Ethanol has been a media darling for several months, but by investor standards, it’s old news. Last month, corn prices reached their highest levels in more than 10 years, capping off a near 74% rally since last September’s harvest lows. Since those highs however, corn prices have gradually tapered off as ethanol news becomes commonplace and speculators take profits and look for the next big story to chase. Now, with some of the luster off of corn prices and investors tiring of the ethanol story, the present may be the perfect time for serious investors to start thinking about positioning in the corn market for the real move in prices.
By real move, we do not necessarily mean an earthshaking rally to all time highs. What we refer to is a price driven by actual realized supply and usage figures, as opposed to price moves triggered by speculator frenzy. The move we have been experiencing in corn was due, in large part, to funds and speculators buying into the story of future expectations for corn and how ethanol demand will affect prices in the future. However, as specs tired of the story, prices have faded. We believe there is now a sizable gap between current prices, and the true value of corn if the full USDA supply/demand projections are realized. We also believe that if these projections are realized, corn will trade at price levels moderately to substantially above February’s highs.
This, however, is not the perspective from which we recommend trading. As our objective is consistent returns, our perspective on a position would be to trade from a standpoint that we could profit as long as corn prices do not decline substantially in the coming months. Therefore, while we would certainly like to see the market rally, we do not necessarily require it to for us to profit. Even bull markets can experience corrections. Being right the market is good for ego. Being right on your trade is good for the bank account. We prefer the latter, which is why we are recommending a put-selling strategy in the corn market.
Investors from around the globe have spent the better part of the last year trying to figure out the best way to cash in on biofuels. Stocks in agricultural companies, ethanol production facilities, limited partnerships, even ETFs are all options that have been suggested by various financial institutions.
However, for investors looking to cash in on the ethanol boom, there are few more direct plays than actually investing in corn itself. For, while many countries make ethanol from sugar, corn is the primary ingredient in U.S. ethanol production. In many ways, investing in corn may be better than buying pure ethanol. For demand for the actual ethanol is not yet booming as much as the demand to produce ethanol. The thinking seems to be that if you create it, they (the consumer) will come.
Granted, we have been hearing for nearly a decade how demand for ethanol is going to drive corn prices to levels never seen before. Until now, it has been little more than a market footnote. But a combination of improved technology, federal subsidies, record oil prices, geopolitical instability and a very public commitment by the President of the United States, the ethanol genie is out of the bottle and the agricultural markets may never be the same. And while the initial speculator mania over ethanol may have faded somewhat, increasing ethanol production will continue to underpin the U.S. grain markets this year and for many years to come.
The recent bull market in corn has much to do with recent government commitments to ethanol as a fuel. The 2005 Energy Policy Act required that 7.5 billion gallons or 5 percent of the United States’ annual gasoline consumption come from ethanol by 2012. Earlier this year, President Bush pledged to increase the use of renewable fuels (read ethanol) almost fivefold through 2017. While headline-grabbing stories such as these may not have much effect on the supply or demand of ethanol in the near term, they were enough to bring heavy investor interest in to ethanol related investments – corn being chief among them. This, more than any near term corn shortages, drove prices higher.
The process of actually achieving these objectives, however, is what we feel will provide the fuel for a longer-term bull market in corn. There are currently 113 ethanol distilleries in operation in the United States. These distilleries produced 4.9 billion gallons of ethanol in 2006, about 2.8% of the total U.S. fuel supply. But there are currently 77 additional distilleries under construction right now. That means that most likely, within 2 years, the quantity of U.S. production facilities will increase by 68%. Of the 190 total production facilities, 182 will produce corn-based ethanol.
More facilities means more – much more- corn needed to produce the desired fuel. In 2006, 20% of the U.S. corn harvest went to make ethanol. Once all of the current facilities are complete, it is estimated that figure could rise to 50%. This is not 10 years from now. This is over the next 24-36 months.
Even at only 20% of U.S. production going to make ethanol, a considerable bite has been taken out of total U.S. corn supply. U.S. Ending stocks (a figure that measures total corn supply left on hand at the end of the crop year – Sept. 1) measured 1.967 billion bushels of corn for the 2005/06 crop year. In 2006, the U.S. crop produced 10.535 billion bushels of corn, the third largest harvest in history. Yet, according to the USDA, U.S. ending stocks on September 1, 2007 are expected to be down to 752 million bushels – a 61% drop from last year’s leftover supply. This would be the lowest ending stocks since the 1995/96 crop year when corn prices spiked to an all time high over $5.50 per bushel.
This alarming figure has brought minds together from ethanol and farming industries as well as the government to come up with a plan to keep corn stocks from falling to zero over the next 1-2 years. The estimate now is that the United States must add 12 million more planted acres over the next 24 months, cut consumption of animal feed by 14% and cut exports by 35%.
As of the latest USDA report, only 87 million acres are slated for corn planting this year in the United States. This would only be an 8.7 million acre increase in corn plantings over last year. If this figure holds true through planting season, it would be unequivocally bullish for corn prices. Even assuming a perfect growing season with maximum yields, 87 million acres would likely result in the lowest stocks to usage ratio on record – meaning there is a fair chance the 1996 historic price highs could be reached or eclipsed.
It is likely, however, that 2 million to 3 million acres will be added to this figure in the coming weeks. However, with such paltry corn supply in storage, the market will need near perfect weather and maximum yield per acre to just to keep from seeing another substantial drop in ending stocks in 2008.
The bottom line is this: Use of corn for ethanol production in the United States is increasing at a much faster rate than farmers can increase the production of corn. In 2006, 2.15 billion bushels of corn were used for ethanol. In 2008, that figure is expected to be 4.3 billion bushels – a 100% increase. By 2009, ethanol production could account for over 50% of the corn consumed in the United States.
This is not a fad or a quickly fading news story. This is a key fundamental shift in a commodity that is going to change the price structure of the market for years. Option sellers take note: While there will be corrections in the uptrend in corn prices, we see few factors that could drive corn prices into a sustained downtrend anytime soon. Ethanol demand should support prices with commercial buying coming in to limit breaks in price. The market will be extremely sensitive to weather developments this spring and summer with the risk of sizable price moves almost certainly to the upside.
We would see 10-15 cent breaks in price as opportunities for selling puts at strike prices far beneath market prices. This allows investors to profit from higher corn prices but also allows room to profit even if the market goes into a more sustained corrective phase. We’re bullish corn. But the put selling approach allows our investors to profit, even if we’re moderately wrong.
One thing is certain. While the media frenzy may be cooling, the ethanol boom is just getting underway.
James Cordier and Michael Gross, Liberty Trading Group
Liberty Trading Group
401 East Jackson Street
Suite 2340
Tampa, FL 33602
(800) 346-1949
www.optionsellers.com
If you would like more information about selling options in the Corn market or building a portfolio based on the option selling approach, please feel free to call or visit us on the web at www.optionsellers.com .
James Cordier is head trader and president of Liberty Trading Group, a futures brokerage firm specializing in option writing on commodities. James’ market comments are published by several international financial publications and worldwide news services including The Wall Street Journal, Reuters World News and Bloomberg Television News. Michael Gross is an analyst with Liberty Trading Group. Cordier and Gross’ book, The Complete Guide to Option Selling (McGraw-Hill 2005) is available at bookstores and online retailers now.
***The information in this article has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.
