Soy Meal/Bean Oil Spread: Almost Time To Get Crushed?

Soy Meal/Bean Oil Spread

When you ‘crush’ a soybean, you get two things: soy meal and bean oil. Since they originate from the same source, it comes as no surprise that these two derivatives of the soybean are highly-correlated in price movement. Looking at a comparison of these two markets over the last forty-plus years will reveal that the correlation is quite strong: When one market goes up, the other usually follows. When market goes down, the other usually drops in sympathy.

Soy Meal Bean Oil overlay monthly

Soy Meal Bean Oil overlay monthly

However, one can also see periods where one of the soy products would make a major move and the other market did not respond. Or at least, it was a delayed reaction. This is because the slightly different usage (soy meal is widely used as livestock feed while bean oil has industrial and food usage) means that the supply and demand factors in these two markets are not always aligned. Ultimately, however, these two soy products have always gotten back in sync.

Spread Extremes

Since 1968 there have only been about half a dozen times when the value of one soy meal contract reached a premium of +$12k or more over the value of one bean oil contract. Usually, the spread would peak and go all the way back down to ‘even money’ where the values of the meal contract and the oil contract were equal.

Soy Meal Bean Oil spread monthly

Soy Meal Bean Oil spread monthly

For the last two years, however, the spread has stayed elevated at historical highs. This is likely due to the fact that livestock prices are at record levels, creating strong demand for feed (soy meal).

Regardless of the high price of the spread, we do not want to become complacent and believe that this is the ‘new normal’. This recent push to record highs with the longest duration of staying at an extreme could be setting the soy meal/bean oil spread up for a major bear market. A short sale opportunity may be right around the corner.

Ratio Extremes

Soy Meal Bean Oil ratio monthly

Soy Meal Bean Oil ratio monthly

The ratio between a December soy meal contract and a December bean oil contract reached a contract high of 2:1 this week, meaning that a soy meal contract is worth twice as much as a December bean oil contract. A nearest-futures monthly chart shows that the soy meal/bean oil ratio has only reached 2:1 half a dozen times in the last forty-five years. This ratio corroborates the theory that the spread is priced at an historic extreme and ripe for a major reversal.

Trend Change Signal

Since we are less than a month away from December, we are tracking the March soy meal/bean oil spread. It’s a little cheaper than the December contracts.

March Soy Meal Bean Oil spread daily

March Soy Meal Bean Oil spread daily

Over the last five weeks, the March soy meal/bean oil spread has run from the October 1st ten-month low of +$9,550 (premium meal) to the November 7th nearly five-month high of +$15,746. The spread has closed above the rising 20-day Moving Average every single day for nearly a month straight. Therefore, a close back below the 20-day MA (currently around +$13,351) could signal a bearish trend change.

Make-or-Break Levels

On the daily timeframe, the March soy meal/bean oil ratio ended the week at 1.8:1 which matches the September 2nd contract high of 1.8:1. The spread closed at +$15,746, which is a mere $892 away from the May 30th contract high of +$16,638. A reversal from this level could start a major decline, but a sustained breakout to new highs could clear the way for the March soy meal/bean oil spread to start a run toward prior peaks on the weekly nearest-futures chart at the summer high of +$24,726 or even the late May top at +$26,920 (the all-time high for the spread).

The current placement of the spread might be a good place to use a reversal system which continually maintains a position in the market. The spread position simply switches back and forth from long to short as per some set price parameters.

To determine the parameters for a reversal system, we will first look at the countertrend moves of the last few months. During the rally from the early March low to the late May top, the largest pullback that the March soy meal/bean oil spread experienced was $1,378. During the decline from the late May top to the mid-June bottom, the largest bounce was $1,260. The largest pullback during the mid-June to early September run was $1,140. The one-month decline from the September 2nd top to the October 1st low was very compressed as the largest bounce was a mere $552. Finally, the largest pullback during the current run from the October 1st low was a more normal $1,514. In light of this, we would be inclined to use a bracket of $2k between the upside buy level for the spread and the downside sell level for the spread. This will hopefully keep the spread placed beyond the noise of random and expected market swings. One could use even larger intervals to filter out false signals, but the trade-off is that the risk/reward would be diminished.

Trade Strategy:

For tracking purposes, the blog will hypothetically implement a reversal system for the soy meal/bean oil spread with a position consisting of one 100-ton soy meal March soy meal contract and one 60,000 lb. March bean oil contract. A long position (long meal and short oil) will be initiated on a close above +$17k and a short position (short meal and long oil) will be initiated on a close below +$15k. Each price level will act as a stop and reverse point. For example, if a long position is entered on a close above +$17k then a close below +$15k will trigger a signal to liquidate the long position and initiate a short position. If a short position is entered on a close below +$15k then a close above +$17k will trigger a signal to liquidate the short position and initiate a long position.

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