FBA Issue 23: November / December 2008
Uncle Sam casts his shadow: China corn overtakes CBOT prices
In the previous article ("Corn gone wild: High strangeness in corn markets, Pgs 14-19), we discussed how CBOT corn is ignoring its own supply and demand fundamentals to follow crude oil prices. Now, we examine the anomalous price movements under way in China's domestic corn market.
At this time, China's corn market walks on a tight rope, with the government acting as a balancing pole between supply and demand. On one hand, Beijing makes sure that supply shortages do not plunge the market into hyperinflationary chaos.
Spectre of US corn haunts policymakers
On the other hand, China is only haunted by the spectre of shortages because its government stubbornly avoids mass corn imports at all costs. With America accounting for 60 to 70 percent of global corn exports, the last thing Beijing wants is to buy Uncle Sam's corn.
Right now, the market is telling us that China will get its wish again this year, but probably for the last time. Imports cannot be avoided for much longer and when they occur, the event will shake up global feed markets. How does the market tell us all this?
Spot corn decouples from CBOT
Mostly through growing price arbitrage opportunities between Chinese and foreign corn. Traditionally a corn exporter, China spot corn prices were historically below CBOT prices. As the accompanying graph shows, this has not been the case in recent years.
Recently, over six weeks in mid-summer, China's spot corn prices only fell 8 percent before recovering slightly while corn's international price fell approximately 30 percent. This is significant, as spot corn plays a far larger role in China than it does in the west, where CBOT futures dominate price trends.
While the most recent price data from the last few weeks is not included on the above chart, it shows China spot prices decisively overtaking CBOT corn. In addition, Dalian corn futures have stayed stubbornly higher than CBOT prices for a long time. This implies that China's domestic market for corn is significantly tighter than in the rest of the world.
All this however, must be qualified by one fact: as the previous article ("Corn gone wild: High strangeness in corn markets, Pgs 14-18) demonstrated, CBOT corn has been tracking oil prices almost perfectly for the last few months.
On one hand, crude oil's own nosedive certainly exaggerated the fall in CBOT corn from its record peak in early July. On the other hand, for many years now, China's domestic corn inventories have fallen far more quickly than those in the rest of the world. Reflecting its rising scarcity, every year, China's corn price climbs to a higher level than the previous one.
Nasty winter, Olympics balance the market
This was true even this year, when some unusual luck significantly reduced the corn demand anticipated by analysts. That, under normal conditions, should have softened prices but instead, China's corn price continues to climb (see accompanying graph). The market tightness implied by all this justifies China corn's stubborn resistance to CBOT price deflation.
Indeed, were it not for a coincidence of two extraordinary events, China corn would remained stayed stable or even risen in the face of CBOT price deflation. In early 2008, exceptionally severe winter storms devastated Chinese livestock inventories, thereby cutting corn demand and helping to balance it against limited supplies. Later, an anticipated recovery in livestock inventories never materialized. Instead 2008's once-in-a-century blizzards kept hog, poultry and layer numbers falling even six months after winter ended.
Later, in mid summer, industrial corn demand was hammered by the forced stoppage of industrial corn processing plants. They were ordered closed in a bid to improve Beijing's air quality. These industrial corn processors only resumed production after both the Olympic Games and September's Paralympics ended. In the face of much worry that dry conditions would lead to a small corn harvest, these two coincidental, one-off events kept corn demand in a delicate balance with supply.
Even so, after their modest summer time decline, China corn prices appear to have stabilised. In the north-eastern corn growing regions of all places, there exists much inflationary pressure. This is because the government deliberately shipped much of its corn to southern coastal provinces such as Guangdong, which would otherwise be tempted to smuggle in foreign corn.
In the northeast, prices are kept from rising in the face of tight supplies by a now routine weekly auction from national corn reserves. Although the auctions sold off only nominal amounts of corn (about 300,000 tonnes in total), the mere threat of the government dumping corn is usually enough to quell inflationary market fundamentals â€“for now. The mere fact that government corn reserves must constantly be used to keep markets orderly says much about the latent inflationary demand just below the surface.
Price gap with CBOT corn keeps on growing...
Yet, for the first week of September, there was bad news that, superficially, looks like good news. Corn prices were stable in most of China's regions. In the Dalian futures market, corn prices initially surged from RMB1,794/tonne to RMB1,864/tonne in early September on news that the forthcoming harvest might be affected by the drought in the north. However, by September 8th, Dalian futures fell to RMB1,761/tonne when fair weather prevailed, thereby implying a larger than expected harvest.
Since this is a price drop of 5.5 percent in Dalian corn futures in just one week, why are we not breaking out champagne and celebrating deflation? Because on closer examination, government intervention is failing to avoid dependence on imported corn, and that implies scarce domestic supplies, irregardless of short-term market spasms.
In early September, Dalian and China spot corn sold at 17 and 12 percent premiums to CBOT corn respectively. Over the next month, the price difference had widened even further. By October 15, Dalian futures were 45.9 percent higher than CBOT prices. China spot prices were a whopping 49.5 percent higher than corn's international price. Hence, CBOT's price advantage over China corn is, if anything, expanding by a profound, unsustainable margin.
The question is, if China's corn prices are significantly higher than CBOT's, what does this imply? Quite a few things, its seems. First, this has more than closed the traditional price gap between CBOT corn and China's domestic corn, where the latter was traditionally cheaper. In addition, it must be noted that China corn's price cross-over does not reflect any increase in the quality of Chinese corn relative to global supplies. Instead, Chinese corn's high price creates a classic, arbitrage opportunity to import less expensive corn. In this respect, domestic corn's premium over the international price reflects China's transition from net corn exporter to importer-in-waiting.
Price gap with CBOT draws in foreign corn
We say 'in-waiting' because as the government's decade long draw down of national corn reserves demonstrates, the Middle Kingdom is uncomfortable with the fact that Uncle Sam accounts for well over half of world's exportable corn. Although China already imports soya beans en masse, at least that legume's import base is diversified by significant Latin American soy production. Therefore, policymakers will fight tooth-and-nail to avoid relying on imported corn, as it implies a dangerous geopolitical dependence on the United States for China's food.
Nevertheless, Beijing appears to fighting a losing battle. This year's unusually low livestock output and artificially depressed industrial corn production probably gave China one year of breathing room. Even so, supply barely meets this year's stunted demand. Indeed, eFeedLink analysts expect prices to rise after the harvest, instead of fall. Hence, it would not be surprising to see the government again open up corn reserves to auction markets in the fourth quarter. Realistically, it is only a matter of time before a combination of relentlessly increasing meat consumption, rising industrial corn use and demand for ethanol clashes with bad weather or China's limited agricultural land area.
Moreover, with China's corn price higher than the world price, any economist will conclude that such a state of affairs, if sustained, will draw in lower priced imports. Should China ban mass imports of corn, the same economist will tell you that in the face of a sufficiently wide enough price difference, this will inevitably lead to smuggling. Needless to say, illegal imports and black markets are something that Chinese entrepreneurs have a long, successful history of undertaking. Whether it occurs legally or through black markets, pressure to commence mass corn importation is always growing. It will only relent when corn is as plentiful inside of China as it is in the rest of the world. Only at that point would long-term CBOT and Chinese corn prices equalise.
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