Todd's Take

Last week in this space, we talked about how, for the past 20 years, grain prices have shown remarkably high correlations to other commodity prices and what that means for understanding grain markets. It still seems odd that corn prices can have so much in common with other commodities such as copper that are not food, are produced year-round and aren't influenced by weather.

The most obvious lesson I tried to point out was that grains are influenced by many things other than just yield estimates, which makes it important to be aware of a bigger picture. In general, the high correlations with commodity prices reflect long-term changes in the value of the U.S. dollar, which also play a part in long-term production cycles.

The dollar also has a role in the cyclic popularity of financial assets, which compete with commodities for investor attention. In fact, the list of influences goes on and on as we contemplate a world of 7.5 billion busy bees interacting with each other. I repeat, corn prices are not just about yields.

I received thoughtful emails from our customers last week and found that, like me, many of you are wondering what this all might mean in more practical terms. I tossed around several ideas before coming up with one that I think will be useful in helping us keep tabs on grain's economic influences.

In fact, the idea is so simple I need to explain how I got there. My first concern after writing last week's article was that some would start thinking, "Oh, copper is up today, so I should buy corn." That is not how correlations work and is not a trading scheme that I would recommend.

Another concern I mentioned last week was that statistical correlations change over time. Even though I anticipated some correlation between grains and other commodities, I am still stunned that coefficients were as high as they have been the past 20 years. And I honestly don't trust that they will necessarily be that high the next 20 years. Functional correlations, yes, but +0.8 and higher? That could be a stretch.

I toyed with the idea of using the trendline formulas provided with the correlation studies in Excel spreadsheets. Going by those, Friday's copper, gold and crude oil prices implied that spot corn should be $4.35, $4.87, and $2.96 a bushel, respectively.

The problem again was that statistical correlations are not permanent. It is more important to think in terms of influence than strain ourselves searching for a mathematical Holy Grail that changes over time.

As I looked at more specific examples in historical charts, it became apparent that, most of the time, commodity prices correlated fairly well, but there were also specific exceptions that would erupt along the way.

Fundamentally, it made sense as examples included oil prices spiking higher in the 1991 Gulf War, gold and silver's famous 1980 spike (remember the Hunt Brothers?), and several grain price spikes related to drought. It soon became clear that what was needed was a simple way to identify the trend of the most important commodity prices, understanding that, sometimes, specific events will distort specific prices.

In older days, we watched the CRB Index as a general indicator of commodity prices, but in this case, we don't want the indicator to include grain prices and a lot of little commodities that are not necessary.

After last week's research, I decided to construct an index of spot crude oil and gold prices, using an 18:1 ratio, which I call the Economic Influence (EI) Index. The formula is: The spot price of gold plus (the spot price of crude oil x 18), all divided by 4.

Some might think two commodities are inadequate, but in my view, giving each of these two a Ph.D. in economics would not honor them enough for the market information they convey.

Since 1997, the EI Index compared to spot corn, soybeans and Chicago wheat futures prices showed correlation coefficients of +0.88, +0.90, and +0.86, respectively. All three were a little higher than the coefficients for gold alone and represent a good mix as gold is a universal monetary indicator, and crude oil has both: it is a monetary influence and is an indicator of world economic activity. I also tested adding copper, but the correlation with grain prices was not improved.

As practical examples of how the index can help, it was interesting that a monthly chart of the EI Index bottomed in late 1998, a year and a half before spot corn found its low. New index highs in 2004 and 2005 were valuable tip-offs to the bull market that launched in corn in late-2006.

In 2013, spot gold broke lower in April and corn followed in July. Crude oil's problems with oversupply didn't show up until a year later, eventually taking the EI Index to a low of 389 in January 2016 that still stands while corn prices have continued to chop lower.

Today, as the U.S. approaches its next harvest, corn prices are depressed, and there is a chance that the seasonal low already arrived on Aug. 31. Friday's CFTC report showed noncommercials largely bailed out of their net longs in corn, holding only 2,376 contracts as of Aug. 29.

Or, this year's low in corn may still be ahead as commercials haven't shown much interest yet. I cannot offer guarantees, but as I see it, corn's normal seasonal influence should take cash prices modestly higher in early 2018.

As far as Dr. Gold and Dr. Crude are concerned, outside market influences are currently stable for grain prices, but are also close to a bullish breakout. The EI Index closed Friday at 547. A close above the 2016 high of 566, if it happened, would indicate bullish outside influence for grains -- something markets have not seen since 2012.

Todd Hultman can be reached at todd.hultman@dtn.com

Follow him on Twitter @ToddHultman1

(AG/SK)

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