Better Decisions: How high should corn go before you hedge?

Thursday, December 3, 2009

The 'Rule of Thirds' may help you decide what hedging strategies to adopt after the great bull market in corn

by KEVIN SIMPSON

Remember the early part of the decade? Back then, ethanol had yet to create an elephant-sized hunger for corn and there had been two back-to-back years of disappointing yields for wheat and other non-GMO grains around the world.

Way back in 2004, corn traded to a lofty price of US$3.20 and two years later fell to $1.86 in the face of a big harvest. The great demand-led bull market of 1996 with its $5.50 corn was fading into history, confirmation that the good times were past and never to return.

The highs in 2008 were $7.62 recorded on the nearest month chart (July) and $7.99 for new crop December corn, the nearest active trading month of the futures market. Consequently it will look similar to a cash chart of the underlying commodity.

Reports of "the new normal" abounded as wheat, beans, crude oil, the Canadian dollar and other commodities traded up into price levels we'd never seen before.

Perhaps to some of us it seemed like that meant prices would never drop again.

However, past experience and a review of long-term charts suggest that commodity prices are cyclical – a bust follows the boom. Now, I may be delusionary about the future, but I see evidence that support is kicking in at higher levels than we saw four years ago. I believe corn has moved to a higher price range and corn below $3.25 is cheap. Cost of production likely has a lot to do with it, with supply drying up as prices get cheaper.

If we get production jitters – and inevitably we will – the question becomes: "How high should corn go before I hedge or forward contract?" Remember this past spring, when there were planting delays and indications that fewer, not more, acres were planted to row crops? In this likely higher range of corn prices, what is a reasonable target?

One of the trading rules I used during the 1990s was what I call "The Rule of Thirds." Simply by taking the range between the previous important high and low and dividing it into three equal parts, hedgers were able to identify buying and selling points. In other words, cash croppers aimed to price corn when it moved back into the top third of the recent range and feed buyers started buying their year's feed needs when it fell down into the bottom third of the range.

Applying the "Rule of Thirds" allows us to make two key observations. First, the upper end "sell" range starts at $5.76. Second, our lower end estimate starts at $3.78. So in case we get into a stressful weather or demand bull market producers should focus on selling corn if and when it approaches $6. Conversely, feed buyers should be alert to buying corn as it approaches the low $3/bu price.

I hope that this analysis of recent history will help you with your marketing plan for 2010-11.  BF

Kevin Simpson, CFA, is an Investment Advisor with RBC Dominion Securities in Waterloo.