Get ready: Spring and summer tend to see the biggest commodity price moves. Here's how to determine when a sizeable price movement may occur.
By Kyle Schrad, INTL FCStone
Volatility is a buzz word that gets used frequently when discussing commodity markets. Since the 2008 spike in volatility, when the CBOE VIX (a benchmark volatility index) traded up over 60, we’ve been moving lower. Currently we’re back near mid-1990s’ levels, trading just above 10. Could it be that this is just a sign of the lower commodity price times? That answer sure seems to be a strong no!
In the last year alone, we’ve seen corn prices rally from the low $5.00s all the way up to nearly $8.50, while Class III prices moved from $15.23 per cwt. in May all the way up to $21.02 per cwt. in October. The risk of strong price movements certainly doesn’t seem to be fading.
Volatility and market price risk are part of everyday business for dairy producers. Many producers are now using exchange-traded tools to help mitigate that risk. One common complaint from producers is that they’ve either felt burned by the market or they’ve missed out on upside potential. With commodity volatility falling toward historically lower levels, options on futures contracts generally become relatively less expensive and thus a more attractive tool.
I like to try to use a few relatively simple market indicators to help determine the timing of when to apply the aforementioned option tools. One of these factors is historical volatility, which, as discussed above, looks to be advantageous currently. Next, taking a look at historical price percentages can offer some insight to the potential size and direction of a market move.
The current market conditions -- with both corn and milk trading in the upper 30th percentile of their five-year historical prices -- open up the opportunity for both products to move rather sharply lower. In fact, USDA’s chief economist Joe Glauber predicted during a presentation at the Ag Outlook Conference just a few days ago that grains would move sharply lower into next year. The upside price potential of the market still has a strong case to be made given the recent poor economic conditions experienced by dairy producers and the significant drought conditions in the plains and Midwest. We don’t need to mention the ever-changing demand factor and any other number of market influences.
Seasonality is the next influencing factor that I like to look at to help determine when a sizeable move may occur. From a seasonal perspective, we don’t typically see big price movements in either the Class III or corn markets during the early part of the calendar year, as you can see in these charts. (Be sure to note the different starting points on the x-axis to the calendar year in the milk vs. corn charts and the subsequent mostly sideways pattern from December through the spring months).
Currently both the grain and milk markets seem to be entering a more sideways "choppy" type of trade consistent with our expectation based on this historical analysis. The biggest moves tend to occur in the spring and early summer months when weather is the biggest influence on both corn and milk production. So, we can target this time of the year as a more opportune time to look for large price movements.
With producer margins having long been negative to just slightly positive, many economists are projecting very good returns for later in 2013, with most expecting corn prices to drop while milk prices remain steady to slightly higher.
I tend to agree that producer margins at some point will be very strong in 2013. My concern, however, is that a sizeable price movement -- either to the upside or the downside in grains -- is likely to be met with a sizeable price movement in Class III futures as well. The best time to plan for stormy seas ahead is when the water is calm.
Whether you’ve been a long time participant in the futures market or you’re just getting started, taking a step back to evaluate the market for opportunities when they arise can be key. In my opinion, the aforementioned factors look to be aligning for an opportunity to use long options, buying calls on corn/soymeal, and buying puts against Class III, to protect against a sizeable adverse price move while still allowing for participation should milk prices rise or grain markets fall.
Kyle Schrad is a Risk Management Consultant with the Chicago office of INTL FCStone. INTL FCStone offers comprehensive risk-management and margin hedging programs and services to dairy producers, processors, traders and end-users. You can reach Kyle at 800-504-5621 or firstname.lastname@example.org.