By Erik Norland
As we observed in our past research, soybean oil prices often lead the movement in crude oil prices. The past year has been no exception. Even as WTI crude prices soared from $42 to $66 per barrel between June 22, 2017, and January 25, 2018, soybean oil traders weren't buying in. Soybean oil prices peaked on November 9, 2017, at 35.38 U.S. cents per pound and began a 10% selloff that started two and a half months before the recent peak in crude oil prices (Figure 1). This is the eleventh such episode of soybean oil prices leading crude oil prices since 2005.
Figure 1: Soybean Oil Prices Often Lead Crude Oil Prices.
Here is a list of the various episodes:
- From January 2005 to August 2006, WTI crude oil prices nearly doubled from $43 to $77. Soybean oil demonstrated little enthusiasm for this rally, peaking at 27.54 U.S. cents in early July 2006 and dipping around 10% before the peak in WTI the next month. WTI prices crashed from $77 to $51 by January 2007, catching up with soybean oil prices on the downside.
- While crude oil prices were crashing to the level of soybean oil prices, soybean oil prices hit bottom in November 2006 - two months ahead of crude oil - and began an enormous rally that took prices from 23.58 U.S. cents to 71.26 U.S. cents by March 2008. WTI prices waited two months to get on board this mega-rally but eventually made a similar move from $51 in January 2007 to $147 in July 2008.
- After peaking in March 2008 soybean oil prices fired a warning shot across the bow of the still rallying crude oil. Soybean oil prices dropped from 71 to 48 U.S. cents - more than a 30% drop - before rebounding to 68 U.S. cents on June 16, 2008. Even this second, lower peak in soybean oil prices occurred nearly one month before crude oil peaked at $147 on July 11, 2008. By the time WTI hit its all-time high, soybean oil prices were 5% off their June peak and nearly 10% below the all-time high set in March 2008.
- During the financial crisis, soybean oil prices cratered to 28 U.S. cents on December 5, 2008, before staging a rally into the year-end. By contrast, crude oil prices didn't hit bottom for another three weeks, on December 24, 2008, when they closed at $35.35. In 2009 and 2010 as both markets recovered, soybean oil again led crude oil in most of the minor zigs and zags on the way up.
- Soybean oil prices peaked on February 3, 2011, at just below 60 U.S. cents, having more than doubled from their late 2008 low. WTI prices, by contrast, didn't peak for nearly three months when they hit $114 on April 29, 2011.
- At this point, soybean oil and WTI began their great divergence. In the wake of the Arab Spring uprising in the Middle East, perceived geopolitical risks kept WTI and other oil benchmarks trading within about 25% of their 2011 highs for the next three and a half years. Soybean oil prices, by contrast, had fallen 40% off their 2011 highs by early 2014 and, after a brief bounce, began crashing again in the summer of 2014 until they got to around half of their April 2011 levels. This presaged the late 2014 collapse in crude oil prices which eventually took WTI to as low as $26.
- Once again, soybean oil prices hit bottom first, reaching a low of 25 U.S. cents in August 2015 - a 60% fall from their April 2011 peak. WTI prices hit bottom in February 2016 - a full six months later - at $26, down over 75% from their local high in 2011.
- By the time crude hit bottom on February 11, 2016, soybean oil prices were more than 20% off their lows. They reached a local peak of 41 U.S. cents on April 19, 2016 - a gain of more than 60% from their lows. Crude oil prices followed them higher but peaked almost two months later on June 8, 2016, at just over $50, up almost 100% from their lows.
- When crude oil prices reached their local high of $51 per barrel on June 8, soybean prices had already fallen as much as 12% and eventually hit bottom on July 22, 2016, at 29 U.S. cents. WTI prices hit bottom two weeks later, on August 2, 2016, at $39.
- Soybean oil prices peaked at 37 U.S. cents on December 27, 2016, and by April 11, 2017, had fallen to around 31 U.S. cents. Meanwhile, WTI prices plateaued at around $54 between December 12, 2016, and March 7, 2017, before eventually correcting lower to $43 by June 22, 2017 - lagging soybean oil by about three months.
- Soybean oil prices peaked at 36 U.S. cents on September 5, 2017. WTI continued to rally until January 25, when it got to $66.
Soybean oil prices have not to-date staged any sort of sustained recovery and this might suggest lower prices for WTI in the weeks ahead. Once soybean oil does eventually hit bottom, however, it will be interesting to see if WTI once again follows it higher for a 12th episode as outlined in our brief history of the relationship between soybean oil and crude oil - a story that works just as well when one looks at Bursa Malaysia's palm oil futures when converted from the Malaysian ringgit to U.S. dollars.
On another note, WTI and soybean options traders perceive largely opposite risks. While they agree that there isn't a huge amount of risk going forward - at-the-money (ATM) volatility is closer to historic lows than to record highs for both products - (Figure 2), the 'smile' chart of option volatility suggests that soybean oil traders fear upside risk (Figure 3), whereas the concerns of WTI traders are dominated by the downside (Figure 4).
This is probably because agriculture traders are concerned that prices for the soy complex (beans, oil and meal) might be close to the marginal cost of production of many producers and therefore can't go too much lower. WTI, by contrast, is trading well above the assumed marginal cost of production of around $40 per barrel for many producers, including many of the key, swing producers of shale oil in the United States.
Figure 2: Implied Volatility On Options Is Low For Both Markets.
Figure 3: Soybean Oil Options Traders Fear Upside More Than Downside.
Figure 4: WTI Options Traders Fear Downside More Than Upside.
While the views of options traders are consistent with the idea that soybean oil prices might continue to lead movements in WTI, we would note that the risks for soybean oil might be more evenly balanced than some might think. Just because agricultural goods prices are low and near the cost of production, it does not mean that they cannot fall further. Likewise, WTI traders would be unwise to ignore the upside risks to oil prices stemming from geopolitical risks in places as diverse as the Middle East, Algeria, Angola, Nigeria and Venezuela.
We remain unsure of the exact reason why soybean oil and other vegetable oils prices tend to lead crude oil prices but we suspect that it results from two factors: 1) the existence of biofuel mandates in over 60 countries around the world (including the U.S. nations in the E.U., Brazil and China), and 2) the modest size of the veg oil market in comparison to the vastness of the crude oil market. The latter is roughly 20x larger and via the biofuel mandates small fluctuations in crude oil supply and demand conditions can have an outsized impact on vegetable oil prices - impacts that may be moving vegetable oil prices in advance of crude oil prices on many occasions.
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