After last fall’s dramatic, 75% improvement in value, the corn market began 2007 under pressure about concerns of disinflation from sharply lower energy prices and fears of reallocation from index funds. The result was heavy liquidation selling in this market. However, the two main reasons for corn’s strength, strong current demand and sharply expanding ethanol production remain intact and could increase further during the first half of 2007.
This year’s corn export sales are 350 million bushels ahead of last year’s pace after the first four months of the marketing year. It is also 155 million bushels ahead of the five-year seasonal average rate to achieve the USDA’s current 2.25 billion forecast of foreign demand. This suggests that overseas buyers’ appetites haven’t been curtailed by higher prices and that this year’s final export sales would be possibly higher than currently projected. If the U.S. dollar were to experience renewed weakness later this year, this also would help partially mask any higher cost of U.S. corn to foreign buyers.
Corn consumption numbers from U.S. beef and pork producers have been robust so far this marketing year with 5% to 10% higher cattle-on-feed and 1% to 1.5% higher market hogs being reported. While poultry numbers have declined slightly, overall U.S. livestock numbers are still projected to be 1% to 2% higher, suggesting that U.S. feed demand for corn should remain robust even with expanded availability of distillers dry grains, a feed by-product from ethanol production.
In December Congress extended the current 54¢-per-gallon tariff on imported ethanol until January 2009. This will assure limited competition from lower-cost foreign producers, such as Brazil, which utilizes sugar cane in its production.
Meanwhile, the dramatic expansion of new ethanol plants being announced by the Renewable Fuels Association, the ethanol industry’s trade group, suggests a substantial jump in ethanol production capacity for the 2007/08 crop year.
Through the past five months, 4.24 billion gallons of additional plant capacity went under construction with 1.71 billion gallons of this amount being announced in December alone. Add this amount to the current 1.7 billion gallons of construction expected to be completed by August 2007, and U.S. ethanol plant capacity is likely to double by early 2008 from the current 5.39 billion gallon level.
With U.S. ethanol output now likely to be 10.5 billion gallons or more during corn’s 2007/08 crop year, corn’s ethanol demand level is likely to be near 3.7 billion bushels compared the 2006/07 year’s 2.15 to 2.2 billion bushel usage, assuming there will be 2.83 gallons of ethanol from each bushel of corn.
All of this together paints a bullish picture for new crop corn this year. To accommodate the coming year’s surging ethanol demand, we need to curtail our domestic feed demand and slow our overseas demand by 350 million bushels each for the crop we will be planting this spring. We also need to attract 8 to 9 million or more additional corn acres from other U.S. crops and have a strong yield of 156 bushels per acre to accommodate the likely expansion in ethanol demand.
With these bullish demand fundamentals, any weather related disruption during this spring planting or summer growing season could cause an explosive move in the corn market. This could be a very bullish year for corn with prices up to $5.00 or even higher for December 2007.
One way to take advantage of the bullish demand fundamentals and limit your downside is through purchasing bull call option spreads. Traders could purchase a December 2007 bull call spread with an 80¢ differential between strikes (400 and 420 buys vs. 480 and 500 sells) for a net cost of about 20¢ per contract or less ($1,000) as a possible approach to the current uncertainty facing the world’s corn market. Any weather scare, increased ethanol demand, crude oil spike or greater export demand, particularly from Asia, would benefit this position.
Pete Thomas is a Senior Broker and analyst at R.J.O’Brien. He covers the agricultural markets for institutional clients and has worked in the industry for 35 years in multiple capacities. Jerry Gidel is the president of Midland Research Inc. In 2003, he joined North America Risk Management Services Inc. as an associate specializing in the cash and futures grain markets. He currently provides agriculture market updates on the CBOT’s Web site.