Monitoring the Upsurge of Biofuels in Commodity Futures Markets

Abstract

This paper investigates interaction between energy and agriculture futures prices shedding lights on the recent upsurge of biofuels. We propose the correlation model of price returns between energy and agriculture taking into account biofuels. The empirical studies on the DJ-AIG commodity indices document that the increase of correlations between energy and grain price returns occurs during high energy price periods, which supports the correlation model. By using petroleum as energy and both soybean and soybean oil as biofuels, we show the sharp rise in the correlations after year 2004, which may correspond to the recent upsurge of biofuels. In addition, we examine the relationship between petroleum and three agricultural sources of bioethanol: sugar, wheat, and corn. It is shown that except corn there exist the increasing correlations of the agriculturals with petroleum. The exception may stem from the different profiles of corn comparing to sugar and wheat such as well-diversified use of corn and low production efficiency of corn as bioethanol. Finally, we offer an illustrative example that the increasing correlation between energy and agriculture is useful for generating profits by applying pairs trading to commodity futures markets.