Monday, April 04, 2011

The Missing Food vs. Fuel Circuit Breaker

Corn futures have spiked to their highest price of the year, and, as the Wall St. Journal reported over the weekend, to their highest level since 2008, following news that US corn inventories had declined by 15%, compared to a year earlier. The Journal noted that prices were likely to continue rising until demand starts to moderate. Unfortunately, nearly all of that demand adjustment must come from consumers, exports, and livestock farmers. That's because corn used in ethanol production has grown to rival corn for livestock feed as the largest segment of domestic corn consumption, and it has been rendered essentially price-insensitive by government renewable fuel mandates.

It's a mark of the success of the nation's ethanol industry that it has grown large enough to be an important factor in two of the largest markets in the world: the US energy market and the US market for agricultural commodities. Yet despite supplying more than 13 billion gallons of fuel ethanol for blending into gasoline last year--the energy equivalent of 560,000 bbl/day of petroleum gasoline--ethanol hasn't eliminated oil or even gasoline imports, and its effect on pump prices is hard to detect, when gasoline prices are driven mainly by the price of crude oil, which is flirting with $120/bbl for UK Brent crude, the best current global oil-price indicator. However, ethanol's impact on corn prices, though subject to considerable controversy, is potentially much larger when the annual number of bushels converted into fuel must increase each year, even if the corn crop is lower than the previous year's.

That's driven by two factors. The less important of the two is that at the current price of oil, corn looks like a cheap source of oil-substitute. Even at $7.50/bushel, the corn inputs to ethanol work out to around $112/bbl., and after factoring in the $0.45/gal. tax credit that refiners and other fuel blenders receive for its use, that shrinks to $94/bbl. Compare that to wholesale gasoline at $132/bbl. In other words, even with competition for corn driving up ethanol prices, refiners have an incentive to use as much ethanol as they can, and they are, subject to the 10% blending limit for most of the fuel used by the public. Unfortunately for the ethanol industry, which has continued to expand capacity beyond the point at which they could satisfy 10% of US gasoline demand, that market is now effectively saturated, and price competition among ethanol suppliers has constrained their margins. Even ethanol producers such as Pacific Ethanol that emerged from bankruptcy after restructuring their sizable debts are making little or no profit from their ethanol operations.

The bigger factor driving ethanol demand--and thus corn demand-- is the Renewable Fuel Standard enacted as part of the Energy Independence and Security Act of 2007, a bill that was passed by a Democratic Congress and signed by a Republican President. If nothing else, this should serve as a reminder that however desirable bi-partisanship in energy policy is, its mere presence doesn't guarantee collective wisdom. What the RFS did was to layer on an escalating annual ethanol mandate on top of the existing system of tax credits for ethanol blenders and small ethanol producers. Unless ethanol producers could figure out how to get much more ethanol from the same amount of corn every year, which they have done to only a modest extent, this effectively created an escalating corn mandate for the fuel sector. So even if oil was still at $60 or $70/bbl ethanol demand, and by extension corn demand, would not decline with higher corn prices.

The current US ethanol policy has accumulated more distortions than you can shake a stick at, including the unnecessary layering of mandates and incentives, which also entrenches an unproductively high tariff on imported ethanol from places like Brazil that can produce ethanol with much lower inputs of energy than we can. But as competition for tight corn supplies intensifies due to a variety of factors, the absence of some sort of food-price-based circuit breaker in the relationship between corn and ethanol could turn out to be one of the most damaging distortions for US consumers and for people in other countries that depend on US corn exports. It's worth recalling that although ethanol had consumed just 14% of the previous year's corn crop when Congress passed the RFS, compared to the 40% expected this year, that expansion was an entirely predictable consequence of the legislation. For all the talk about the externalities of fossil fuel markets, this seems like an internality that merits a serious reexamination.

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