would cost more in commissions. The SRW carryout this summer will be around 43% of usage, far less than the HRW carryover of about 61%, and quality problems have supported domestic basis this year and reduced the market carry. But a number of Eastern elevators have no choice but to hold hedged SRW from ’14 and ’15 crops into ’16 crop due to vomitoxin or other quality problems. Their best strategy would have been to lock in the 60¢ futures carry last summer. Waiting can come at a cost.

Flexibility for the Plains

Setting big KC wheat futures carries a year or more forward provides a backstop but it doesn’t obligate an elevator to carry cash wheat that long; it just covers their costs if they do wait. Basis will tell elevators when to liquidate hedged ownership— when the total cash carry no longer exceed costs.

The world may not want our HRW right now, and the domestic market can’t absorb it all, but the futures market is compensating elevators or other firms to own and hold HRW, for years if necessary. In some cases the return may be big enough to justify building additional space — that’s the market doing its job. The challenge for managers is to define their strategy, set futures carries to protect the projected return, then settle in and watch for favorable basis opportunities to develop.

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