Over The Barrel: Focus on The Battle for Value

Although everyone talks about the battle for acres, a larger standoff appears to be brewing. This new contest is what I call the battle for value. The battle involves the productive use of finite energy supplies for the production of essential renewable resources such as corn, soybeans, cotton, rice, and wheat. The relationship between the costs of the underlying energy component relative to the price of the output will have a tremendous impact upon the ultimate supply and demand response of each, as well as the speed with which alternative fuel sources are mainstreamed. The cycle has been tumultuous as each commodity begins to make the adjustment to a new energy paradigm marked by high prices and volatility.

Charts Courtesy of DTN

The input and output relationship has been amply demonstrated by the ratio of corn to crude oil. Looking at it from a longer-term perspective, the relationship has been relatively constant at a ratio of approximately 8 bushels of corn equaling 1 barrel of crude. This relationship has changed radically since 2000. From that point prices have been marked by increased valuations for crude oil relative to corn. The all time high of 34.2 bushels equaling one barrel of crude was reached in August 2005 on the heels of sharp crude and gasoline gains linked to hurricane Katrina. Even when gasoline refining margins reached a record high in May 2007, the ratio failed to move up to new highs and reached a level of 25.4 bushels to 1 barrel of crude. The ratio has remained under pressure as ethanol has re-entered the picture, and reached 18.72 to 1 following the USDA supply/demand report on Friday. Given the back month discounts in crude, the ratio in the December contracts is even lower at 17.3 bushels to 1 barrel.

Given the adjustment in corn prices relative to crude, one wonders whether the cure is worse than the disease. Just as the strength of crude relative to corn helped encourage Congress to adopt the Energy Bill of 2007 that supports renewable fuels, the drive higher in food costs holds out the potential for similar intervention by Congress as they try to mitigate the impact. Undoubtedly, any action is still a long way off.

For now it looks like grain prices will be relatively stronger, as the need for more corn acres due to prospective demand will continue. On the crude side, uncertain demand prospects will help dull price increases and slow the projected decline in stocks. However, limitations on supply are a far more onerous factor to the crude market, which will likely underpin the downside movement of the ratio toward the 12:1 level, where support to crude relative to corn should develop, particularly if political pressure builds for the restraining of commodity prices.

Questions/Comments about Over The Barrel, please contact Steve Platt at 1.877.377.7931 or email at stephen.platt@archerfinancials.com.