With crude oil stuck at $50.00 or less per barrel, grain producers and purchasers should understand how much this limits the upside opportunity for corn. Ethanol remains the single largest purchaser of corn in the U.S. agricultural complex. In early March 2014, spot ethanol prices in Iowa were $2.30 per gallon, and cash corn prices were $4.50 per bushel. This combination gave ethanol producers a gross margin of $2.75 per bushel of corn to cover processing costs. As of early March 2015, spot ethanol prices in Iowa were $1.35 per gallon and cash corn prices were $3.70 per bushel. This means ethanol producers have approximately $1.00 per bushel gross margin to cover the same ethanol processing costs. The only time margins were tighter than now was during the drought-induced corn spike in late 2012.
All corn producers are hoping for a spring or summer rally in corn prices, but how much could corn rally before ethanol producers reduce production? If we use the assumption of $50.00-per-barrel-oil, historically Conventional Gasoline Blending Components (CBOB) gasoline should be priced at $1.40 per gallon Free on Board (FOB) the Gulf Coast. At the moment, strikes and supply concerns have resulted in a price premium of approximately 15% compared to the historical trade over the last decade. Over the same decade, Iowa ethanol has been priced at a 7% discount compared to the Gulf Coast CBOB pricing. That would put the price of ethanol at approximately $1.30 per gallon. Ethanol might be underpriced at the moment, but gasoline is overpriced by a greater percentage on a normalized trade basis. Without a doubt, you take your trading life in hand when talking about averages in markets as volatile as the energy markets. Both the crude-to-gasoline and the ethanol-to-gasoline markets have seen huge divergences from their averages over the last decade. And, divergences can get much worse before returning to the “normal” range. However, markets work their way back to the averages time and time again because that’s where the profits equalize.
If the corn acreage comes in lower than expected and/or the yield potential is reduced due to weather, the corn market would rally first, and then worry whether the buyers can afford the higher price. During the 2012 drought spike, U.S. crude oil traded in the $90.00-per-barrel range with CBOB gasoline averaging $2.73 per gallon FOB. This crude oil/gasoline combination allowed ethanol to average $2.35 per gallon FOB Iowa plant. Even with this much stronger pricing support, ethanol production dropped to approximately 800 barrels per day. At the same time, the U.S. switched from a net exporter of ethanol to a net importer of ethanol. This export/import swing dynamic could be intensified with the much stronger U.S. dollar versus the Brazilian real. Compounding this exchange rate differential, international sugar prices are much lower today making sugarcane-based ethanol more attractive to international buyers.
The wildcard in any valuation model of corn/ethanol comes from Renewable Identification Number (RIN) value. Under the Renewable Fuel Standard (RFS), gasoline blenders/distributors are required to use a certain percentage of ethanol to gasoline. The value of the RIN is set by the surplus or deficit of the blending relative to the target. Ultimately, the U.S. Environmental Protection Agency (EPA) sets the blend requirement for ethanol relative to the RFS, and the EPA has yet to announce 2014 blending requirements as of early March 2015, thus placing them 16 months behind schedule, and counting. If they reduce the blending requirement, the value of the RINs will be dramatically reduced. At the moment, the EPA is being intensively lobbied by both sides of the trade. The most likely outcome involves the EPA minimizing the political heat they will receive from either side of the lobbying effort.
When a major component of corn pricing involves a political decision from the EPA, producers would be wise to temper their optimism for price support. Ultimately, $50.00-per-barrel crude puts a hard cap on ethanol values with or without RIN support. Both producers and purchasers of grains and oilseeds will need to understand this pricing mechanism if they want to trade the “new corn” dynamic. If will be difficult to be bullish on corn without being bullish on crude oil at the same time. The economic and geopolitical risks of energy will increase the volatility of grains and oilseeds. At the same time, the price volatility of feed costs will work into the protein markets. This increased volatility demands that producers and purchasers make changes in their risk management. At the end of the day, the two strategies that will work are more true hedges, or less leverage. Neither of those strategies will appeal to producers, but they will work.
Reference: For a further education in the arcane and speculative world of RIN pricing, the U.S. Energy Information Agency website offers an interesting series of articles.