Long-Term Soybean Crush Spread Trading Strategy
Global protein demand has been one of the primary drivers of grain prices as meat consumption over the last 15 years has increased by more than 13% in the same period. Soybean meal is a primary ingredient in protein production, primarily as feed but also as a meat substitute for people. As a result of this demand, soybean meal prices have gotten out of whack compared to its brother, soybean oil. This week will be a chart intensive study on the impact a slowing global economy will have on soybean meal’s multi-year trend. Finally, we’ll address some of the issues associated with trading the soybean crush spread or simply, the bean meal versus bean oil spread.
First, let’s set the fundamental stage a bit. Two thousand and fifteen was a fantastic year for growing soybeans and set another year of record global production. We’ve now had two consecutive years of stock surpluses, domestically and three years, globally. This only adds to the current inventories, which have swelled to a 42 day domestic supply, the highest since 2006. Finally, the current Brazilian crop is expected to set another record with Brazil’s National Commodity Company(CONAB) raising their 2016 estimate to more than 102 million tons this week. Fundamentally, the bears are in charge of the soybean complex.
The soybean complex is currently very similar to the crude oil market. There are more crude oil and soybeans in the world than we know what to do with. However, we keep pumping and growing because there’s money to be made in the crude oil and soybean products. Shale oil is being refined into gasoline and sent all over the world just like soybeans are being crushed into soybean meal and soybean oil. In the crude oil market, gasoline is the main beneficiary as the world modernizes. Meanwhile in the soybean complex, it has been soybean meal. Animal feed has been the primary beneficiary of the global jump in protein demand as the world’s diets modernize. Let’s get to the charts.
The soybean crush is the difference between the prices received for the soybean products versus the price paid for the soybeans themselves. There are many different ways to calculate this spread, each of which has its place. The spread gets complicated because bean meal trades in 100 ton contracts and soybean oil trades in 60,000 pound contracts while beans trade in 5,000 bushel contracts. For crush purposes, I’ve calculated everything in price per bushel. This allows us to compare apples to apples or beans to bean products. Finally, we’ve used the Chicago Mercantile Exchange’s crush margin ratio of 1 bushel of beans equals 80% bean meal and 18.3% bean oil and the rest as waste.
Soybean meal has led the bean complex higher for several years. We expect this trend to end shortly. The global growth of protein demand is beginning to slow as the developing world’s appetites are being fulfilled. China’s bean meal imports are expected to grow about 2.5% in 2016. Many analysts have forecasted that even if Chinese growth were triple that number, there are still more than enough beans to sate demand. Finally, the Brazilian Real has been in free fall. This has made Brazilian beans cheap on the global market. Given their economic situation, another record Brazilian crop is forecasted for 2016 further adding to the bearish tone for beans in general and its derivatives, specifically bean meal.
This shift from expansion to contraction should cause this spread to implode rather significantly and it has to do with more than just bean meal based protein demand. The other part of this trade focuses on soybean oil, which is expected to strengthen. Obviously, El Nino has had an impact on global weather conditions. So far, our thesis has been, “Much ado about nothing.” We’ve written extensively on El Nino’s historical impact on the global agricultural markets. This year’s has upset Asian regions that normally grow a significant amount of Palm oil to be used regionally. Due to the production deficits in India and China, we expect to see soybean oil imports increase substantially. The combination of lighter bean meal demand along with higher bean oil demand will cause this spread to tighten. This will also negatively impact processor margins as less than 20% of a bean is oil while 80% can be ground into bean meal.
Three more charts to go. The next one shows the weekly correlation between bean meal and bean oil. As bean products tied to the underlying market, it’s logical that these two generally move together. Both of these markets have moved lower since the July highs. This has caused the positive correlation between these markets to increase to very near its historical peaks levels. You can see on the chart below that it’s been over three years since these two markets have been so tightly tied to each other. We see this as a critical timing tool in executing the spread as we are clearly selling bean meal and buying bean oil at a time when these two markets have been tied too tightly for too long and are expected to revert based on bearish demographics and fundamentals.
Moving to the underlying charts of soybean meal and soybean oil reveals critical clues from the commercial growers and processors and remember, these are the people who know these markets the best.
Commercial bean meal buyers have most likely met much of their 2016 input needs already. They’ve clearly been big buyers heading into the new year, amassing their largest position since 2012 and their second largest position since 2006. We analyze both their net position and their total position in order to get an understanding of their current needs in the market place. We feel their next move will be distribution and expect this selling to shift momentum into negative territory thus, putting us on the lookout for outright short sale opportunities in bean meal futures.
The soybean oil market’s recent rally has been met by heavy processor selling as the opportunity to hedge any forward production at decent prices has been tough to come by. Understanding that a bean oil hedge only covers about 20% of the beans being grown provides anecdotal evidence of the soybean growers’ concern for the coming marketing year as they sell what can be sold. Based on recent market action, we feel their net position of short more than 100,000 contracts may be the beginning of the end of this selling considering they are very close to their net short record level of just over 117,000 contracts. Meanwhile, the typical high end of their range is net long roughly 30,000 contracts over the last 15 years. This suggests their selling capacity may be about exhausted.
Wrapping up this whole piece consider the following points. Macro-economically, global demand for protein is beginning to slow down along with the global economy in general. This includes China, which had been the primary source of growth. This means less need for feed and human consumption. This slowdown comes on the heels of record crops along with a record global production forecast for 2016. Furthermore, the domestic bins are full. This leaves two options, cut production or funnel it into products that can be stored like bean meal and oil. Both depress prices. Given the effect of this year’s El Nino on major palm oil producing countries like India reveals a deficit that will be filled by soybean oil which as a complimentary good. Finally, examining the commercial traders’ positions in bean meal and bean oil reveals their needs as being fully met (hedged) on the recent rally and decline respectively. The unwinding of these positions along with additional bean oil demand in Asia and China will cause the bean meal versus bean oil spread to narrow. Finally, the positive weekly correlation between these two markets has reached its highest level in over three years and should be very near a major inflection point (trigger).
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