Mecardo Analysis - Oil is important to Ag

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By Andrew Whitelaw | Source: CME, Mecardo

Key points

· Crude oil has increased dramatically after an attack on a Saudi Arabian oil facility.

· Diesel prices will likely rise in the coming week as a result of higher crude.

· Higher oil prices can promote higher grain prices.

During the weekend there was an attack on a Saudi Arabian oil facility which has led to a 5% reduction in global oil supply. This has caused reverberations throughout the markets including agriculture. What does this mean for grain producers?

The NYMEX sweet light market posted its largest gain since December 2008 as a result of an attack on a Saudi Arabian oil facility (figure 1). A Yemeni rebel group (Houthi) have claimed responsibility for the attack, however the US government believe the attack was carried out by Iranian forces.

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This attack comes at a time when tensions in the Hormuz strait have been extremely high after several incidents in recent months. The attack has resulted in 5% of global oil output being removed, which will reduce the worlds capacity to cope with any further reduction in supply.

The supply reduction will eventually be met by production increases in other regions, however this may take some time. There is however a likelihood that the market will price in a higher price premium as any further supply shocks will exacerbate the issue.

So how does this impact upon producers? Firstly, and most obviously is with the price of fuel. In figure 2, the NYMEX and Australian diesel price is displayed in A¢/litre. Diesel is a derivative product of oil, when oil moves diesel follows. The correlation between the two pricing points is 0.9, with 1 being a perfect correlation.

Secondly, it is the relationship between oil and agricultural commodities. Our econometric modelling of wheat pricing has shown that oil is a major influencer of price. As an example, high oil prices leads to higher ethanol production. This then increases the price of corn, which flows through to wheat pricing.

What does this mean?

If the current higher price in crude oil is maintained, then Australian diesel prices will increase within the next week. This will impact upon the cost of production for growers as we head into harvest.

It looks like cooler heads are prevailing, however if there is an escalation of hostilities in the middle east then we could see a dramatic rise in oil price. A higher price will test the global economy, with an impact on demand.