What drives corn prices?

In a nine-page paper, two Growmark analysts say the ethanol effect, while obviously dramatic, is not the only, and indeed, not the biggest factor in the increase in corn prices.
By Susanne Retka Schill | February 04, 2013

Two analysts with Illinois-headquartered regional farm cooperative Growmark, Kel Kelly and Scott Hornblower, have tackled an important issue to ethanol industry in a recent paper: “4 Reasons Why Ethanol Doesn’t Drive Corn Prices – A Tale of Two Forces.”

In the nine-page paper, the two authors say the ethanol effect, while obviously dramatic, is not the only, and indeed, not the biggest factor in the increase in corn prices. Kelly and Hornblower lay the case that investment flows channeled into the corn market by investors/speculators has the larger effect.

Yes, the ethanol industry does consume around 5 billion bushels of corn annually. “It might seem obvious that the increased demand for ethanol would have had some effect on corn prices,” they write. “The question, however, is exactly how great that effect has been. Our research suggests that the ethanol industry has had only a very minor effect on the price of corn.”

The first reason they give is that ethanol demand is relatively small. “According to our calculations, as of 2012, the increase in ethanol demand over the last 12 years could have driven corn price up by a maximum of only $1.68 per bushel from the price of $1.85 in 2000.” One of the things they looked at to reach that conclusion was who spent money in the corn market and what happened when the corn market tanked. Ethanol’s share in the increased spending for corn amounted to about 44 percent of the total, they said. “The fact that corn prices fell substantially while ethanol demand remained strong proves that it was the larger spending by other market participants, not the smaller spending by ethanol buyers, which had the dominant effect on corn prices.”

That analysis leads to their second observation: corn prices do not move in line with ethanol demand. “Ethanol demand for corn increased 24 percent between 2008 and 2009, while corn prices fell 20 percent (from the intra-year high to intra-year low, corn prices plummeted by a whopping 60 percent!). Had ethanol been a dominant corn price driver, the continued strong ethanol demand would have prevented a sell-off in the corn markets, and would have instead driven corn prices higher due to the increased corn demand.”

In reason three, the two analysts recast the food versus fuel argument in their examination of the impact of the distillers grains coproduct. Ethanol producers extract just the sugars from the corn, adding value to the 5 billion bushels of corn processed, leaving about 33 percent to re-enter the market for food processing and feed use. “This should lead to less competition in the corn market, thus reducing ethanol producers’ need to out-compete other buyers in the primary market by bidding up corn prices. With ethanol producers giving back a third of their corn purchases, their impact on the market—whatever it is—is weaker than is apparent on the surface.”

And, reason four is that all commodities have experienced similar price volatility. “Perhaps the most obvious evidence that ethanol demand is not the primary driver of corn prices is the fact that it is not just corn and other biofuel-oriented commodities that have experienced increased spending since 2006: monetary demand and prices for almost all commodities have risen—and fallen—together.” Besides food commodities, that includes such things as silver, platinum, zinc, steel, coal, propane.

“All the other commodities that moved in a similar fashion to corn were not driven by biofuel demand. This co-movement between corn prices and all other commodity prices once again suggests that a common factor, unrelated to ethanol, is shared among these disparate commodities, and, is likely the significant driver of their price movements.”

The last section of the paper deals with “The Real Answer,” which the authors say is that speculation demand trumps ethanol demand. “It is large volumes of new Wall St. cash entering and exiting the market, not ethanol corn demand, which is the driving force responsible for sending corn prices on a rollercoaster ride. While it is evident that ethanol demand can indeed contribute to corn price movements, its actual magnitude necessarily renders its influence smaller than that of investor money flows.”

I’ve just outlined the basic argument here. To see the charts Kelly and Hornblower use to support their reasoning and the complete discussion of their points, check out the paper here. It is the best explanation I’ve read of something I’ve often heard said – that speculators drive market spikes.