Ethanol Featured Articles
The Role of Biofuels and Other Factors in Increasing Farm and Food Prices
Written by Keith Collins, Ph.D. (economic advisor, Keith J. Collins LLC) as supporting material for a review conducted by Kraft Foods Global, Inc. of the current situation in farm and food markets.Executive Summary
Farm and Food Price Increases. Farm-level prices have increased sharply over the past two years. The index of prices received by farmers for all farm products increased by 34 percent over the period January 2006 through May 2008. The index of prices received for feed grains and hay, led by surging corn prices, increased by 144 percent over that period. High prices for farm products have led to significant retail food price increases, rising 4.9 percent during 2007, the highest increase in 17 years.
Factors Behind the Increases. Many factors are contributing to higher farm-level and retail food prices. They include: (1) strong global economic growth, thereby increasing demand for U.S. commodities; (2) the declining value of the dollar, although recent real trade-weighted exchange rates suggest that the weakened dollar has been less important to corn and other key crops; (3) reduced supplies of some crops, such as wheat and rice, due to adverse global weather; (4) higher energy prices that have increased farm production costs and food processing and distribution costs; (5) changing foreign agricultural policies that insulate countries from higher global prices; (6) increased investment by index funds and other managed investments that probably have increased price volatility but are not likely to have sustained effects; and (7) biofuels, particularly corn-based ethanol. Biofuels have been a major factor for feed grain and livestock markets, with corn used in ethanol rising from 2.1 billion bushels in 2006/07 to an expected 4.0 billion in 2008/09. This increase in corn for ethanol production exceeds the entire expected increase in total corn demand over this period.
Role of Ethanol. The expected increase in corn used as a feedstock in ethanol plants from 2006/07 to 2008/09 is equivalent to the production of corn on about 12 million acres. The increase in corn demand due to ethanol is rising faster than growth in corn yields per acre. So long as that situation continues, corn will have to attract acreage from other crops to meet its expanding demand. This shift will mean higher prices for all crops that compete, directly or indirectly, for acreage with corn. The market projects a continually tight corn supply and demand balance for the next several years, evidenced in current high cash prices and futures prices for the next several years.
This paper reviews various studies that have examined the relationship between corn used in ethanol production and corn prices. They suggest increased corn demand for ethanol could account for 25 to 50 percent of the corn price increase expected from 2006/07 to 2008/09. Another analysis presented in the paper suggests that ethanol could account for 60 percent of the expected increase in corn prices between 2006/07 and 2008/09 when market demand and supply are inelastic with respect to price—i.e., a period when stocks are very low, feed use is slow to respond, export demand is strong due to foreign agricultural policies, and acreage is very constrained.
Ethanol drivers. There are two important factors that have increased the price of ethanol. First, high crude oil prices and correspondingly-high gasoline prices have helped establish the current level of ethanol capacity. Second, Federal biofuels policies are encouraging continued ethanol production even with record-high and steadily rising corn prices. The ethanol tariff limits U.S. access of foreign supplies; the tax credit enables ethanol producers to pay the equivalent of up to $1.43 more per bushel for corn used as feedstock; and the Renewable Fuel Standard (RFS) mandates steady, undeviating annual increases in ethanol demand. These requirements must be met regardless of what happens to the prices of oil, ethanol, or corn. The RFS is likely to be an increasingly important factor in determining the direction that ethanol and corn prices will take over the next several years. The rate-of-return received by ethanol plants has been declining over the past year as corn prices have increased, and ethanol prices, excluding the tax credit, have declined to a level that reflects their energy (BTU) value relative to gasoline prices. Without Federal biofuels incentive programs, it is increasingly likely that the RFS levels of ethanol production would not be realized with this year’s expected decline in corn supplies.
Extraordinarily Low Feed Grain and Oilseed Stocks. With Federal biofuels programs assuring future expansion of corn for ethanol production, the corn and soybean supply/demand balance is expected to be very tight. Unless quantities demanded for exports, feed, seed, and food uses drop below the recent average levels and/or acreage expands beyond similar levels, corn and soybean inventories will fall to historic lows. These reserves provide the industry with a cushion to protect against low yields and adverse weather. Without sufficient reserves, any disruption will result in significant price increases, placing all users at substantial business risk, including livestock and poultry producers and many ethanol plants.
Food Price Effects. The increase in farm-level prices has contributed to higher retail food prices, which were up 6.9 percent at a seasonally-adjusted annual rate during the first 4 months of 2008. This increase compared with a 4.9 percent increase during 2007. Food price increases have exceeded forecasts, and many studies offer various conclusions about the causes for these increases and the prospect of future food prices. Higher energy prices, overall inflation, and biofuels are major contributors to recent food price increases. This latter factor – biofuels – is likely to have more of an impact over the next few years as meat production slows due to higher feed costs.
One way to gauge the potential increase in food prices due to biofuels is to estimate the increase in costs for livestock producers and other U.S. users of feed grains and oilseeds. If these costs are fully passed on through the food chain, they eventually will be reflected in higher retail food prices. For example, assume, as this paper suggests, that 60 percent (or $20 billion) of the expected increase in feed grain and oilseed product costs between 2006/07 and 2008/09 is accounted for by biofuels. These increases, in turn, translate into increased U.S. personal consumption expenditures on food, over a 2-3 year period, of 1.8 percent. While 1.8 percent may, on its face, appear small, it must be viewed in the context of the long-term annual average increase in food prices of about 2.5 percent per year. Thus, the increase in retail food prices due to biofuels is estimated to be 23-35 percent above the normal increase in food prices that would occur over 2-3 years. Accordingly, biofuels is now becoming a significant factor in higher food prices.
Policy Options. There are several global options for addressing extraordinarily low commodity stocks and higher farm and food prices. Governments could take actions to increase worldwide food production and increase investment in agricultural research and adoption of biotech seeds and other technologies. U.S. Federal biofuels policy could also be reconsidered.
As discussed, with ethanol plant margins declining over the past two years and corn prices soaring, tax credits and the RFS mandate will increasingly keep ethanol production capacity expanding, plant utilization high, corn prices rising, livestock producers under stress, and pressure on food price inflation. Government support for corn-based ethanol ensures a permanent, significant, and increasing demand for corn. These policies interfere with the normal price rationing function of markets when supplies are short. This is the situation today with production being reduced by flooding and excess moisture. In this “short-crop” environment, biofuels policy, including the RFS mandated use, causes even higher corn prices, eliminates the need for ethanol producers to adjust production based on market conditions, and shifts that burden to other users of corn (e.g., the livestock sector), and puts continuing pressure on retail food prices.
Therefore, the Federal Government should give serious consideration to whether (1) biofuels programs should be permitted to intervene significantly in corn and soybean markets, or (2) consumers, acting through market forces, should be the primary mechanism for allocating crops between food and fuel uses, with Government-supported biofuels programs functioning only as a safety net for biofuel producers.
Figure 1 illustrates the price history and includes USDA projections and futures prices as of June 10, 2008 (USDA, WASDE). During the 1974 crop year as global grain demand increased sharply, season-average corn prices received by farmers set a then-record high of $3.02 per bushel. Two years later, however, prices averaged $2.15, a decline of nearly 30 percent.
In the 1980 crop year, the next record-high corn price was set at $3.11 per bushel when weather reduced corn yields. Again, two years later, corn prices averaged $2.55, nearly 20 percent lower.
In 1983, low yields again pushed corn prices to another record high at $3.21 per bushel. But prices declined 30 percent to $2.23 two years later.
In 1995, the next record-high corn price was reached at $3.24 per bushel, as weather again reduced production. This record prevailed until 2007. But three years after the 1995 record was achieved, corn prices had fallen 40 percent to $1.94 per bushel.
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June 2008
