Ethanol demand, like oil demand, likely to last

(from an article “Is Ethanol Sitting on A Bubble?” By Christine Stebbins, published by Reuters news service)

Grain farmers in the Midwest may want to pinch themselves.

In recent years they have been buoyed by a dream scenario. Record high prices. Record high profits. Record high farmland values. Near record production. Farm debts paid off.

“Historically agriculture has been asset rich, cash flow poor, profit poor. This time we are asset rich and profit rich. That makes for a very combustible brew,” said David Kohl, professor emeritus of agricultural economics at Virginia Tech.

“It’s a super cycle. It’s only happened four times in the past 100 years,” Kohl told U.S. agricultural bankers at their annual meeting this month.

But can it last?

Analysts often cite the rise of China and India as the main driver of the boom, with their hundreds of millions of hungry and wealthier consumers lining up at the table for grain from the United States, the largest food exporter in the world.

But the single biggest consumer which has changed the game in farm country in recent years is closer to home: ethanol.

The alcohol-based fuel has, in less than a decade, gone from consuming less than 10 percent to currently 40 percent of the giant U.S. corn crop.

That enormous slice of the pie — which exporters and starch makers and food processors and livestock feeders must also still fight for — is the key to the recent farm boom.

“That is a huge factor” and likely the single biggest cause behind the surge in corn prices and farm income, according to Leland Strom, chief executive of the Farm Credit Administration, regulator of the government-linked Farm Credit System, the largest real estate lender to American farmers.

The dynamic has been simple. The 2007 U.S. energy bill mandated that a total of 15 billion gallons of renewable ethanol must be produced by 2015 for energy independence. Almost all that fuel is “blended” with gasoline.

Demand for corn skyrocketed, with prices of corn and then corn land following it up. Other grain prices have risen just to assure that farmers don’t all switch to corn. Farmers have reaped the benefits, as have their suppliers from John Deere to Monsanto to fertilizer producers to land auctioneers.

“There are a lot of people betting a lot of money on land right now. Land wouldn’t be going for $9,000, $10,000 an acre in the Corn Belt unless people were convinced that corn prices were going to stay strong,” said Bruce Babcock, director of Iowa State University’s biobased industry center.

But will corn prices stay strong? More to the point, will ethanol prices? And if they don’t, will the bubble burst?

Confidence in ethanol is being tested in the current U.S. budget environment, where Republicans in Congress have been pushing for major cuts in spending that include long-standing subsidies and incentives for ethanol production.

A blenders tax credit and a tariff on ethanol imports are set to expire on January 1, 2012. Most experts do not expect either to be renewed given Republican-led budget pressure.

But the mandated use target remains 12.6 billion gallons of ethanol in 2011, peaking at 15 billion by 2015, or roughly 10 percent of the fuel burned by cars and light trucks.

FINE-TUNING OR PLAYING WITH FIRE?

“There is currently fine tuning going on in policy. We anticipate the blender’s credit is going away at the end of the year but the mandate is still going to exist to blend. It’s not going to change the amount of corn we’re blending,” Strom told Reuters in an interview.

“It would take a major shift away from the mandate to have a strong effect in challenging these corn prices and the demand for corn,” he said.

As for the lending stance of FCS to farmers who may be seeking loans to buy more land to plant corn?

“I’m not ready to term it an asset bubble. I think we are in an era that warrants extreme caution by those in the industry, the farmers or investors who are purchasing land,” Strom said.

If ethanol is the key to corn prices and land prices, then experts say crude oil remains the key to ethanol.

“A bubble implies it’s going to burst some time and the farm economy would go into the tank — or the ethanol bubble will burst,” Babcock said. “Demand for ethanol derives primarily from the price of crude oil. As long as crude oil is high, the demand for ethanol is going to be high and agriculture is not on a bubble.”

(Graphic: corn vs crude oil, ethanol: link.reuters.com/fuc25s)

But Babcock and others, including ethanol producers, also say $30 billion in investment and growth in ethanol in recent years has changed the outlook. Ethanol producers, for instance, now export almost 1 billion gallons a year, mostly to Brazil where sugar-based ethanol is common.

“If you let the free market work and crude oil fell substantially,” Babcock said, “you would still have a robust ethanol industry. Why they would stay in business is that the price of corn would fall. That is their number one cost.”

Kohl also sees ethanol on solid ground without subsidies: “Much of the industry could survive. If it went away four years ago it would have had a big impact. Today, much less.”

Ethanol producers cite the benefits of lower corn prices. But there is also a subtle political factor for those in Congress: corn is grown in most U.S. Congressional districts, where farmers have reaped the dream scenario of ethanol.

“The ethanol industry has rejuvenated rural America,” said Todd Becker, head of Omaha-based Green Plains Renewable Energy. “We bring high paying jobs back to small towns. It has huge impact on the local community. The brain drain out of rural America has been incredible. We’re able to bring it back with good, high paying jobs,” Becker said.

Kohl also said though lower ethanol and corn prices would hurt all those now benefiting from the farm boom, farmers would be in far better shape for a downturn now than 30 years ago when the last big farmland bubble burst in the 1980s.

“Today we have an asset bubble, we don’t have the credit bubble like we had in the 1980s,” Kohl said in an interview. “The owner has more skin in the game, has plowed their profits in. So when that corrects … they have resilience through the equity.”

Our Take:
The farm economy and energy markets have been inextricably linked for a while now, but ethanol forges that link in the strongest possible way. We have an ethanol industry that can stand on its own now, say the experts—thanks to the inherent fiscal conservatism of farming with its waste-not/want-not pragmatism.

At this point, if oil prices fall, all commodities will follow, including corn, which would help the ethanol industry to healthier margins. To the extent that corn farmers are invested in ethanol production, this will work as a hedge.

The key for farmers is to be extremely cautious about the current price of land. Since farmers have taken the profits of the last few years and invested these in land and capital equipment, they won’t face the same kind of bust from falling prices that created the credit crisis of the late 1980s. So say the experts quoted by Reuters. Knowing that all markets, including farm commodities, have always been cyclical, caution is always warranted.

With all these elements lined up favorably for farmers, the one major element beyond their control is public policy regarding farm-based energy. Ethanol can stand without subsidies, unlike the oil industry. But to compete with oil’s virtual lock on the transportation fuel market, the one thing ethanol needs is a guaranteed floor, a minimum required use. We are convinced that a tipping point will be reached—when say the 20 millionth flexible fuel vehicle hits the road and higher level ethanol is available at say ten percent of the nation’s fueling stations, then ethanol will be able to compete with gasoline on price alone.

Until then, Congress needs to realize that a lot of agricultural jobs and wealth are tied up in today’s renewable energy policy. To end the RFS would pull the rug out from under rural main street businesses and private family budgets across the US farm belt and beyond. People whose employment or wealth comes not only from farming, but also from equipment manufacture or agricultural tech providers like Monsanto and Pioneer—many millions of Americans would experience terrible losses without the renewable energy requirement that contributes to the value of today’s agricultural production.

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