Trading with Soybeans, Soybean Meal and Soybean Oil FuturesCBOT: Soybean ( CBOT:ZS1! ), Soybean Meal ( CBOT:ZM1! ), Soybean Oil ( CBOT:ZL1! )
This is the second installment on CBOT Soybean Complex. If you have not read the first piece, please click the link at the end of this idea.
Let’s start with a discussion of two reports followed by soybean market participants.
The Crop Report
U.S. Department of Agriculture (USDA) closely monitors agricultural market conditions and publishes the monthly World Agricultural Supply and Demand Estimates (WASDE).
WASDE, commonly known as the Crop Report, provides a global view of key agricultural products including wheat, rice, coarse grains (corn, barley, sorghum, and oats), oilseeds (soybeans, rapeseed, palm), cotton, sugar, meat, poultry, eggs, and milk. The Crop Report is the most important report followed by agricultural commodities traders.
What’s the key takeaway from the April 2023 Crop Report on Oilseeds?
U.S. soybean supply and use forecasts for 2022/23 are unchanged. However, relative to 2020/21, planted acreage is higher while export is lower. Global 2022/23 soybean supply and demand forecasts on lower production, crush, and exports. Global production in current crop year is reduced by 5.5 million tons.
Overall, the April WASDE shows plentiful supply, weakened demand and higher inventory, the recipe for price trending down.
CFTC COT Report
Commodity Futures Trading Commission (CFTC) publishes the Commitments of Traders (COT) reports and provides a breakdown of open interest for futures and options markets. It categorizes the reportable open interest positions into four classifications:
• Producer/Merchant/Processor/User: An entity that predominantly engages in the production, processing, packing, or handling of a physical commodity and uses the futures markets to manage or hedge risks associated with those activities.
• Swap Dealers: An entity that deals in swaps for a commodity and uses the futures markets to manage or hedge the risk associated with those swap transactions.
• Managed Money: Commodity trading advisor (CTA) or Commodity pool operator (CPO). They are engaged in organized futures trading on behalf of clients.
• Other Reportable: Every other reportable trader that is not placed above.
What’s the key takeaway from the May 2nd COT report on Soybean/Meal/Oil Futures?
o Soybean futures ZS open Interest: 601,051, down 4.7% from previous week;
o Managed Money increased ZS short position by 80.1%; their long/short ratio is 2.1. Note that the ratio was 8.3 on April 18th. This indicates that speculative traders are no longer bullish on soybeans.
o Soybean Meal ZM open Interest: 408,013, down 2.9% from previous week;
o Managed Money decreased ZM long position by 22.3%; their long/short ratio is 3.7. Note that the ratio was 7.9 on April 18th. Again, this is a bearish signal.
o Soybean Oil ZL open Interest: 472,547, up 0.6% from previous week;
o Managed Money increased both long and short positions modestly; their long/short ratio is 0.7, the same with April 18th.
Popular Soybeans Futures Trading Strategies – Explanation and Illustration
There are different types of traders in the soybean futures market: Producers, Grain Elevator (Storer), Processor, Livestock Farmer (User), and non-commercial traders.
We will discuss how they use the futures market, each with a hypothetical trade example for illustration purpose.
Investor
Non-commercial traders are not participants in the soybean industry. They hold a market view and hope to profit from such view through futures trading. Investors could draw ideas from futures price chart, the Crop Report, and other relevant market information.
Case study #1: Directional Trade with Stop Loss
Market information
1) April WASDE shows plentiful supply, weakened demand and higher inventory;
2) Following the release of WASDE, soybean price has been trending down;
3) News surfaced that Smithfield, the largest US hog producer, plans to liquidate 10% of its sow. This indicates lower soybean meal demand in the future.
Trade Setup
To express his market view, on May 10th, a trader sells one July 2023 contract (ZSN3) at 1412’6/bushel ($14.1275), which gives the contract a notion value of $70,637.5. He deposits $5,000 margin on his futures account. At 7.1% of the cost, he participates in the price exposure for 5,000 bushels of soybeans. The use of leverage, in this case by 14.1 times, is an advantage of cost-effective trading with futures contracts.
Potential Profit and Loss
1) In June, ZSN3 declines to 1350’0 ($13.50), the trader would gain $3,137.5 = ($14.1275-$13.50) x 5,000. Using the original margin deposit as a cost base, this short futures trade would potentially realize 63% profit, excluding trading fees;
2) If the soybean market rallies to 1480’0 ($14.80), the trader would lose $3,362.5, or a return of -67%;
3) Our trader could set a stop loss at 1450’0 ($14.50), to cap the maximum loss at $1,862.5 and avoid margin calls.
An outright trade with futures contract allows the trader to profit from a correct market view. Leverage built into futures could significantly enhance the profitability, while stop-loss could limit the exposure if the view proven to be incorrect.
Soybean Farmer and the Production Hedge
When a US soybean farmer plants the crops in April, he is said to have a Long Cash position. The farmer is exposed to the risk of falling soybean prices during the November harvest season. To hedge the price risk, our farmer could enter a Short Futures position now, and buy back the futures when he is ready to sell the crops.
The effective sales price equals spot price in November plus gain/loss in the short futures position. Since the cash market and futures market are highly correlated, loss (gain) in the cash market will be largely offset by the gain (loss) in the futures market.
Case study #2: Production Hedge (Short Hedge)
Market information
1) The farmer planted 1,000 acres of soybeans in his Central Illinois farm;
2) Total production cost per acre is estimated at $859, which includes variable costs (seed, fertilizer, pesticide), overhead (building, storage, machinery) and land;
3) Yield per acre is estimated at 69 bushels. His cost per bushel will be $12.45;
Trade Setup
On May 10th, ZSX3 is quoted at 1254’2 ($12.5425). The farmer expects to sell 69,000 bushels. Since each ZS contract has a notional of 5,000, he needs to sell 14 lots of ZS contracts. Soybean basis in Greene County, Illinois is estimated at $0.20.
The Hedging Effect
1) The farmer effectively locks in the sales price in April for his November soybean crop at: $12.5425 (futures) + $0.20 (basis) = $12.7425;
2) Production hedge helps our farmer to protect a profit margin of 29.25 cents =($12.7425 - $12.45) per bushel, or $20,182.5 for his entire crops.
The farmer is left with basis risk. In the context of commodity futures trading, basis refers to the difference between the spot price of a commodity and the price of a futures contract for that same commodity. Basis risk is usually smaller than outright price risk.
Grain Elevator and Futures Rollover Strategy
After the crop is harvested, farmers or merchandisers usually store the soybeans in a grain elevator and wait for the right time and price to sell. Soybeans could be stored for a year but would incur monthly storage costs. The decision to store depends on whether expected future price gains outweigh the storage costs.
A merchandizer is exposed to the risk of falling soybean price, which would cause his soybean inventory (old crop) to decline in value. To hedge the price risk, he could employ a rolling futures strategy.
Case study #3: Rollover Front-month Soybean Futures
“Rollover” refers to the process of closing out all positions in soon-to-expire futures contracts and opening contracts in newly formed contracts. The rollover process impacts market volatility, prices, and volume.
Trade Setup
1) Sell 14 lots of July contract ZSN3 at 1412’6 ($14.1275) on May 10th;
2) At any point before expiration, if we decide to sell soybeans in the spot market, we could exit our futures position by buying 14 lots of ZSN3 at prevailing price;
3) If we plan to hold our inventory for a longer period, we will buy back ZSN3, and simultaneously sell 14 lots of August contract (ZSQ3);
4) ZSQ3 is quoted 1345’4 ($13.455) on May 10th. If you hold the soybean from July to August, you will incur extra storage cost, but would get 67.25 cent less per bushel. This is clearly very bearish.
The Hedging Effect: Rolling futures positions allows our merchandizer to extend his hedge beyond original futures expiration.
You may ask, why not use a longer-dated contract to begin with, say July 2024? This is because the front month contract is usually more liquid. It is easier to put the hedge on and off quickly. By sticking with liquid nearby contracts, we could avoid the cost of price slippage generally associated with less liquid deferred contracts.
Soybean Processor and the Board Crush
In soybean industry, “crush spread” is the market value of meal and oil byproducts subtracted by the cost of raw soybeans. In the cash market, the relationship between prices is commonly referred to as the Gross Processing Margin (GPM).
In the futures market, the crush value is an inter-commodity spread transaction in which Soybean futures are bought (or sold) and Soybean Meal and Soybean Oil futures are sold (or bought). Soybean crush spread is also called the Board Crush.
Case study #4: Soybean Crush Spread
Trade Setup
1) The November-December Board Crush (buying November Soybean futures and selling December Soybean Meal futures and December Soybean Oil futures) is used to hedge new-crop gross processing margins;
2) CME Group facilitates the board crush that consists of a total of 30 contracts: 10 Soybean, 11 Soybean Meal, and 9 Soybean Oil;
3) Implied Soybean Crush (SOM: Z3-Z3-X3) is quoted at 172’6 ($1.7275) on May 10th. Each contract has a notional of 50,000 bushels and is currently priced at $86,375;
4) If we process 100,000 bushels a month, we would short 2 board crushes. On May 10th, the margin for this spread is $1,650 each.
The Hedging Effect: Board Crush enables processors to lock in his operating profit.
Livestock Farmer (Soybean User) and the Hog Feeding Spread
Livestock farmers buy corn, soybean meal and other ingredients to produce animal feed. For example, hog farmers’ gross profit is represented by gross feeding margin, also known as the hog feeding spread, which is the value of lean hog less the cost of weaned pig, corn, and soybean meal. Therefore, hog farmers are exposed to the risk of rising ingredient costs. To manage price risks, they could trade the hog feeding spread, which isa long hedge by selling CME lean hog futures (HE) and buying CBOT corn (ZC) and soybean meal (ZM) futures. A typical hog feeding spread is expressed as:
Hog Feeding Spread = 7 x HE – 3 x ZC – 1 x ZM
Case study #5: Hog Feeding Spread
Market information
1) USDA daily hog and pork report shows that cash market hog price averaged $73.59/cwt nationwide on May 9th, up 78 cents from prior week;
2) Cash hog is down 31.4% year-over-year. However, it seemed to bottom at $66 in mid-April and rebounded after the news of Smithfield sow liquidation.
3) Our farmer expects hog prices to rise faster than feed prices in the next few months. To capture an expanding margin, he plans to long the hog spread.
Trade Setup: For every 280,000 pounds of lean hogs (approximately 1,120 pigs):
• Long 7 lean hogs futures HEM3 at 0.84575/lb., giving a total notional value of $236,810, as each contract has 40,000 pounds (lb.);
• Short 3 corn futures ZCK3 at 646’4 ($6.465)/bushel. Each ZC contract has 5,000 bushels of corn, leaving this leg of trade at $96,975;
• Short 1 soybean meal futures ZMK3 at $415.0/short ton. Each ZM contract has 100 short tons of soybean meal, leaving this leg of trade at $41,500;
• The combined total, $98,335, represents the gross margin of raising 1,120 hogs, or about $87.8 per pig.
The Hedging Effect: It takes 5 months to grow a piglet to marketable weight. Factoring in breeding sows, the full production cycle for hog farmers could last 1-1/2 years. Pork prices and feed costs could vary significantly during this period. Hog Feeding Spread enables hog producers to lock in their operating profit.
Spread Trading in CBOT Soybean Oil and BMD Crude Palm Oil
Vegetable oils are the most crucial cooking ingredients in the world. Soybean oil and palm oil dominate the global edible oil marketplace with 2/3 of market share. Soybean oil and palm oil are considered substitute goods because food processors often switch between the two as the prices fluctuate.
Soybean oil and palm oil are driven by different market fundamentals. World soybean production is centered mostly in the U.S., Brazil and Argentina, and most palm oil comes from Indonesia and Malaysia. A drought in the U.S. or in South America could drastically alter soybean oil supply one year, while disease in Southeast Asia could affect palm oil supply the next year. This can create tremendous volatility in the spread relationship.
The CBOT Soybean Oil futures (ZL) consists of 60,000 pounds, equivalent to 27.22 metric tons. The BMD Crude Palm Oil (FCPO) futures contract is 25 metric tons (mt).
Case study #6: Soybean Oil/Palm Oil Spread
Observation: Soybean oil and palm oil markets have been in decline since July 2022. In the past two months, soybean oil drops by a faster rate compared to palm oil.
There could be plausible cause for the abnormal trend. However, if the relationship were to reverses back to normal, the spread will be enlarged.
If an investor holds this view, he could long the spread by buying CBOT soybean oil and selling BMD crude palm oil.
Trade Setup
• Provided ZL at $0.5255/lb. and FCPO at MYR 3570/mt with prevailing USD/MYR exchange rate at 4.46, the ZL/FCPO spread could be derived at:
• ZL = $0.5255 (per lb.) x 2204.622 (lbs. per mt) = $1,158/mt
• FCPO = MYR 3570 / 4.46 /mt= $800/mt
• ZL/ FCPO spread = $1,158/mt -$800/mt=$358/mt
Potential Profit and Loss
1) For an investor, a profit could be realized if the spread gets bigger. He would incur a loss if the spread narrows instead. The USD/MYR exchange rate could affect the trading result;
2) For commercial hedgers such as edible oil processors, hedging would allow them to maintain stable production formulas even though oilseed spot prices change unexpectedly.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
