The IMC blog has traded the soy meal/bean oil spread a few times. As a quick review, these two markets are the products of a crushed soybean. Not surprisingly, the correlation between them is quite strong.
However, there are still periods where one of the markets will substantially outperform the other. There are also times when one market will make a trend reversal before the other. These occasions can offer spread trade opportunities.
Over the last couple of months, the soy complex has been ripping higher. Soy meal has led the pack as it has outperformed both the soybeans and the bean oil.
About a month ago, the ratio between the value of one 100-ton soy meal futures contract and the value of one 60,000 lb. bean oil contract reached 2:1. At this level, the meal was worth twice as much as the bean oil.
Historically, this is pretty expensive for soy meal. The meal/oil ratio has only reached 2:1 or higher (basis the nearest-futures weekly chart) a handful of times in the last forty-five years.
The weekly close of 2.14:1 that was posted four weeks ago took the spread a hair beyond the 1997 multi-decade high of 2.13:1. This puts it in close proximity to the 2000 high of 2.24:1 and the 2014 forty-one year high of 2.29:1.
How’d It Work Out?
In the past, anytime the meal/oil ratio has only reached 2:1 or higher it has ultimately reversed. Major bear markets followed.
The historic 1973 top at 3.47:1 was followed by a bear market that took the ratio to 0.53:1 (where a soy meal contract was worth about half of a bean oil contract) fifteen months later.
The meal/oil ratio made a double top at 1.98:1 in 1987 and 1989 (not quite 2:1, but close enough for demonstration purposes) and then sank to 1.16:1 by the summer of 1990.
In the spring of 1997, the ratio crested at 2.13:1. Just sixteen months later, it bottomed out at a thirteen-year low of 0.81:1.
The meal/oil ratio punched through 2:1 again in 2000 and peaked at 2.24:1 and in the second-to-last week of the year. Just three months later, it was at 1.53:1. The bear market actually didn’t end until twenty-three months after the top when the ratio finally bottomed at 1.21:1 in November of 2002.
Although it wasn’t quite 2:1, the ratio hit 1.95:1 in the summer of 2004 and dropped to 1.15:1 by the time harvest rolled around a few months later. It peaked at 1.95:1 again in the summer of 2009 and dropped to 1.06:1 nine months later.
The last time the meal/oil ratio reached 2:1 was two years ago. The peak was established in August at a forty-one year high of 2.29:1. By the summer of 2015 the ratio was as low as 1.46:1 and as recently as April 2016 the ratio bottomed at 1.32:1.
These historical examples certainly are not a crystal ball that tells us what will happen in the future. However, it tells us what the behavior pattern has been and, therefore, what the likely outcome will be. Therefore, the smart money will bet on a bear market in the meal/oil ratio and get on the short side at some point.
The Soy Spread Says…
Now it’s time to examine the spread between soy meal and bean oil. Since the meal/oil ratio reached 2:1, we will normalize the spread by comparing the value of one soy meal contract against the value of the sum of two bean oil contracts.
At today’s close, one September soy meal contract is at a premium of +$1,060 over the value of two September bean oil contracts. So far, the spread has been as high as +$1,982.
Prior occasions where the spread reached a premium on the soy meal side were followed by sizable declines.
The soy meal/bean oil (x2) spread hit a record high of +$16,760 (premium meal) in the summer of 1973 and then crashed to a low of -$38,950 (premium bean oil) by the fall of 1974.
In 1987, the spread didn’t quite get to where meal had the premium…but it got awfully close. The spread peaked at -$238 (premium bean oil) in November of that year and hit -$9,950 (premium bean oil) the following summer. It ramped back up to -$330 (premium bean oil) in January 1989 and started its journey toward -$12,430 (premium bean oil) by the summer of 1990.
The soy meal/bean oil (x2) spread reached +$1,802 (premium meal) in the spring of 1997 and chopped back and forth for a few months. It gave up the ghost in September and the bear market that followed dragged it down to -$19,524 (premium bean oil) by the spring of 1998.
Meal gained the premium again in late 2000. It topped at +$2,104 (premium meal) at the end of the year. A twenty-three month bear market dropped it to -$10,774 (premium bean oil) by November 2002.
The last time the soy meal/bean oil (x2) spread went positive was in 2014. The top was established at a forty-one year high of +$5,502 (premium meal) in August. A volatile bear market, full of fast breaks and huge bounces, took it down to -$14,110 (premium bean oil) by the end of Q1 this year.
Just like we saw with the ratio, the current high reading in the soy meal/bean oil (x2) spread indicates that it is ripe for a significant bear market. Prior declines point to the possibility that a decline of several thousands of dollars should eventually take place.
Trend Change Signal
The September soy meal/bean oil (x2) spread has been climbing for the last two and a half months. The 30-day Moving Average has been progressing higher for about two months and the spread has closed above the 30-day MA every single day since the first half of April. This is a strong uptrend.
Furthermore, the September soy meal/bean oil (x2) spread cleared resistance at its 2015 high of -$2,518 (premium bean oil) on May 19th and has never been back below it. This is a breakout market.
At the very least, a close below the 30-day MA for the first time April 11th could indicate that the run has lost its momentum. It may even mean that the run is over. A close back under the August 2015 high of -$2,518 (premium bean oil) should confirm it.
So here’s our plan: The IMC blog will get positioned on the short side once the 30-day MA is breached and consider increasing the position size once the spread is back under the 2015 top.
The blog will work a hypothetical order to sell one 100-ton September soy meal contract and simultaneously buy two 60,000 lb. September bean oil contracts if the spread closes below the rising 30-day MA (currently around -$281). If filled, exit on a two-day close $500 above the contract high that precedes the entry.