Where it all started for commodities
The history and development of the futures market in the US, is inextricably linked with the development of the grain markets and dates all the way back to 1848 with the advent of the first futures exchanges. In considering the soft commodities in general, it is perhaps appropriate to start this section by considering grains, one of the most popular sectors. There are of course many other commodities in this sector, which are generally categorized by those products which are grown, rather than those which are mined or extracted. So within this sector are some of the other ‘everyday’ commodities, such as coffee, cocoa, sugar and orange juice, all of which are traded through the futures exchanges of which the CME is the largest.
Types of grains
The grains market is generally categorized into three broad markets:
- Those grains which are used for food and food related products. Food grains are those primarily produced for human consumption including both wheat and rice.
- Those grains which are used for animal feed. Feed grains on the other hand are those produced primarily for animal feed and related products, and are generally characterized in being high in starch or energy content, helpingto add bulk and weight to livestock. As such the feed grains include corn, milo, oats and barley, and are also often referred to as the coarse grains.
- Grains which can be categorized as oil seeds, and indeed this is a market which is increasing in size due to the economic and political factors now driving world demand for alternative energy sources. Oil seeds are generally crushed and then processed to extract the valuable oils. This group includes soybean, sunflower, and canola oil, along with palm oils such as palm and palm kernel.
The most actively traded futures contracts within the grains market are corn, wheat, soybean, soybean oil and soybean meal.
Supply and demand in grains
Of all the commodities traded in the futures markets, the price of soft commodities in general, and grains in particular are fundamentally driven by the balance between supply and demand. The starting point for many soft commodity futures traders is the US Department of Agriculture, which, amongst many other regular fundamental news releases, publishes an annual table of supply and demand for each of the major soft commodities, such as corn and wheat, which provides a detailed historical record, along with forecasts and projections for the forthcoming year. These tables are often referred to as the supply and demand balance sheets, and include everything from the acreage planted, to yields, imports and export quantities, and the average price per bushel.
Whilst these reports are extremely comprehensive, and indeed overwhelming for the new or novice commodity trader, the release of these reports has two distinct impacts. Namely due the so called ‘weather months’, in other words the principle growing seasons, and the ‘non weather months’ when the growing season has come to an end. The key here is to recognise that during the ‘weather months’ then the focus of the market will be on the supply issues, and therefore prices are more likely to react to changes in this side of the equation such as issues affecting acreage, weather conditions and weather patterns and the potential yields as a result. In the ‘ non weather’ months the market focus shifts to the other side, and concentrates on demand issues, such as domestic consumption, export demand, and growing conditions in other parts of the world, such as South America, a major competitor to US grain producers.
As a result statistics and fundamental releases play a key role in determining the daily price action in the soft markets, with traders paying very close attention to data such as ending stocks, and ending stocks as a percentage of total use, which again can be confusing for the novice trader. To complicate matters further each of the primary soft commodities such as corn, wheat and soybean, are influenced by their own unique set of market fundamentals, so let’s take a brief look at each of these in turn.
The primary corn growing states in the US are those in Iowa and Illinois, with the crop generally planted in late Spring and then harvested in early Autumn. The success of the crop is measured in terms of yield, and the primary factors which dictate the yield are the timing of the planting in Spring, regular rainfall during the growing season, moderate temperatures, sufficient moisture when the crop is pollinating in the summer months of July and August, and finally harvesting the crop before the onset of any early frosts.
Both yields and acreage have increased over the last few years, and in particular the demand for renewable fuels such as ethanol, which has tended see growers moving from the feed grains to the food grains, where higher prices and reduced competition have offered better returns.
The CBOT corn futures contract has an underlying 5,000 bushels, and is traded for delivery in March, May, July, September and December, with the price quoted in cents per bushel and in a minimum increment of 0.25 cents per bushel or $12.50 per contract. So for example if we see that the corn futures quote is $4.2550 per bushel then a single corn futures contract would be valued at 5,000 x $4.2550 or $21,275.00. So if the price per bushel moves to $4.3550, or ten cents higher, then the contract value would increase to 5,000 x 4.3550 or $21,775, an increase of $500.
There are two primary grades or types of wheat, namely Winter wheat and Spring Wheat, which are then further sub divided into other classes and categories. One of the primary differences between wheat and corn in terms of their yields, is that wheat is far more tolerant of extremes of weather and is therefore a far more resilient crop, able to withstand weather extremes and sudden changes in weather patterns. This is in stark contrast to corn, which is extremely sensitive, and as a result, changes in weather( good or bad) will always have a more dramatic and significant impact on the price of corn, than on wheat. So in simple terms, weather is a key issue for corn, but much less of an issue when we trade in wheat. This is also seen in the areas where wheat is grown predominantly, as it tends to be planted in those regions which would be too dry or harsh to support corn or soybean production.
The term Winter wheat is perhaps a little misleading as it is in fact planted in the Autumn( Fall), and then requires a blanket of snow which serves as an insulating layer for the crop to protect it during the winter months. It then starts to grow in the early Spring before being harvested in early summer. The primary growing region for winter wheat in the US is in Kansas with two main types grown, namely hard red winter wheat and soft red winter wheat. The former is used for bread making and baked goods that need to rise, whilst the soft wheat is used in biscuit and cracker products. These products are delivered against the KCBT wheat futures contract ( Kansas City Board of Trade ).
Spring wheat on the other hand is planted, as you would expect in Spring, and then harvested in Autumn and is grown primarily in the North Dakota and Minnesota regions of the US. The most popular is the hard red variety, which is delivered against the MGE wheat futures contract ( Minneapolis Grain Exchange ). Of these the primary products are Durum wheat which is used for making pasta, with white wheat used for cereals and other food products. Both contracts have the same underlying as for the corn futures contract with a 5,000 bushels contract size.
Just like Spring wheat, soybeans are planted in the Spring and then harvested in the Autumn, and is one of the fasted growing futures markets due to the dramatic increases in demands over the last decade. Coupled with this, soybean crops are easy to grow and also enjoy a long so called ‘blooming’ period, which is generally between three and six weeks. In addition soybean crops are also relatively immune to changes in the weather.
The crop thrives well in the same growing regions as for corn, and is generally grown in rotation with other grains, to protect against disease and insect infestation. All these factors have combined to see corn acreage fall, and soybean acreage increase, with growers increasing supply as demand for the raw and refined by products increases around the world, led by one of the biggest markets, China.
The decision to grow soybean, is generally one based on price, but in addition soybean also offers the grower the option of ‘double cropping’ , mixing a second crop with the winter wheat, and thereby increasing income and growing yield from the available acreage.
The world’s largest producer of soybean is the US, closely followed by Argentina and Brazil. Whilst a significant proportion of the crop is consumed locally, increasingly export markets are also growing very fast, with China, the EU, Japan and Mexico leading demand for imported soybean and soybean derivatives. With increasing demand comes a lack of supply and a consequent rise in price, as growers rush to convert their acreages to soybean and away from more conventional wheat and corn. This leads to falling supply in these markets and rising prices once again.
Soybeans are processed and crushed into two major product types, namely soybean oil and soybean meal and this gives rise to the so called ‘crush ratio’ or in other words the yield expected from one bushel of soybean. As a rough rule of thumb, sixty pounds of soybeans, will produce approximately eleven pounds of soybean oil and forty seven pounds of soybean meal.
Speculative futures traders will often take opposite positions in the meal and oil to exploit potential differences in the crush ratio as the fundamental factors play out on the price chart.
As with the corn and futures contracts, the soybeans futures contract on CBOT, calls for delivery of 5,000 bushels, once again with a minimum price increment of 0.25 cents per bushel. In the last few months the futures contract touched an intra day high of almost $15 per bushel, before declining to settle once again in the $11 to $12 per bushel price level.
Who trades softs?
Until relatively recently trading in soft commodities tended to be the preserve of the professional futures traders and pit traders on the exchange, along with growers selling their products for physical delivery. In the last few years of course this has changed dramatically as the major exchanges, such as the CME have given the smaller trader and speculator the opportunity to trade in these exciting markets. First was the advent of electronic trading such as Globex with the contracts now trading virtually 24 hours a day, and second was the creation of mini futures contracts, which are now extremely popular. As a result, we now have mini corn, mini wheat and mini soybean contracts, which are generally one fifth the size of the standard contract, requiring significantly less margin, and the opportunity for small traders to learn in a low risk way.
Why trade softs?
Soft commodities are one of the most fascinating of all commodity markets, with supply and demand driven by a variety of factors from the weather, to economic and political fundamentals, and finally of course natural disasters, all of which play their own unique part. For traders who enjoy the analytical elements of trading, and in particular the fundamentals which lie behind the daily price action, then trading softs is the market for you.