New York, 6 August 2010

After trading in a boring range for most of 2010, wheat prices have exploded, with CBOT prices posting their best performance since August 1973, higher by 42.3%. The move in price has been stoked by production concerns in the FSU and Europe where hot and dry weather threatens production, at a time when the market was positioned extremely short - the net position in CBOT wheat, prior to the onset of the rally, was at its shortest since December 2005.

Morgan Stanley believe that the rally in wheat prices is overdone, but would not short wheat as the latest CFTC data reveal lingering short positions, and industry contacts highlight that consumer nervousness is growing. "Finally, as affected countries assess production shortfalls and potentially opt to limit exports (as Russia has done), prices could move higher still.

"Where production ultimately settles is uncertain with weather conditions still unfavorable. A significant cushion for disruption exists, however, with global S/U starting the current marketing year at 25% (unlike in 2005/06 when S/U stood at 20%). The USDA's July WASDE estimates pegged production globally at just above 661 mln MT, which if realized would have left S/U in 2010/11 at an above-average 24%.

"USDA's production estimates will need to be revised lower. Taking the average of more recent production estimates for the EU, Russia, Kazakhstan and Ukraine would force a 13.0 mln MT downward revision to the current USDA estimate, leaving global production at 648.0 mln MT and reducing global S/U to 22% (comparable to the 10-year average). More bullish, is the inventory position in exporting countries - in 2006/07-07/08, S/U in the top exporting countries fell to average 13%, a level comparable to where S/U would fall if the aforementioned production losses were realized.

"Even still, a simple scenario analysis suggests that the market is pricing in bigger production losses. If we temper production by 13.0 mln MT and reduce exports from the EU, Russia, Kazakhstan and Ukraine so that S/U in these respective countries is held steady with the USDA's July estimates, some 11.8 mln MT of exports are lost. If this demand is picked up by the US, S/U in the US would fall materially, albeit from a very high perch. Specifically, lifting US exports by 11.8 mln MT to 39 mln MT would lower domestic S/U from 48% to 25% - still well above the 13% exhibited in 2007/08 - and historically associated with a sub-$6.00/bu wheat price. If the Russian export ban persists, however, our estimate on the nation's exports will prove optimistic. If Russia exports only 10% of their production (as they did in 2003/04), demand for US exports could theoretically increase by nearly 19 mln MT, forcing US S/U to a low 13.5%, comparable to 2007/08. This scenario, however, is entirely dependent on weather in the next 4-8 weeks and the ability for farmers in the FSU to plant their winter wheat - an outcome on which we have no view or ability to predict.

"While we are hesitant to short wheat given its recent momentum, any production loss further strengthens our bullishness for corn. Reduced wheat production will result in reduced feed demand, benefitting corn demand as a feed substitute. In 2006/07 and 2007/08, US corn exports moved to 2.13 bln bu and 2.44 bln bu, respectively, on wheat shortages. Higher wheat prices will also increase the incentive of US farmers to plant winter wheat, threatening soybean acreage. A tighter bean balance would require even higher corn prices to garner needed acres from beans. At current prices, wheat planting is nearly 150% more profitable YoY vs. corn and beans, which are up at best 30% YoY.

"Weather is the biggest risk. To date, the adverse weather has largely threatened spring wheat production, which makes up less than 20% of total wheat production in most of the areas affected. However, winter wheat planting typically begins in mid-August, continuing through September. If weather conditions remain hot and dry, planting could be delayed or not occur at all, presenting downside to inventories and upside to price. In this scenario, wheat prices would average higher than we are expecting, but our constructiveness on corn would be magnified."

Ends --

Source: USDA, Morgan Stanley Commodity Research estimates