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The Phase One China deal and cash corn basis

Mandel Ngan/AFP/Getty Images US President Donald Trump and China's Vice Premier Liu He sign a trade agreement.
President Donald Trump and China's Vice Premier Liu He sign a trade agreement between the U.S. and China during a ceremony in the East Room of the White House on Jan. 15, 2020
Why there are solid reasons to be optimistic about grain markets in the next 90 days.

During the post-signing period of the China Phase One trade deal, soybean prices have done nothing but decline. Most recently, this weakness was accentuated with China’s coronavirus battle and the panic associated with it. This panic also roiled corn prices Monday.

All this is quick to elevate discouragement in both trader and producer circles. The trade has been saturated by discouragement and fear since last summer’s price collapse and fears about large 2020 acreage.

We have seen it in every USDA report. The trade appears to embrace anything that could be bearish. This week’s coronavirus panic in ag markets has amped up fears over agricultural consumption. The coronavirus outbreak is troubling and will impact tourism and travel, but nobody will be reducing caloric intake as a result of this outbreak.

This market reaction is not uncommon

I have been in this business for 40 years, witnessing export business with the former USSR, Russia and China. I can assure you, it is not at all uncommon for something like Phase One to be followed by a market reaction that traps initial buyers of headline announcements. It is almost as if the post-announcement trade is hand-delivering a buying opportunity to the new large customer, as initial buyers are chased to the exit door during a long liquidation phase.

So let’s put Phase One in perspective. It will be a two-year process. Attempting to judge the entire agreement by price action and China’s presence, or lack of presence, during the first two weeks after the signing, is a big mistake.

China moved dramatically towards the U.S.’ stance to achieve Phase One. The U.S. did not remove all tariffs and remaining tariffs will remain in place long enough to have China’s compliance with Phase One play an integral part of whether or not China receives tariff relief.

China’s need for tariff relief is real. It is probably a major reason for China’s drive to sign Phase One. Let that sink in.

Data was clearly showing a loss of economic activity from the U.S. tariffs, but more importantly, China was gravely concerned that companies were in the process of moving manufacturing out of China due to the uncertainty of U.S./China trade. This was unacceptable, but China had no leverage or recourse to prevent it from occurring, without further exasperating the problem and elevating the concerns. So China’s only course that could stem such activity was to reach a trade agreement with the U.S. and ease trade tensions in the eyes of the global community.

Who needs who?

It is also reasonable to conclude that China needs to have agricultural trade with the U.S., which may have been another strong reason for them moving so far towards the U.S. position. This theory is difficult to prove, but all the soy and pork acquisitions made by China during the past year were NOT at all “olive branches,” but necessary purchases.

China saw soybeans as their big leverage stick with the U.S. during trade negotiations. But they do need our grains and soy.  

When you view Phase One from this perspective it is virtually certain that China will in fact live up to Phase One ag commitments, at least during the next two years. This will likely include at least 8 mmt (million metric tonnes) U.S. corn purchases. The trade does not have this plugged into their balance sheet mentality, and we have not seen USDA yet incorporate such export business, either. Thus, U.S. corn carryout ideas will decline in the months ahead.

Plus, China is likely to increase purchases of U.S. soybeans above what is built into current balance sheets. With U.S. soybean carryout at only 470 million bushels, it won’t take much new business to suddenly make the supply situation much tighter.

It should also be noted that despite the U.S.-China trade war, Asian Swine Fever, and China drawing down their own soybean reserve stocks, China imported 88.5 mmt of soybeans during 2019. That is a slight increase from 2018 levels.

The take home message? Global soy demand is not in trouble.

What’s behind U.S. corn basis

This is another reason for optimism towards price levels during the next 90 days. U.S. corn basis has been stronger than most expected throughout the entire summer and harvest season of 2019. Here’s why this is happening.

Let’s go back in time to harvest 2018. Basis levels were extremely wide in both corn and soybeans. Futures spreads were wide. Do you know what commercial elevators do in this environment, from the first buyer of the producers’ grain to the last buyer of the producers’ grain, who is the exporter? They build long cash basis positions. They hedge their inventories in deferred contracts and they capture carry, knowing full-well that basis levels will eventually tighten.

Every co-op and elevator did exactly that, as did each commercial participant down the supply chain, including exporters. However, exporters have maintained that long basis stance, hoping to liquidate that position with an increased U.S. export program between now and the fully operational U.S. river export system opening this spring.
As commercial entities held inventory from the fall of 2018, they gradually moved through that inventory for a variety of reasons in the months that followed. However, the export channels faced more difficulty in being able to move through that position.

In the spring of 2019, flooding hindered the river navigation system, limiting their ability to execute export activity. By the middle of May 2019, it became very apparent that a major problem was developing in the U.S., and future domestic corn supplies were threatened. Very large commercial grain trading firms and export firms were actively assessing the situation and dispatching high level observers to the eastern Midwest to address supplies.

Collective decisions were made to create an environment where U.S. exports were less competitive and non-U.S. origins would become the shipper of choice. This then led to front-loaded export programs from other destinations and record monthly exports for those locations.

During this time, spreads and basis continued to tighten. When it became apparent that the U.S. corn situation would be different than worst fears, the futures spreads collapsed, but basis stayed firm.

Why basis remained firm at harvest

If you ask why would basis remain firm at harvest, keep in mind who in the above story-line was still long basis—the commercial exporters. As the annual “tin can harvest” failed to materialize, it was apparent that the U.S. producer was carrying a much smaller than normal old-crop inventory. And that he should, as basis, spreads and futures all combined last summer to maximize enticement for farm producers to unload inventory.

The lack of inventory was further proven when just prior to harvest virtually all Midwest country elevators had very low supplies. Yet, USDA said carryout was 2.114 billion bushels. How could this be, you ask?

My theory is that an unusually large inventory was held in the export tributary system and elevator facilities. These folks set global price relationships and they elected to hold greater than normal U.S. supplies, while exporting more aggressively non-U.S. origins.

Proof of this can be seen in the record monthly export shipments from U.S. competitors and the front-loaded nature of their exports, vs other years. Another proof of this was Argentina’s decision to impose export taxes, which are designed to hold back supplies in protection of domestic supplies.

With this backdrop, consider that it is in these large global firms’ best interests to keep basis values firm, because they are long U.S. cash basis. Basis levels will remain firm until they have been given an opportunity to exit this position, with their next best chance being the export season between now and, say, May.

Now, enter Phase One. Along comes China and they will be a major buyer of U.S. supplies. And, who owns a chunk of that inventory? Yes, the global exporters are long U.S. cash supplies. They have incentive to drive business to U.S. shores and China has incentives through Phase One to purchase U.S. grains and soy.

It’s the perfect meeting of two necessities by two giants in their fields. This export program will happen. China’s purchases tied to Phase One will happen.

Proper U.S. farmer response?

If China purchases do unfold as I am confident they will, what will that landscape look like? It will be filled with optimism about U.S. export activity, very firm export basis values, and strong domestic basis values as domestic buyers fear they will need to compete with the export market in a greater way than they have been lately. Fears of large 2020 corn acreage may be less concerning.

In a nutshell, the trade rhetoric will be very bullish.

The U.S. farmer will need to try and not get too emotional during such a situation. See it as an opportunity to liquidate 2019 inventory and watch for attractive 2020 sales opportunities. The challenge to producers will be their willingness to execute a pricing/delivery strategy when everything seems bullish all around.

Will we see pricing opportunities at some point between now and May? If this occurs and we see the U.S. 2020 crop off to a good start, that would open the door for price weakness into June and maybe early July.

From there forward, weather dictates supply expectations.

I challenge you to print this article, post it on your office door and if we begin to see these conditions evolve, be willing to seriously consider taking profitable opportunities when they are presented.

As always, feel free to contact me to discuss this or any questions/concerns that you may have. My contact information is below.

Duane Lowry
Senior Risk Manager and Market Research Director
Silver Creek Commodities
Twitter= @DuaneLowry
Phone/text= 563-419-1300
The opinions of the author are not necessarily those of Farm Futures or Farm Progress. 
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