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It has been awhile since we at Liberty Trading recommended selling soybean put options. In fact, the last time we made such a suggestion was last December. We made this suggestion based on the premise that global demand would outpace global supply in 2008 as the undersized US harvest had trimmed global supply numbers. Soybean prices did not disappoint and managed to rally by more than 33% in the ensuing months. It is ironic, then, that as we now are once again ready to recommend selling soybean puts, prices are all the way back to December’s trading levels.

How they got there is an interesting story and probably a bit of good fortune for prospective put sellers. However, to make a long story short, they took the stairs up and the elevator down. Soybean''s sharp decline over the past few weeks was, like many recent commodity corrections, driven mainly by speculators liquidating long positions in an overreaction to a current news item. In the case of soybeans, this was largely due to the latest USDA planting intentions report. This correction has substantially increased volatility in soybeans and soybean options.

As we discuss in our free Option Seller Email Seminars, volatility can create opportunities on both sides of the market. However, it is the investor who knows the underlying fundamentals of the market that will have the advantage in capitalizing on such volatility. As we will see, the fundamentals driving the soybean bull are still well entrenched, and prospective option sellers could be presented with a once-in-a-cycle opportunity for selling distant puts.

Soybeans have been a leader in the global commodities boom that accelerated in 2008. It is true that, like other commodities, a falling-dollar and a “flight to quality” mentality of investors fearful of further stock market declines have helped fuel the push to historic highs in soybean prices this year. However, unlike some other futures markets, soybeans are a physical commodity that is produced and consumed. Its end use as a product and demand from consumers is so large that it will outweigh its demand as an investment vehicle. Thus, like many agricultural commodities, its supply/demand fundamentals will carry more weight in its price determination than a more financially focused market, such as gold.

The underlying fundamentals driving soybeans ''08 bull were fairly simple: surging demand and a shortfall of supply.

Demand: While the shift to biofuels has been a global phenomenon, in the US, the primary product is ethanol. And the primary ingredient in most US ethanol is corn. US ethanol production, however, has actually eclipsed demand, at least for the short term. Asia, however, is more partial to biodiesel, much of which uses palm oil as a primary ingredient. This new source of demand has created a shortage of palm oil for food usage. Imported US soybean oil is one way Asian nations are making use of a substitute product. The year 2007’s substandard global wheat harvest has also created a sharp demand increase for high-protein soybean meal as a replacement. Use of soybeans to meet a growing global demand for food and energy produced record consumption for the 2007/08 crop year near 240 million metric tons. This outpaced 07/08 global soybean production by approximately 12 million tones – even with hefty Brazilian production.

Supply: As we have explained in previous articles, one of the key figures of determining grain prices is ending stocks, which encompasses the total of both supply and demand.  Ending stocks measures the amount of product left in storage after all demand has been met at the end of the “crop year,” which is September 1, right before the new harvest comes in. In 2007, US farmers chose to shift more acreage to corn and wheat, cutting back soybean acreage to 63.6 million acres, the lowest in over a decade. As a result, 07/08 US soybean production fell to 2.585 billion bushels, with ending stocks falling to 140 million bushels – both the lowest since 2003. With US and global stocks near multi-year lows and ''08 demand expected to surge ahead of 2007’s record levels, soybean prices reflected global supply worries. Along with speculator interest and a falling dollar, it was enough to drive soybean prices to all time highs in February of 2008, with prices trading above $16 per bushel.

High Prices Curing High Prices

Farmers, of course, watch soybean prices probably more than anyone else (even fund managers).  The US Farm industry can typically plant a variety of crops on a certain percentage of their acreage in any given year. Farmers will tend to plant the crop they feel will give them the highest profit in the fall. After all, regardless of what the going price is for the cash crop, planting and growing costs will typically remain fixed.  While corn and wheat prices have also had banner years for appreciation, soybeans had outperformed up through March.

This week, the USDA released its 2008 planting intentions report.  It showed that US farmers increased 2008 soybean planted acreage substantially over 2007. US growers project planting 74.78 million acres of soybeans this year, up 18% over 2007. If an average yield is realized, and demand meets expectations, this would result in an 84 million bushel increase in 08/09 ending stocks to 224 million bushels.

This shift in acreage was larger than most analysts had expected and soybean prices plummeted on the report.

Liberty Trading''s view, however, is that this sharp correction was a gift for bulls looking for entry points. This is why…

• Although current planting intentions would project larger ending stocks than last year,  224 million bushels would still make stocks relatively tight. Consider that ending stocks in 2005 were at 450 million bushels and 2006 saw ending stocks above 550 million bushels. Current quarterly soybean stocks remain 20% below year ago levels.
• Global soybean consumption is expected to reach a new record in 2008 which should continue to add a general backdrop of support to prices over the longer term.
• US planting season will begin over the next several weeks. With global demand stressing supplies, prices will be extremely sensitive to the slightest negative weather developments.
• Key factor:  With soybeans plummeting in price the last week, corn prices have surged as corn plantings gave up acreage to soybeans. With this reversal in price direction, it is now more profitable for farmers to plant corn over soybeans.  According to Purdue University, returns for planting corn are now about $135 per acre more than soybeans on average quality land and about $200 per acre more on high quality land. With this type of discrepancy, we would expect farmers will indeed shift a certain percentage of soybean acreage back to corn as planting season actually begins. This would make soybean prices look like a bargain at current price levels.

Liberty''s strategy, of course, does not revolve around buying the actual soybean contract, but rather selling put options far beneath the contract’s current price. With this strategy, investors collect the premiums for selling puts. As long as the futures price is anywhere above the option’s strike price at option expiration, the option expires worthless and the put seller keeps all premium as profit. This puts the investor in the position of profiting if soybean prices increase. But the put seller can also profit if prices remain stagnant or even if our analysis is wrong and soybean prices decline further (but remain above the option’s strike price).

Figure 1: Soybeans, July ''08

Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.

James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group
Optionetics.com ~ Your Options Education Site
Questions for James and Michael? Visit the Optionetics.com Discussion Board 

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