- 1998: Volume 7, No. 4 A Summer Strategy for Trading the Wheat Market

The impact of the internet on global markets is potentially huge. While we rush into that high speed future, remember that it is what we are buying or selling and why we are doing it that is more important than how fast we do it. Markets are still subject to the same forces-supply and demand, emotions and herd psychology, etc.-that have always affected them.

As technology increases the pace of modern life, the quality of the information we receive becomes even more important. Therefore, my focus continues to be less on technological change and more on getting the information I need and the best interpretation of that information.

The international wheat market is some 200 years old. It came about during a period known as the great enclosure when farmers left the countryside and moved to London to work in factories during the industrial revolution. With a large population to feed, London merchants found they could import wheat from France more cheaply than they could buy it in England, where production had declined due to farmers leaving their farms.

Today the wheat market is a truly great international market with trade occurring in almost all nations throughout the world. The spread of global information and communications have helped this market to grow and become more global in nature. While 200 years ago a London grain merchant had only a few choices of where to buy, today he might buy from France, Australia, Argentina, Canada, the U.S. or Rumania.

When reviewing the last 200 years of international wheat markets, a couple of important tendencies become apparent. When there have been shortages of wheat, the world's grain farmers have often increased production to the point that prices declined to below where they stood before the shortage occurred.

Most recently, shortages developed in 1995 due to poor weather around the world. In March, 1996, prices reached a record high price of .50 per bushel. Grain farmers around the world responded, increasing production to a new record. As a result of this huge production prices have now declined to the lowest level since 1991.

This brings out another tendency witnessed in the history of grain markets. When prices get low enough, farmers either plant something else or, if prices get really low, may idle land. In many areas farmers can choose between several crops and many are choosing to plant other crops rather than wheat. The old saying, "Nothing cures low prices like low prices" comes to mind.

A recent Wall Street Journal front page article discussed the decline of wheat farming in the northern Great Plains. Many North Dakota farmers are getting out of farming either voluntarily or through bankruptcy, as low prices are forcing their hand. Among those farmers successfully staying in farming many are planting crops other than wheat-such as canola.

There are basically three grades of wheat grown in large quantities in the U.S. First is hard winter wheat, by far the largest U.S. variety, grown in the southern Great Plains states of Texas, Oklahoma, Kansas, Colorado and up into Nebraska. This wheat is use for breads and pizza dough. It is our largest export variety of wheat.

In the southern Midwest farmers grow soft red winter wheat. This is a much smaller crop than the hard winter wheat crop. It is also a poorer variety and is used for low grade breads and pizza dough. It is often exported to third world nations because it is the cheapest variety and is also used as a feed grain by livestock producers.

In the northern Great Plains and up in the Canadian Prairies we grow spring wheat. This is the highest quality wheat and is prized by pastry manufacturers. It is a small crop and very little if any gets exported due to its high demand among bakers.

In Figure 1 we show the decline in acreage for U.S. wheat. These declines occurred before prices dropped down to the lowest level in eight years where they are this summer. Given the further erosion in wheat prices continued declines in acreage can be expected in the coming crop year, starting with the planting of winter wheat this fall. Winter wheat farmers don't have the same ability as spring wheat farmers to plant other crops. This is because winter wheat is one of the few crops that can be planted in the fall and harvested in the spring. As a result, it is likely that the loss of acres will continue to be greatest for spring wheat which is planted in the spring and harvested in the fall just as many other alternative crops. All the same declines in winter wheat planting can be expected as farmers decline to plant marginal acreage that is too costly relative to the expected yield and price per bushel.

Figure 1

Decline in Acreage for U.S. Wheat (1997 to 1998)
	1996/97 acreage	1997/98 acreage	% change
All Winter wheat	48.3 million	46.8 million	- 3.1%
Spring wheat	19.3 million	15.2 million	- 21.24%
Total US wheat	67.6 million	62 million	- 8.3%

Acreage has not just declined in the U.S. Canada's acreage has dropped to the lowest level since 1972. Argentina's winter crop acreage is down 15% from last year. We have been hearing reports of northern European farmers changing from wheat to sugar beet production.

Given all this cutting back in production why are prices so low right now? There are two basic reasons. First, when we had record world production just last winter we built up a large surplus of wheat. We have to work through that abundance before prices can work their way higher. Secondly, weather has mostly been pretty good for wheat growing areas. El Niño rains in the plains this winter produced a bountiful Kansas winter wheat crop, larger than expected. In its July 10th monthly crop production report the USDA reported U.S. production at a 9% higher level than their June estimates and now only slightly lower than 1997 production. On the other hand world ending stock estimates declined from last month's 132.5 million tons to 131.5 million tons. The decline, despite the increase in U.S. production, is due to the very poor Russian crop.

Until the full impact of decreased acreage is felt in the U.S., prices will have a hard time advancing. Since the greatest declines in acreage are in the U.S. spring wheat, Canadian spring wheat and Argentine winter wheat, the impact of that smaller acreage is not likely to be felt until after the harvesting of those acres this coming September.

From 1996 to the present the wheat market transited from shortage to plenty. Looking forward it now appears the market is going to make the reverse move, from plenty to shortage. What is the best way for an investor to take advantage of this information?

Combined with a little bit more history and a simple strategy it may not be hard to make money on this anticipated transition all through the summer and fall of this year. The history to which I refer is Moore Research Center's seasonal pattern charts showing the tendency for December wheat to make seasonal lows in the July/August time frame.

The winter wheat harvest is now over 75% complete. The dry weather in the southern plains has allowed the harvest to proceed at a rapid pace. The early harvest and the smaller acreage of crops in the field makes it a good bet that prices will experience a seasonal low no later than early August.

Figure 2

The simple strategy we propose to use is known as Scale Trading. Scale Trading was first developed about 25 years ago by Robert Weist. The method is simplicity itself. First, look for low prices as determined by prices being in the lowest 1/3rd of prices over the last 10 years (though the number of years can vary according to commodity). Wheat prices definitely qualify. Then study fundamental reports for news of production cutbacks. The drop in planted acreage definitely qualifies. Once these two qualifications are met, begin a campaign of acquiring long positions on a "scale" down basis, such as every 5 or 10 cents lower in wheat. This method of building your position has the great advantage that you don't have to try to "pick a bottom". I like that advantage because I know that I am not a genius and rarely am able to buy the bottom or sell the top.

The next decision to make is when to sell. Again the method is elegantly simple. Sell each contract at a modest profit, say 5 to 10 cents higher, depending on your judgment of market volatility. Why not just accumulate a bunch of contracts and ride the market up? Certainly you could try to do that. I like the scale trading method because, just as I don't have to pick a bottom, I also don't have to pick a top. Let others profit from big rallies, I'd rather look to make money in big and little rallies by taking modest profits. The really big advantage is that markets often languish on the bottom for sometime before moving higher in earnest. These elongated bottoms often try traders patience and drive them a little crazy. With this method you can buy low, sell a little higher, and then buy back at the same place again. This means that those boring sideways markets that take forever to form a bottom are the ideal market for you because you can keep buying low and selling high through the whole period. Incidentally, most summers, this is precisely the kind of bottom wheat forms. This summer is not likely to be an exception.

What can go wrong? Lots. The most common difficulty with this strategy is that, despite the best analysis, the trader is a little too optimistic about when the bottom will come in and starts buying too high. The only thing to do to compensate is plan for this possibility by having enough money so that you don't get knocked out if prices go lower than you thought. The keys to success are careful planning, adequate capital reserves and doing your homework.

And remember, even with our method commodity trading always involves a high degree of risk. As the National Futures Association wants you to know, you could sustain a loss in excess of your account funds. The high leverage of futures can result in big profits or big losses. Given that fact, you should carefully consider whether commodity trading is appropriate for you.

Hal Masover is the author of Invest Like the Pros: Value Investing in Commodity Futures. He publishes a month newsletter, The Crown Value Investment Letter and a daily advisory on agricultural markets, Crown Jewels. Hal is founder and part owner of Crown Futures Corporation. You can contact Hal at 800-634-9650, by e-mail at crownfutures@lisco.com or visit the Crown Futures web site at www.scaletrading.com.