Inverse: a basic explanation

Recently the wheat market has moved to an inverse market. Fine you say, the market is upside down, so what does that mean?

A few of us have been discussing the market situation, on twitter. Happily we discuss the pros and cons of this situation, and what it means for marketing decisions. A few have questioned us as to what language we are speaking. I will attempt to translate for those who are not aware of what an inverse market is.

Wheat is traded on a “commodities market”. Basically a commodities market is designed to sell something today, for future delivery. Like it or not, wheat is in continual over supply, that’s what makes it a commodity, it’s easily interchangeable with other wheat. Because it is in over supply, and it’s easily substituted by other wheat there is not enough demand to use it all today. To encourage future delivery the market is always paying a higher price tomorrow. Most of us know this as carry, thus commodity markets can be described as carry markets, or “contango”.

When a market loses its carry, occurring when spot prices, or inter crop prices become higher in the nearer months, or crops, than the future crops this is described as a market inverse, or “backwardation”.  Another term used by traders is “bull spreads”.

The signal the market is sending is “sell today, not tomorrow”. As the price is higher in the nearer month, or the closest crop the incentive is to sell sooner rather than later.

Anyone watching the wheat market on CBOT will notice this currently. March 2013 offers the highest quote for wheat on the board. And then the market goes into “backwardation” or is described as inverse. For us Australian’s December is the quote used to price our different season’s grains. Again, a glance at the quotes will show an inverse between Dec 2012 and Dec 2013. The market is saying sell your grain to me this year; don’t store it for selling next year. See CBOT Wheat  here

An even better illustration is the Winnipeg Canola market and the CBOT Corn market, both inverse from the front month (first month quoted) and between crops. You will also notice the spot, or cash price is the highest price quoted.

For a further explanation on this, from the NYSE, check out the link in the comments section of my blog on pricing grain. Open the link “ENHANCING MARKET TRANSPARENCY”

While there is much more to understanding market signals, a basic understanding on carry and inverse market conditions can help, and I hope this assists.

 

2 thoughts on “Inverse: a basic explanation

  1. Thanks Corey, I thought this is what you were on about.

    The other observation is that the growing season is getting closer to an end in the US, and with prices this high it will encourage more area to be planted the following year. My guess is that the inverse will grow until other exporting nations start to give indications of the state of their crop this year. Also there is an assumption with the inverse that the following year will be close to average in the market’s eyes. If an average year happens next year I would expect the price for Dec 13 crop to fall especially just before planting in US. My conclusion would be to take a little Wheat/Corn for next year’s crop as the prices are very good. I have already done this with our 12/13 sorghum crop. Thoughts?

  2. John,
    Depending on if you are talking about wheat or corn, the seasons are slightly different stages. Wheat is 50% harvested in the US, corn is silking-blistering.

    The wheat market inverse is more between seasons, only showing a slight inverse at marketing YE, where corn is inverse intra season. Another factor I haven’t touched on is the amount of carry. Full carry is not evident in wheat where there is carry.

    With regard to acres, I don’t believe it is as simple as saying there will be more acres go in of one crop or another.

    Corn and Soybeans stocks are at historic lows in the US, and the US is the world’s tradable wheat stockpile. The July WASDE projected the US to be holding 18mmt at marketing YE 2012/13. This is down from 2010/11 when stocks were 23.5mmt. Soybeans and Corn have very tight S and D equations. Wheat appears to be a follower in this market, not the leader.

    For this reason there will need to be pricing to attract as many acres of all crops to be grown. This will be an economic decision, not only between crops but also about bringing marginal land into production. Should the pricing matrix (wheat/corn/soybeans) be pulled to hard on one front, the supply will collapse on the other (figuratively speaking).

    There is also a theory, if prices are higher front end than back end the signal is sell now, but if everyone sells now and surpluses are extinguished then there could be a void in the market. Refer to 2007-08 for that result.

    I agree with you re coverage, I have taken coverage for 12/13 and 13/14 but there is no simple answer to what will happen at the end on an inverse market. The old adage: nothing fixes high prices like high prices may well be the answer.

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