By Ole Hansen, Head of Commodity Strategy at Saxo Bank

United Arab Emirates,  October 11, 2020:  The agricultural sector has continued to build on the strong gains seen during Q3 when the Bloomberg Agriculture Index recorded its best quarter since Q2 2016. The grains sector in particular was, and continues to be, the sector which is driving these strong gains. An unexpected decline in U.S. inventories, strong U.S. export demand from China, dryness in key growing areas together with growing concerns over La Nina are all potential strong forces that may support a sector that has already rallied by close to 15 percent during the second half of Q3.

This week, the price of Chicago Wheat raced past $6/bushel to reach the highest levels since December 2014, before seeing some profit taking ahead of a global supply and demand report from the U.S. Department of Agriculture on Friday. The latest rally has been backed by Russia and U.S. dryness worries, at a critical time as it challenges the establishment of the winter wheat crop. Bloomberg reports that in eastern Ukraine, some areas have been the driest on record since mid-July, while in Russia some regions are the most arid in three decades.  

Soybeans, meanwhile, continue to find fresh buying interest with the price of the current front month contract reaching $10.65/bushel, the highest since 2018. On top of continued strong buying interest from China, the planting progress in South America has also been hampered by dry conditions across Brazil and Argentina. In Brazil, a bumper export program to China has reduced supplies while farmers have been hoarding stocks as a dollar-linked hedge against a weakening peso. 
 
The result of these developments across the grain market can be seen in the weekly COT report, released on Fridays covering the week ending the previous Tuesday. In the latest reporting week to September 29, the combined net-long speculative position in U.S. based grain and soy futures reached 533,000 lots (one lot equals 5000 bushels), very close to the previous two peaks in March 2018 and June 2016.

The total net-long in soybeans, oil and meal reached a record 396,000 lots or 74 percent of the total sector long, while corn at 107,000 lots took up 20 percent. That left just 6 percent or 30,000 lots of the total exposure in the Kansas and Chicago wheat contracts. While soybeans will need continued fundamental and technical support to sustain a speculative position this elevated, wheat is a different story with plenty of room before reaching the February high at 79,000 lots or the August 2018 record of 130,000 lots. 
 
The risk of food price inflation emerging again following years of stable to lower prices was highlighted in the United Nations FAO’s latest update on food prices for September. The FAO Food Price Index which tracks the change in international prices of a basket of 95 food commodities rose by 2.1% to the highest since February 2020. The year-on-year rise reached 5 percent with firming in prices of vegetables oils and cereals being the main driver. Not all sectors rose with those of sugar and meat retreating from their August levels. 

In a separate cereal supply and demand brief they did however say that: 'Global cereal markets are expected to remain adequately supplied in 2020/21 despite this month’s downward revisions to production and inventories. With trade in cereals seen expanding in 2020/21, global cereal markets continue to demonstrate their resilience amidst the challenges and uncertainty caused by COVID-19.'
 
Bulging stocks from a continued rise in production in recent years helped keep the forward curves in a state of contango where the spot futures contract traded lower than the next. This meant that long-only investors were facing headwinds from negative roll yields.

The rally during the past quarter across the whole agriculture sector has flattened the forward curves and sharply reduced the mentioned headwind. The grains sector in particular has seen its average one-year roll move from a contango, averaging -5 to -10 percent since 2016, to backwardation for the first time since 2014 (see insert in chart below). 

While supply and demand differences will always be the ultimate determining driver for prices, the removal of the contango headwind may potentially now also attract increased investment demand. ETF’s that are designed to track the performance of a basket of agriculture commodities are showing signs of breaking the downtrends which for most was established close to ten years ago. 

An example being the WisdomTree Grains ETC (Ticker: AIGG:xlon and UCITS eligible) which is designed to track the Bloomberg Grains Subindex Total Return Index. As per the chart, the recent rally has triggered a breakout with the price currently trading around $3, an area that has provided support and resistance on few occasions since 2018.