Todd's Take

It has been a while since we have seen a strong bull market in grains, but this summer's climb in Minneapolis wheat has already been breathtaking and may not be over yet. Just since the end of May, September Minneapolis wheat gained nearly $2.40 a bushel, increasing over 40% in value. For a wheat contract that spent most of the past two years with a $5 in front of the price, the rate of ascent has been dizzying.

By now, it is well understood that spring wheat prices are responding to drought in the northwestern U.S. Plains, which is also stressing crop conditions in southern Saskatchewan. Several weeks of seven-day forecasts have come and gone, and so far, rain has been mostly absent, and temperatures are expected to turn hotter this week.

While the reason for spring wheat's sudden popularity is not in dispute, what is difficult to understand is how high we should expect prices to go. After all, 2016-17 ended with world wheat supplies estimated at nearly 35% of annual use, the most in 15 years.

Back in June, USDA estimated that the U.S. will account for less than 7% of world production in 2017-18 and so far, wheat production outside of North America is reported to be doing generally well. It is understandable that the kind of high-protein quality that spring wheat provides will command a premium this year, but I don't hear anyone suggesting that physical quantities of world wheat are in any danger of becoming scarce.

We could go the traditional route and try to guess what U.S. and world production will be in 2017, given the current forecasts, and then look at a historical comparison of ending stocks-to-use ratios versus prices. As logical as that might sound, the best guesses will only be very rough estimates with big margins of error.

One of the first problems is that guessing production in the midst of a drought is no easy task, and even small errors can make big differences in expected results. Second, the historical relationship between ending stocks and actual prices has a wide range of correlation. It is easy to find years with similar ending stocks-to-use ratios that have significantly different price outcomes.

Finally, I contend again that markets are not necessarily rational or mathematically predictable. Markets are people and like people, markets have flaws. Specifically in the case of today's one-way bull market in Minneapolis wheat, the price discovery function has been temporarily derailed, and it is difficult to say when it will be back.

What do I mean by that? If we go back to Economics 101, the price discovery process is described as an interaction of supply and demand. Producers of wheat and potential buyers of wheat negotiate back and forth, and in this process of two-way haggling, a price and quantity are settled upon that strikes a balance between the two competing interests.

In the current environment, however, the two-way haggling has been disrupted. Noncommercial buyers of spring wheat have not even accumulated positions as large as they held in January, but prices have gone much higher than they did in January. The reason is an obvious lack of willing sellers in the face of worsening drought.

Don't get me wrong. I am not blaming sellers for leaving the market -- their response is understandable and entirely human. From an economic point of view, however, suppliers of a commodity are supposed to respond to higher prices with higher quantities supplied, and that is not happening. The supply curve has largely disappeared from the economic model, resulting in an ever-rising spiral of bids for spring wheat that no longer reflect two-sided interaction.

This dynamic is powerfully bullish right now, but also inherently unstable and vulnerable to volatile correction when suppliers eventually return. Granted, it is easier to describe these things in hindsight than predict when they might happen.

Here are two benchmarks to help give an idea of how high Minneapolis wheat prices may go this time around. First, consider the drought year of 2012. Not only did the U.S. experience drought, but Russia was also severely hit with drought and wildfires. The world's ending wheat stocks-to-use ratio at the end of 2012-13 was 26%, significantly less than the 35% that USDA is expecting at the end of 2017-18 -- even if we make some allowance for this year's U.S. drought.

Spot Minneapolis wheat peaked at $10.35 in July 2012, $2.23 above Monday's spot close. It is difficult to make any argument that today's wheat price deserves to exceed or even match the 2012 price -- especially with most wheat regions outside North America doing well.

The second comparison involves the pricing relationship between Minneapolis and Chicago wheat contracts. Going back to 1980, the two wheats have had a relatively stable track record with Minneapolis wheat typically priced at a 14% premium to Chicago wheat. In fact, there have only been five years when Minneapolis wheat traded at more than a 33% premium, and all five times lasted less than a year.

The most expensive Minneapolis wheat has ever gotten relative to Chicago was February 2008 when Minneapolis briefly rang up a 69% premium. As of Monday's closes, spot Minneapolis wheat was 51% above Chicago, which is the second largest premium since 1980.

One could say that Chicago wheat could correct the imbalance by trading higher, but in this particular situation, it seems more likely that Minneapolis wheat prices may have already gone too high.

Trying to pick a top in a drought-fueled market is foolish and far too dangerous for most traders. For any producer fortunate enough to own spring wheat, however, it is difficult to pass up the selling opportunity that current prices are offering. I cannot guarantee spring wheat prices won't go higher, but I can point out several years when selling opportunities this good didn't last long.

Todd Hultman can be reached at todd.hultman@dtn.com

Follow Todd Hultman on Twitter @ToddHultman1

(BAS/SK)

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