December corn futures, this year’s crop, have sold off more than 25% in the last month due to three primary concerns. First of all, the market was significantly overbought by speculators. These included near record net long positions held by Commodity Index Traders, managed futures programs and small speculators. Commercial sellers established their maximum short position at the market’s high above $7.50 per bushel in June and have since held fast against the other market participants. The commercial trader commitment to their short position suggested that farmers growing corn this year collectively felt like this was the best possible price they could receive for this year’s crop.
Secondly, September’s weather was perfect for finishing the crop. This has caused expectations of yields to be better than the USDA’s abysmal August forecast. The season’s weather, which was so damaging early on, has presented the crop with a chance to catch up. This was the tide that slowly turned the market negative. Once the market started heading south, speculative long liquidation fueled the fire.
Traders who had bought into the bull run in grains this summer began heading towards the exits. The final straw was the materialization of European troubles and the withdrawal of capital from all risk related asset classes. The run to U.S. Dollar safety in turn made our grains more expensive on the open market while facing declining global demand as the expectations for a slowing economy increased.
The corn market’s sell off has brought the fundamental laws of supply, demand and profitability back into the equation. Corn at $6 per bushel is much more attractive on the open market. Corn at $6 per bushel also brings back profitability to hog, cattle and ethanol producers. Remember that 40% of this year’s corn crop has been mandated to ethanol production and China is intent on developing a self-sustaining hog industry by 2013.
I expect corn to rebound smartly from these levels based on the demand side of the equation. This should be seen in large commercial purchases through this week’s Commitment of Traders Report. However, the short-term wild card in this equation is the next USDA Crop Production Report on October 12th. This is an update of the same report that that fueled our rally this summer. The industry whisper is that yields could be higher than expected. However, I’m pretty sure local farmers may argue with the USDA on that one.
A Crop Production Report surprise to the downside would be short lived. Unfortunately, initiating new positions heading into a report is always a risky proposition. November corn options expire on October 21st. This is more than a week after the crop report. The market should have sorted itself out by then. Currently, the October corn $6 put option is priced at about $1,000. This is equal to a $.20 move per bushel of corn. Buying this option as well as December corn futures on a one to one ratio will provide traders with downside protection into the report while not limiting their upside profit potential. The market could very well run back to a $7 per bushel equilibrium price. This would equal a $5,000 profit in the futures for a realized net profit of $4,000 and maximum risk of $1,000 via the purchase of the option.
