Ethanol Nose Dives With Archer Daniels Midland Shares

Source: By Andrew Hecht, Motley Fool • Posted: Wednesday, August 21, 2019

The price of ethanol has declined since hitting a high at $1.645 per gallon wholesale in mid-June. As of Monday, August 19, the price of nearby September futures was trading at $1.286 after trading to a low at $1.252 per gallon on August 14 and 15.

In the United States, corn is the primary ingredient in ethanol. The biofuel is blended with gasoline under a mandate from the US government. Therefore, the price of ethanol futures tends to follow both the gasoline and corn futures markets. When the demand for gasoline rises, it tends to push the price of ethanol higher. As corn moves higher and lower, the input for processing the biofuel impacts the price of ethanol. At the same time, the spread between corn and ethanol prices is a critical factor for the companies that process the grain into the fuel. Archer Daniels Midland (ADM) is a leading US agricultural company that processes the grain into the biofuel. On the company’s website it states:

The world is expected to consume 28 percent more energy by 2040 than it did in 2015. In today’s economy, there is a growing need to draw upon cleaner, renewable, sustainable energy sources to meet rising global demand. Renewable energy is the world’s fastest-growing source of energy – expected to double from 2015 to 2030.

Today, biofuels such as ethanol and biodiesel are the leading alternative transportation fuels available to consumers, and ADM is a leading producer of both.

The price of ethanol, gasoline, and ADM shares have been falling over the past weeks. One of the leading reasons for the weakness in prices has been the trade war between the US and China.

Increased volatility in ethanol since late 2018 and declining interest in the market

We have seen wide price variance in the thinly traded ethanol market since late 2018.

Source: CQG

As the weekly chart highlights, after making lower highs and lower lows since late 2016, the price of ethanol fell to a record low at $1.198 per gallon in November 2018. When the price was near the lows, open interest rose to almost 3,000 contracts, the highest level since early 2018. In past years, the metric that measures the total number of open long and short positions in the ethanol futures market on the CME peaked at over 12,000 contracts in early 2012.

The price of ethanol turned higher in late 2018 and exploded to a high at $1.645 per gallon in mid-June 2019, a rise of over 37% from the low. At the same time, the open interest declined to under 1,000 contracts when the biofuel futures were on the high. In a futures market, rising price and falling open interest is not typically a technical validation of a bull market. Over the recent weeks, open interest continued to decline as was at only the 657-contract level as of the end of last week, the lowest since 2007 when the contract was less than one year old. Daily volume has also been falling. Last Friday, only 141 contracts changed hands in the ethanol futures market.

Meanwhile, weekly historical volatility was at the 19.96% level late last year when the price traded to the low. After a dip to 10.48%, the price variance indicator moved to 37.62% after the price peaked and was on its way to the most recent low at $1.252 last week. The volatility measure was at 28.24% as of August 19.

Lifting the E15 ban caused prices to rally – exemptions have the opposite effect

The move by the Trump Administration to lift the ban on summer E15 caused the price of ethanol to move to its high in mid-June. The blend with gasoline is typically 10%. The additional 5% lifted the prospects for demand during the summer months, the peak season for gasoline consumption in the US.

The President lifted the ban because of the ongoing trade dispute with China. Chinese retaliation over US tariffs focused on US agricultural exports. Therefore, the move to increase the demand for corn-based ethanol was a carrot for farmers suffering under the weight of the trade dispute with the Chinese.

Meanwhile, on August 1, President Trump upped the ante by slapping China with another 10% tariff on $300 billion in Chinese exports to the US. The move weighed heavily on the agricultural sector. At the same time, growing fears of a global recession caused crude oil prices to fall and gasoline demand to decline. When it comes to corn, the latest WASDE report showing increases in projections for production and inventories weighed heavily on the price of ethanol futures.

Over the past weekend, Senator Chuck Grassley from Iowa blamed the administration for the decline in ethanol prices when the Environmental Protection Agency granted 31 waivers to small petroleum refineries which exempt them from having to use more ethanol in their products. “They screwed us … when they issued 31 waivers,” Grassley said on August 16. He added, “What’s really bad isn’t a waiver, it’s that it’s being granted to people that really aren’t (in financial) hardship.” Farmers are suffering from a record number of bankruptcies related to the trade war with China. Grassley said the “buck stops at the Oval Office.” Curt Mether, president of the Iowa Corn Growers Association, called the waivers “ridiculous” and a “slap in the face to farmers.” While E15 caused the price of ethanol to rise, the waivers to refineries, some run by Exxon Mobil and Chevron Corporation, had the opposite impact on the price of the biofuel.

Ethanol follows gasoline and corn to the downside

The prices of gasoline and corn have not helped the ethanol futures market over the past days and weeks.

Source: CQG

The chart shows that the price of nearby NYMEX gasoline futures declined from $1.9713 per gallon in mid-July to $1.6596 at the start of this week, a drop of over 15.8%.

Source: CQG

New-crop December corn futures fell from $4.6475 in mid-July to $3.745 per bushel at the start of this week, as they lost 19.4% of value.

The decline in gasoline is seasonal as the peak driving season will end with the summer. In corn, the recent WASDE report and trade war have weighed heavily on the price of the grain. Since mid-July, nearby ethanol fell from $1.609 to under the $1.30 level on August 19 or just under 20%. Ethanol kept pace with corn on the downside. The processing spread remained constant, but the demand for gasoline has dropped, causing the price of the fuel to plunge by over 15%.

Ethanol processing spreads are volatile

The earnings at companies that process corn into ethanol in the United States are highly sensitive to the price action in the corn market compared to the ethanol market. Since ethanol kept pace with corn since the middle of July, earnings should be stable. Ethanol processing spreads can move dramatically over time. The refining spread was working against companies like Archer Daniels Midland when the biofuel fell to a record low in late November 2018 at $1.198. At that time, corn was around the $3.66 per bushel level. However, the rise to the mid-June high in the price of the biofuel took ethanol over 37% higher while corn rallied by just under 27% over the same period creating an improvement in the processing margin. The recent declines in both corn and ethanol took the price of both around 20% lower.

Meanwhile, since late last November, the price of ADM shares has declined steadily.

Source: Barchart

As the chart illustrates, when ethanol was on its low during the week of November 26, ADM shares were at $46.48. The high in ethanol and corn prices in mid-June came as the price of ADM stock was trading at a lower level with the high for the week at $41.72 per share. As of August 19, ADM was trading at $37.99 per share after hitting a low at $36.45 in early August. At the low, ADM shares traded to the lowest level since April 2016.

ADM suffers from the trade, the dollar, and the stock market. The shares are falling into the buy zone – follow the CEO

ADM is a company with a market cap of $21.171 billion. Average daily volume is over 3.8 million per day. The company pays a 3.70% dividend based on its most recent price at $37.99 per share. At 16.37 times earnings, the P/E ratio is low compared to many of the other companies that trade on the stock market these days.

ADM shares are suffering from an almost perfect bearish storm these days. Even a significant rise in the processing spread for ethanol would not necessarily boost the share price in the current environment. The strong dollar is weighing on the company’s international sales. The trade war with China has created an environment where a substantial percentage of the addressable market will not deal with the US company. And, the recent turbulence in the stock market has not helped matters. Attempts by the administration to increase ethanol demand were derailed by exemptions to 31 refineries. During corrective periods, the weakest stocks when it comes to price performance often do the worst. Therefore, it should come as no surprise that ADM shares recently traded at the lowest level in over three years, while the rest of the stock market is not far below its recent record high.

One sign that ADM is a buy around the current share price was news that the CEO, Juan R., Luciano is buying the company’s stock. On August 5, the CEO bought 5,457 ADM shares at an average price of $36.65 per share. On the same day, Ray G. Young, the company’s CFO bought 3,400 shares at an average of $36.74 per share. ADM recently met its Q2 earnings forecast at 60 cents per share.

When insiders are buying shares, it is often a sign that the prospects for the price of the stock are positive. At around $38 per share, ADM is in the buy zone these days. However, I would leave plenty of room to buy at lower levels if the stock market continues to move to the downside over recession fears.

When it comes to ethanol, the price action in the biofuel will continue to be a function of the price action in gasoline and corn markets, as well as policy changes. I believe we have seen the high and the low for a long time in the biofuel, and the futures market has become untradable given the low level of volume and open interest.