EXECUTIVE SUMMARY US WHEAT MARKET

Transcription

1 MERRICKS CAPITAL SOFT COMMODITIES QUARTERLY THOUGHT PIECE DECEMBER 2016 IN THIS QUARTERLY THOUGHT PIECE WE HIGHLIGHT HOW THE EXIT OF BANK FUNDING AND LARGE GRAIN INVENTORY IS PROVIDING OPPORTUNITIES IN COMMODITY CASH AND CARRY TRADES 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 10%+. + 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 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. 1 MERRICKS CAPITAL SOFT COMMODITIES QUARTERLY THOUGHT PIECE

2 US WHEAT MARKET CONTINUED This has led to US wheat storage costs exceeding storage costs in other locations. US wheat stocks have reached their highest levels since 1989 and have 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. Chart 1. Source: USDA, Merricks Chart 2. Source: CBOT, Merricks 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 The 12 month US carry is now near its highest level in the past decade at 20%. 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 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 2 MERRICKS CAPITAL SOFT COMMODITIES QUARTERLY THOUGHT PIECE

3 PLAYING THE COST OF CARRY CONTINUED + 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 2017 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 10% 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. 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 $17/mt. At this level, breakeven for the trade would be where realised basis is $0/mt. Our expectation, based on historical analysis, is that realised basis is likely to be in the range of between $30 and $40. If that occurs, then the trade would generate a return of 20%. Chart 4. Source: ASX, CBOT, Merricks Chart 5. Source: Profarmer Australia, CBOT, Merricks The main risk to the trade is a depreciation of the current Australian wheat premium. A decline to $0/mt would offset all gains made in the carry differential and represents the breakeven level for the trade. Our analysis suggests that current price levels are already buying export demand. Australia has a high level of intrinsic demand, therefore it s need to buy demand is limited. This is a strong fundamental factor that will help support Australian wheat values after the November/December harvest. As shown in Chart 5, 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. 3 MERRICKS CAPITAL SOFT COMMODITIES QUARTERLY THOUGHT PIECE

4 RISK OF THIS STRATEGY - AUSTRALIAN WHEAT BASIS FALLS BELOW ENTRY POINT CONTINUED + Australian wheat tends to be sold at or above export parity pricing, while US wheat does not trade the same way Australian wheat has a high level of intrinsic export demand due to its freight advantage into Southeast Asia, it s high quality and lower moisture. As a result (and as shown by Chart 6) Australian wheat production is usually consumed and not stored as inventory. When there is high intrinsic demand wheat will be sold at or above export parity. US wheat does not have the same level of intrinsic demand which means that it will tend to trade to the lowest global price to win market share. Chart 6. Source:: USDA, Merricks + Historical analysis of Australian basis since 2004 illustrates that basis trades regularly between $0 and $50 + The period immediately following the GFC in 2008/2009, when the AUD fell 40%, was not completely reflected in an appreciation of the Australian wheat price. GFC results in a 40% devaluation of AUD Worst US drought in 50 years + In 2012, the worst US drought in 50 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. Chart 7. Source: ASX, CBOT, Merricks The events of 2008/09 and 2012 are unlikely to be repeated. In 2008 the AUD/USD was 0.98, which at the time was it s highest level against the USD in 25 years. Today the AUD/USD is 0.74 which reflects a more moderate valuation for the AUD. The drought that occurred in 2012 was the worst in over 50 years and is unlikely to be repeated in 2017 with long term weather patterns suggesting neutral La-Niña/El-Niño conditions, lowering the probability of an extreme weather event in Macro risks are prevalent with firming bond yields and an increase in US inflation expectations results in financial flow into commodities as an asset class. This may serve to support financial flows from time to time that would induce brief bouts of short covering on the CBOT wheat futures market which may periodically outperform Australian wheat prices. + A more detailed analysis of historical basis outcomes suggest minimal downside 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. 4 MERRICKS CAPITAL SOFT COMMODITIES QUARTERLY THOUGHT PIECE

5 RISK OF THIS STRATEGY - AUSTRALIAN WHEAT BASIS FALLS BELOW ENTRY POINT CONTINUED Chart 8. Source: Bloomberg, Merricks A broad macro relief rally from low price levels induced a sharp short covering rally in October of Australian wheat futures lagged the rally in CBOT futures A sharp depreciation of the AUD from 1.07 to 0.94 in September and October of 2011 was not matched by an equal appreciation in the Australian wheat price. + Opportunity to capture a higher basis 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 a basis which is higher than current entry level and to take profit earlier than expected was the only year in which this did not occur when the worst drought in 50 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 + Australian wheat is trading below the cost of production which will prevent farmer selling lower than today s price level. This places a floor on Australian wheat prices Australian wheat prices are expected to be supported by the fact that market prices are at or below the cost of production. This is expected to limit the downside to Australian prices as farmers choose to store and wait rather than sell their wheat. Australian cost of production Chart 10. Source: ASX, Merricks 5 MERRICKS CAPITAL SOFT COMMODITIES QUARTERLY THOUGHT PIECE

6 RISK OF THIS STRATEGY - AUSTRALIAN WHEAT BASIS FALLS BELOW ENTRY POINT CONTINUED + On an export parity view, Australian wheat is trading at a discount to US wheat into key export markets It is expected that once the Australian harvest is complete at the end of December, Australia will trade into Indonesia at parity with the US. Asian buyers will favour Australian wheat over US wheat due to its superior quality and familiar milling attributes. This suggests that basis is currently 4%-9% undervalued and basis should increase by ~US$17. Chart 11. Source: Merricks + US wheat supply is at it s highest in over a decade. High inventories will limit the ability for US wheat to trade higher while Australian wheat is already trading at its cost of production, limiting farmer selling 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. Chart 12. Source: USDA, Merricks POTENTIAL FOR AN EARLY EXIT Chart 13. Source: Bloomberg, Merricks Chart 14. Source: Bloomberg, Merricks 6 MERRICKS CAPITAL SOFT COMMODITIES QUARTERLY THOUGHT PIECE

7 POTENTIAL FOR AN EARLY EXIT CONTINUED 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 2017 despite the large US inventories. In the past, as shown in Chart 13, 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. Chart 14 illustrates the highest monthly average basis price for each of the past 12 years. A basis of $40 would increase realised returns by more than 10% to 20%+. Annualised return would be even higher. CONCLUSION Base case returns from buying Australian physical wheat and simultaneously selling CBOT wheat December 2017 futures contract and carrying the Australian physical wheat forward through to November 2017, would provide a base case gross return of 10% 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 10-15% 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 10% downside of Australian basis representing the investment breakeven level. 7 MERRICKS CAPITAL SOFT COMMODITIES QUARTERLY THOUGHT PIECE

8 CONTACT Adrian Redlich Chief Investment Officer enquiries@merrickscapital.com 8 MERRICKS CAPITAL SOFT COMMODITIES QUARTERLY THOUGHT PIECE