China shouldn’t get fooled by soybean futures

One of the key planks in China’s strategy to deal with food inflation is to boost the supply of hogs and contain the runaway increase in pork prices.

One can’t be sanguine that the authorities will emerge victorious in this mission in 2008.

This year’s projected increase in pig population, according to one Chinese government analyst, may represent only a 3-percent increase over 2007 when a disease curbed supplies.

The additional supply may not be enough to tame wholesale pork prices, which have risen 74 percent in the past year in China, pushing the annual inflation rate to 8.3 percent.

More animals don’t mean cheaper meat if demand continues to outstrip supply, and farmers pass on higher feed costs to consumers. But what if it becomes cheaper to raise pigs?

That possibility is suggested both by the US Agriculture Department’s “Prospective Plantings” report, as well as the commodity-futures markets.

The March 31 report says farmers in all but one US state intend to plant more soybeans this year.

An estimated 75 million acres will be dedicated to the crop, an 18-percent jump from 2007. The US is the world’s No. 1 soybean producer.

Futures contracts on both soybean and soy meal are in “backwardation” on China’s Dalian Commodity Exchange, meaning that longer-dated futures are progressively cheaper than nearer-term contracts.

Backwardated contracts

Soybean futures for delivery in January 2009 are 21-percent cheaper than those that mature next month; for soy meal, the difference is about 14 percent.

China is the world’s biggest buyer of soybeans, which are crushed to make cooking oil and the protein-rich soybean meal. The latter is mostly fed to hogs, poultry and cattle.

A steeply backwardated market typically suggests that soybeans are in extremely short supply. As stocks get replenished by new harvests, the deficit will ease.

Such a view may not always be correct.

One can’t rely on the futures contract for a pure estimate of the expected spot price tomorrow.

The futures price subtracts, from today’s expectation of tomorrow’s price, a risk premium that hedgers have to pay to speculators to buy
insurance.

When inventories are too low to absorb shocks to the demand-supply equilibrium, spot prices rise more than futures (because tomorrow’s stocks can’t be consumed today) and cause backwardation.

Risk premium

In such instances, the risk premium also often tends to rise and makes the futures contract cheaper—in relation to today’s—even when there’s no drop in the expected spot rate for tomorrow.

For an elaboration of the theory, see “The Fundamentals of Commodity Futures Returns,” a recent paper by Gary Gorton, who is a finance professor at the University of Pennsylvania, and two other researchers.

We don’t know for sure if risk premiums have gone up for Chinese investors in soybean, though inventories are certainly low. US Agriculture Department statistics show global soybean stocks at the end of March 2008 were the lowest since 2004.

Farmers in Argentina, the world’s third-biggest producer of soybeans, have already pushed all the land they could into growing the legume; so much so that they have run out of pastures to graze their cattle.

Biofuels, interest costs

Even then, the crop that’s being harvested—following a truce in a strike by growers—will probably not exceed last year’s record production, according to the government’s estimate.

And while US soybean acreage is increasing this year, it would still be lower than in 2006.

Nor is there a letup in the biofuel craze.

A fifth of the domestic use of soybean oil in the US is now as feedstock for biodiesel.

Finally, China’s negative real interest rates may be playing a role by reducing the cost of precautionary hoarding.

The price of soybeans in China has risen 82 percent in the past year. Since a hog farmer earns only 4.1 percent a year on the money he keeps in a yuan-denominated bank account—not even enough to compensate for half of the annual inflation rate—it may be reasonable for him to stockpile all the soy meal he needs.

The downward-sloping shape of the futures curves in soybeans—or copper, for that matter—suggests supplies are now tight; yet they don’t confirm that shortages are expected to ease.

The Chinese authorities shouldn’t allow themselves to become complacent.

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Andy Mukherjee: China shouldn’t get fooled by soybean futures

One of the key planks in China’s strategy to deal with food inflation is to boost the supply of hogs and contain the runaway increase in pork prices.