A Primer on Soybean Crush SpreadSoybeans are one of the most versatile and important agricultural commodities in the world, consumed extensively by humans, livestock, and industry. Soybean prices have an undeniable impact on the global economy and their importance is only increasing with the rapidly growing bio-diesel industry.
In our previous paper Heavy Exports Weighing Down Soybeans , we described factors affecting the supply of Soybean and their seasonality.
Supply is largely driven by harvest cycles and crop yields. Demand can shift for multiple reasons. Live stock feed, Cooking oil and Biodiesel form the largest demand source for Soybean. These are all derived from the two by-products of Soybean – Soybean Meal (“Meal”) and Soybean Oil (“Oil”)).
During Soybean processing, the seed is crushed to separate the oil from the meal. These by-products can be traded as separate commodities.
Traders can harvest gain from the shifting relationship between the by-products and soybean using the crush spread. This paper will describe the crush spread, its computational methodology, and the methods for investors to harvest gains from it. The paper will also look into the factors defining the crush spread in 2023.
The Crush Spread
The Soybean crush spread refers to the value of Soybean’s gross processing margin, which is the difference between the value of the outputs (Meal Price + Oil Price) and the value of the inputs (Soybean Price).
The crush spread is traded on the cash and futures markets and is often used by Soybean processors to hedge their margins for the actual process. It can also be used to harvest gains from the shifting dynamics between Soybean and its byproducts.
Factors That Affect the Spread
The crush spread can be influenced by the price of soybeans, the demand for its byproducts and the cost of production.
Production costs can vary due to energy prices, labor conditions, carryover stock, and health of supply chains.
Demand for by-products is driven by some common factors such as macro-economic conditions but also by factors unique to each commodity.
Meal is used for livestock feed while Oil is used as a cooking oil and as biodiesel.
Livestock feed demand is driven largely by China to feed its large swine population. Like soybean supply, feed demand also shows high seasonality. Due to a shortage of grass in the winter, Soybean Meal is consumed during these months leading to higher demand.
Additionally, unlike other commodities, Soy Meal cannot be stored for longer than 3 weeks. So, during the US harvest (October), Soy Meal prices plummet due to oversupply.
Cooking oil demand is sensitive to the supply and price of Palm oil, which is also widely used for cooking. Both can be used interchangeably; they are the so called substitute products. So, the decision of which product food producers choose depends on prices, supply, and import/export policy decisions.
Moreover, Soybean Oil is far more suitable for the production of biodiesel than Palm Oil. This is why Soybean Oil generally trades at a premium of $100-$150 tonnes to Palm Oil. In the US, Soybean Oil demand for biodiesel is even higher owing to a fast-growing renewable diesel industry.
Shifting Dynamics of Soybean By-Products
Downbeat Macro
With recession risks and inflation running high in many countries, the macro-economic outlook is downbeat. This weighs on the demand for Soybean and its by-products, resulting in lower prices and a narrowing spread.
China’s Reopening
China’s reopening from pandemic restrictions last year is in full swing. Although initial recovery was sharp, conditions have started to cool due to downbeat macroeconomic conditions weighing on export demand and still weak domestic demand.
China’s large swine population is a major driver of meal demand. Heading into the winter, in case domestic demand starts to recover, it would lead to far higher meal demand and prices resulting in a narrowing spread.
Rising Demand for Soybean Oil
In the past, crush demand was driven largely by demand for Meal, Oil was considered a surplus without enough uses. However, rising demand for green energy across the globe and tax incentives for producers have led to a sharp increase in demand for Soybean oil in the past few years, particularly in the US.
Biodiesel production capacity nearly doubled between 2021 and 2022. Since then, markets have normalized with higher planting of crops and increased Soybean crushing capacity installed.
Despite the downbeat economic conditions, demand for Soybean Oil is expected to increase 4.9% this year after surging 6.5% last year, according to the USDA. With higher demand for Soybean Oil, crush demand will also increase. This would result in a change in the price relationship between Meal and Oil as well as a narrower crush spread due to higher volumes.
Harvesting Profit from Crush Spread
Investors can take a position on the crush spread in a capital efficient manner using CME’s Soybean (ZS), Soybean Oil (ZL), and Soybean Meal (ZM) futures. CME offers margin offsets for a crush spread position using these contracts. In addition, the Soybean crush can be executed on CME Globex as a single trade.
Each of these 3 contracts are quoted in different units. ZS is quoted in cents/bushel. ZM is quoted in dollars/short ton. ZL is quoted in cents/pound. As such, in order to calculate the value of the spread, the price of each contract needs to be converted to cents/bushel.
A bushel of Soybean (60 pounds) yields 11 pounds of Soybean Oil and 44 pounds of 48% protein Soybean Meal. The conversion factors are given below
Soybean Oil per bushel: ZL Price x 0.11
Soybean Meal per bushel: ZM Price x 0.022
Crush Spread ($/bushel) = (Soybean Oil per bushel + Soybean Meal per bushel) - ZS Price/100
As per each contract's exposure size, a long crush spread position using CME futures comprises long eleven (11) Soybean Meal futures contracts, long nine (9) Soybean Oil futures contracts, and short ten (10) Soybean futures contracts. This position would normally require a margin of $67,625 for the nearest month contracts. However, with the 88% margin offset, investors can go long on the crush spread with exposure to 50,000 bushels for just ~$8,115 in margin.
Alternatively, investors can also get direct exposure to the crush spread using CME’s options on the Soybean Board Crush Spread. Each contract gives exposure to 50,000 bushels.
Example Trade
Like Soybean prices, the crush also shows seasonality. This is due to the combined seasonal effects of Soybean and each of its byproducts. In our previous paper, we highlighted that Soybean prices are at their lowest in October due to the US harvest.
Due to a low input cost (Soybean price), Board crush expands during this time. The same uptrend can be seen during the summer months representing the harvest from Brazil and Argentina.
It should be noted that seasonal trends are not a guarantee as other factors can have outsized effects on markets.
A long position in the Board crush would represent a short position of 10 Soybean contracts and a long position in 11 Soybean Meal contracts & 9 Soybean Oil contracts.
As an example trade, consider the board crush in Jan 2019. Going long on the board crush on 9th Jan with an entry level of USD 1.02/bushel and an exit at USD 1.37/bushel would yield 34% profit. However, investors should note that the board crush value is highly volatile, as it is derived from three volatile underlying drivers. So, stop loss needs to be adjusted for the high volatility.
Positions on 9th Jan:
● Short 10 ZS1! at entry level of 924 c/bushel
● Long 11 ZM1! at entry level of USD 323.4 /short ton
● Long 9 ZL1! at entry level of 28.6 c/lb
Note that the crush declined to 0.91 on 15th Feb representing downside of 10.7%:
● ZS1! at price level 921.5 resulting in profit of USD 1,250
● ZM1! at price level 310.5 resulting in loss of USD 14,190
● ZL1! at price level 29.95 resulting in profit of USD 7,290
Net loss: USD 5,650
Crush started to rise in April and peaked at 1.37 (+34%) on 30th May:
● ZS1! at price level 877.85 resulting in profit of USD 23,075
● ZM1! at price level 327.4 resulting in profit of USD 4,400
● ZL1! at price level 27.8 resulting in loss of USD 4,320
Net Profit: USD 21,155
Key Takeaways
1) Board Crush or the Crush Spread represents the Gross Processing Margin (GPM) of crushing Soybean into its by-products as quoted by cash and futures markets.
2) Board Crush allows traders to replicate the Soybean Processing Value Chain. It enables traders to harvest gains from changing crush margins while enabling crushers to hedge their GPMs.
3) Board crush can be volatile which requires astute risk management while trading it.
4) Trading board crush using CME futures is margin efficient due to substantial margin offsets (88%).
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