Cause, Effect and Ethanol prices

By EidoSearch

 

“Cause and effect are two sides of one fact” – Ralph Waldo Emerson           

Ethanol prices are spiking.  The continuous contract price is up 62% since January 27th and at its highest level since November 2011.  In environments like this, investors look for the linkages between Ethanol and the potential causal factors as a measure for what’s likely to happen with prices going forward.  Will they continue to sky rocket or are they set for a pull back?

When we started this week’s post, we figured that looking at the cause and effect relationships around Ethanol prices would be a valuable study.  We wanted to identify the other commodities, assets and factors that have had the most powerful linkages to the forward price and trading in Ethanol historically as an objective input for where the prices are likely to go next.  Because of the power of EidoSearch, running these scenarios each takes just seconds, so we figured this would be a piece of cake.  With no experience investing in Ethanol however, knowing what “causes” to analyze is the key so I began to research and find the common ones.  As I should have expected, what I came away with was a dizzying array of factors and some contradictions:

  • Conventional wisdom says that Ethanol prices drive corn prices.  Farmdoc daily, however, says that as long as the E10 blendwall is binding, that Corn prices actually drive the price of Ethanol (Scott Irwin, Oct 9, 2013)
  • Crude Oil is the main driver of Ethanol prices (Rudy Ruitenberg, Bloomberg, Dec 3, 2013)
  • Uncertainty over Ukraine is pushing Ethanol prices hire since they are a major corn exporter (Trilby Lundberg Survey/Minnesota Cornerstone)
  • Cold weather is creating rail car delays and therefore supply issues (Myke Feinman, DTN the Progressive Farmer, Feb 25, 2014)
  • A projected US Corn crop near 14.5bn bushels in 2014, will allow a further build-up of inventories and keep corn prices lower (Univ. of Illinois/agrimoney.com)

At some point, as the smoke was pouring out of my ears trying to make sense of the correlations, I realized that I didn’t need to try and sort out of all of the cause and effect relationships.  Why?  Because the best measure for what is likely to happen with Ethanol’s price is how investors have reacted to similar price trends in Ethanol’s history itself.  All of these factors and correlations I was stressing about trying to work out, are in fact already incorporated into Ethanol’s price.  Sure, at times historically, the geopolitical‎ issues override weather issues, or the price of corn is more of less of a factor, but investors through the price of Ethanol have always determined the importance of these various factors and correlations based on how it is being traded.

Looking at Ethanol’s history alone is not 100% predictive without fail.  If it were, this blog would be a note to investors in our fund instead!  Similarly, there is no perfect cause/effect relationship for Ethanol prices.  What we’re after is projecting the range of potential outcomes, and to understand how investors in Ethanol have reacted to similar environments in the past as a proxy for their likely reaction in the future.  That being said, there is predictive nature to the use of historical analogs if captured objectively, as EidoSearch simulations prove, and this is a critical tool and signal for the investor to incorporate into the decision making process.

So then, let’s take a look at Ethanol’s current price trend.  We took the current 3 month pattern in Ethanol (ZK), and ran it through EidoSearch to find the most similar instances of this price trend historically and how investors reacted in the next 10 days.  We found 23 similar instances historically, and on average Ethanol is down -6.5% in the next 10 days, and the price falls back almost 80% of the time.

3 month price chart, and the average (red line) and range of returns (orange lines) historically in the next 10 days

ethanol project

Display of the 23 similar historical instances of the current 3 month price trend in Ethanol, and how they performed in the next 10 days.  Only one historical instances had a return above 3% in the next 10 days, where 14 historical instances were down over 3% in the next 10 days.

ethanol return

Replicating the above study in EidoSearch (for subscribers)

  1. Do a New Search for Ethanol (selection ZK) or Symbol ZK and hit Enter
  2. Hit the “3 month” button above the price chart
  3. Hit the “Search One” button in the bottom right hand corner of the chart to look for the trend in Ethanol’s history
  4. You’ll get the current projection chart, and can view different time horizons as well as the historical instances

Have a great week.

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