An ignorable drought... for now
It’s been a warm winter everywhere, but the higherthan-usual temperatures have taken on different manifestations around the Corn Belt. In Illinois and Indiana, farmers have been fighting mud while trying to bring their winter corn commitments to market. Meanwhile, on the wrong windy day in Iowa or southern Minnesota this winter, you might have seen an eerie haze of dust blowing across the horizon. For the past 21 weeks, the U.S. Drought Monitor has identified a severe short-term drought across portions of northern Iowa, southern Minnesota and eastern South Dakota.
I am by no means a meteorologist, but data is data, and while we’ve been watching a South American drought add volatility to the nearby corn and soybean futures markets, it’s been interesting to see new-crop (December ’12) corn futures stay within a 45-cent trading range since November.
The market doesn’t seem too worked up about the potential for that U.S. drought to affect upcoming corn production.
Nor should it, really. Any attempt to find a correlation between February soil moisture and final crop yields would be spurious, at best. Rational people (and traders) pay the most attention to weather risk premium when weather has a real chance to affect final yield. In 2004, researchers at the National Drought Mitigation Center at the University of Nebraska determined they can assess the drought risks for final yield with a 60 percent accuracy rate in late April, a 76 percent accuracy rate in early July (when corn is in a vegetative state), and an 89 percent accuracy rate in late August and September. Their study considered that the moisture recharge period begins in September or October of the previous year, but the pre-planting period just wasn’t statistically influential enough to make predictions about yield. In a more concrete example, USDA doesn’t report row-crop ratings in winter for the simple reason that there is no crop in the ground to observe right now. Anything could happen between now and planting, let alone between now and harvest.
Nevertheless, there is a persistent belief that the current drought is an omen of worse things to come. You wouldn’t have to look too hard to find a farmer willing to tell you this winter has felt “just like 1976” or “just like 1988.” And historical data also documents this. Twice since 2000, northwest Iowa experienced a moderate or severe drought in February, and at the harvest time frames following both those instances (2000 and 2003), the drought had grown even more severe. There were four years the Drought Monitor called just abnormally dry, but the subsequent harvests had a 50/50 chance of being normal or abnormally dry.
Earlier this month, Klaus Wolter at the National Center for Atmospheric Research stated he thinks there’s a 50/50 chance of La Nina remaining into summer 2012. Currently, DTN’s Spring Outlook reflects that continuation, with limited drought relief in the area currently affected and a spring rain surplus in the already muddy areas of the eastern Corn Belt. But Wolter also noted that in six of the 10 two-year La Nina events between 1900 and 2009 (what we are experiencing right now), the scenario switched over to an El Nino event. That doesn’t necessarily mean drought relief, either. DTN’s Bryce Anderson pointed out to me that El Nino conditions in the northwestern Corn Belt actually imply above-normal temperatures and below-normal precipitation.
Altogether, it seems too soon for the market to know what precipitation the crops will have available, and therefore too early for the market to care.
However, if we get through a nice dry planting season and then June and July come along with no abatement to the drought, the truly justified worry is that crops will have to start their season already behind on soil moisture. Two of the most disastrous years for Iowa’s corn yield in recent memory occurred in 1977 and 1988, when central and northwest counties had yields 74 and 42 bushels per acre below local trendline, respectively. And the data confirms what farmers have been saying: those winters, like this winter, were dry. In February 1977, the National Oceanic and Atmospheric Administration weather stations across Iowa did indeed show precipitation totals about half an inch below normal for the month, and it was a continuation of months of similar data. The deviation from normal was even greater in February 1988. However, in 1993, when final corn yield during a droughty harvest was 62 bushels per acre below local trendline in Iowa, the early months of the year were actually quite wet, which just demonstrates how quickly and dramatically a climatic situation can change.
You may recall (I didn’t) that in 1977, the eastern Corn Belt actually had a very good year. New yield records were set in Ohio. The national average yield, 90.8 bushels per acre, was right on trendline. This year, however, with global feed grain ending stocks already tight and looking to get tighter once the full impact of the South American drought is known, the market may have much less tolerance for any dip in U.S. production.
The whole point of a market building in a weather risk premium is to recognize that price not only reflects what is known about supply right now, but that it also reveals what might happen in the future. Unfortunately for market bulls, there is a very real chance that 94 million acres (or more) could be planted to corn and the whole Corn Belt could receive adequate moisture and reach trendline yield above 160 bushels per acre. So at this point, weather risk leans toward a discount rather than a premium.
There are a couple of trading implications resulting from all of this. In the immediately observable universe, old-crop corn futures (July) have a fullymaterialized South American drought at their backs and are already trading at an 80-cent premium over new-crop corn futures (December). That’s a full 80 cents above the average spread for this time of year. In 2011, that same old-crop/ new-crop inverted spread traded as wide as $1.33 in March.
On the other hand, looking forward into the unpredictable future, if the current drought extends into an even deeper one during a more critical time period, crops will have a harderthan-usual time dealing with low precipitation, and thus, there will be a stronger-than-usual chance of price volatility this summer. If ever there was a year for marketing strategies that don’t commit a farmer to margin calls during a crop shortage, I think this may be it. — Elaine Kub, DTN