What's Going on with Corn?

Just last week, our own Brad Zigler was talking about the ethanol bust; in particular, how the boom in corn prices (and inflation) had made being an ethanol refiner a pretty dismal proposition, and highlighting how the push-me-pull-you of inflation was hitting corn prices.

Good points, but I'm a simple guy. I like to stick to the things I can point to with some real assurance. That's part of what's so great about commodities investing - you're making bets on stuff, not just opinions and potential.
So when I see the kind of action we've seen in corn this summer, I am inclined to think there's something going on that's a bit more than just investor sentiment. Here's how it's gone lately:

So let's recap: This summer we had a huge run-up to $7.50/bushel in corn based almost entirely on a theoretical supply shock. Iowa briefly became a destination for boaters as millions of acres went under water from floods. The headlines at the time (in June) were predictably hyperbolic, prices spiked as traders bet against the character and ingenuity of Iowa farmers, and then, as Don Bousquet covered in July, the USDA dropped a surprise on the markets: Those crafty farmers had actually sewn a million or so more acres than previously thought. Supply shock over, the market then turned to the demand side, and saw the effect of the Corn Crush Squeeze that Brad highlighted last week.

And so, late summer has been a strictly "look out below" affair. Until last week, when corn started gobbling back pennies 25 at a time. So, why the pop?

First off, corn is at a critical point. The meme du jour is that ethanol's a bust, so that's bad for corn bulls. And weather is showing even more mixed signals now. July's good news for buyers - that the crops were just fine - was supported by the mid-August crop report from the USDA, which suggested farmers would be harvesting 79.3 million acres, pretty much in line with most analysts' expectations.

You'd expect that all this would continue corn's decline, so why the pop? One interesting theory is that speculators, having either been burned by staying in corn for too long, or being fat and happy on their realized gains, are out of the mix. That would imply a bit more stability in prices than we've seen this summer and a return to somewhat more rational-looking trading sessions that we saw in 2007. That's likely a win-win both for commodity producers and consumers long term.

But if you believe this theory, then supply and demand become even more fundamental drivers for immediate prices. One of the bigger surprises (at least to me) about the price spike was how elastic demand seemed to be. It turns out that cattlemen were more than willing to either slaughter earlier or just feed their cows something other than corn, like peas and barley: After all, cows are designed to live on grass in the first place, and corn was only introduced into the bovine diet as a matter of cost and convenience. With corn prices coming down, it's essentially the matter of a phone call for a feedlot to switch back from a substitute feed to corn.

All that speaks for a bit of stability, and a natural floor in corn prices, which is what we're seeing play out in recent sessions. It's quite possible that for many actual end users of corn - feedlots, ethanol plants - $5.00/bushel is a psychological trigger point; a price at which they say "OK, we're back in business" and they can survive the corn crush and feed all those pigs and cows.

Sometimes I just can't help myself; this chart had to be drawn. It's way too early to call this any kind of a new bottom - it hasn't been tested in any meaningful way. But what is clear is that the hyperbolic trend has been broken, and pretty dramatically. I'm not a voodoo chartist, but sometimes a few lines help make an obvious point. (A "real" chartist would talk about how this could be an emerging head-and-shoulders pattern, the beginnings of a pennant formation or look to that central black trend line as the new potential point of resistance. And they'd have a long litany of reasons, too.)

This is all just (pardon the pun) speculation. But this basic question of what kind of money is in the market is crucial to understanding market dynamics. Speculators, in an abstract sense, are critical to making the futures market work. But that's speculator with a capital S - the consistent market participant. That's not necessarily the same as bandwagon jumpers who hopped on the commodities train and have now moved on to greener pastures, and at least some people claim to have evidence that that's just what's going on.

The bottom line is this: Eventually, supply and demand rule the market. No matter how many tulip-chasers enter the market, at some point there are only so many tulips and so many gardens out there. Or to torture the metaphor a bit less, there are only so many acres that can grow corn, and only so many cars and cows that can eat it. Neither supply nor demand is truly infinite, but nothing has changed in the long-term fundamentals here: There are more uses and users of corn than ever, and with both plantings and yields already at record levels, supply seems less elastic than demand. In fact, the USDA long-term projections suggest near-zero growth in planted acreage of corn over the next 10 years.

And this moderate increase in planted area, supported by increases in yield, would just about keep things in balance with the 10-year demand projections:

The implication is that we're zeroing in on a new equilibrium price for corn (and most other agricultural commodities). My guess is that for corn, it's going to keep a moving average much closer to $5.00/bushel than the historic $2-and-change.