Corn on the cusp

Corn prices have slumped by almost a quarter since the end of June to around 325 cents per bushel on speculation of a record harvest in the US. The U.S. Department of Agriculture released a forecast in mid-August confirming this view. It predicted a record U.S. corn crop and the biggest yields ever, with a national average of 175.1 bushels an acre

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However, the USDA’s forecasts have been prone to major revisions in previous years. In 2010 producers were slow to realize the damage heat had caused, and this year may be no different. Hot weather across the U.S. corn belt in June and July came during critical periods of ear development.

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The USDA estimates are made based on farmer surveys, field inspections (known as windshield tours, that are essentially drive-by’s) and satellite images. But, as the image below shows, they are no substitute for actually checking the quality of the corn.

Corn prices are sitting on a key support level that was previously touched in October 2014 and June 2010. Meanwhile, market positioning shows that corn prices could be very vulnerable to a strong short-covering rally, if yields disappoint.

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Crying wolf: For OPEC talk is cheap

When will the oil market crumble?

In the past couple weeks OPEC members, led by Venezuela and Saudi Arabia have attempted to talk back up the price of oil. Besides the obvious why are they doing this?

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The last time OPEC made such an active roile in trying to talk up prices was at the start of 2016 when oil prices fell below $30 per barrel.

“The price itself is irrational if you ask me,” Khalid al-Falih, the chairman of the Saudi state oil company Aramco and one of the Kingdom’s most influential energy figures, said at the World Economic Forum annual meeting in Davos.

“Prices are supposed to be set by the marginal barrel. The marginal barrel is certainly way higher than $30 a barrel.”

Then, in February Saudi Arabia, Qatar, Venezuela and non-OPEC Russia agreed to freeze output at January levels. Buoyed by large unplanned production cuts in OPEC and non-OPEC, the threat of cuts at their June meeting and weakness in the US dollar, oil prices then rebounded to over $50 per barrel by the summer.

And now after oil prices briefly tipped below $40 per barrel Saudi Arabia’s energy minister, Khalid al-Falih, said members of the OPEC cartel and other major producers would “discuss the market situation, including any action that may be required to stabilize prices.”

Despite protestations that cuts to production are on the table, the reality is that OPEC are very unlikely to actually do that which is why they are being so robust in their efforts to talk up the market.

It all comes down to debt.

When oil prices were high oil producers borrowed heavily against the value of that oil. This year OPEC’s net oil export income this year is forecast by the Energy Information Administration to hit its lowest level since 2003 in real terms.

As Bloomberg’s Gadfly notes “suddenly finding yourself saddled with huge debts and savage cuts to your income understandably leaves you feeling depressed. And when oil producers get depressed, they don’t retreat — they pump more oil.”

As Jaime Caruana of the Bank for International Settlements laid out in a speech earlier this year:

Highly leveraged [oil] producers may attempt to maintain, or even increase, output levels even as the oil price falls in order to remain liquid and to meet interest payments and tighter credit conditions. Second, firms with high debt levels face stronger imperatives to hedge their exposure to highly volatile revenues by selling futures or buying put options in derivatives markets, so as to avoid corporate distress or insolvency if the oil price falls further. If financial constraints contribute to keeping production levels high and result in increased hedging of future production, the addition to oil sales would magnify price declines.

There is another weak link in the debt burden, one that if prices fell below a certain level could provoke much sharper falls.

At the start of the year, Sovereign Wealth Funds (SWF) belonging to oil-exporting countries dumped billions in risk assets to help prop up their current account and budget deficits, that due to the sharp drop in the oil price had been been made worse.

However, as JP Morgan calculate if oil prices fell below $40 per barrel on a sustained basis this could provoke SWF into more selling. Indeed, the faster oil prices drop the faster the value of oil and other risk assets will recouple, increasing the risk of a return to the situation at the start of 2016 where pretty much all assets – oil and other commodities see sharp falls.

How long though before the market realises that OPEC can only talk up the market for so long? Oil producers can only cry wolf for so long.

Related article: Oil’s latest bear market – 6 factors to watch

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Oil’s latest bear market – 6 factors to watch

Weaker demand: Concern over an oversupplied crude market has moved on to concerns over an oversupplied product market – particularly gasoline. As refineries have cut back utilisation to protect their margins (in the face of low gasoline prices), refinery demand for crude has fallen.

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Reduced ‘risk premium’: One of the main factors supporting prices earlier in the year was the large supply disruptions – at least 1 million b/d and up to 2 million b/d at its peak. The ‘risk premium’ (estimated at $15 per barrel) has gradually been eroded as output has returned. Nevertheless, its worth looking forward to potential future sources of disruption, and hurricanes in the US Gulf could present the next risk to output. In addition the slow train wreck that is OPEC member Venezuela gradually moves towards complete chaos (lower oil prices will only make it worse). Any disruption here would quickly be felt in oil markets. 2016-08-01_2216

Hedge funds: After amassing a near record long position in crude contracts earlier in the year, short positions (bets on prices falling) in WTI crude have increased at their fastest rate since 2006. As quick as sentiment has switched from bullish to bearish, it can very quickly switch back if prices fall too far too quickly or an adverse market ‘event’ flushes out the short positions.

US production: Rig activity has gradually begun to increase over the past two months in response to $50 per barrel oil, supporting the view of shale oil as a much more price elastic form of supply. At the same time productivity (output per rig/well) continues to rise.

Battle for market share: Over the weekend Saudi Arabia cut the price it sells crude to Asian customers, the sharpest cut since November last year. Competition in Asia is hotting up as Iran, having increased output by 25% in 2016 aims to reach an 8 year high of 4 million b/d by December. Meanwhile, demand from refineries in Asia has stalled.

Macro concerns: The US dollar strengthened on a trade weighted basis between May and July, as speculation mounted that the Federal Reserve would increase interest rates following better than expected economic data. A stronger US dollar tends to result in weaker crude prices. Meanwhile, uncertainty at least partly Brexit induced, has hit prospects for global economic growth and so for oil demand (oil prices closed at $51 per barrel on the day of the EU referendum).

However, the weaker economic outlook now means that the chances of higher interest rates have diminished. Indeed, recent data out of the US points to a slowdown in growth. Meanwhile, the likelihood of policy divergences between the US, Europe and Japan appear much more limited (note Japan’s pullback from ‘helicopter money’). All of which implies that a weaker US dollar in coming months could be supportive of higher oil prices.

Related article: Life after 50? Shale oil’s true test as a swing producer awaits

Related article: How big is the oil price ‘risk premium’?

Related article: Hurricane season: La Nina could lead to late summer oil price spike

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