FBA Issue 31: March / April 2010

Volatility, uncertainty & questionable numbers: When corn, money and statistical truth are all in short supply

  

 

 

It has not been a good month for grain markets. After a widely doubted USDA report broke an early year grain market rally, the situation was made worse by growing global liquidity problems. Within days of the USDA report, both equities and commodities were both pulled down sharply after China, the only major economy growing strongly, tightened credit conditions.

 

All this coincided with a Greek government bond sales that nearly failed and estimates of negative US M2 monetary growth. A contraction in the broad money supply usually signals recessionary conditions, lower commodity prices.

 

 

With first Dubai World and later Greece rocking global liquidity flows, negative M2 growth can also be an early warning signal of an impending financial crisis, especially with a new, larger wave of US mortgage refinancing looming later in the year. The latter risk was further implied by rising credit default swap and VIX (stock volatility index) index values, both of which imply that a major bankruptcy might be looming.

 

A rising US dollar and the fleeing of money into safe treasury bills (which briefly paid a negative interest rate) is further evidence of tightening monetary conditions that could easily hold down grain prices. By late January, corn was battered down to as low as US$3.55/bushel and soy to US$9.31/bushel, down roughly 15% and 10% from their recent rally peaks.

 

Yet, amid this darkening picture, opportunities, though not easily evident, are as plentiful as the risks. For one thing, while the gathering monetary storm clouds threaten to choke both liquidity and CBOT futures, underlying grain market fundamentals are in all likelihood, tighter than they may initially appear to be. Should the liquidity storm clouds pass, this may cause a handsome price rebound within a few months' time. Should the worst case financial crisis scenario happen, corn and soy's fall will be constrained by their production costs, which have risen considerably in recent years.

 

Most interesting of all, while CBOT corn started falling towards US$3.50/bushel, in China's Jilin province, corn touched RMB1,720/tonne (US$6.40/bushel). Hence, while CBOT corn is barely higher than it was a year ago, China's corn price jumped approximately 25% over the same time.  Before shipping and taxes, the price difference between CBOT and China corn ranges from 70% to 80%. After shipping and taxes, foreign corn is slightly cheaper, thereby opening an import window last seen briefly in September of last year.

 

In his daily CBOT market report, Victor Lespinasse, chief trader at Grainanalyst.com noted that given China's disappointing corn harvest, "This much lower crop could force China to import large amounts of corn for the first time in years but don't expect this to happen for several months or more, if then. This is something that could have a bullish impact on our corn market in the long term but shouldn't have any impact at all in the short term."

 

What we can say with confidence is that for a little while longer, this price difference might grow but sooner or later, it will narrow again. What matters is how this import window will close. It is most likely that the price differential between CBOT and Dalian futures will narrow via international corn price inflation more than by Chinese domestic prices deflating.

 

 

That is because USDA may soon learn the same lesson which China is currently experiencing: No matter how much an over-optimistic official corn harvest projections initially depress markets, sooner or later, if supplies really are tight, prices will catch up to the underlying fundamentals. The last two weeks have seen us pick apart USDA grain production statistics. Now, it is China's turn.

 

According to a report prepared by US embassy staff, not only are USDA and Chinese estimates of China's grain harvests wrong, they may have been based on false information. Moreover, after touring China's corn growing regions, the US embassy attaché's report made significantly lower corn crop estimates than those found in the USDA's latest report.

 

According to the report, Beijing's over-optimistic crop estimates is the result of an official reporting system that is distorted by monetary incentives. The attaché report states that, "To gain more allocation of financial aid from the central government... provincial government authorities are occasionally tempted to overstate their grain output in a given year even if the crop was impacted by adverse weather."

 

That would not be the first time such a thing happened. In early 2008, it was discovered that in China's northeast, many corn storage facilities reported nearly full were actually empty. Just as was the case in this corn growing season's overly optimistic harvest projections, this happened because incentives were given out in proportion to reported inventory sizes.

 

The US embassy's reduced corn harvest estimates were based on actual crop tours, which made attachés conclude that the crop had been suffering damage since early 2009 due to "winter drought, plant disease, hot and dry wind before harvest, and rain damage around harvest time." In addition, China's corn was also damaged by high winds in northern regions during the last stages of the growing season, which broke many of their stalks.

 

 

The report estimates that, "corn production in 2009-10 dropped 9% from the previous year to 150m tonnes." This is 5 million tonnes lower than the USDA's surprisingly large January projection. However, it is still significantly higher than the latest forecasts of firms like eFeedLink, which will have to revise its 145 million tonne corn harvest estimate further downwards, probably to around 140 million tonnes. Given that the US embassy's estimate remains above China's official estimate of 148 million tonnes, perhaps this high number was chosen with the intention of not strongly contradicting official USDA estimates, which stubbornly stayed at 155 million tonnes.

 

The fact that China does not have the corn its statistics expected it to have is also impacting corn reserve replenishment. Less than two months ago, China's government announced its intention to restock national corn reserves over the winter months. Apparently, that plan has been put on hold. According to eFeedLink's late January report, "Although they were assigned the task of re-stocking national corn reserves, state-owned grain companies stayed prudent as prices remained high."

 

Needless to say, prices stayed high because corn was in short supply. Beijing is eager to replenish its grain reserves but tight supplies are preventing it from doing so. If China's government purchased corn at this time, it would make the country's corn shortage even worse than it already is.