Merricks Capital Wheat Basis and Carry Trade

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1 Merricks Capital Wheat Basis and Carry Trade Executive Summary Regulatory changes post the Global Financial Crisis (GFC) has reduced the level of financing available to a wide range of markets. Merricks Capital believes that this reduction in available capital will create opportunities which will allow investors to generate higher returns with lower levels of risk than has traditionally been the case. Merricks Capital has identified one such opportunity in wheat where the relationship between the current physical wheat price (including storage) and the future wheat price imply an annualised return of 1%+. Theoretically the future price of wheat should be equal to the current price plus the cost of holding wheat until the later date. This is known as the cost of carry and is comprised of storage, handling, insurance and financing costs. Historically when financing has become tight the implied cost of financing embedded in the cost of carry has increased substantially, beyond the usual cost of finance, providing an arbitrage opportunity. Global commodity merchants that would typically participate in this trade and close the arbitrage are under financial pressure and unwilling to apply capital for the duration that is required to capture this opportunity. In order to capture this opportunity you need to be able to source, store and trade physical wheat and be prepared to tie up the associated capital for up to 12 months. Merricks Capital has extensive experience in this area and a successful track record in repeatedly executing this trade profitably since the inception of the commodity strategy in 28 and most recently in 217. US Wheat Market The US wheat market is the global benchmark for global wheat pricing. The US is the largest exporter of wheat in the world and is home to the world s most liquid wheat futures contract on the Chicago Board of Trade (CBOT). A vast majority of global markets are priced relative to the CBOT wheat price in what is known as basis contracts. The CBOT sets minimum storage rates for wheat stored within the exchange approved delivery network. These rates are set via a formula that is linked to the degree of the contango in the CBOT wheat futures market. Large wheat supplies generally lead to a futures curve that is in contango resulting in increasingly higher minimum US wheat storage rates. The minimum storage rate policy is designed to encourage the delivery and storage of wheat in the CBOT approved storage network with the primary objective of forcing convergence between financial derivative and physical pricing. This has led to US wheat storage costs exceeding storage costs in other locations. US wheat supply remains high, increasing the implied cost of storage. 4 US Wheat Fundamentals ('mt) 8 4.% CBOT Wheat Futures 12 month Carry % % % 2 4.% % % % -4.% Exports Carry-Out Production CBOT Wheat Futures 12 month Carry Chart 1. Source: USDA, Merricks Chart 2. Source: CBOT, Merricks

2 US wheat stocks reached their highest levels since 1989 in 16/17 and coincided with record production of corn and soybeans. This is placing significant strain on the US grain storage system and, as discussed before, led to storage costs to increase substantially CBOT Wheat Futures Curve As can be seen from Chart 2., which tracks the implied cost of carry in forward futures prices, the combination of a higher cost of storage and finance has led the market to nearly the highest cost of carry since 26. The 12 month US carry is now near its highest level in the past decade at 2% July Sept Dec March May July Sept Dec March CBOT Wheat Futures Curve Chart 3. Source: CBOT, Merricks Playing the cost of carry The easiest way to play this carry trade is to buy physical US wheat to store for 12 months and sell the 12 month forward US futures contract. However, commercial storage rates currently charged are more than the return received from carrying the wheat in those storage facilities and selling forward. This prohibits those that do not have their own storage from exploiting the steep futures curve by carrying wheat in the US. For those who do not have their own storage the next best play is to find a proxy for US wheat by identifying a wheat market that has a high correlation with US wheat but has a lower cost of storage, and to buy physical and store for 12 months and sell the 12 month forward US futures contract. Australian wheat is the ideal proxy for US wheat as: Australian wheat price is highly correlated to the US wheat price Australian wheat is of equal or higher quality than US wheat Australian wheat competes with and is sold into the same markets as US wheat Australia has a high quality, secure, centralised storage system with a fixed storage cost of US$12/mt or 8% The opportunity to perform this trade in other locations is limited by sovereign risk and available public storage. Australia is unique in that it has low sovereign risk, a central storage system with unlimited public access and fixed storage rates. Executing the trade Buy Australian physical wheat in December in an approved bulk handling facility Simultaneously sell December 218 CBOT wheat futures and hedge the USD/AUD exchange rate Hold the physical wheat for 12 months In 12 months, sell the Australian wheat and buy back the CBOT futures, cover the USD/AUD hedge This strategy has a net return of 1% assuming no change in Australian basis. Merricks Capital currently has in place all the necessary documentation and capabilities to deploy capital to take advantage of this opportunity.

3 Risk of this strategy - Australian wheat basis falls below entry point The primary risk to the thesis is that the premium for Australian wheat declines over the term of the carry period. This is known as basis risk, with the basis defined as the premium of Australian physical wheat price over CBOT wheat futures. Below we explore why the basis risk of this trade appears to be substantially mitigated. Basis is currently trading at $2/mt. At this level breakeven for the trade would be where realised basis is $/mt. Our expectation, based on historical analysis is that realised basis is likely to be in the range of between $3 and $4. If that happens then the trade would generate a return of 2% Australian wheat basis is expected to fall over the course of harvest in November and December, providing an optimal entry point. Based on the current basis level, breakeven would be equal to basis falling to $. Each $1 decrease in Australian wheat basis trade entry point causes the breakeven for the trade to fall by $ Chart 4. Source: Merricks As shown in the chart below, Australian wheat is highly correlated with US wheat and has correlation of 72%. This high correlation makes sense as Australian and US wheat compete into similar export markets. Australian APW WheatTrack Geelong Spot vs CBOT wheat spot (USD/mt Geelong Aust. APW spot Chart 5. Source: Profarmer Australia, CBOT, Merricks Australian wheat tends to be sold at or above export parity pricing, while US wheat does not trade the same way

4 Australian wheat production is expected to normalise after record production in 216/17 Australian wheat fundamentals f Carry In Production Exports After achieving an all time record production in 216/217, Australian wheat production is expected to normalise in 217/218 as dry weather during the early stages of the growing season resulted in lower acreage and crop failure. This normalisation is expected to support a higher basis throughout the 217/18 marketing year. Chart 6. Source: Merricks Historical analysis of Australian basis since 24 illustrates that basis trades regularly between $ and $5. 8 Recent periods where basis has traded below $ are isolated to: GFC results in a 4% devaluation of AUD -6 11/8/29 11/8/21 11/8/211 11/8/212 11/8/213 11/8/214 11/8/215 11/8/216 Chart 7. Source: Profarmer, CBOT, Merricks Worst US drought in 5 years The period immediately following the GFC in 28/29 when the AUD fell 4% which was not completely reflected in an appreciation of the Australian wheat price. In 212, the worst US drought in 5 years resulted in a sharp reduction of US corn and wheat production and resulted in US corn and wheat futures rallying over 35%. Australian wheat prices lagged the strong rally in US futures. The events of 28/9 and 212 are unlikely to be repeated in the foreseeable future. In 28 the AUDUSD was.98 which at the time was it s highest level against the USD in 25 years. Today the AUDUSD is.76 which reflects a more moderate valuation for the AUD. The drought that occurred in 212 was the worst in over 5 years and is unlikely to be repeated in 218 with long term weather patterns suggesting neutral la-nina/el-nino conditions, lowering the probability of an extreme weather event in 218. Macro risks are prevalent with firming bond yields and an increase in US inflation expectations resulting in financial flow into commodities as an asset class. This may serve to support financial flows from time to time that would induce short bouts of short covering on CBOT wheat futures market which may periodically outperform Australian wheat prices.

5 A more detailed analysis of historical Basis outcomes suggest minimal downside Average October Basis (USD/mt) Analysing the October average basis over the last 12 years provides a historical context of likely basis which will be achievable at exit. Chart 8. details the average basis level and shows that the basis trades at or above the proposed entry point of $15. In the one circumstance that it did not, basis recovered to $17 in December Chart 8. Source: Bloomberg, Merricks 29 - A broad macro relief rally from low price levels induced a sharp short covering rally in October of 29. Australian wheat lagged the rally in CBOT futures. 211 A sharp depreciation of the AUD from 1.7 to.94 in September and October of 211 was not matched by an equal appreciation in the Australian wheat price. Opportunity to capture a higher basis Historical Monthly Average Basis High (USD/mt) Analysis of the historical trading range of basis during each year suggests that over the next 12 months we will get an opportunity to close out the trade at basis which is higher than current entry level and to take profit earlier than expected. 212 was the only year this did not occur when the worst drought in 5 years in the US caused wheat prices to rise 35% in 4 weeks. Due to the high level of existing inventory levels in the US and the benign long term weather outlook, the chance of this happening again is very low. Chart 9. Source: Bloomberg, Merricks

6 21-Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Despite some normalisation in 217, US wheat supply remains at its highest in over a decade. High inventories will limit the ability for US wheat to trade higher while Australian wheat is already trading just marginally above its cost of production, limiting farmer selling. US Wheat Fundamentals ('mt) Large US wheat inventories will limit the upside to US wheat prices. This situation is in contrast with the period when US wheat supplies were declining and US corn supply hit multi year lows Exports Carry-Out Production Chart 1. Source: USDA, Merricks Potential for an early exit W 1 Comdty - W 6 Comdty Highest Monthly Average Basis (USD/mt) Chart 11. Source: Bloomberg, Merricks Chart 12. Source: Bloomberg, Merricks Flattening of the futures curve CBOT wheat futures are heavily shorted by speculative funds. This crowded positioning increases the possibility of a short covering rally based on real or perceived wheat/grain global supply risk in 217 despite the large US inventories. In the past, as shown in the chart above left, these short covering rallies have served to flatten the futures curve, i.e. spot wheat outperforms wheat 1 year forward. Rally in Basis Australian wheat basis has the potential to appreciate during the term. This would provide an opportunity for an early exit to the trade. The chart shown above right illustrates the highest monthly average basis price for each of the past 12 years. A basis of $4 would increase realised return by more than 1% to 2%+. Annualised return would be even higher.

7 Conclusion Base case returns from buying Australian physical wheat simultaneously selling the CBOT wheat December 218 contract and carrying the Australian physical wheat forward through to November 218 would provide a base case gross return of 1% on futures curve carry alone. While this trade involves taking on basis risk the case for further upside for Australian wheat relative to CBOT wheat is supported by low Australian wheat inventories, aggressive export buyers, limited farmer selling and the opening up of new export opportunities to India and China that are deficient in high quality wheat. The appreciation in the Australian premium has the ability to add 1-15% on top of the base case return assumption. A sharp short covering rally in wheat markets and subsequent flattening of the CBOT futures forward curve would serve to provide an early realisation of the strategy profit. Risks to the strategy are limited to the underperformance of Australian wheat to CBOT wheat (contraction in the premium) with 1% downside of Australian basis representing the investment breakeven level. If you would like any further information please do not hesitate to contact Adam Lindell, Chief Operating Officer Merricks Capital on or adam.lindell@merrickscapital.com

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