Dr. Ken Rietz
This is the monthly spreads issue. This month we will cover the crack spread, as usual, and talk about the intramarket ratio spread, specifically using the example of the soybean-corn ratio spread. (There is an options strategy called a ratio spread, in which you buy and sell different numbers of options. That is not what I am doing here.) Plus, we will also give a detailed reason why ratio spreads are the best way to compare the relative strengths of two commodities (or stocks).
First, we cover the crack spread using the standard 3-2-1 ratios, starting with the graph. (I covered this spread in some detail in the original spread issue, dated October 12, 2023.)
We will focus on the three largest soybean consumers and producers: China, US, and Brazil. China is the largest importer of soybeans, to the extent that Brazil (the largest exporter of soybeans) is arguably dependent on Chinese imports of soybeans. Since the Chinese economy is becoming more unstable, this is a concern. The US is less dependent on China. But the price of soybeans is highly dependent on Chinese imports. This is a source of unpredictability that is hard to eliminate.
The USDA FAS office predicted a record-setting soybean crop for Brazil as late as October 2023, but the weather did not cooperate. Brazilians planted an early soybean crop, but those crops are poor. Later plantings seem to be doing somewhat better, but still not doing well. But the soybean meal from that first crop should hit the markets earlier than usual. The NOAA weather forecast for the next month for Brazil is not encouraging, with decent rainfall in small parts of northern Argentina and very little extra rain in southern Brazil. On the other hand, the soybean crop yields from the US should still supply a large portion of the soybean meal that the world needs from production and storage (as indicated by the much lower price), although this puts China in the awkward position of importing from the US.
The overall situation for soybean prices is unstable. However, a mildly bearish slant seems more likely than alternatives. Keep a close eye on the Chinese economy and southern Brazilian weather, either of which could affect those prices considerably.
It is interesting to note that there was little effect on the crack spread due to the disturbances in the Red Sea. But after a brief moment, that makes sense, since the entirety of the WTI crack spread was completely isolated from that conflict, and any global impact on prices would have affected all the components of the spread similarly.
We now move to the ratio spread section. We will first discuss a less obvious theoretical aspect of the ratio spread, and then move to practical considerations. The overall idea is simple: use the ratio of prices of the futures as a means of understanding the relative strength of price movements of a pair of commodities. Contrast that to looking at a single chart that plots the futures of both commodities, typically with two different vertical scales, one on the left side and the other on the right side. All graphing platforms will attempt to maximize the vertical movements of the graphs, because that displays the most details in the movements. But that makes comparisons difficult. Consider the classic ratio spread of gold versus silver. From the start of 2023 to the present, gold futures, from low to high, changed about 14%, while silver futures changed about 30%, or relatively twice as much. Thus, simultaneous graphs of the two can be deceiving, because the gold graph will be stretched by a factor of 2 relative to the silver graph. Only a detailed look at the left and right scales, and some calculator punching will show that, though. The graph of the ratio of the two prices doesn’t fall into that trap. In short, ratio spreads are a superior way to compare commodities.
For this issue, I am looking at the soybean-corn ratio spread. Note that the futures contract months for soybeans and corn do not overlap, so we pair the November soybean contract with the December corn contract. This is near the end of both harvests in the northern hemisphere. Here is the graph for 2023 and 2024.
The ratio spread is useful for determining which of two commodities to use, in this case, which crop to sow. Note that the red graph is for the 2023 contracts, and the thicker, black graph is for 2024. If you look at the current trends for the futures of both soybeans and corn, the predominant direction is down. This is what makes the ratio spread useful; it tells you which of the two is down more. The drop between the end of 2023 and the current ratio is quite prominent, roughly −15%. That would mean that the top of the ratio is dropped more than the bottom. Then the continued decline in the ratio spread during this year means that the difference is getting stronger. Now, it must be remembered that futures are somewhat more flexible than options and should not be used to estimate final prices, yet there is plenty here to indicate that corn is the crop to choose. Reports from Argentina and Brazil show that corn is indeed becoming more popular than soybeans for next year, but the ratio spread is not automatically the reason for the shift. By using the data from the previous harvest, the same can be deduced. But it requires much more work.