Follow Us
Become a Fan
Commodities, it’s All in the Family…
In the world of commodities trading, there are often pricing relationships that occur and reoccur when it comes to the value of one commodity versus the value of another commodity.
Some commodities are from the same family as other commodities; sometimes they are even closer than that! These types of relationships are important to understand when it comes to analyzing past, present and future price movements of some commodity futures contracts.
Sometimes two commodities or an entire commodity sector can have prices that are highly correlated or can move together in the same direction. Sometimes there may be no correlation between the two commodities at all.
Currently, I am a big fan of soybean prices when compared to corn prices. I believe that an excellent opportunity exists in the long soybean and short corn inter-commodity spread.
Let’s understand inter-commodity spreads and then we can examine the current relationship between soybeans and corn…
Certain commodities have a special relationship…
History tends to repeat itself when it comes to commodity prices, and that is why it is important to understand the historical relationships between certain commodities. Often a trader or speculator will try to take advantage of historical price relationships by entering into a long position in one commodity and a simultaneous short position in another related commodity.
This type of trade or investment position is referred to as an “inter-commodity spread.”
An inter-commodity spread is simply the price difference or ratio of the value of one commodity to another. This type of position is structured in order to take advantage of the value of one commodity versus the value of another commodity.
While at face value an inter-commodity spread may appear like a less risky and “hedged” position, often, inter-commodity spreads can be more volatile and risky than any one individual long or short position!
So what types of relationships are there between commodities? When it comes to inter-commodity spreads I like to break them down into two different types of relationships that occur:
A parent-child relationship:
A parent-child relationship is one in which one commodity is actually derived from or processed into another commodity. An example of this parent-child type of relationship would be a crack spread or a crush spread.
Crude oil is sent to a refinery and it is processed into heating oil and/or gasoline. This refining process is known as a cracking process. So, the crude oil (the parent) is actually refined or processed into the oil products, the heating oil or gasoline (the children).
There is a very active market in trading crack spreads, which means taking a long or short position in crude oil and the opposing position in the heating oil or gasoline. If you think about it, oil refining companies like ExxonMobil (XOM), British Petroleum (BP) or Chevron (CVX) are examples of businesses that have huge positions in the crack spread. They take crude oil and refine it into oil products such as heating oil and gasoline. These companies often have to buy crude oil to turn it into the products that they have capacity for. In other words, these companies are long the oil products and short the crude oil. If the price of the products goes higher relative to the price of crude they make more money! Let’s take a look at a chart of the gasoline crack spread:
As you can see from this chart the gasoline crack spread today is trading at $33.15, which means that refining companies (like those listed above) are making lots of money from the refining process. Because of the price of the crack spread, it costs these refineries a lot less to buy the crude oil (the parent) relative to where they get to sell the gasoline (the child).
This type of inter-commodity spread, long gasoline and short crude oil, has been very profitable for those who are long the gasoline and short crude oil since October 2010.
A crush spread has the same characteristics as a crack spread; however, a crush spread is a soybean spread rather than a crude oil spread. Soybeans (the parent) are taken to a processing plant and are crushed into soybean meal and soybean oil (the children).
There are many companies such as Archer Daniels Midland (ADM), Bungee (BG), Cargill and Louis Dreyfus that buy soybeans from farmers and process them into soybean meal and soybean oil. The higher the prices of the products relative to the price of the soybeans themselves, the more money these companies make, just like the oil refining companies.
Let’s take a look at what crush spreads have been doing for the past few years:
As you can see from this chart, those companies involved in crushing soybeans into soybean oil and soybean meal are having a rough time of it! The crush spread has been in a downtrend since peaking in 2009 — the companies that process and crush the soybeans (the parent) into the products (the children) have seen their margins cut substantially over the past two years because they are paying higher prices for the soybeans relative to the prices that they are selling the processed products for.
The crack spread and the crush spread are two great examples of “parent-child” inter-commodity spreads. But there is more to inter-commodity spreads than just this relationship…
The extended family relationship:
There are some relationships that exist in the world of inter-commodity spreads where relationships are not as tight as the parent-child relationship that exists when one commodity is derived or processed from another. I like to call commodities that are related but not derived from one another cousins. An example of this type of relationship would be commodities that have price relationships because they are in the same sector. Let’s look at a few examples:
Metals: Each futures market for individually traded industrial metals has distinct and different fundamentals. The supply and demand equation for copper is different than the equation for aluminum. The same is true for nickel, lead, zinc and tin. Each of these markets move based on fundamental and technical factors that are independent of one and other.
However, there are times when these metals move together as a sector. When there is increasing or decreasing economic growth in certain areas of the world this will affect demand for all metals or the entire metals sector. The metals sectors are cousins, and as such they tend to move in the same direction based on macroeconomic events. An example of an inter-commodity spread in this sector could be an investment position that is long copper and short aluminum. Although these two metals are “cousins,” this spread can move in a very volatile fashion.
Precious Metals: Gold acts like a reserve asset and a currency while silver has a dual role. Besides having many of the same characteristics as gold, it is also an industrial metal. There are many market participants who trade the silver market relative to the gold market. Gold and silver are both precious metals and therefore can be characterized as cousins. The trade is known as the gold-silver ratio.
A market participant will take an equal value position long or short position in gold and the opposite position in silver. The gold-silver ratio trade is an inter-commodity spread. Over the past 10years the price of silver has outperformed the price of gold on a percentage basis. Therefore, those market participants who have been long silver and short gold have done very well. There are times that the gold-silver ratio trade can be more volatile than the price of gold or the price of silver alone!
Grains: Corn, wheat and soybeans are cousins. When it comes to planting time, farmers often have the option to grow different types of grains. Weather has a tremendous effect on the crop year, and while some grains are heartier than others, a poor weather season will affect the entire sector and make the grain sector move higher as a whole.
There are some interesting relationships that occur between the prices of these grains. Often some grains can be substituted for others. When the price of corn is too high, animal protein producers will feed livestock soybean meal or wheat in order to control costs. When the price of wheat is too high it may disappear from animal feed entirely! A position that is long one of these grains and short another can be termed an inter-commodity spread. This brings me back to my comment at the very beginning.
Soybeans versus corn: a compelling opportunity…
Now that you have a basic understanding of what inter-commodity spreads are, let’s take a look at the soybean-corn ratio. This spread is simple the price of soybeans divided by the price of corn:
As you can see from this long-term chart, the soybean-corn ratio is trading at a pretty low level historically of 1.9 : 1. This implies that soybeans are cheap relative to the price of corn –or—that corn is expensive relative to the price of soybeans!
Let’s look at a shorter term chart:
This monthly chart shows that the average price for this ratio is 2.6 : 1. Each time over the past 20+ years the ratio has trade above 2.6 it has been slapped down and each time it traded below it has rebounded.
So what does this mean for the price of corn and soybeans today?
Well, if history repeats itself and this ratio will eventually move back to 2:6 : 1 it makes sense to enter into an inter-commodity spread today! Based on this analysis the rational position would be to buy soybeans and take an equally-weighted dollar position of short corn against the long position in soybeans.
To put this into perspective the current price of active month corn is $7.14 per bushel. The current price of active month soybeans is $13.35 per bushel. If the corn price is right then soybeans should be trading at $18.57 or $26,100 more per contract than it is today! If soybeans are correct then corn should be trading at $5.14 or $10,000 less per contract than it is today! Those are some pretty big differentials… this is an inter-commodity spread really worth looking at in today’s market!
Understanding inter-commodity spreads can unlock profitable opportunities in the commodities markets that are right under your nose. History tends to repeat itself, and the price relationship of one “related” commodity to another is something that a participant in the commodity markets should not ignore.
Keep an eye on your favorite commodities and their relatives – you never know when a juicy opportunity will appear!
Happy trade hunting…
Other Posts from the Author
- How to Profit from the Changing Chinese Diet - May 15th, 2012
- Emerging Market Demands Mean Volatile Food Prices Are Here to Stay - May 10th, 2012
- Who’s an Uncivilized Jerk? - May 7th, 2012
Interested in More Articles Like This? Sign up for The Sovereign Investor today! (It's FREE!)
[...] In a previous article, we examined the family relationship that different commodities can have with one and other. I explained that buying one commodity and selling a related commodity is known as an inter-commodity spread. These spreads can often be more volatile than the underlying individual commodities themselves and can give clues as to the future performance of one or more commodities. I pointed out the relationship between soybeans and corn and that historically soybeans were cheap relative to the corn price. [...]