April 27, 2015
Is This Agriculture Trade
Ready to Break Higher?
By Joseph Hogue
For the past five years, investing in agricultural commodities has not been for the faint of heart.
After rebounding quickly from the Great Recession on heavy demand from emerging markets, record harvests and slowing Chinese demand led to a general downtrend in prices, with volatile spikes in 2012 and 2014.
This year, we've seen corn and wheat prices fall on an upgrade in production forecasts by the USDA and lowered expectations for export demand. Beyond strong expectations for this year's harvest, a strong dollar is making U.S. crops relatively more expensive on the global market.
But could this be a repeat of prior years when prices spiked due to higher demand or lower-than-expected supply? Beyond long-term catalysts to support prices, there are several near-term issues that could drive prices for corn and other grains higher this year.
Population Explosion Supports Grain Demand
It may have taken more than 200,000 years for the global population to reach 1 billion, but it took only 123 years to grow that number to 2 billion. In 2012, that number hit 7 billion, and the UN predicts we'll add our next billion by 2026, a span of just 14 years.
Beyond the absolute increase in population numbers, economic growth in developing countries means higher caloric consumption and higher demand for grains. As incomes rise, so does consumption of meat, which requires several times the amount of grain used in livestock feed relative to the amount of meat produced.
Based on expectations for population and economic growth, the Food and Agricultural Organization (FAO) projects that food production will need to increase by 70% over the next 35 years to meet global demand.
Near-Term Catalysts for Higher Corn Prices
Besides the longer-term fundamentals that should support prices for grains, this year could see significant short-term catalysts for higher prices.
As part of trade talks in December, China lifted import restrictions on several genetically modified (GMO) crop strains. After China announced its decision, analysts at Shanghai JC Intelligence forecast that inbound shipments could double from the U.S. Department of Agriculture's previous estimate of 2 million tons to 4 million tons once the ban was lifted.
China is expected to harvest 215 million tons of corn this year, down from 218.5 million tons in 2013. During that same time, the country's population has grown by 4 million people.
If the first three months of 2015 are any indication, we may be in for a repeat of 2012's spike in corn prices. Globally, March was the hottest month on record, and the first three months were the warmest start to a year, according to the National Oceanic and Atmospheric Administration (NOAA). Thirteen of the 14 hottest years over the past 135 were in the 21st century. Whether from man-made factors or just a natural warming cycle, temperatures are rising, making agriculture production more volatile.
Using Call Options to Reduce Risk and Amplify Gains
Strong harvests and solid supply in the United States continue to weigh on grain prices, but long-term demand should help create a floor for prices. While I like the near-term potential for a price spike, I also want to hedge my risk in case we see solid crop production that continues to overwhelm demand.
The trade is well-suited for a covered call option strategy. With this trade, I can take a long position in a stock or ETF and simultaneously sell call options against the position. This lowers my cost basis for the shares while still providing the opportunity for upside potential.
In exchange for lowering my risk on the trade, I'm agreeing to limit my potential upside. This may mean that I miss out on some of the gain if prices do spike, but in my opinion, that's a worthy tradeoff for significantly hedging my risk if prices don't shoot higher. The fact that I lower my cost basis below current prices also means I amplify my return if the shares trade up to the strike price by expiration.
Teucrium Corn ETF (NYSE: CORN) offers investors exposure to corn prices without the need for a futures trading account. The fund invests in three futures contracts: 35% of the fund is in the second-to-expire contract on the Chicago Board of Trade (CBOT), 30% is in the third-to-expire contract and 35% is in the subsequent December contract expiration.
With shares of CORN trading at $23.84 at the time of this writing, we can buy 100 shares and simultaneously sell a CORN Aug 25 Call, which is trading around $1.20 per share ($120 per contract). This gives us a cost basis of $22.64 per share, which is 5% below current prices and just above the fund's all-time low of $22.62, set in October.
If CORN closes above the $25 strike price at expiration on Aug. 21, our shares will be sold for that price. In this case, we will make $2.36 per share in capital gains for a profit of 10.4% in just under four months. This compares to a return of only 4.9% for those who did not sell a covered call if the price moves to $25 a share.
I like the trade as long as you can get in for a cost basis of $22.95 or less, which still leaves you with a gain of 8.9% and a 3.7% discount to the current price.
If the price of corn fails to rally on near-term factors, and CORN is below $25 when the option expires, we keep the shares and the option premium. We'll then have the opportunity to sell another call to generate more income and lower our cost basis further. With volatile weather patterns and rising demand, it should not be long before we see another year of spiking prices.
Not selling covered calls each month on at least some of the stocks you own is like passing up free money. One of my colleagues likens it to owning a rental property and not collecting rent. You wouldn't do that, so why would you pass up on the opportunity to generate income on the stocks in your portfolio?
Some traders are using covered calls to earn an extra 9%-plus monthly on the stocks they own. If you want to learn how you can get started doing that today, follow this link.
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