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March 18, 2009
Commodity, Food, Fuel Prices: What Goes Up Must Come Down, But, Really Now, Why Is That?
The rise in commodity price from 2007 into the spring and summer of 2008 sent food prices upward to the point of consumer complaints and finger shaking at farmers, farm policy, bio-fuels and anything they could imagine that might be to blame. Since that time commodity prices have retreated 50% or more, but food prices have fallen very little. We’ll put those commodity and food prices under the microscope to see what dynamics are or are not at work.
Thanks to the Farm Foundation, which sponsors analysis of agricultural issues for the benefit of Congress and the public, Purdue economists Chris Hurt, Wally Tyner, and Phil Abbott recently updated their 2008 study to find out why economic forces at work last year reversed course and what the results were. The March Update followed last year’s findings that said food prices were driven upward by global consumption outpacing production, the low value of the dollar, and the linkage between energy and agricultural markets. All contributed to tighter stocks of grain and oilseeds.
The 180 degree turnaround was the result of many factors, and not the least was supply and utilization. Low prices caused production declines and stocks diminished, resulting in some price rationing going into 2008. The higher prices spurred more production globally, and in the past 8 months production grew, consumption declined and ending stocks doubled for corn and wheat. While early 2008 production challenges did not seem to hamper crop yield, they caused markets to peak early as perceived shortages were resolved. The economists say higher production last year was an important factor in increasing stocks, particularly for wheat and soybeans.
The impact of price was felt after May 2008, say the Purdue researchers. First was the upward surge from perceived crop shortages, then growing conditions improved about the time the dollar was rising in value, and finally prices fell from declining demand for food and fuel. They say, “The financial crisis further reduced demand for grains and oilseeds for both food and energy uses as world income growth eroded.” They say USDA’s Supply/Demand report for May 2008 forecast an average $5.50 corn price based on a 6% stocks to use ratio, but by January 2009, stocks had climbed to 15% and prices had fallen to $3.90 per bushel of corn. The economists say with lower market prices now, and higher production costs, the low margin awaiting producers will result in reduced production.
The rising commodity and food prices in 2008 was also the result of the declining value of the US dollar which made our commodities less expensive to foreign buyers and that cut the inventory available to the US consumer. The lower dollar caused higher oil prices, which are quoted in dollars. The Purdue economists also report that global growth, the recession, and the financial crisis were responsible for not only the rise in commodity prices into last summer, but the dramatic decreases in commodity prices since then. While the dollar was falling, then rising, it was engaging in a volatile dance with other world currencies, even to the point of helping the balance of payments and reducing the trade deficit.
The economists say, “The recession, which is now expected to be longer and more severe than recent recessions, coupled with the financial crisis that has also spread across the globe, led to much weaker demand for energy and strengthening of the dollar.” Consequently, that weakened demand for agricultural commodities beginning at mid-summer 2008.
The bio-fuel demand served to drive corn, and to some extent soybean, prices, which were linked to the market for crude oil. Since ethanol is a substitute for gasoline, the price of gasoline will drive the price of ethanol, and subsequently the price of corn. But when crude oil rose to $140, taking ethanol and corn up with it, then fell to $40, the demand for corn to make a low margin ethanol quickly diminished. Many ethanol plants were either halted or production slowed because, “The price relationship between ethanol and corn became very important as plants opened or closed depending on margins driven mainly by these two prices.”
Significant to the discussion about the impact of ethanol on commodity prices are the federal policy issues of tariffs on imported ethanol, the blenders’ credit, and the 10% blending wall, which puts a 12 billion gallon upper limit on production. All have a potential impact on ethanol supply and demand.
The Purdue economists attribute the commodity price rise and fall to macroeconomic forces and say the depth and length of the recession will play a key role in how long food and crude oil prices stay where they are. They believe the inflation anticipated with a recovery will influence commodity prices, and the price of oil (along with ethanol and corn) will be linked to the exchange rate. They wonder aloud about the movement of crude oil and how that integrates with the renewable fuels mandate, the blending wall, and other policy issues. But they believe the big question is whether and when supply will catch up with increasing demand for food and fuel and where commodity prices will settle.
Summary:
The rapid rise in commodity prices in 2007 and early 2008 is attributed to several macro-economic forces including low stocks, increasing demand because of exchange rates, and the growth in the connection between food and fuel markets. But the collapse of commodity prices resulted from an unwinding of those forces, exacerbated by a global recession that diminished demand for both food and energy commodities. The gradual return to normalcy expected within a year will create a likelihood for some inflation and whether commodity supplies will be sufficient to meet the demand growth.
Posted by Stu Ellis at March 18, 2009 12:54 AM | Permalink
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Buying Puts, Build Fences or Making Cash Sales
The “Crowd” appears to be more positive about 2009-10 soybean prices than we are. The price action of the last couple of days may be the proof of our error (a “high” level of mandated bio-diesel would change our outlook). We have compared risk management tools to find one that provides the best worst case scenario for our model. The model uses an updated scenario for each year back to 1974. These 35 scenarios provide a net income projection based upon those updated inputs. We have included in our estimates of farm and input cost, revenue crop insurance and a projection for government payments (ACRE is included and with our assumptions appear to provide significant protection). The price for each scenario was Zoodooed from 77 million planted acres and 3,080 million bushels of consumption. Puts were purchased in the model in increments of 5. (Options generally trade in 5,000 bushel increments. So real life, on farm, applications may not work out as well as illustrated.)
………………………………No Action… Cash Sale 27% crop @ $8.20 Cash
Lowest Loss (LL) per Acre … ($73.96)………….. ($42.86)
Mid-Point (MP) Return ……… ($2.77)…………… ($2.19)
Put Strike Price ….. ..740……..800…....860….....860…....920
Number Options ........25.......25........25........15........10
Buy Put LL……..... ($71.20) ($62.54) ($55.61) ($62.58) ($62.12)
Buy Put MP…….... ($15.67) ($15.87) ($13.90) ($8.18)... ($6.47)
Fence above Puts
Sell 11.60 Calls LL... ($58.29) ($43.29) ($28.29) ($46.19) ($49.45)
Sell 11.60 Calls MP... ($2.77)......$3.38…$13.42…$8.21…..$8.21
Or
Sell 9.00 Calls LL ... ($58.29) ($56.67) ($79.25) ($48.66) ($49.45)
Sell 9.00 Calls MP… ($17.05) ($4.80)...$1.92….. ($9.52)... ($11.72)
With no action, we expect one scenario to have a per acre loss of $73.96 per acre. One half of the time we would anticipate a return above ($2.77) per acre and half of the time returns will be below the mid-point. (We do not know which of the 35 scenario will be most like this coming year. But if action can be taken to increase the low return without seriously reducing the potential return of the other scenarios, we have reduced our potential risk.) Pre-harvest selling 27% (14.6 Bu/Acre) of the anticipated crop had the low scenario netting a loss of $42.86 per acre with a mid point of a loss of $2.19 per acre. Purchasing 25 860 Nov puts had a low loss (worst scenario) with a loss a $55.61 per acre and a mid-point loss of $13.90. The 860 puts were trading about $1.0925 per bushel (price not included in above chart). Twenty five (25) puts would cost around $27.31 per acre. Selling 11.60 calls to fund the put purchase is illustrated next. When the 25, 860 puts are funded with the sale of the 11.60 calls the lowest loss is $28.29 per acre and a mid-point of a profit of $13.42 per acre. The sale of calls subjects the seller to unlimited risk. The total implication of that risk is not illustrated on the chart. When calls are sold a margin requirement is trigger. The cost of that margin money is not included in the example. We have included a “Bankers Call” in this illustration. A $14.00 call is purchased in the same amount as the number of calls that were sold. In theory that should limit ones risk to $2.40 (14.00 - 11.60 = 2.40) per call. In the case of the 11.60 calls, 6.2 calls were sold to cover the cost of one put. So the risk is limited to $14.88 per put (6.2 X $2.40 = $14.88) or $372 per acre ($14.88 X 25 puts = $372). We coined it a “Bankers Call” because very few bankers will lend money for a strategy with unlimited risk. The $14.00 call defines that risk, though be it large. Many actions can be taken to avoid the $372 per acre risk illustrated here but one should be fully aware of the potential risk. (These are very aggressive fencing illustrations. Most of the time not 100% of put cost is covered by the sales of calls.)
Funding 25 860 puts with the sale of $9.00 calls does not appear to improve low return scenario. The lowest low is a loss of $79.25 per acre which is lower than our do nothing approach. The mid-point return is a positive $1.92 per acre which is $4.77 per acre higher than the loss of $2.77 with do nothing approach. Selling the $9.00 calls to fund 15 860 puts reduces the lowest low to a loss of $48.66 per acre but also lowers the mid-point to a loss of $9.52 per acre.
Fencing the total purchase of 25 Nov 8.60 puts with Nov 11.60 calls has the best targeted result of the examples presented here. The risk of this strategy is potentially large. Should one not wish to make such a bold statement the cash sale appear to be a reasonable alternative. (We are not advocating any action now or in the future. We are just trying to illustrate potential outcome of different risk approaches. The markets, prices and values of options, futures and the cash market change. The value used in this example will not have the same relationship in the future. Ones own values should be used, reviewed and understood before taking any action of any kind.)
Posted by: Freeport, IL at March 18, 2009 2:35 AM
Three Questions two with may be easily answers the third not so much.
1) How much did the high prices of the 2008-09 period cause the economic recession we are currently in? If the housing collapse is one of the major parts of the world wide recession then a pretty good argument can be made for a direct cause; higher prices result in less money available for mortgage payments. We understand that it was a house of cards waiting to collapse but lower living expenses and a smaller recession (more employment) would mean fewer mortgages in default.
2) It is indicated in the report that low World stocks of commodities were part of the reason for higher price later. The question is, Would a different US farm policy (one not moving so much to WTO compliance) have provide more of a safety net for the World and a World wide recession hedge?
3) As the US moves in the direction of WTO compliance we become more market driven. Large ending stock are to costly to maintain. We start looking for other meaning to use our excess production (ethanol and bio-diesel for example). We no longer provide that supply buffer of large ending stock. The World cannot have it both ways, having the US in WTO compliance and Blaming Alternative uses of our production for the cause of their hardship. The question; Can the World afford the US to be 100% WTO compliant? Or can we afford to be 100% WTO compliant?
Posted by: Freeport, IL at March 18, 2009 9:15 AM
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