Grain Market Correlations
The grain markets are highly correlated with each other, some of them even more so than others. In general, the similarities in growing seasons and their usage in food products explain why they normally move together.
There will be times, however, when one particular grain will move substantially more than the other grain markets. It may even buck the trend and go the opposite direction. Such occurrences are usually driven by a specific event. If Russia suspends wheat exports, for instance, the wheat market could soar while the rest of the grains are lackluster. But over time, the grain markets tend to get back in sync with each other and resume their normal relationships.
The mean-reverting nature of the grain markets is why an aberration in a normal relationship can offer trading opportunities. Basically, you want to see a grain spread reach levels that it rarely gets to and then watch the price action in order to time the trend reversal. Perhaps we have a candidate for this scenario right now with the bean oil/corn spread.
Bean Oil and Corn
A strong correlation exists between the bean oil and corn. This makes sense because both markets are used in food products. Bean oil is used in cooking oils and it is also found in salad dressings, mayonnaise, and even margarine. Corn is used as food for us humans and also for animal feed.
Another usage that these two markets have in common is biofuel. As a matter of fact, over one-third of the last US corn crop was used for ethanol production. But whether or not allocating such a big portion of corn supplies for ethanol is a worthwhile endeavor is a whole different discussion. It’s a politically-charged topic, so we’ll avoid it in this particular post.
As spread traders, what matters to us is that bean oil and corn have had strong ties for decades. Take a look of how these two markets have trended since 1970. An overwhelming majority of the time, they went in the same direction. Knowing the fundamental link between the two markets and then seeing the history of highly correlated price action to confirm it lays a good foundation that we need for future trading opportunities.
Historic Spread Range
Over the last several decades, the difference between the value of a 60,000 lb. bean oil contract and a 5,000 bushel corn contract has oscillated back and forth in a wide range. As in most spreads, there are a few outliers as well. The bean oil contract seems to have a premium over the corn contract more often than not.
When the bean oil contract premium swells to +$6k or more, things appear to be stretched a bit too far. This has only occurred a little over half a dozen times since 1970. Each time it did, the spread eventually rolled over and retreated until bean oil had surrendered its entire premium.
On the other side of the ledger, the bean oil/corn spread appears to be historically cheap when the value of the bean oil trades at a discount of $4k or more. Such an event has taken place about half a dozen times in the last forty-five years. On the occasions where bean oil traded at a discount of $4k or more, it ultimately turned around and soared until it was trading at a premium of +$3,500 or more over corn.
Smooth It Out With a Ratio
As always, it’s a good ideal to take a peek at the ratio between the markets in the spread that you’re analyzing. The ratio normalizes the relationship. If the markets are priced at record highs or lows the spreads are often trading at historical extremes as well. The ratio will tell you whether or not the relationship between the two markets really is out of whack or not. This isn’t to say that an extreme spread price is not a high-probability setup for a reversal. History shows that it is. But having the same sort of setup in the ratio will increase the odds even more.
The bean oil/corn ratio has spent the last four and a half decades flip-flopping back and forth over 1.1:1 (where bean oil has a 10% premium over corn). The ratio would often stay a year or so above 1.1:1 and then drop back below it. Then the ratio would often stay a year or so below 1.1:1 and then rally back above it. Whichever side of 1.1:1 the ratio is on, you can bet that it’s just a matter of time until it switches sides again.
So perhaps there’s a correlation between this spread and anyone running for office? Is it a coincidence that we expect a reversal during the upcoming election year?! Anyways, let’s get back on topic.
When the bean oil/corn ratio is heading either north or south through the 1.1:1 level, we don’t give it much thought. Our interest doesn’t get piqued until the ratio keeps on moving and finally hits an extreme level. Our opportunities are found in the margins.
Heading north, the ratio gets expensive once it reaches 1.4:1. That’s happened a little over a dozen times since 1970. A close at 1.5:1 or higher (basis the nearest-futures weekly chart) is even more intriguing as it has only happened about half a dozen times in the last forty five years. When the ratio reaches this nose-bleed level, it’s a good idea to start looking for a reversal to the downside. Either bean oil is getting ready to spill or corn is about to pop.
When the bean oil/corn ratio heads south, it’s time to start paying attention when it descends to 0.8:1 (where a bean oil contract is worth only 80% of the value of a corn contract). It’s happened just over half a dozen times since 1970. Each event only lasted a few months or even weeks before the ratio recovered and bean oil finally regained its premium over corn.
Here and Now…and Next Summer, Too
We’ve established the fact that the bean oil/corn spread is worth looking at for a buying opportunity once bean oil drops to a discount of $4k or more. We also pointed out that the ratio is a good way to filter things. A ratio of 0.8:1 or lower is a setup for a future recovery. As fate would have it, the bean oil and corn relationship hit both these spread and ratio levels last month.
But wait! There’s more!
While the December 2015 bean oil/corn spread dropped as low as -$3,500 (premium corn) and the March 2016 bean oil/corn spread dropped as low as -$3,760 (premium corn), it was the July 2016 bean oil/corn spread that closed below -$4k (premium corn) on September 15th. This may be a rare gift from the market gods. Often when a spread or ratio reaches its historical extreme, it is the nearest-futures contracts that do so the most. The deferred contracts are normally priced closer to the mean. Sometimes, the disparity between the nearest-futures spread and the deferred spreads is so wide that it becomes impractical to even consider for a trade. In this case, however, the 2016 summer spread could be the trading opportunity worth pursuing. Thank Ceres for that!
Since the contract high was established back in mid-February of 2013, the July 2016 bean oil/corn spread has been stair-stepping lower on the daily timeframe. Each time a prior correction low was broken the spread made a recovery and rallied for several thousand dollars.
The mid-July correction low was breached in mid-September. By the end of the month, the spread had closed back above the mid-July correction low. If the pattern of the last couple of years stays intact, the July 2016 bean oil/corn spread should be in the midst of a run back above the ‘even money’ level where bean oil regains the premium over corn.
Another observation is that the declining 50-day Moving Average has been a level of technical resistance for this spread since the last week of June. That’s when a bearish trend change was triggered via a close below the 50-day MA for the first time since early April. The July 2016 bean oil/corn spread rolled over after it closed in close proximity to the 50-day MA in late July and again at the end of August.
Perhaps a strong close back above the declining 50-day MA (currently around -$2,800) for the first time in three and a half months could indicate that ball is back in the (Chicago?) bull’s court again. If so, spread traders would have a technical reason to get long.
For tracking purposes, the blog will make a hypothetical trade by purchasing one 60,000 lb. July bean oil contract and simultaneously selling one 5,000 bushel July corn contract if the spread closes above the 50-day MA. Initially, the spread will be liquidated on a two-consecutive day close $200 below the contract low that precedes the entry.