In this report

Soybean crush: oil share of the crush over time

As we know, the soybean crush produces two major products such as soybean meal and soybean oil. Historically, about 30% to 35% of the value of soybean crush products came from soybean oil, as the bulk of the value went to soybean meal. However, over the last few years, this percentage has risen to over 50%. The relative change can be attributed to the changes in the market for either product, though most may attribute the change in percentage to the demand for soybean oil for renewable energy purposes. While this percentage peaked over 50%, it has recently pulled back to the lows of the past few years. Is this an opportunity?

Ratio of soybean oil to soybean meal compared to the generic front month Crude Oil futures

Perhaps corroborating the idea that the relative demand for the spread is spurred by demand for renewable energy, we can compare the ratio of prices between the generic front month Soybean Oil and Soybean Meal futures and overlay that versus the generic front month Crude Oil futures. As we can see, this ratio compares very favorably relative to oil prices. If anything, one might say that this ratio has some leading properties to the price of oil.

If we add to this mix that the Environmental Protection Agency (EPA) has raised the Renewable Volume Obligation (RVO) for biofuels in 2024 from 15 billion gallons to 15.25 billion gallons, we can see that the current administration is supportive of an increase in demand for biofuels. If more biofuel plants come online in 2024, we can expect the demand to increase even more. In fact, in an election year, it might even be considered that many Midwestern states, which generate the most biofuels, could be beneficiaries of favorable renewable energy subsidies. Perhaps this is too cynical, but one might suggest that there are more exogenous demand drivers for oil versus meal in the coming year. Working against this is the global supply of crude oil, which has been increasing more than expectations and weighing on the price of crude.

This time of the year, with the U.S. seeing cooler temperatures, all eyes turn to South America for the quality of the planting season in the Southern Hemisphere. Hot and dry conditions, which some characterized as drought-like conditions, delayed the planting of soybeans in Brazil and in the region’s top soybean exporter Argentina. However, recent rains after a delayed planting season have led to expectations that the crop will not be as bad as feared, with a recent Reuters article reporting that the crops that were planted are developing with optimal humidity conditions or better.

Update on Argentina planting season from the Buenos Aires Grain Exchange

On December 28, 2023, we received an update on the Argentine soybean planting season from the Buenos Aires Grain Exchange. It reported that planting progress was up 9.5% week over week with normal to excellent conditions at 97.8%. Given the negative expectations at the start of the planting season, this sudden burst of good news for crops may not be welcome news for soybean prices, which were already struggling under their own weight.

Commitment of Traders Report for soybean oil and soybean meal

If I look to the recent Commitment of Traders Report, I can see how managed money is set up in the futures contracts for both oil and meal. In the top picture, managed money is back to the shortest position it has had this year in oil, which is reflective of the recent weakness in prices but may fly in the face of any expectation for higher renewable energy demand in an election year. In the bottom picture,  the managed money positioning in meal is now giving a strong signal as it is in the middle of the range for the past 12 months.

Chart of the generic front month Soybean Oil futures and Soybean Meal futures

Turning to QuikStrike, I can plot the futures price of both oil and meal and see that both have been under pressure for the better part of 2023, with only a brief respite for oil over the summer and with a brief spike in meal at the start of the South American planting season. At this point, both futures prices look very heavy and are heading lower, below both the 50- and 200-day moving averages, suggesting lower prices could be ahead.

Relative price graph for Soybean Oil futures vs. Soybean Meal futures

For those traders with a contrarian bent like me, it may take some creativity to find a way to dip into these markets. As we saw above, both products individually look heavy, with charts that are headed lower and unable to sustain a rally on any favorable news. However, looking at the relative price chart I can start to see where an opportunity may present itself. When I look at the relative price of oil vs. meal over the last three years, I can see that it has largely stayed in a range. Using a ratio of eight to one to reflect the price ratio, this relative price has averaged 1.20 over the last three years with a low around 0.9 and a high of 1.8. It currently sits just below 1.0, which is very close to the lows of the last three years. Is this a chance to get long oil vs. meal?

Futures spread position – long 8 contracts ZLH4 vs. short 1 contract ZMH4

Using that same eight to one ratio, I turn to QuikStrike futures spreadbuilder and build that position. I can see that on a price basis, the spread is at zero, which is very close to the lowest we have seen over the last 12 months. If I look at the relative performance of this spread vis a vis the futures charts for each component above, I can see that the bigger driver of this relative performance is the price of soybean oil -- when it moves higher, this relative spread moves higher even after adjusting for price differences. Thus, looking for an upside in this spread is akin to looking for upside in oil, with an expectation that meal prices will be relatively stable.

CVOL tool for CME Ag products

The next stop for me is to always turn to the CVOL tool to see how the options market is pricing risk. I pulled up the Ags product to compare the CVOL for each to the other Ag products and to its own history for the past year.  Looking near the top, I can see that soybean meal CVOL is 25.67, which is on the higher end of all products, but is roughly toward the middle of its range for the past year. Similarly, soybean oil is also at the higher end for all products with a CVOL of 28.06. However, this level is near the low end of its 24.89-44.98 range for the past 12 months. So, while it is a bit higher in an absolute sense versus soybean meal, it is lower from a relative standpoint.

Time series of CVOL and Skew ratio for soybean oil and soybean meal

The CVOL view above is a bit of a snapshot, so to get the moving picture, I click on the small graph icon on the left to pull up the time series for CVOL for both products. Not only do I bring up the CVOL, but I also bring up the skew ratio to see how upside options are priced relative to downside options for each product. Visually we can see what I had discussed before, that the CVOL for oil is at the lows for the year, while the CVOL for meal is more in the middle of the range that it has experienced. One thing that is common to both pictures is that the skew ratio for each product is near the lows of the year, suggesting the pricing for calls relative to puts is quite low. This suggests there may be an opportunity to get long some calls as a better way to play a countertrend move in the futures.

Expected return charts for -1 OZMH4 400 c vs. + 8 OZLH4 49c

Pulling together the last several charts, this is how I see the set-up in oil and meal right now:

1.     The price of both oil and meal looks very heavy and they are not responding to positive news making a countertrend trade in either individually more difficult.
2.     There is potentially more upside catalysts for oil, particularly if there is more demand for biofuel in an election year.
3.     The relative price of oil vs. meal looks to be strong, coming in at one versus a range of 0.9-1.80.
4.     One could set this up with a ratio of futures, which one could also enter near the lows of the year.
5.     However, the options market may provide a more attractive way to play this idea, limiting the downside risk should both futures continue to head lower.
6.     Oil CVOL is relatively lower than meal CVOL.
7.     Calls for both oil and meal are relatively inexpensively versus puts.

I can see the ease and appeal of a futures spread with tight stop losses. However, there are a couple reasons why I’d use options. If the spread moves higher, this is most likely because oil price itself has moved higher. If the trade loses, and the spread moves lower, both futures likely are lower and options present a limited risk. The price of calls is relatively low and so if the spread and futures move higher, CVOL and implied volatility will likely move higher, particularly if managed money feels the need to cover a short position that is at the shortest of the year. Thus, I like the idea of buying eight March calls on oil and subsidizing this buy selling one March call on meal. There is a risk that the calls on meal are in the money. However, I think if this is the case, the calls on oil will be even more in the money and I own even more of them, so I should have leverage to a move higher in both oil and in the relative spread.

The premium I spend on oil calls is 13.35 x 600 = $8,010. The premium I take in selling meal calls is 9.16 x 100 = $916. Thus, I am not able to do this at zero cost and have a risk in the premium outlay. There is also a risk that the relative spread moves lower and this is driven by meal moving higher while oil moves lower, and not from both moving lower. If this is the case, I am at risk of ending up in-the-money on the calls I sell while the calls I buy end up out-of-the-money. However, there is also a risk if I were to do this trade in the futures market, and I am focused instead on the leverage I can get to a move higher in both markets and the spread, and the limited risk I have if both markets continue lower. Thus, I am willing to take the risk of being exercised on meal calls with oil calls expiring worthless.

I admit that I am a contrarian by nature. I also prefer relative value trades having been both a market-maker and a long/short portfolio manager. However, I think the set up in the calls versus calls trade, giving positioning, catalysts and pricing, is attractive. I think it is a good way to start the year for Excell with Options.

Good luck trading and stay vigilant!

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