Is Wheat Undervalued on the Futures Market?

(Reuters) – Given the world’s ever-expanding inventories of wheat and corn, it seems hard to argue for higher prices for either one. Although the currently low wheat-to-corn price differential is particularly favorable for the use of feed wheat worldwide, support for Chicago wheat futures may lie within the fundamentals.

Since Aug. 31, December wheat futures have tacked on 6 percent and December corn is up about 13 percent. But should the wheat contract be the one with the bigger gains?

The global supply situation certainly might suggest so. The 2016-17 global wheat to corn carryout ratio as projected by the U.S. Department of Agriculture – about 122 percent – has historically led to greater seasonal disparities in wheat and corn futures prices.

Such a low carryout ratio, boosted this year by a substantial increase in world corn supply and stagnation in wheat, should lead the price of wheat much higher relative to corn, perhaps to the greatest degree since the commodities bubble of 2007-08.

Using this relationship and assuming that CBOT corn futures are fairly priced implies that wheat should be trading about $1 per bushel higher than it is today.

In this exercise, Chinese wheat and corn stocks have been subtracted from the world numbers since China has spent the last decade amassing excessively large stockpiles of both grains, and virtually none of it ever ends up on the world market.

The ratio of wheat to corn futures prices during the 2010-11 marketing year was nearly identical to today’s value of about 116 percent, but world wheat ending stocks excluding China were nearly double those of corn in that year.

Fast forward to 2016-17 and world wheat carryout is expected to be almost identical to what it was in 2010-11, but corn carryout has swelled by more than 50 percent over those six years. The same wheat-corn price ratio under such a different supply situation is a bit tough to explain.

Looking at this in a different way, given how the market has priced wheat relative to corn, the relationship with world carryout ratios would suggest that the world is much more oversupplied with corn than it is with wheat. And perhaps this may not imply only some upside for wheat futures, but also possible downside to corn futures.

FEEDING FRENZY?

When wheat is relatively cheap compared with corn, the global use of wheat for livestock feed tends to increase. Last week, CBOT wheat futures traded about $0.54 per bushel above corn, which is roughly the narrowest margin in over three years.

In 2016-17, the world has the potential to feed a record amount of wheat as the USDA currently projects a 6 percent increase on the year. Previous estimates for the current marketing year have been higher, but when larger U.S. wheat stocks were revealed at the end of September, this implied less domestic wheat feeding and prompted the downward adjustment.

Aside from a few outlying years, the spread between corn and wheat futures throughout the marketing year is a fairly good indicator of how strong world wheat feeding should be during that year.

Almost all of the significant outliers in this comparison were years in which more feed wheat usage would have been expected given the price differential. Without launching into a completely new investigation, the ratio of feed-grade to milling-quality wheat in those years could potentially have had an impact, but a shortage of feed versus milling wheat is not a situation we are facing in 2016-17.

In 2011-12, when the wheat-corn spread was a mere $0.14 per bushel – the lowest in over 20 years – world wheat feeding shot to an all-time high, some 16 percent above what a yearly trend would suggest. USDA’s current estimate for wheat feeding in 2016-17 is 5 percent above the long-term trend, which is very reasonable if the wheat-to-corn price ratio were to remain in the vicinity of today’s levels.

But there is still more than half a year left in the 2016-17 season. Should the futures prices of wheat and corn continue to converge as they have over the past couple years, then USDA may have to increase world wheat feeding into the second half of the year