The Big Short?

Recently, a lot of folks like me have gotten our hopes up for a bit of a corn price recovery on the idea of “speculative short covering.”  As the theory goes, large speculators (i.e. hedge funds) have aggressively sold corn futures short since this spring as prices have fallen, but now are “too short” during “too season” (i.e. too hot, too dry), and so will be forced to aggressively buy back their positions, causing a glorious rally in the process.

I started to notice their positioning two weeks ago, and have been expecting to see the funds start covering their positions, but the opposite has happened: each week “managed money” (MM) speculator net positioning has gotten shorter as they continue to sell more corn futures.  Analysts have noted that MM net positioning is the second largest on record, and MM has only been this short once since 2006, and that was in April 2019, just before a face-ripping rally in corn futures.  In all instances when MM has gotten short near these extremes, their act of liquidating short positions then going long has resulted in a quick price bounce of at least 40 cents.  So why wouldn’t that happen again this time?  After taking my own look at the data, I believe speculators could get even record…er short, and it doesn’t appear they face much risk of a “short squeeze” any time soon.

CFTC – CoT Reports

Every Tuesday, major participants in the commodity futures markets must disclose their positions to the Commodity Futures Trading Commission (CFTC), which they quickly compile…then sit on…until they publish their weekly Commitments of Traders (CoT) report after the markets close on Friday afternoon.  You can access the CoT reports for free at www.cftc.gov.  While the CFTC has been compiling these reports for decades, every once in awhile they change their format, with the most recent revisions beginning in 2006, with their release of the “Dis-aggregated Futures-Only Report.”  This report tracks the positions of five categories of traders:

1. Producer/Merchant – aka “Commercial Traders”: think Cargill, ADM, Bunge, CHS, etc.
2. Managed Money: I’m pretty sure it’s mostly just this guy…
3. Swap Dealers: According to the CFTC website, the swap dealers consist of big banks and other institutions who offer swaps for other hedgers, speculators, or other participants offering over-the-counter (OTC) trading and hedging structures.  Got that?  Basically they don’t know what’s in there…
4. Other Reporting Traders:  They don’t know what’s in here, either…
5. Non-Reporting Traders: I’m assuming this is mostly Millennial dudes trading on Robin Hood in their mom’s basement…

Since nobody really knows what the heck is going on in the other categories, most market analysts focus on the long, short, and net positions of commercials and managed money traders.  It is interesting, but probably not surprising that the commercial and managed money positions tend to be mirror images of each other (Figure 1):

CoT Signals as Price Indicators

The standard view for how to use CoT signals in predicting price trends depends on whether you are analyzing managed money or commercial positions.

The few trading books that discuss CoT reports cast commercial traders as ‘crafty insiders with deep pockets who know the truth behind the markets!’.  They observe that commercial traders tend to trade against the market, selling against rallies, or buying against routs, until they’ve built a large position and the market is forced to go their way!  The truth however, is much less exciting.  A huge fraction of corn consumption is price inelastic – end users or exporters need to buy corn every day to feed animals, feed grinders, or fill ships, whether the price is high or low.  Commercial users tend to buy futures as they sell cash (products), and their long futures are offset as they hedge purchases from producers.  When the biggest holder of them all (i.e. the farmer) is selling aggressively, commercials tend to be short futures when they own a bunch of cash grain, and when the farmer welds the bins shut, commercials eventually get flat, or even long futures (as they are now).  It is actually unprecedented for commercial traders to have a net long position.  I believe the three big factors behind this situation are:

1. Free Price Later programs offered by end-users are allowing them to consume cash corn without selling futures
2. Heavier than usual farmer use of basis contracts (ditto #1)
3. Government payments (MFP, CFAP, etc.) have put cash flow into farmer pockets, allowing them to stave off grain sales

Managed money traders, such as hedge funds or pension funds, etc., are typically viewed as being trend followers: when prices are going up, they buy, and when prices are falling, they sell.  The corollary to this is that prices won’t rise until managed money stops selling and has to start buying it all back, and vice versa.  Since managed money and commercial net positions are so highly (inversely) correlated with each other, I really don’t care which one folks ascribe to, because they’re essentially two sides of the same coin.

Figure (2) shows the managed-money net position relative to nearby corn prices going back to 2006.  It would be easy to infer that the current extreme positioning suggests a rally is imminent.  Indeed, for fundamental reasons that we don’t yet know about, a powerful rally in corn prices might just be right around the corner!  The standard narrative revolves around the fact that speculators can’t give or take physical delivery; therefore, they either have to sell their longs, or buy-in their short positions a few weeks before each futures contract expires, whereas commercials can wait all the way until contract expiration to either make or accept delivery of the physical (it’s actually not quite that simple, and for many reasons delivery rarely occurs, but it’s the credible threat of delivery that makes the system work).  While it is true that managed money has never carried a net short position this large through the growing season without inducing a significant futures price rally, I don’t think we can bank on that rally for the following reasons:

1. Managed Money isn’t as concentrated in old-crop corn as you think.  Since it’s really a pain to gather and organize the data, most folks don’t realize that CFTC publishes separate indices for old- and new-crop futures.  If you look at the net short just in old-crop (i.e. the JULY and SEP contracts), the managed money position really doesn’t seem all that extreme (Figure 3):
2. Rather than outright selling, liquidation of managed money long positions has been the bigger driver in net positioning so far.  Managed money gross long positioning is now the shortest it’s been since early 2009 (Figure 4):
3. On a trend-adjusted basis, speculators could potentially sell another 150,000 futures contracts (i.e. another 750,000,000 bushels) before their gross short position would be truly extreme (Figure 4 above).
4. Even if managed money is near a nadir in their positioning, without an unexpected catalyst, funds could hang around record short for many months.  During the past several years it has been common to see positions stay near an extreme for at least two months before reversing.  Between late-2010 and mid-2013 speculative funds maintained a continuous net long position in corn; why are we to believe they can’t do the opposite (Figure 4 above)?
5. Finally, let’s all keep in mind the elephant in the room: un-priced farmer holdings of old-crop and new-crop bushels far exceed the managed money short position.

In summary – while we are likely to experience some significant upside in corn prices whenever managed money speculators decide to cover their short positions, there’s nothing in the data (yet) to convince me that it will happen either imminently, or even from the current price levels.