Friday, July 20, 2012

Food vs. Fuel and the Midwest Drought

It was bound to happen.  As long as US corn output continued to climb year after year, the federal mandate to blend steadily increasing quantities of ethanol into gasoline could be accommodated without creating a shortage of this staple grain.  Unfortunately, crops are subject to all sorts of uncertainties, including the severe drought conditions that the middle of the country is experiencing this year.  Estimates for this year's corn crop have been revised downward, and corn prices have already broken through $8 per bushel, up from less than $6 a month ago, with consequences for the livestock, processed food and ethanol industries, as well as for export markets.  As soaring feed grain prices begin to translate into higher grocery prices for meat, poultry, dairy and other goods, will consumers demand relief from the EPA, which has the authority to curtail ethanol volumes?  The current betting appears to be that the administration will stand fast on the mandate, but anything can happen in an election year. 

Ethanol now accounts for at least 10% of US gasoline blending, by volume.  To meet that demand, ethanol producers will require around 5 billion bushels of corn.  In recent years, the ethanol industry's expanding corn demand was met by a combination of increasing yields and planting more acres in corn.  However, corn yields per acre are dropping sharply this year, potentially pushing output below last year's 12.4 billion bushels, if conditions don't improve soon.  That's in contrast to earlier expectations that this year's corn crop would exceed last year's by 20% .  This isn't the first time that the food vs. fuel trade-off inherent in crop-based biofuels has become an issue, but it might be the first time when both the demand for corn for ethanol is so high and the need for that ethanol in the gasoline blending pool is arguably so low.  In this context, food vs. fuel quickly boils down to a debate over the tangible benefits of corn-based ethanol as a fuel.  There's growing evidence that those benefits have been oversold, despite industry claims.

Start with the widely touted study from Iowa State University indicating that ethanol saved consumers $1.09 per gallon at the gas pump in 2011 and $0.89/gal. in 2010.  I read both the original study and its updated version when they came out.  It seemed obvious to me that the authors' grasp of gasoline markets and oil refining were inadequate, but I lacked the time necessary to dig through their math to uncover the source of their exaggerated results.  Fortunately, a pair of researchers from MIT and my alma mater, U.C. Davis, have now done that work and concluded that the Iowa State paper's findings--and the claims based on them--depended on a "spurious correlation": the relationships they saw were coincidental.

In contrast to the Iowa State studies, the MIT/Davis paper is very readable, and I recommend it to you.  In addition to debunking the statistics, the authors point out the key flaws in their counterparts' logic.  Foremost among these is that in order to have a large influence on gasoline prices, ethanol would have to have had a large impact on crude oil prices, which are the largest determinant of gas prices, by far.  From 2005-11 US ethanol production expanded by 10 billion gallons per year, the energy equivalent of 350,000 barrels per day of oil, or 0.4% of 2011 global oil supply. I've argued many times that the oil market responds disproportionately to modest changes in supply and demand, but the idea that a few hundred thousand barrels per day could translate into the equivalent of $45/bbl exceeds the wildest dreams of any trader I ever met.  The MIT paper concludes with the authors summarizing the likely impact of ethanol on gasoline prices as "near zero and statistically insignificant."

However, if ethanol hasn't done much to hold down gas prices, could a drop in US ethanol production resulting from paring back the ethanol mandate to reduce the pressure on corn prices cause a big spike in gasoline prices?  That's where the analysis in a paper presented to members of Congress yesterday comes in.  Dr. Elam's report suggests that rather than displacing imported crude oil, the main effect of increasing US ethanol use in fuels has been to divert domestic gasoline production into exports, while US crude imports have fallen based on a combination of lower demand (from the recession) and improved product yields per barrel of crude oil refined.  Even if you are inclined to be skeptical of these findings because the study was supported by poultry interests, data from the US Energy Information Agency and elsewhere show that US refineries are not fully utilizing their capacity, are exporting significant volumes of gasoline, and have a wider array of domestic and imported crude oils at their disposal than they did just a few years ago. In short, we're in a far better position to forgo a few billion gallons of ethanol this year than we would have been in 2008, the last time food vs. fuel concerns spiked along with gas prices. 

Corn growers have experienced droughts before, and in the past the price of corn sorted out who needed it most.  However, the market can't prioritize fairly among the competing calls on a drought-diminished corn crop when the single largest segment of demand is locked in place by a federal mandate. This represents a massive distortion that only the government can rectify. I'm sympathetic to the ethanol industry's dilemma.  After all, the federal government virtually begged them to overbuild capacity, but it couldn't guarantee they would earn a profit, even when it was providing a $0.45/gal. subsidy for their customers, who are required by law to use their main product.  However, the economic and environmental benefits of ethanol are too modest to shield this industry while forcing all other corn users to absorb the likely shortfall in corn supply.  The most sensible remedy would be to unshackle ethanol demand, at least temporarily, and waive at least a portion of the ethanol mandate for 2012-13.