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2006 The Year It All Changed

It’s a new dynamic. Today, crude oil prices and global currency trading are huge drivers across farm commodity markets, affecting prices much more than the spec funds, and often much more than simple supply and demand.

Dr. Julieta Frank joined the Department of Agribusiness and Agricultural Economics at the University of Manitoba in early 2009 and recently completed a study of the linkages between agricultural, oil and exchange rate markets. COUNTRY GUIDE caught up with Dr. Frank earlier this spring to ask what her research has uncovered, and to find out what it all means for the future of farm marketing.

CG: What attracted you and your colleague to this particular topic?

JF: The starting point for our work was the movement of prices in both the agricultural commodity markets and the oil sector as well as the decline in the value of the American dollar relative to other currencies. When you look at the graphs of these prices alongside exchange rates for the U.S. dollar, there are certain emerging patterns that we wanted to delve into to a greater extent.

CG: Is this a new topic or is this something that researchers had looked at previously?

JF: People have been trying to forecast agricultural commodity prices for a very long time and there has certainly been a lot of work into how exchange rates in particular can be used to predict agricultural markets.

CG: Has any of this previous research work been conclusive?

JF: Not really. Some people have determined that there is a correlation, others have found that there isn’t. It would seem that, from the work that we looked at, a lot depended on the models that were used. What we did is, we looked at the period from 1998 to 2009 and we used a basket of foreign exchange rates for the U.S. dollar that included its value relative to the euro, the Japanese yen, the Canadian dollar, the British pound, the Swedish krona and the Swiss franc. This basket allowed us to capture more accurately changes in the value of the American dollar.

CG: What commodities did you include in your study?

JF: We looked at the price of oil, basis West Texas Intermediate crude, which is commonly used as the benchmark for oil pricing. Then, we looked at corn cash prices in central Illinois, wheat cash prices in St. Louis, cash prices for hogs from the United States Department of Agriculture (USDA) and live cattle prices for the Texas/Oklahoma region. We also included the value of ethanol at an Iowa location starting in 2005.

CG: Why not soybeans?

JF: Well, we thought of soybeans. But soybeans and corn behave so similarly that it is difficult to generate results in the model that we chose for this study.

CG: So how did you go about looking at the relationship between all of these different factors?

JF: We basically took weekly prices and U.S. dollar exchange rate data for the entire period and tried to determine the extent to which there was an interrelationship between the factors. We then divided the study into two periods, one pre-September 2006 (Period 1) and the other from September 2006 to November 2009 (Period 2).

CG: What happened in September 2006?

JF: If we go back to the graphs that I talked about at the start, it’s clear that there was a sudden shift in the markets at that point. Grain and oil prices began to climb well above historical levels, culminating in the records that were set in 2008. Had we given the priority to another agricultural commodity other than corn, the date might have been slightly different but when we ran the numbers, we found that September 2006 was the critical “break point” for corn values.

CG. Do we know why?

JF: Our study wasn’t really focused on why the change occurred as much as it was on what the changes were. But I suspect that it had to do with supply and demand factors like droughts and other agronomic problems in key producing regions as well as increased demand for American corn that was fuelled partly by the lower value of the American dollar and partly by the increased domestic use of corn in the production of ethanol.

CG: How about the increased presence of investment funds in agricultural commodity markets?

JF: We did not make this part of our study but some of my colleagues at the University of Illinois have looked into this and their findings suggest that investment fund activity has not had a major influence on commodity prices. First of all, the timing of the price spikes in the commodity markets does not seem to match the timing of the influx of the investment funds and secondly, it would appear that investment funds have generally been positive for commodity markets as a whole.

CG: So what were your findings?

JF: In Period 1, we found that, for the most part, markets appear to be affected by the lags in their own prices while exchange rates and the price of oil have only limited effect on agricultural markets. The price of corn, for instance, is most affected by the values in the corn market in previous weeks. The largest macroeconomic impact on commodity values is the effect of exchange rates on the price of corn. Other statistically significant factors, like the effect of the price of oil on wheat, are of a much smaller magnitude.

The picture changes quite dramatically in Period 2 however. Both crude oil prices and the foreign exchange index have a much more pronounced effect on commodity prices while the effects of the lag in their own prices on commodity values is reduced relative to Period 1.

CG: What are some of the main interrelationships that emerge in the period after September 2006?

JF: First of all, exchange rates and oil are more closely connected than before. Each is influenced in the short run by lagged values of the other variable. The short-term exchange rate effect on the price of corn is more pronounced and the effect of oil on agricultural markets is stronger and more widespread. While ethanol doesn’t seem to have significant effects on oil, corn or livestock, it still shows up in the model: if it had no impact, it would have been eliminated in the model we were using. Overall, the price of oil, in particular, has become a lot more significant for corn and wheat prices.

CG: To what extent does your research indicate long-term, sustained effects on the price of commodities when the price of oil shoots up as it has in recent months?

JF: The other part of our study was to examine how agricultural commodity prices respond when the model that we developed is “shocked” by a sudden increase in oil prices or the exchange rate index.

What we found is that in Period 1, there was a short-term effect but that within a four-week period, prices quickly returned to equilibrium. In Period 2, however, the impact of the same type of shock was more pronounced and longer lasting. In the case of an increase in exchange rates, for instance, the price of corn stabilized at about four per cent below the initial equilibrium price after about 16 weeks.

A sudden increase in the price of oil appeared to have the most significant effect on the long-term price of hogs.

CG: What advice do you have for farmers looking to make sense of volatile markets?

JF: A break point happened in the fall of 2006 and since that time, agricultural commodity prices are less influenced by lags in their own prices and more affected by macro-economic factors like the price of oil and U.S. exchange rates.

These are now being transmitted into agricultural commodity markets in a very significant way, especially when we look at the influence of oil prices on the price of corn. I think it’s very important for producers and policy makers alike to keep these macro-economic factors in mind when developing marketing strategies and new policies for the agricultural sector.CG

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