What an interesting time; a time where people no longer brag about the look of their car or its speed, but rather its mpg rating; a time when homeowners go to lengths to build energy-efficient homes; a time when “alternative energy” became a household phrase.

This is a time when the consequence of people’s actions is measured in barrels and gallons. Welcome to the 1970s! Sound familiar? What has happened in the last 30 years that so many people have forgotten where we came from? Is it simply a generation gap? Is it denial? Is it a conspiracy? …a coincidence? Is it the cycle of the marketplace returning? Or is it something different?

Anyone who lived through the 1970s can tell you stories about the energy crisis. People would stand in line to purchase their ration of gasoline at prices that they wouldn’t have dreamed about only years earlier. People began to travel less. Instead of making multiple trips around town, they would plan one. Prices rose on all fronts. Inflation became a concern of everyone. All in all, we began, for the first time, to recognize our dependence on oil and the impact a major price change in that essential commodity could have on our society at all levels.

So what is happening now? I would suggest that the last three years of market action are the beginning of something not witnessed in the last three decades since the first energy crisis. World population and GDP have steadily grown during this period. As world population adds 80 million people a year to its roster, a growing demand for food, largely wheat and rice, has surfaced. As several of these undeveloped or lesser-developed countries grow economically, their demand for protein increases. In modern agriculture, protein energy is born out of a corn base.

Simultaneously, growing wealth creates an exponential growth in the need for fuel and electricity. It takes a variety of energy sources to power these growing societies, though fossil fuels have been the supply of choice in recent years. Oil consumption by China alone has more than doubled since 2003, with all of this growth being supplied by other countries. The last five years of market activity are the realization of these compounding and colliding growth trends. The prices of corn and crude oil reflect the effect that these growing demands have placed on their tightening supplies. How else could two markets which have existed a world away from each other share such a similar story in recent years?

There is one more thing. Ethanol has bridged the ocean of distance between the two and has drawn a new parallel between their prices. In a free market economy, problems attract solutions. The world demanded more energy. An infant industry grew quickly to cater to that need. Say what you will about it, it has had an obvious effect on the way we view corn. New technologies continue to develop to provide alternative feedstocks to biofuel producers. However, so long as corn is the preferred source for ethanol in the U.S., we must manage the fact that the price of corn and the price of crude will be fused together.

This becomes starkly apparent when viewing a chart (See Figure 1) of the last few years of market activity. Notice also that when ethanol futures began trading in 2006, the industry still had an identity all of its own. However, as plant construction boomed and corn demand grew, the correlation began. While corn-based ethanol has worked its way into the blend and nations strive to become less energy-dependent on foreign suppliers, crude oil, corn and ethanol have charted very similar courses.

Even though there is much to be said about this new relationship, let us not be fooled. There is an old expression that says “there is nothing new under the sun.” Because of the booming demand for nearly all goods, many believe that we have seen a fundamental change in our marketplace. They look at this change as some sort of point-of-no-return. They believe that we are in a new era of agriculture. Perhaps you have seen someone deliberate to that end.

The events of the last few months should serve as a great reminder of the error of that position. I suggest, rather, that we are witnessing the most recent major market transition. In this transition, an industry was born. Though the ethanol industry was the first of several alternative energies to capture the momentum of this age, others will follow. For now, it stands to reason that anything tied to the price of corn will also be affected indirectly by the price of energy products such as crude, heating oil (diesel) or gasoline.

This should have all of us in the dairy industry sitting up straight in our chairs. For decades, producers have long been aware of the correlation between corn price and milk price. Given the new relationship between the corn market and the energy complex, one should recognize this for what it is worth. This is not a new evil injected into our market, but rather a change that we must incorporate into our business plan. Milk price, in following corn, will become more tightly woven with crude oil and distillate energy markets. But make no mistake; though they walk very closely with each other, each brings with it unique seasonality and fundamental factors.

Corn price will still be impacted by weather, carryout and other supply and demand factors. Milk price will still be influenced by cow numbers, retail demand for dairy products and federal order functionality, among others. Crude oil prices will still stay tuned to OPEC production, weather events, and the value of the U.S. dollar. You will notice this in Figure 2 as you retrace the events of 2008. Despite the weather events that drove corn to all-time highs in July, milk price began to fade in June due to mild weather, strong production and weakening product demand. Even though fourth quarter economic woes continued to weigh on crude oil prices, corn prices (led by soybeans) began to rally around dryness in South America. Each of these markets will find a way to ultimately move together, but in the short run will take on price adjustments individual to its own conditions.

So what difference does this make, anyway? Let’s go back to earlier conversations that we have had concerning managing margins. You have heard me press on the idea of managing margins (In the futures market this is measured by milk price over feed cost.) Given the lead-and- lag effect that is witnessed within this crude, corn and milk trio, not all of these markets will move at exactly the same time. Corn may be responding to its fundamentals and pull away from the other two. Milk price may have its own set of circumstances that sets it apart from the others. However, since crude oil will most often take the lead in this dance, producers will have a new signal to alert them towards managing current margins.

Work with your market adviser to learn how to position yourself for changes in this new market dynamic. In days gone by, crude oil movement was only a casual watch point to milk market participants. However, its effect today is a crude reality of our business. PD

UPDATE: Since the publication of this article, Mike North has left First Capitol Ag and is now the president of Commodity Risk Management Group. Contact him by email.

Mike North
Senior Risk Management Adviser