All else being equal, history shows rising crude oil prices lift agricultural commodities. The relationship seems straightforward: Rising production costs are passed through to end users. On top of that, there is oil’s position as a price leader in the raw commodities sector. But history suggests there’s a limit.
Extreme price swings can distort the usual relationship between individual commodities. Analysis of weekly closes in nearby West Texas Intermediate (WTI) futures compared to the weekly closes in nearby crop futures over the last decade mostly confirms the strong correlation we would expect between oil and crop prices. SRW wheat saw the highest correlation coefficient at .704, though none of the studied crops strayed far below that, with soybeans seeing the weakest relationship at .684. A correlation coefficient of “1” indicates prices between commodities are moving in lockstep, with a “0” indicating no statistical relationship at all. Linear regression analysis shows similar results. R2 values, which measure the amount of change in grain prices explained by the price change in oil, ranged from 0.468 in soybeans to 0.496 in SRW wheat across all weeks in the past 10 years.
When the relationship breaks down
However, that relationship quickly deteriorates when oil approaches the top end of their price range. Examining just the weeks when oil prices were in the top quartile over the period, the correlation drops to a range of 0.515 to 0.527 in corn, soy, and cotton, with similar declines noted in R2. SRW is an outlier at 0.663, but given that geopolitical shocks in the Black Sea have had outsized impacts on both oil and wheat supply chains for the last five years, that is to be expected.
While price action can be complex and difficult to untangle, the breakdown of this key relationship can likely be attributed to what economists term “demand destruction.” End users of commodities face budgetary constraints. When the price for any commodity hits a certain level, consumers of that good will reduce demand due to the prohibitive costs.
In the commodities we cover, this leaves cotton particularly vulnerable. One of the main uses for cotton is apparel, a category where consumers are quick to cut back spending when wallets are feeling pinched. Grains and oilseeds are somewhat more insulated given their inclusion in biofuels and relatively inelastic demand for food, though with diesel prices setting all-time highs and gasoline not far behind, those products may see less consumption as well.
What does that mean for prices right now?
Comparing the ratio of nearby crop futures (¢/bu.) to oil ($/bbl) over the studied period shows grains are underpriced compared to the historical average relationship to oil. While that indicates grain prices could still go higher, the upside opportunity may be limited. The ratios tighten in the subsets where oil prices are historically elevated, showing that prohibitively high oil prices limit the ability of grains to push higher. Don’t forget that both corn and soybeans are supported by strong demand. Demand destruction could quickly change the fundamental outlook.
The bottom line is that with WTI oil prices threatening to close above $100 per barrel this week, a feat seen just 22 other times, markets are poised to enter rare and highly unpredictable territory.
