Corn Set to Bounce Back with the Ethanol Boom

Includes: ADM, ANDE
by: Dan Carty

One of the biggest stories of the past few years has been the development of the ethanol industry. Once regarded as unprofitable, the industry has seen a recent surge in demand. This surge has been supported by the general need for alternative to fossil fuels as well as the local governmens mandating the use of ethanol instead of MBTE in unleaded gasoline blends.

In turn, this demand for ethanol created a very large interest in corn and the futures market for corn has risen, by open interest terms, dramatically. A good deal of volatility has been injected into a market that for a long time did not have much going for it.

Both volitility and price swings have risen simultaneously for the product. Using the September contract, as the accompanying chart shows, corn futures had a very nice run from December of last year through May of this year. Then the bottom fell out and these May highs have not been seen since.

Interestingly enough, May was also a period where the interest in ethanol was very dramatic and popular. A representation of such can been viewed in the charts of the Andersons (NASDAQ:ANDE) and Archer Daniels (NYSE:ADM), both of which hit multiyear highs in that month (and have not seen those highs since). Since the corn sales began in May, there have been very few bounces as the speculators and hedgers sell the contract. The selling has taken the Dow Jones AIG Grains index through the 2002 lows and to new lows since 1991. Given this capitulation, is it now time to buy corn?

As the speculators have so soundly pounded this contract, one has to wonder if this is the time to begin to build a position for corn. The fundamentals perhaps support such a move. According to Bear Stearns, the USDA is forecasting that 19% of corn production will go to ethanol in 2007.

Based on current estimates, there is currently 4.8 billion gallons of ethanol consuming 16% of corn production. By the end of the year, there will be an additional 2.6 billion gallons online which would take total usage of corn production up to 26%. This would mean there is a difference of roughly 7% between the forecast by the USDA and the current market. Since the corn market follows these USDA forecasts quite closely, an upgrade by the USDA for the demand and the price of corn is probable. At the moment, the forecast is for a price of $2.50 per bushel.

Another factor in the ethanol/corn story is the price of natural gas. Since natural gas is an input in ethanol production, the cost of producing ethanol can vary based on the movements in the natural pits. My forecast for natural gas is a continued move lower towards the $5 level over the next few months which implies the forward curve for natural gas should correct lower.

The fall in the input price for ethanol raises the margins for ethanol to the producer. This in turn encourages more investment in the industry as margins are high (currently 145%) creating more producers which then creates more demand for corn. I believe such a development could be some sort of support for corn for the rest of this year into 2007.

Using strict seasonality, corn should probably be weak through the fall (as it is each year when corn demand in general falls off in the fall). Thus the pounding we have seen in the price of the corn contract, probably in theory should continue. But with demand for the product rising each year, seasonality to some degree is influenced perhaps by changing of the length or timing of a given cycle and thus the seasonality involved.

For example, the dive in corn over the past few months is in anticipation of a dive in the price through the fall. Looking ahead, there could be some degree of stability in the price of corn in the near future. Add in the fact that on the intermediate chart, the sellers seem to have been exhausted over the past few weeks (and a bullish reversal was seen off the lows). This could allow for a bounce in the contract to the previous range.

Generally speaking when a stock or commodity returns to a previous range, its next target is the top of the previous range. This would imply corn returns to the $3.00 level. When? Not sure but given the current reversal of sorts on the chart, I would be a gentle buyer at this point.