MERRICKS CAPITAL SOFT COMMODITIES
QUARTERLY THOUGHT PIECE
DECEMBER 2016
IN THIS QUARTERLY THOUGHT PIECE WE HIGHLIGHT HOW THE EXIT
OF BANK FUNDING AND LARGE GRAIN INVENTORY IS PROVIDING
OPPORTUNITIES IN COMMODITY CASH AND CARRY TRADES.
EXECUTIVE SUMMARY
+ Regulatory changes post the Global Financial Crisis (GFC) has reduced the level of financing available to a wide range
of markets. Merricks Capital believes that this reduction in available capital will create opportunities which will allow
investors to generate higher returns with lower levels of risk than has traditionally been the case.
+ Merricks Capital has identified one such opportunity in wheat where the relationship between the current physical
wheat price (including storage) and the future wheat price imply an annualised return of 10%+.
+ Historically when financing has become tight, the implied cost of financing embedded in the cost of carry has increased
substantially, beyond the usual cost of finance, providing an arbitrage opportunity.
+ Global commodity merchants that would typically participate in this trade and close the arbitrage, are under financial
pressure and unwilling to apply capital for the duration that is required to capture this opportunity.
+ In order to capture this opportunity you need to be able to source, store and trade physical wheat and be prepared to tie
up the associated capital for up to 12 months.
+ Merricks Capital has extensive experience in this area and a successful track record in repeatedly executing this trade
profitably since the inception of the commodity strategy in 2008.
US WHEAT MARKET
The US wheat market is the global benchmark for global wheat pricing. The US is the largest exporter of wheat in the world
and is home to the world’s most liquid wheat futures contract on the Chicago Board of Trade (CBOT). A vast majority of global
markets are priced relative to the CBOT wheat price in what is known as basis contracts.
The CBOT sets minimum storage rates for wheat stored within the exchange approved delivery network. These rates are set via
a formula that is linked to the degree of the contango in the CBOT wheat futures market. Large wheat supplies generally lead to
a futures curve that is in contango, resulting in increasingly higher minimum US wheat storage rates.
The minimum storage rate policy is designed to encourage the delivery and storage of wheat in the CBOT approved storage
network with the primary objective of forcing convergence between financial derivative and physical pricing.
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US WHEAT MARKET CONTINUED
This has led to US wheat storage costs exceeding storage costs in other locations.
US wheat stocks have reached their highest levels since 1989 and have coincided with record production of corn and
soybeans. This is placing significant strain on the US grain storage system and as discussed before led to storage costs to
increase substantially.
Chart 2. Source: CBOT, Merricks
Chart 1. Source: USDA, Merricks
As can be seen from Chart 2, which tracks the implied cost of
carry in forward futures prices, the combination of a higher
cost of storage and finance has led the market to nearly the
highest cost of carry since 2006.
The 12 month US carry is now near its highest level in the past
decade at 20%.
Chart 3. Source: CBOT, Merricks
PLAYING THE COST OF CARRY
The easiest way to play this carry trade is to buy physical US wheat to store for 12 months and sell the 12 month forward US
futures contract. However, commercial storage rates currently charged are more than the return received from carrying the
wheat in those storage facilities and selling forward. This prohibits those that do not have their own storage from exploiting the
steep futures curve by carrying wheat in the US.
For those who do not have their own storage, the next best play is to find a proxy for US wheat by identifying a wheat market
that has a high correlation with US but has a lower cost of storage, and to buy physical and store for 12 months and sell the 12
month forward US futures contract.
Australian wheat is the ideal proxy for US wheat as:
+ Australian wheat price is highly correlated to the US wheat price
+ Australian wheat is of equal or higher quality than US wheat
+ Australian wheat competes with and is sold into the same markets as US wheat
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PLAYING THE COST OF CARRY CONTINUED
+ Australia has a high quality, secure, centralised storage system with a fixed storage cost of US$12/mt or 8%
+ The opportunity to perform this trade in other locations is limited by sovereign risk and available public storage. Australia is
unique in that it has low sovereign risk, a central storage system with unlimited public access and fixed storage rates
Executing the trade:
+ Buy Australian physical wheat in December in an approved bulk handling facility
+ Simultaneously sell December 2017 CBOT wheat futures and hedge the USD/AUD exchange rate
+ Hold the physical wheat for 12 months
+ In 12 months, sell the Australian wheat and buy back the CBOT futures, cover the USD/AUD hedge
+ This strategy has a net return of 10% assuming no change in Australian basis
Merricks Capital currently has in place all the necessary documentation and capabilities to deploy capital to take advantage of
this opportunity.
RISK OF THIS STRATEGY - AUSTRALIAN WHEAT BASIS FALLS BELOW ENTRY POINT
The primary risk to the thesis is that the premium for Australian wheat declines over the term of the carry period. This is known
as basis risk, with the basis defined as the premium of Australian physical wheat price over CBOT wheat futures.
Below we explore why the basis risk of this trade appears to be substantially mitigated.
Basis is currently trading at $17/mt. At this level, breakeven for the trade would be where realised basis is $0/mt. Our
expectation, based on historical analysis, is that realised basis is likely to be in the range of between $30 and $40. If that occurs,
then the trade would generate a return of 20%.
Chart 4. Source: ASX, CBOT, Merricks
Chart 5. Source: Profarmer Australia, CBOT, Merricks
The main risk to the trade is a depreciation of the current Australian wheat premium. A decline to $0/mt would offset all
gains made in the carry differential and represents the breakeven level for the trade.
Our analysis suggests that current price levels are already buying export demand. Australia has a high level of intrinsic
demand, therefore it’s need to ‘buy’ demand is limited. This is a strong fundamental factor that will help support Australian
wheat values after the November/December harvest.
As shown in Chart 5, Australian wheat is highly correlated with US wheat and has correlation of 72%. This high correlation
makes sense as Australian and US wheat compete into similar export markets.
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RISK OF THIS STRATEGY - AUSTRALIAN WHEAT BASIS FALLS BELOW ENTRY POINT CONTINUED
+ Australian wheat tends to be sold at or above export parity pricing, while US wheat does not trade the same way
Australian wheat has a high level of intrinsic export demand
due to its freight advantage into Southeast Asia, it’s high
quality and lower moisture. As a result (and as shown by
Chart 6) Australian wheat production is usually consumed
and not stored as inventory. When there is high intrinsic
demand wheat will be sold at or above export parity.
US wheat does not have the same level of intrinsic demand
which means that it will tend to trade to the lowest global
price to win market share.
Chart 6. Source:: USDA, Merricks
+ Historical analysis of Australian basis since 2004 illustrates that basis trades regularly between $0 and $50
+ The period immediately following the GFC in 2008/2009,
when the AUD fell 40%, was not completely reflected in
an appreciation of the Australian wheat price.
+ In 2012, the worst US drought in 50 years resulted in a
GFC results in a 40% devaluation of AUD
Worst US drought in
50 years
sharp reduction of US corn and wheat production and
resulted in US corn and wheat futures rallying over 35%.
Australian wheat prices lagged the strong rally in US
futures.
Chart 7. Source: ASX, CBOT, Merricks
The events of 2008/09 and 2012 are unlikely to be repeated. In 2008 the AUD/USD was 0.98, which at the time was it’s highest
level against the USD in 25 years. Today the AUD/USD is 0.74 which reflects a more moderate valuation for the AUD. The
drought that occurred in 2012 was the worst in over 50 years and is unlikely to be repeated in 2017 with long term weather
patterns suggesting neutral La-Niña/El-Niño conditions, lowering the probability of an extreme weather event in 2017.
Macro risks are prevalent with firming bond yields and an increase in US inflation expectations results in financial flow into
commodities as an asset class. This may serve to support financial flows from time to time that would induce brief bouts of
short covering on the CBOT wheat futures market which may periodically outperform Australian wheat prices.
+ A more detailed analysis of historical basis outcomes suggest minimal downside
Analysing the October average basis over the last 12 years provides a historical context of likely basis which will be
achievable at exit. Chart 8 details the average basis level and shows that the basis trades at or above the proposed entry
point of $15. In the one circumstance that it did not, basis recovered to $17 in December.
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RISK OF THIS STRATEGY - AUSTRALIAN WHEAT BASIS FALLS BELOW ENTRY POINT CONTINUED
Chart 8. Source: Bloomberg, Merricks
2009 - A broad macro relief rally from low price levels induced a
2011 - A sharp depreciation of the AUD from 1.07 to 0.94
sharp short covering rally in October of 2009. Australian wheat
in September and October of 2011 was not matched by an
futures lagged the rally in CBOT futures.
equal appreciation in the Australian wheat price.
+ Opportunity to capture a higher basis
Analysis of the historical trading range of basis during
each year suggests that over the next 12 months, we will
get an opportunity to close out the trade at a basis which
is higher than current entry level and to take profit earlier
than expected. 2012 was the only year in which this did not
occur when the worst drought in 50 years in the US caused
wheat prices to rise 35% in 4 weeks. Due to the high level
of existing inventory levels in the US and the benign long
term weather outlook, the chance of this happening again
is very low.
Chart 9. Source: Bloomberg, Merricks
+ Australian wheat is trading below the cost of production which will prevent farmer selling lower than today’s price level.
This places a floor on Australian wheat prices
Australian wheat prices are expected to be supported by the
fact that market prices are at or below the cost of production.
This is expected to limit the downside to Australian prices as
farmers choose to store and wait rather than sell their wheat.
Australian cost of production
Chart 10. Source: ASX, Merricks
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RISK OF THIS STRATEGY - AUSTRALIAN WHEAT BASIS FALLS BELOW ENTRY POINT CONTINUED
+ On an export parity view, Australian wheat is trading at a discount to US wheat into key export markets
It is expected that once the Australian harvest is complete
at the end of December, Australia will trade into Indonesia
at parity with the US. Asian buyers will favour Australian
wheat over US wheat due to its superior quality and familiar
milling attributes. This suggests that basis is currently 4%-9%
undervalued and basis should increase by ~US$17.
Chart 11. Source: Merricks
+ US wheat supply is at it’s highest in over a decade. High inventories will limit the ability for US wheat to trade higher while
Australian wheat is already trading at its cost of production, limiting farmer selling
Large US wheat inventories will limit the upside to US wheat
prices. This situation is in contrast with the 2011-2014 period
when US wheat supplies were declining and US corn supply
hit multi-year lows.
Chart 12. Source: USDA, Merricks
POTENTIAL FOR AN EARLY EXIT
Chart 13. Source: Bloomberg, Merricks
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Chart 14. Source: Bloomberg, Merricks
POTENTIAL FOR AN EARLY EXIT CONTINUED
Flattening of the futures curve
+ CBOT wheat futures are heavily shorted by speculative funds. This crowded positioning increases the possibility of a
short covering rally based on real or perceived wheat/grain global supply risk in 2017 despite the large US inventories.
In the past, as shown in Chart 13, these short covering rallies have served to flatten the futures curve, i.e. spot wheat
outperforms wheat 1 year forward.
Rally in basis
+ Australian wheat basis has the potential to appreciate during the term. This would provide an opportunity for an early
exit to the trade. Chart 14 illustrates the highest monthly average basis price for each of the past 12 years. A basis of $40
would increase realised returns by more than 10% to 20%+. Annualised return would be even higher.
CONCLUSION
Base case returns from buying Australian physical wheat and simultaneously selling CBOT wheat December 2017 futures
contract and carrying the Australian physical wheat forward through to November 2017, would provide a base case gross
return of 10% on futures curve carry alone.
While this trade involves taking on basis risk, the case for further upside for Australian wheat relative to CBOT wheat is
supported by low Australian wheat inventories, aggressive export buyers, limited farmer selling and the opening up of new
export opportunities to India and China that are deficient in high quality wheat. The appreciation in the Australian premium
has the ability to add 10-15% on top of the base case return assumption.
A sharp short covering rally in wheat markets and subsequent flattening of the CBOT futures forward curve would serve to
provide an early realisation of the strategy profit.
Risks to the strategy are limited to the underperformance of Australian wheat to CBOT wheat (contraction in the premium)
with 10% downside of Australian basis representing the investment breakeven level.
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CONTACT
Adrian Redlich
Chief Investment Officer
+61 3 8319 8111
[email protected]
WWW.MERRICKSCAPITAL.COM
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