Blog: Be careful what you wish for

becareful-what-you-wish-forMichael Swanson, Ph.D., Wells Fargo Chief Agricultural Economist

The drop in crude oil prices has acted as both a symptom and a cause in the agricultural economic outlook. According to the Baker Hughes rig count, only 571 active rigs were working in February 2016, down an astounding 71% in 18 months. Since drilling activity peaked in September 2014, crude oil production has risen by 5% highlighting the lag in the energy production system loop.

With the slowing growth rate of global gross domestic product (GDP), the market issued a “full stop” order to the energy exploration and production system. And this complete mindset reversal for the energy sector has leaked into the mindset for the global agricultural sector. So, what will farmers do in 2016 with this “full stop” order in place for the energy market now spilling over into agriculture?

The scatter diagram below shows the last 10 years of crude and gasoline pricing. Even without accounting for the pronounced factor of seasonality, crude oil price predicts 88% of gasoline price. With West Texas Intermediate stuck at the $30-a-barrel level, the historical relationship calls for 95 cent-per-gallon gasoline from the refinery. So, how exactly does this impact the ethanol market, which is consuming 5.3 to 5.4 billion bushels of corn on an annualized basis year-to-date? Who knows is the real answer.

WTI Crude versus Gulf Coast CBOB

The Renewable Fuel Standard (RFS) is a government policy that consistently careens between normal and bizarre. We know that the RFS calls for 16.2 billion of ethanol-equivalent utilization without regard to price and consumer demand. Government policy requirements act as a “cut out” of the loop system between gasoline and ethanol. Both gasoline and ethanol are fuels that consumers buy, but don’t directly consume. Electricity shares this same type of demand structure. Just as consumers don’t buy and directly consume electricity, instead lighting houses or powering smart phones, consumers also don’t buy gasoline or ethanol for direct consumption. Instead, they buy them to fuel vehicles that “get them down the road”, so their real metric is their value as a transportation service.

In a competitive market, ethanol and gasoline would be priced to make the consumer indifferent to their performance as a transportation service. This type of market has existed in Brazil for decades. But the United States short-circuited the development stage of ethanol with the RFS, so the pricing mechanism of gasoline and ethanol is dependent on regulatory oversight from the Environmental Protection Agency (EPA).

The following chart shows the national ethanol-to-gasoline pricing ratio dating back to October 2006 when the USDA began consistently collecting ethanol spot pricing. The average over that period shows that ethanol “typically” is sold at a 6% discount to gasoline on a gallon basis, which in no way reflects in BTU value to the consumer as a transportation fuel. This average is just about as useless as the average temperature in Minneapolis throughout the year. The following graph shows that the pricing mechanism swings wildly from highs to lows based on factors that do not benefit the consumer.

Ethanol-Gasoline Prices

 

The current price ratio of 145% of ethanol-to-gasoline pricing is the third highest ratio since the data series became available. Typically, the market has found some feedback loop to correct this ratio, pushing it back down to its long-term ratio, but what will happen in 2016?

Already, the market gurus have begun to whisper into farmers’ ears about a “la niña” market developing with late season dryness robbing crop yield and setting the stage for a big price rally. This works just about as well as talking to a person dying of thirst for a glass of cold water. They want to quench their thirst so badly, they can’t think about anything else. With the losses of 2015 working their way through the farmers’ accounting systems and the bankers’ loan calculations, 2016 has been set up for another miserable year of losses. These losses make it even more difficult to be disciplined about already selling a reasonable portion (30-60%) of the 2016 crop.

The problem with the “la niña” price rally will be its collision with the low crude oil market. A 5-10% drop in yield would kick-off a major rally, but oil won’t rally on dryness in the I-states. Fuel blenders would be forced to “pay up” for ethanol to keep the plants running in order to meet the 10% blending requirement. In the grand scheme of things, it is not a huge number relative to the overall energy market. However, it will take the value of ethanol to gasoline to even higher ratios, which doesn’t help the driving public. While the public might not notice the pricing mismatch, petroleum producers certainly will notice. In the ongoing fight for the RFS, one of the worst scenarios would be the development of this pricing mismatch. This brings the old admonition to mind, “Be careful what you wish for, because you might just get it.”

 

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