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Grains Cheatsheet, Part 2: Don’t Follow The ‘Record Crop’ Trap

Courtesy of ZeroHedge View original post here.

Part 2 out of 3 in a weekly miniseries, by Macro Ops Substack,

Part 1 can be found here.

A Thing On Volatility

Grains volatility goes up when prices are high, and volatility goes down when prices are low. It’s the opposite behavior to stocks. When grain prices go up it doesn’t mean good things for the economy. There are production concerns. The market thinks that the harvest won’t be enough to fit everybody´s needs. Prices rise and volatility climbs until the uncertainty is resolved.

The Carry-Over Explained

The carry-over is the remaining supply from the previous year plus current year production, plus imports, minus demand. 

Previous Year Supply + Current Year Production + Imports – Demand = Carry-Over

The carry-over is the link between futures prices and different crop years.

What Is The Stocks-To- Use Ratio?

Stocks to Use Ratio is a really important indicator for the grains market. It measures how much grain is left as carry-over relative to its use (demand).

If last year’s production of Soybeans was 100 tons, and the demand was 90 tons, that means that the carry-over from the year was 10 tons. The stock to use ratio would be: 10/90 or 11.11%. So in the case of a bad crop the next year, there will be still 11% of the total demand already accounted for. 

Following this example, if the next year’s production rises to 110 tons and demand stays the same (90 tons), we will have a 20 ton surplus. The carry-over will be the 10 tons that we had on stock plus the new surplus.

Our new stock to use ratio will look like this 30/90 or 33.33%. There are more than enough Soybeans to go around for everybody who wants them. 

Now let’s say in the third year it´s a completely different story. China´s GDP keeps growing, more people join the middle class and have bigger incomes so they start eating more meat. China’s meat producers need grain feed for their cows, so the demand for Soybeans rises to 100 tons.

At the same time, El Niño decides is a good time to play with the American Farmers… this year crop production falls to 75 tons due to poor weather conditions.

So in year 3 we have a shortage of 25 tons. To meet the shortfall the savings from year 1 and 2 are consumed. The total carry now drops to 5 tons (30 in savings minus the 25 shortage). 

Now the stock to use ratio looks like this… 5/100 or 5.00%. The ratio captures the relationship between 3 variables: Supply, Demand, and Inventories.

Supply could be growing, but if Demand is also growing at the same rate they should offset each other. The stock to use ratio should stay the same.

If Demand grows faster or there’s a production issue, the ratio will fall. (Less stock per unit of demand).

If Demands falls or supply grows faster, the ratio will increase. (More stock per unit of demand).

Stocks-To-Use Ratio And Volatility

This ratio should not be used to simply predict price. (Sadly, It ain´t that easy). But it’s a great tool to predict volatility. 

When the ratio goes up volatility goes down. There´s enough grain for everybody and people aren’t worried about shortage shocks. 

If the ratio goes down, volatility goes up. People fear a grain shortage and price action turns wild.

Don’t Follow The RECORD CROP Trap:

Everybody likes to scream New Record! And Biggest Crop Ever!

Check how this will affect the Stocks to Use Ratio, and you will have a better sense of the impact this crop will have on the market and ultimately price.

It doesn’t mean anything for traders if farmers produce their biggest corn crop ever but demand from China follows the same growth rate. The effects should offset each other and price probably will remain the same.

Nevertheless, Kudos to the farmers! Their hard work and effort will earn them more income from record output.

USDA The “FED” of Grains Markets

The data from the USDA is important… REALLY important. They work as a benchmark and a reference for the entire market, from farmers, to grains processors, to commodity hedge funds. Everybody checks their releases.

Here are some key reports:

WASDE

On the second week of every month the USDA releases it´s WASDE report. (World Agricultural Supply and Demand). Here you will find the Balance Sheet, which has all information you need to know regarding Supply, Demand and Inventories from the most important Countries.

Please notice that not all WASDE are equally important, some are more than others, and this has to do with the planting season. The USDA does a first forecast and adjusts it when needed from month to month until harvest time. 

Their forecasts are usually very accurate.

Prospective Planting Report

This one is released on the last day of May. It’s a producer survey, and it tries to forecast how many acres of Corn, and how many acres of Soybeans they will plant.

It’s important to understand that this report expresses the ​Intentions ​of the Producers, so the crops aren’t on the ground yet.

Acreage Report

This report shows the effective distribution of acres between Corn and Soybeans. It is released in June. If farmers decided to change their mind during planting season, you will find that the numbers on this report are different from the ones in the Prospective Planting report.  

USDA is the benchmark but be aware of consensus.

Alongside the USDA forecasts, there are a number of private reports who try to do the same, and they are fairly accurate too.

But sometimes USDA numbers will differ greatly from the consensus of the private reports.

When this happens a shock in prices usually occurs. 

Story time: In 2016 USDA had a forecast for the Corn Yield of 175 bushels per acre. This was a record yield, and implies a really big crop. The biggest American Corn crop the world has ever seen actually.

With such an abundant amount of Corn prices SHOULD go lower right?

Well, the consensus of the market was that USDA was overestimating its yield numbers, and the crop should be smaller than what the USDA predicted. Around 170 was the private yield forecast. The price reaction to this situation was that Corn Futures went UP instead of down after the USDA report was released. 

Fast-forward a couple of months later, and guess what the final yield was? Yup, 175… Old USDA had it right all along.

Please notice that I’m not suggesting to trade the consensus side. That would be equally as bad as blindly trading the USDA numbers.

All I’m trying to say is that you should know what the benchmark is. Check if the consensus agrees or diverts from the benchmark, and then focus on price reaction. You will need to develop your price action skills sharply! That will help you more on the long run than just memorizing fundamental data.

Don’t Fall For The Most Accurate Forecast Trap

Our last point should tell you a thing or two about forecast reports. If you are a TRADER your focus must be on PRICE, period.

If you’re an analyst who is getting paid a salary to come up with a forecast, then yes, you should commit yourself to be as accurate as humanly possible.

But if you want to trade grains and be profitable, you shouldn’t pay that close attention to the actual yield number. You must look for the benchmark and the consensus, that´s it. (Benchmark=USDA Consensus=Private Reports)

As a Trader it just doesn’t matter if your forecast of a number is correct. You want to be right on price! So don’t waste your energy trying to forecast where supply or demand is going to be. Focus on market expectations, price reaction and trade accordingly. Play The Player! 


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