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'Game of Chicken' Will Drive Oil Prices; Slide Expected For At Least 6 Months

Crude oil is cheap right now, and there's not a lot going on -- at home or abroad -- to change the downward direction of the market.

There are 2 sides to current action in the crude oil market for farmers; on one hand, farmers are happy to have a key input cost component in lower territory, while on the other, the downturn could have longer-term bearish impacts on the ag markets. But, there are other moving parts within that equation that make oil's fall a more complex issue at the farm level and beyond.

"Lower transportation costs are the obvious benefit for grains with this sinking crude market but we need demand, especially in corn. Some may make the argument that discretionary income will increase due to lower gasoline prices and that may lead to more demand for expensive beef. Maybe, but it’s a bit far-fetched in my opinion," says Peter Meyer, senior director for agricultural commodities at PIRA Energy Group. "In addition to lower transportation costs, continuing lower fuel costs will obviously be welcomed with open arms by farmers struggling with profit margins for 2015. It may be a small comfort given current 2015 crop prices but at least it’s something."

"Since it’s the largest demand sector for corn, lower gasoline prices will almost certainly lead to lower blend rates for ethanol and thus lower ethanol prices. This is obviously a negative for grain prices," Meyer says.

But, there's another variable in the equation that may mean this threat of lower corn prices is overstated. There's still a biofuels mandate in place, and if it continues at its current rate, the "blend wall," or point at which the maximum amount of ethanol is being blended in gasoline, could actually keep ethanol demand constant.

"Our analysis suggests this risk is over-stated. Key to our analysis is the assumption that RFS mandates are likely to return to statutory volumes for 2014 and beyond. So, even with an extended period of high ethanol to gasoline prices, domestic ethanol consumption would be supported at the 10% blend wall," according to a report from University of Illinois Extension ag economists Scott Irwin and Darrel Good. "We also argue that the blend wall represents a cap on domestic consumption for now -- regardless of the level of ethanol and gasoline prices -- because of the constraints on the expansion of the use of higher ethanol blends."

There's also an export market for U.S. ethanol that remains fairly strong, and if movement in that market in the last year or so continues, it should continue to keep demand at current levels or better, the economists say. U.S. ethanol exports have fallen since the high in 2011, when more than 1 billion gallons of the fuel was exported. But, they've risen since 2013, and Irwin and Good expect them to trend higher in 2015 unless prices between ethanol and gasoline get too imbalanced.

"U.S. ethanol exports peaked at 1.2 billion gallons in 2011 when Brazilian ethanol production was limited. Exports totaled 732 million gallons in 2012, 618 million gallons in 2013, and are on track to reach 750 to 800 million gallons this year. Earlier this year, low prices of ethanol relative to gasoline prices created an opportunity for ethanol consumption to expand in other parts of the world and pointed to the potential for even larger U.S. exports. A continuation of current price ratios, however, would not favor ethanol and could result in some decline in exports rather than further growth," the economists say. "However, it is unlikely that exports to Canada, which accounted for 45 percent of U.S exports during the first nine months of 2014, would be adversely affected since ethanol consumption is also mandated there. Demand for ethanol in other countries, however, might be negatively impacted by an extended period of high ethanol to gasoline price ratios, putting a few hundred million gallons of U.S ethanol exports at risk. This likely would only represent a drop in corn use for ethanol of about 150 million bushels."

In the grand scheme of things, this dip would likely end up "negligible" to overall ethanol and corn demand, Meyer says. That's true unless the investment community absorbs too much of the bearishness generally permeating the grain markets right now. Despite the fact fundamentals will likely keep the bottom from falling out from under the ethanol market, sentiment could go a long way in guiding that market's future.

"The other negative surrounds the investor’s mentality. Long term investors, who invest in so-called commodity Index Funds on a long-only basis, have been a bit shell-shocked of late with pretty bad returns for their commodity portfolio, and that was before this latest rout in the oil markets. As they get their November monthly statements this week, sticker shock will almost certainly ensue. We have seen some liquidation of grain positions by the Index Funds of late but it’s had a negligible effect," Meyer says. "Since almost every Index Fund is much heavier invested in oil than grains, oil position liquidation may have a more dramatic effect on prices. It will be very interesting to see how investors react to their poorly performing commodity portfolio. Thankfully, the stock market continues to make record highs on a seemingly daily basis so the so-called 'balanced' investor may have a bit more patience with his/her smallish stake in commodities."

Beyond these fundamental and outside factors, Meyer says there's a "game of chicken" evolving as the Bakken Formation in the northern U.S. Plains continues to generate crude oil supplies for both domestic use and export sales. OPEC still controls that vast majority of the world's marketed crude oil, and what those Middle East nations do to counteract growing production in the U.S. will go a long way to dictating prices in the medium and long term, the timeframe when a turnaround in oil prices might happen.

"Regarding a possible turn-around, it seems highly unlikely in the near term at least. OPEC is playing a game of chicken with Bakken oil producers to see how low the market needs to go before U.S. wells get folded up," Meyer says. "Bakken producers reportedly have done a pretty good job of hedging their output near the $90 level so this drop means nothing until their hedges come off. Whenever they do come off, which some suggest could be 6 to 9 months from now, the situation will be re-evaluated."

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