The effect of supply and demand determines the price of corn in the futures markets. For those investors without a futures account, the Teucrium Corn Fund ETF (NYSEARCA:CORN) provides investors unlevered direct exposure to the corn market. By understanding the supply and demand model in corn investors can take advantage of the opportunity currently available. To start the supply and demand model ,prepared by the USDA, is the World Agricultural Supply and Demand Estimates Report or WASDE. Figure 1 below shows the USDA WASDE Report for US Corn.
Figure 1: data source USDA
Short term price gyrations will occur in corn because of market reaction to events such as news on weather or government reports or policies. This article is intended to educate the reader so they can understand how the impact of these events likely effect the price of CORN. Additionally, at the end of the article we will delve into some of the mechanics of CORN which present the investor some additional risks beyond the inherent risks of the futures market alone.
Let's explore the major factors effecting the supply and demand in the market. On the supply side there are basically 3 sources for US corn.
- Leftover stocks from the prior crop year.
- Current domestic production driven by planted acres and yield.
- Imports which is so small it's insignificant.
There are also 3 major sources of demand for corn.
- Feed and Residual.
- Food, Seed, and Industrial which the largest component is ethanol consumption.
- Exports which typically accounts for less than 15% of total demand.
What I see on the demand side is fairly steady demand for the past 4-5 years, with the volatility coming on the supply side. The supply side volatility is coming from Planted Acres and Yield.
We'll have a better idea of Planted Acres on March 31
The number of acres planted generally reflect the producers view of net returns on corn compared to competing crops such as soybeans. This corn versus soybeans decision is especially important this year. The Iowa State Ag Decision Maker web site estimates that breakeven corn for corn on soybeans is around $3.90/bushel and above $4.20 for corn on corn. (Source: Iowa State Extension) In Chart 1 you can see the last few years the number of planted acres has been reduced. This 2015/2016 crop year the current estimate for planted acres is 88 million acres. The United States Department of Agriculture (USDA) will publish a March 31 prospective plantings report on acres expected to be planted. This should reduce the uncertainty surrounding the planted acres. An increase in planted acres will put downward pressure on CORN price. The planted acres and the yield combine to determine the harvested acres and the overall size of the domestic corn crop.
Chart 1: data source USDA
Yield is the wildcard
Of all the factors effecting the supply and demand yield is the most variable. The uncertainty of the weather, the production practices of the farmer including land preparation, planting dates, and seed and input selection all play a factor. This is especially true in regard to planting and harvest dates, both of which impact the total size of the crop.
Chart 2: data source USDA
Look at the regression analysis we created in Chart 2 showing trend line yield in the diagram above. For the 2015/2016 crop year the trend line yield is just above 162 bushels/acre. Last year we had outsized yield at 171 bushels/acre as compared to trend line. This year the USDA is estimating another outsized average yield at 168.4 bushels/acre. In the past 20 years we haven't seen back to back years producing outsized yields, so I think it's a reasonable assumption to expect the USDA to lower their yield estimate this year closer to trendline. We ran a Monte Carlo simulation on the yields for the past 11 years and the simulation suggests a sub 159 bushel/acre yield.
Figure 2 shows an average market price sensitivity model for corn futures. We created this proprietary model to attempt to predict the average market price based on historical USDA data. What this model shows is the corn futures price is very sensitive to yield changes. CORN is currently trading at a reference futures price of around $3.80/bushel. At trendline yield of 162 bushels/acre we see significantly higher expected prices that we have today. At trendline yield in a reasonable case the price will be about 8% higher in the underlying futures market equating to about 6-7% higher in the CORN ETF. CORN is currently trading at $21.30/share up from its recent low of $20.54. Therefore, we think it's reasonable to assume the risk remains to the upside in this market.
Figure 2: proprietary pricing model
Why Food, Seed, & Industrial demand should remain constant
Roughly 40 percent of the corn supply is used for Food, Alcohol, & Industrial uses. The major component of this is ethanol production. Currently ethanol production consumes about 5.2 billion bushels. Although margins are breakeven at best the ethanol industry had great margins last year which allowed plants to build surplus to ride out the current storm. You can see in Chart 3 that usage has been nearly constant for the past 6 years. The exception is the drought year that saw yields fall significantly below trendline. We see no reason for this demand to reduce.
Click to enlarge Chart 3: source data USDA
Why Feed & Residual demand should hold steady
Roughly 35 percent of the corn supply is used for feeding animals which has been roughly 4.5 to 5.5 billion bushels for the past 10 years. For the past 8 years we have seen a general reduction in the feed demand as shown in Chart 4. This has turned around in the past couple of years due to good margins in the livestock business. However, we have seen margins erode and go negative for cattle over the past months. So we could see some pressure on the feed side with reduced demand in future reports. We think any reduced demand will be insignificant due to the current low corn prices.
Click to enlarge Chart 4: source data USDA
Why Exports demand is reasonable at current levels
The US is a major supplier of corn to many countries. Over the past decade the US has exported around 1.8 to 2.2 billion bushels a year as shown in Chart 5. The exception to this is the 2012/2013 crop year when reduced production and high prices reduced demand for US corn. Over the past year the US dollar has significantly strengthened against most world currencies. This stronger dollar makes our exports less attractive. In addition, South America is continuing to increase exports and a regime change in Argentina looks to ease export restrictions. The WASDE model has already taken some of this headwind into account and reduced export expectations for the current year. We think the bad news here is already factored into the numbers.
Chart 5: source data USDA
Additional Risks for Holding Commodity ETFs
Commodity ETFs have certain risks that come from holding long futures contracts rather than the physical commodity. Because futures contracts have certain expiration dates, the owner of the futures contract must roll the contract to a subsequent contract month to avoid taking physical delivery of 5,000 bushels of corn. This roll as we will explain is the where the risk comes in.
The CORN ETF is designed to hold an index of corn futures contracts. Specifically, CORN will hold 35% of its funds in the second to expire CBOT corn futures contract (July 2016), 30% of its funds in the third to expire CBOT corn futures contract (Sep 2016), and 35% of its funds in the December CBOT corn futures contract following the third to expire month (Dec 2016). Starting May 10th, CORN will roll it's July 2016 futures contract to Dec 2017. The current price of the July 2016 Corn futures contract is $3.74 and the Dec 2017 Corn futures contract is $3.94. When subsequent futures contract months are more expensive than prior contract months this is called a contango (The opposite is backwardation). The mechanics of the roll is the fund will sell all of it's July 2016 contracts and subsequently buy the Dec 2017 contracts. Since the Dec 2017 contact is currently $0.20 higher than the July 2016 contract if the price difference remains the same on the roll date the fund will purchase about 5% fewer shares. Because only 35% of the shares are being rolled, the drag on the fund will be about 1.8%. This drag in a contango market lowers the CORN investors return and is the additional risk that is present.
We think the demand side of the corn market is reasonable given the current market conditions. The market is setup for a supply side shock from potentially reduced yields. This should have the effect of raising the price of CORN 6%-7% over the next few months with limited downside risk. The March 31 USDA Stocks and Prospective Plantings Report should clarify planted acres and reduce the downside risk from an increase in corn acres. With good upside potential and limited downside risk, I feel comfortable owning CORN rather than cash.
Disclosure: I am/we are long "CORN".
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The information contained in this article is taken from sources believed to be reliable, but is not guaranteed by AgTrades, LLC, nor any affiliates, as to accuracy or completeness, and is intended for purposes of information and education only. Nothing herein should be considered as a solicitation to trade commodities, equities, or a trade recommendation by AgTrades, LLC. Futures, equities, and options trading involves the risk of loss. Past performance is not indicative of future results.