Commodity consumers, processors, and producers have recently been affected by increased pressure to reduce carbon intensity as governments commit to addressing sources of climate change and consumer preferences evolve. What’s more, the introduction of an implicit or direct carbon tax is expected to strengthen the connection between—and the potential convergence of—related markets with high greenhouse gas (GHG) emissions.
When previously isolated markets are forced to connect to incorporate the carbon intensity of production, price volatility can reverberate across markets as participants adjust to new price clearing mechanisms. As an example, over the past few years, the renewable-fuels market has seen high levels of convergence, which typically occurs when the price discovery of feedstock is influenced by newly connected energy demand in addition to the traditional demand for feedstock as nutritional supplementation for food ingredients and animal feed.
The scale of the resulting price swings when markets converge can be dramatic and particularly damaging to businesses that are underprepared to deal with them. But industry players that are prepared to identify and capture trading opportunities can establish themselves as early leaders in new profit pools.
This article looks at how certain segments of the agriculture market are connecting to the fuel refining market because of capital investments in production capacity of low-carbon fuels, including corn ethanol and renewable diesel (such as hydrotreated vegetable oils). Such instances of market convergence pose broad implications beyond renewable fuels and across industries, including agriculture, basic materials, chemicals, and energy.
Convergence life cycles: An overview
Shifting market dynamics that determine the prices of gasoline, corn, ethanol, diesel, soybean oil, and renewable diesel provide examples of how related markets can evolve following strengthened linkages established by environmental regulations, such as blending mandates, and capital investments in biofuel production capacity. Many of these examples are at different points in their convergence life cycles because of varying adoption levels, staggered technological developments, and regional regulatory differences.
The US corn market provides a good example of a recently completed convergence life cycle. After the Renewable Fuel Standard (RFS) was signed into law in 2005 and expanded in 2007,1 ethanol production increased, and the corn market converged with the gasoline market. This convergence resulted in corn being priced against gasoline markets during certain periods because ethanol is now blended into 98 percent of gasoline in the United States.
By contrast, an example of an early-stage convergence is the soybean-oil market, recently influenced by energy markets due to its importance as a feedstock for renewable diesel. Renewable diesel is a drop-in biofuel that is chemically identical to petroleum diesel fuel and can be used in existing petroleum pipelines, storage tanks, and diesel engines. Its production accelerated as a result of California’s Low Carbon Fuel Standard (LCFS), which seeks to reduce the carbon intensity of the state’s transportation fuels and provide an increased number of renewable alternatives to petroleum.2
Many other states are implementing or considering standards like the LCFS, and further growth of the renewable-diesel market is expected to drive considerable industry investment in the years to come. Both new and existing energy players are more aware that they need to respond to increasingly volatile markets. In thinking through which segments of the market are likely to be affected by converging energy markets, participants will likely need to address several challenges.
For example, renewable fuels are destined to compete with electric-vehicle batteries, hydrogen, and traditional petroleum fuels for transport-sector demand. And supply and demand in renewable fuels will drive prices in the context of similar dynamics in competing sources of energy. The degree to which this happens will be a function of shifts in supply and demand, which could be caused by blending regulations, tax credits, investments in production capacity, or price elasticity of competing demand, such as agricultural demands for corn or soy.
Further complicating matters is the application of carbon taxes and the impact of a carbon-trading market that efficiently allocates carbon credits to the most effective part of the renewable-fuels market. Government policy could amplify some of these effects because it will determine incentives, taxes, and, in some cases, the scale of each energy source in the transport sector. And power generation and traditional oil and gas could be affected by increased investment in hydrogen in the years to come.
Converging energy markets: Findings and implications
Since the Paris Agreement signing in 2015,3 many countries around the world have made commitments to reducing GHG emissions as quickly as possible, with a larger goal of reaching net-zero emissions by 2050. As the growth of renewable fuels continues, new or changing regulations and advancements in renewable-fuel technologies could lead to new market shifts. Each of the following sections focuses on use cases for corn and ethanol and soybean oil and renewable diesel to illustrate market convergence, volatility ratios, and market shifts.
Government regulations can lead to convergence
Since 2005, the corn market has been converging with the gasoline market as ethanol becomes increasingly important in the broader energy market (Exhibit 1). Since ethanol produces significantly lower GHG emissions than gasoline, blending the two fuels reduces emissions compared with traditional gasoline. In addition to the original RFS rules, bans on methyl tert-butyl ether (MTBE) in the United States increased ethanol consumption. Ethanol was the only price-competitive and widely available substitute for MTBE, an oxygenating agent that was commonly used to improve gasoline octane and that accounted for about one-third of US gasoline demand. When MTBE was banned, producers had to switch gears nearly overnight to replace MTBE with ethanol.
Broadly, the price discovery of corn before 2005 was driven by leading agricultural indicators of supply and demand for food ingredients and animal feed. Common supply factors included yield improvements from seed breeding and crop protection, federal crop subsidies, the effects of weather patterns on yield, planting progress, harvest timing, and inventories at the end of a crop year (otherwise known as carry-out). Determinants of food and animal feed demand included livestock population statistics, such as the USDA’s Cattle on Feed survey4; competitiveness of substitute sources of carbohydrates such as wheat; forecasts of Chinese grain imports based on household wage growth and modernization of livestock producers; and shifts in consumer preferences, such as the expected displacement of sugar demand with high-fructose corn syrup.
Concurrent with rising ethanol quotas from the RFS and rising crude oil prices, the corn market began to converge with the gasoline market, resulting in the break-even price of converting corn to ethanol becoming an implied price floor for corn. US domestic ethanol usage tripled from four billion gallons in 2005 to more than 12 billion gallons in 2010, and the integration of ethanol into the US gasoline supply drove the convergence of the corn and gasoline markets. This event expanded the price drivers for corn to include traditional supply-and-demand forces along with the macroeconomic drivers of ethanol and the broader energy market.
Throughout the 2010s, California’s adoption of, and amendments to, the LCFS increased the growth of renewable diesel, renewable natural gas, and biodiesels, including vegetable oils, animal fats, and used cooking oils (Exhibit 2). Renewable diesel and hydrotreated vegetable oils are chemically the same as petroleum diesel fuel, meaning they meet the Standard Specification for Diesel Fuel Oils (ASTM D975) and can be used in existing petroleum pipelines, storage tanks, and diesel engines. The blending of biodiesel (such as SME5 and FAME6), however, is limited and seasonal and presents usability challenges.7 Many established renewable-diesel players are facing new competitors, some of which have plans to convert their units or to build new units to produce renewable diesel.
The growing mutual dependence of these two commodities has led to a convergence of the soybean-oil market with diesel and larger energy markets. If the progress of this convergence is similar to that of the corn and ethanol convergence, the soybean-oil market could be determined by both its agricultural value and its energy value.
Once connected, market natures can change
As markets mature through the convergence life cycle, their natures can change. These market changes could manifest in the soybean-oil and renewable-diesel markets as the convergence relationship matures.
The growing influence of the price of ethanol can be seen in the break-even relationship between corn and ethanol. This price relationship was established as ethanol production levels increased in the late 2000s. Due to both the cyclical and volatile natures of the energy and corn markets, both drivers led corn prices at varying times. Our analysis shows that during the convergence life cycle (post-2007), corn alternates between the influences of agricultural fundamentals and energy fundamentals (Exhibit 3). When markets are in an energy-driven regime, the energy and corn markets are converged. More specifically, during the non-convergence period, from 2016 to 2020, low and stable energy prices allowed corn fundamentals to be the main driver of corn price behavior. In contrast, convergence in 2021 brought an energy bull cycle that has been identified as a potential upward driver for the price of corn.
Patterns in volatility also shift during the convergence life cycle (Exhibit 4). When markets first converge, and as the consequent uncertainties cause prices to swing, there is an early period of increased volatility. Eventually, this volatility peaks and gives way to late-stage decline.
These changing market dynamics and relationships are similarly reflected in the correlation of the two markets. Prior to 2007, gasoline and corn spot markets showed virtually no correlation (Exhibit 5). During the ramp-up of ethanol production between 2007 to 2010, analysis shows a large rise in correlation, which peaked in 2011. The following period, post-2016, is characterized by a decrease in correlation—but one that is materially higher than pre-convergence levels.
Regarding soybean oil and renewable diesel, publicly announced industry investments signal that the industry is building infrastructure to meet expected demand. For instance, Platinum Crush plans to invest $350 million in a new soybean-crushing plant in Iowa,8 and ADM has announced plans to invest the same amount to construct a new plant in North Dakota.9 In addition, regulations similar to LCFS are set to expand to regions outside of California. For example, Oregon currently has a Clean Fuels Program, and Washington, Colorado, South Dakota, Minnesota, New York, and Iowa have all proposed or launched studies to explore adoption of LCFS-type regulations for their states. Finally, Canada’s Clean Fuel Standard is currently in progress, with regulations targeted for publication later in 2022.
If the new convergence relationship holds, the relationship between corn and ethanol suggests that the volatility of soybean oil may also increase due to the influence of diesel. Similarly, the soybean-oil market could enter periods when the price is driven by diesel and periods when the price is driven by soybean-oil fundamentals.
Market shifts can create new opportunities and risks
In 2011, long-standing ethanol federal tax credits were allowed to expire. The tax credits, which amounted to nearly $6 billion in 2011, typically went to independent fuel wholesalers that mixed ethanol with gasoline. A tariff on imported ethanol also expired at the same time. As the expiration of these policies became more certain, ethanol spot prices dropped more than 20 percent in November 2011, the final month of support.
The US Environmental Protection Agency is responsible for setting fuel-blending mandates, such as those found in the RFS, and historically has adjusted these mandates as necessary. Biofuel supporters and the oil industry closely watch these decisions.
Similarly, government regulation is likely to continue evolving in response to the current expansion of renewable-diesel production (Exhibit 6). Since renewable diesel is a replacement product for petroleum-based diesel, demand is projected to expand. Given the uncertainty about soybean capacity growth and its secondary effects, future regulations could curb the expansion of soybean acreage. Regulation and subsidies provide incentives for capital investments in production capacity to convert crops to fuel. Once capacity is built, a long-lasting price floor is established at the breakeven between hydrotreated vegetable oils or corn ethanol and feedstock commodities. All that is needed is marginal profit because fixed costs are sunk. The greater the capacity, the stronger the linkage and the more quickly excess stocks of corn or soy can be converted to fuel and burned. This dynamic increases the likelihood of a lower feedstocks-to-use ratio for corn and soybeans because large bumper crops reduce prices below breakeven, eventually eliminating reductions.
Seizing the market convergence opportunity
Producers, processors, and buyers of agriculture and energy commodities should consciously manage price risks as markets converge. However, doing so requires making tough decisions about capturing the trading margin. A company’s approach should be informed by the company’s asset portfolio and depth of physical trading expertise, especially relative to its peers.
The following three actions can help players calculate risk and seize the market convergence opportunity:
- Pursue joint-venture partnerships. Partnerships between energy and agricultural players can quickly leverage each player’s distinctive advantages, such as access and trading expertise in their complementary markets, established networks of assets along each partner’s supply chain, and market intelligence that can identify new opportunities when integrated across both domains.
- Develop new commercial skills to combat volatility. Past examples of convergence life cycles have shown that market participants become exposed to more volatility as the energy component of feedstock influences agricultural product pricing. Traditional oil and gas players will have to develop new commercial skills in the agricultural space. Players that sufficiently advance their commercial capabilities within both energy and agricultural markets can establish a competitive advantage that will enable them to capture new trading profit pools in both markets.
- Monitor risk. Volatility resulting from market convergence and shifts in supply and demand creates different upside and downside risks based on a company’s asset footprint and volumetric position. Regulatory changes that cause abrupt price shifts in markets through unexpected changes in demand (such as through blending mandates) or supply (such as through export bans) can be particularly difficult to anticipate. Market participants that have equipped their teams with the capabilities to adequately model the risk/reward and financial implications of risks will have a significant advantage. These companies can more quickly decide which opportunities justify the deployment of their risk capital and how much capital they can deploy while remaining within predefined financial and operational constraints.
The global energy supply is changing, and so are fuel sources, regulations, and subsidies. Few industries will be unaffected. Understanding the convergence events that have occurred over the past decade is the first step in preparing to navigate future market transitions. And planning today will enable companies to better mitigate risks and capture opportunities in both early- and late-stage market convergences in the years to come.
