Soybean/Cotton Spread: When Will It Unravel?

Playin’ It Loose

We’re going to take a look at a spread that has a sloppier correlation than most: the soybean/cotton spread.  The reason for the lower price correlation in this spread is obvious since there isn’t exactly a strong bond between the fundamental demand factors.  After all, you can’t exactly substitute soybeans for cotton or vice versa.  When was the last time you went to Gap and bought some jeans and T-shirts made out of soybeans?  Or ordered a cotton milk latte at the local coffee shop?

However, there are some commonalities between these two crops.  The growing season is the first thing that comes to mind.  Both soybeans and cotton crops in the US are planted in late spring/early summer and harvested in the autumn.  The specific dates will differ, depending on the weather conditions and which state the crop is grown in.

Another commonality is where the two crops are grown.  Many of the same states have land that can accommodate both soybean and cotton crops.  Because of this, you can get a lot of crop rotation where farmers will switch from raising one crop to the other.  This usually depends on the price differences between the two crops.

Since the crop years and locations are similar, it also means that the weather patterns can have a similar impact on both crops.  A good planting season that leads into ideal summer growing weather, followed by agreeable harvest conditions can mean bumper crops in both beans and cotton.  Conversely, a US drought in June or July can simultaneously wipe out both crops.

Soybeans & Cotton = A Volatile Relationship

When you compare the price charts of how these two markets have interacted over the last four decades, it appears that the relationship between the two has been as tumultuous as Rihanna & Chris Brown; sometimes the two run together, sometimes they seem to repel each other.  At the end of the day, though, they always seem to get synced back up.

Soybean Cotton overlay weekly

Soybean Cotton overlay weekly

This lower correlation means that the spread between the soybeans and cotton is more likely to experience outliers than something with a stronger correlation like crude and gasoline, gold and silver, feeders and live cattle, etc.  However, we still like to play it the same way.  First, we look for the soybean/cotton spread to reach levels that it rarely gets to.  Then we look for a change in the price action to tell us when to get involved and enter a position.

Historic Spread Levels

To examine the spread relationship between soybeans and cotton in the futures markets, we don’t just compare the prices of the two markets.  Instead, we look at the difference between the values of the 5,000 bushel soybean contract and the 50,000 lbs. cotton contract.

soybean cotton spread weekly

soybean cotton spread weekly

Looking at 45 years of price history (basis the nearest-futures weekly closing prices), it appears that the spread is expensive whenever a soybean contract is worth $20,000 or more than a cotton contract.  Conversely, the spread is historically cheap whenever a cotton contract is worth $10,000 or more than a soybean contract.  It may take months or it may take years, but whenever the soybean/cotton spread hits or surpasses either one of these levels it has ultimately reversed and gone back to even money where the two contracts have the same value.

Normalize It

Given the fact that the ag and grain markets have had some huge moves in the past and the fact that soybeans are priced at levels that were unheard of until less than a decade ago, it is possible that the spread relationship between beans and cotton can be unrealistically skewed.  The ratio can help us determine if this is the case or not.

soybean cotton ratio weekly

soybean cotton ratio weekly

Using the same 45 years of price history, we can get the bird’s eye view of the soybean/cotton ratio.  By our account, the ratio is expensive whenever it reaches 1.8:1 or higher (where a soybean contract is worth at least 80% more than a cotton contract) and it is cheap whenever it sinks to 0.66:1 or lower (where a cotton contract is worth at least 50% more than a soybean contract).

Armed with both the spread and ratio parameters, we can now look at the current situation to see if a trading opportunity is materializing.

Where It Stands

This year started out with the new crop spread between November soybeans and December cotton priced either side of +$12k (premium beans).  This was certainly nothing to raise eyebrows.  However, the spread started trending higher from the early January lows and hit the +$20k threshold in early May.

Here we are a month later and the spread is accelerating.  Today it closed at a new contract high of +$24,532.  This is a strong bull run.

Nov-Dec 2016 soybean cotton spread daily

Nov-Dec 2016 soybean cotton spread daily

The Nov-Dec bean/cotton ratio hasn’t quite reached the historical expensive marker of 1.8:1 yet, but it’s getting close.  So far, the ratio has reached 1.76:1.  It wouldn’t take much to ring the bell at 1.8:1 sometime soon.

The bull run in this spread has been supported by the rising 30-day Moving Average.  The Nov-Dec bean/cotton spread has closed above the 30-day MA every single day for five consecutive months.  In addition, the pullback in early April and the correction into late May both stopped near the 30-day MA.  Therefore, the IMC blog will use a two-day close below the 30-day MA for the first time since the first week of 2016 as a green light to take a shot at the short side of the spread.

Trade Strategy:

For tracking purposes, the blog will make a hypothetical trade by selling one 5,000 bushel November soybean contract and simultaneously buying one 50,000 lbs. December cotton contract on a close below the rising 30-day Moving Average (currently around +$21,332).  Initially, the spread will be liquidated on a two-consecutive day close $500 above the contract high that precedes the entry (currently +$24,532).

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