Corn Prices Will Soon Follow Fertilizer Higher – Be Long Corn

Summary

• Fertilizer prices spiked upward of threefold over the past year due to supply chain and geopolitical factors.
• Corn prices tracked rising fertilizer prices through October 2021, then plateaued when natural gas prices – a key fertilizer input – dropped sharply.
• We see little likelihood of fertilizer prices following natural gas lower in the foreseeable future.
• If this scenario plays out, we expect corn prices will rise further in coming weeks or months.

Investment Implications

• Investors can be long corn outright by holding corn futures or buying the CORN ETF.
• Investors who prefer a long/short strategy can buy corn and short soybeans, either through futures or the CORN and SOYB ETFs. Soybeans are less exposed to fertilizer prices.
• More aggressive traders can capitalise on an inverted futures curve for corn (front month trading higher than back months) by either positioning for the inversion to worsen in the short term or looking for opportunities to position for the inversion to normalize.

Amid the many supply chain disruptions and price dislocations of recent months, fertilizer prices have been less noticed. Over the past year, a fertilizer index maintained by Green Markets is up 160%, and urea – a key ingredient – is up 215% (Chart 1). Fertilizer in turn is a key input for many agricultural products, accounting for about a third of operating costs for corn and wheat and about 17% for soybeans and rice.

Yet corn and soybean prices, which initially tracked the rise in fertilizer prices, have been on hold as natural gas prices fell in October.

Is Natural Gas the Problem?

Nitrogen-based fertilizers are manufactured in multiple steps. First, natural gas is combined with atmospheric nitrogen to make ammonia. Ammonia is then converted to nitric acid, which is used to manufacture ammonium nitrate fertilizer and urea-based fertilizer.

Fertilizer prices rose in line with natural gas for the first three quarters of 2021, then gas relinquished half their gains (Chart 1). Fertilizer and urea continued to rally another 8-10%.

Will fertilizer prices soon start falling more in line with natural gas? Not likely: indications now are that supply chain and geopolitical forces are driving fertilizer prices.

• Hurricane Ida halted production at several Gulf-area chemical plants for weeks.
• China exports about 10% of the global supply of urea. Problems with electricity supply have curtailed or stopped production at chemical plants. China has limited exports to ensure its farmers have sufficient supply.
• Russia has also limited exports to ensure its farmers are well supplied.
• Sanctions on Belarus have limited the supply of potash, another fertilizer ingredient.
• Natural gas and energy prices have been far more volatile in Europe than the US, further pressuring fertilizer prices.

These factors are unlikely to reverse soon, which probably ensures fertilizer prices will be slow to follow natural gas prices lower.

What About Corn Prices?

As noted, fertilizer is a significant input for growing corn. Faced with fertilizer prices that have risen far more than corn prices (Chart 2), farmers have the choice of taking smaller margins on their corn harvest; switching some acres to soybeans, which is less fertilizer intensive; or perhaps planting more corn if prices rise.

Farmers will probably try to avoid accepting lower margins but the latter two scenarios are plausible. If farmers plant less, that will put upward pressure on corn prices. And export demand for US corn has been heavy in recent years, especially from China and EM countries with growing populations. Faced with the risk of reduced supply, prospective buyers may start buying futures to lock in current prices.

The most likely scenario in our view is upward pressure on corn prices in coming weeks and months. The key risk to this view is a sharp drop in fertilizer prices before the planting season begins.

How to Position for Rising Corn Prices

There are several possible strategies.

First, buy corn outright, whether through corn futures or buying the CORN ETF, which holds a basket of corn futures.

For investors who want to take less risk, there are two long/short strategies.

First, buy corn futures and sell soybean futures. Alternatively, buy the CORN ETF and sell short the SOYB ETF, which holds a basket of soybean futures. The rationale here is that corn prices will outperform soybeans, either because farmers switch acreage from corn to soybeans or strong buying emerges for corn to lock in current prices. A second strategy is to capitalise on the inverted corn futures curve. Normally, the back months trade at a premium to the front month – normal backwardation in futures lingo. It is very unusual for this relationship to be inverted; it has only happened a few times over the past 20 years, most notably during 2009 when the Global Financial Crisis skewed trading, then 2010-2012 when a strong La Niña weather pattern caused a severe drought that hurt harvests (Chart 3).

The futures curve inverted again earlier this year as natural gas and fertilizer prices started to rise and demand spiked due to drought in Brazil, China demand, and uncertainty about extreme weather. In recent weeks it has started to invert again.

At some point, the futures curve will return to normal. The medium-term trade to capitalize on this is to short front month futures and be long futures four to six months out. However, this trade will underperform as long as the front month future rises relative to the back months – a likely risk in our view.

Given the many variables that will drive fertilizer and corn prices in coming months, a more conservative approach is to position for normalization in steps. Start with a small, short front month/long back month trade, then add to the position in small steps as corn prices rise.

More aggressive traders may consider buying the front month future and shorting the future four to six months out, then reverse the trade once they think the corn rally has run its course.

We stress this strategy requires ongoing, active management!

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)