Todd's Take

Heading into August, we have had plenty to talk about in grains this year. But the king of price moves so far has been Minneapolis wheat, where drought in the northwestern Plains wreaked havoc with this year's spring wheat crops.

The shorthand explanation is that drought caused spring wheat prices to go higher. That is true, but beware of a common trap that comes with that easy explanation. For producers and traders both, this year's spring wheat rally offers a good example of what to expect from prices in drought situations.

For starters, let's go back to May 9 when I wrote "The Other Wheat Sneaks Higher" (http://bit.ly/…). The price of September Minneapolis wheat at that time was near $5.50 a bushel, and a forecast for warmer weather in the northwestern Plains was actually seen as a positive for fieldwork at that time -- certainly better than the heavy snowstorm that hit western Kansas a week and a half earlier.

The U.S. Drought Monitor released on May 11 showed an area of abnormally dry conditions in southern North Dakota and northern South Dakota, but drought was not yet a significant concern. The bullish market clues that I wrote about at the time included a return of commercial support in early April, a new eight-week high in the July contract on May 1, and a bullish turn in the weekly stochastic for spot Minneapolis futures.

If we follow the weekly progression of the University of Nebraska's U.S. Drought Monitor since then, the first patch of moderate drought (D1) appeared on May 25, followed by the first sighting of severe drought (D2) in the Dakotas on June 8. The first sightings of extreme drought did not come until June 22, but July and September Minneapolis wheat prices were already anticipating what lay ahead. Both contracts broke new 2017 highs on June 1 and followed up with progressively higher prices through the month of June.

In the July 5 DTN article, "When Prices Go Vertical," I explained why spring wheat prices were "inherently unstable and vulnerable to volatile correction..." I didn't realize that prices would peak the exact day the article came out, but that is what happened. Since then, September Minneapolis wheat is down $1.37 from the high, finishing at $7.31 1/4 on Monday.

The fact that prices have been chopping lower the past few weeks has been puzzling for some, as drought conditions have gotten markedly worse. The latest U.S. Drought Monitors showed that exceptional drought conditions appeared in the Dakotas and Montana on July 18 and expanded on July 25.

And this is where many market watchers go wrong. We hear about drought and watch prices go up as drought conditions get worse. This gets reinforced day after day, and when we see another forecast with no rain, we expect prices to keep going up. Behaviorally speaking, we may not realize it, but we are being trained better than Pavlov's dogs.

Nearly three weeks after Minneapolis wheat prices hit their July 5 peak, large and small speculators were net long 10,860 futures contracts, waiting for that next morsel of food in the form of a higher price.

Markets being markets, I can't guarantee that some other factor won't come along and send prices higher, but in the case of drought, it is important to know that prices typically peak well before conditions get better. Just as Minneapolis wheat prices started making new highs well before extreme drought conditions showed up on June 22, those same prices are apt to hit their highest point long before drought conditions actually show improvement.

What happened in 1988, the last time the northwestern Plains had a drought this bad? USDA's poor-to-very-poor crop ratings for spring wheat on July 31, 1988, were 73%, much worse than Monday's poor-to-very-poor rating of 43%. However, it is interesting that prices in both years followed a similar path, climbing in May and seeing their biggest gains in June.

September 1988 Minneapolis wheat posted its highest close of $4.66 1/2 on June 27, 1988, even though drought conditions showed no sign of improvement until September, well after the spring wheat harvest was over. From May's lowest close to the June 27 peak, September 1988 Minneapolis wheat prices gained 49.6%.

(For more about the drought of 1988, see "The Drought of 1988 and Beyond," Proceedings of a Strategic Planning Seminar Co-sponsored with the National Academy of Science and Resources for the Future, Oct. 18, 1988, Washington, D.C., found at: http://bit.ly/…)

So far in 2017, the highest close in September Minneapolis wheat has been $8.19 3/4, posted on July 5, even though drought conditions continue to grow worse, just as they did in 1988. And the percentage gain from the low of May to the July 5 peak? 49.9%.

The lesson here is that it is easy to understand how market prices are influenced by drought, but it is also important to recognize that prices never equal the things that influence them. Markets are people and like people -- right or wrong -- market prices often get out ahead of the events that shape them.

Again, I can't guarantee that the July 5 peak in Minneapolis wheat prices will stand as the high in 2017, but held up to the drought of 1988, it sure looks likely.

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

Follow him on Twitter @ToddHultman1

(AG/BAS)

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