Sunday, October 23, 2011

Markets respond to incentives the case of corn and livestock

Everyone in agricultural markets has been surprised by the increase in corn stocks with the latest USDA report, yet we only have to go to basic economics to understand what may be happening. While the evidence is limited, there is clearly changes in market dynamics which provide a rational for the wild inventory discrepancies.

There has been a substition effect between corn and wheat by livestock operators. When corn is more expensive than wheat, which usually sells at a premium, there will be a switch. The result is then an excess inventory of "found" corn. The issue is to what degree this substitution occurs. 

But, wheat stocks also were surprisingly higher. Again incentives and arbitrage were the likely causes. Canadian wheat was of lower quality this year which meant that there was an oversupply of feed wheat which was then shipped to livestock operators in the US. The flood of cheap Canadian wheat meant that counting bushels in the US showed a higher level. This is also one of the reasons for sharply higher Minneapolis wheat.

Always follow the money and the incentives. 

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