Ethanol and Its Place in U.S. Agriculture

Transcription

1 Ethanol and Its Place in U.S. Agriculture Bruce A. Babcock Center for Agricultural and Rural Development Iowa State University Presented at the conference, Rising Food and Energy Prices: U.S. Food Policy at a Crossroads, Oregon State University, Corvallis, Oregon, October 2, 2008.

2 Ethanol and Its Place in U.S. Agriculture Introduction U.S. ethanol production is the ready answer for a host of questions concerning agriculture today. Why are the prices of corn, soybeans, wheat, and rice so high? What caused the food riots in Haiti? Why is food price inflation running at 6%? Why are rain forests being cut down in Brazil? Why is the price of land so high? Why is the price of fertilizer so high? One reason why ethanol is often given as the answer to these questions is that federal ethanol mandates and a phenomenal expansion in ethanol production coincided with the large changes that we see happening in U.S. and world agriculture. This answer might get partial credit on an exam. But, of course, the full answer to these questions is much more complicated. And even with all the research that is being conducted on this topic, nobody knows with any precision what the full answer is. But all of this research does give us a general idea of the role that corn ethanol has played and will continue to play in U.S. and world agriculture. The purpose of this paper is to discuss what we know about ethanol s place in U.S. agriculture both today and tomorrow. We know, for example, that if higher crude oil prices are with us to stay, then long-run biofuel feedstock prices will largely be determined by oil prices, regardless of whether current biofuel production and consumption subsidies and mandates stay in place. High crude oil prices signal the world that substitute fuels are needed, and for the time being, a prime source of substitute fuels is biofuels. If we continue to rely on biofuel feedstocks that are used directly to produce food or that are produced on land that would otherwise be producing food, then we will strengthen the direct link between crude oil prices and food prices. That is, food prices will reflect crude oil prices not only in terms of energy used to grow the crops, manufacture the food, and transport and store the food but also in terms of the cost of raw ingredients such as grain, meat, milk, and vegetable oils. Our discussion of this new link between agriculture and energy markets and its impact on agriculture will begin with an overview of what we have seen to date. 1

3 Impact of Ethanol s Expansion on U.S. Agriculture Higher crude oil prices, federal subsidies, and inexpensive corn combined to create a boom in the construction of ethanol plants. Figure 1 shows the phenomenal growth ethanol in capacity. A simple exponential growth curve is not adequate to capture this trend because annual growth rates have actually accelerated over this time, from 14.5% in 2003 to 37.7% in 2008 as of August 26. Another 37.6% increase in capacity is under construction Million gallons Figure 1. U.S. Ethanol Production Capacity on December 31 of Each Year Source: Renewable Fuels Association Until 2006 the increase in demand for corn for ethanol was largely met by a combination of yield growth and a drawdown in stock levels. But in the fall of 2006 it became apparent that the growth in ethanol plant capacity would require a large expansion in corn acreage. U.S. farmers responded to relatively higher corn prices by 1 The growth in U.S. biodiesel capacity has been even more explosive. Annual growth rates in capacity were 85% in 2005, 100% in 2006, and 219% in

4 planting 14% more corn in 2007 and 2008 than they planted on average from 2000 to Higher prices for corn increased the prices of other feed grains also, so farmers responded by planting more barley and grain sorghum. As shown in Figure 2, farmers switched out of cotton, soybeans, oats, and sugar beets to make room for more feed grains and minor oilseeds. Acreage in soybeans would have dropped even more and wheat acreage would have been lower than it was except that acreage double-cropped with wheat and soybeans increased significantly over these two years. Total acreage of all these crops increased by 2.5% (6.3 million acres). 30% 20% 10% 0% -10% Corn Soybeans Wheat Upland Cotton Sorghum Barley Oats Rice Sunflowers Peanuts Canola Sugar Beet -20% -30% -40% Figure 2. Percent Change in Average Planted Acreage in 2007 and 2008 Relative to 2006 Source: Calculated from NASS data. The change in acreage shown in Figure 2 is much greater than has taken place in U.S. agriculture in recent times. One way to measure the degree of acreage switching that has taken place is to sum across crops the absolute value of the change in planted acreage on an annual basis. Such a measure counts a drop in acreage equal to an increase in acreage. As shown in Figure 3, acreage switches in 2007 and 2008 have been much 3

5 greater than any year since Figure 4 puts the recent changes in acreage into a longer historical context by charting changes in acreage back to There have been only three years in which acreage changes have been greater than what occurred in What makes the recent acreage changes different from those in past years is that they are due to farmers responding to changes in market prices. Previous acreage changes were due to changes in government programs. For example, in 1951 cotton acreage allotments were dramatically increased. In 1954, wheat allotments were adopted, resulting in a 20% drop in wheat acreage. In 1983 the government paid farmers to reduce their acreage of corn, soybeans, and wheat, a decision that they reversed in 1984 because of the severe 1983 drought. The relatively large changes in other years were due to changes in acreage set-aside requirements. Figure 4 demonstrates that the agricultural policy changes initially made in the 1996 farm bill and maintained in subsequent bills gave U.S. agriculture the flexibility it needed to respond to the challenge of producing adequate feedstocks for the expanding ethanol industry Million acres Figure 3. Sum of Absolute Values of Year-over-Year Annual Crop Acreage Changes since

6 Figure 4. Sum of Absolute Values of Year-over-Year Annual Crop Acreage Changes since 1951 Figure 5 shows how real (CPI-adjusted) prices received by farmers have changed since Prices in 2008 are taken from the mid-point of the forecast range in the August World Agricultural Supply and Demand Estimates published by USDA. Two things are apparent from Figure 5. First, USDA expects 2008 real prices for corn, cotton, rice, and soybeans to be more than double their levels in Second, prices for soybeans and wheat have increased faster than corn prices, and rice prices have increased almost as rapidly. If all commodity price changes were due to expansion of ethanol, one would think that corn prices would rise the most, followed by soybeans, because soybean production is a direct substitute for corn production. Wheat and rice have little relationship to the price of corn, except that corn prices create a floor for wheat prices. Thus, the recent increase in real prices for commodities is not all due to expansion in ethanol. 5

7 Corn Cotton Rice Soybeans Wheat Marketing Year Figure 5. Index of Real Prices Received by U.S. Farmers Abbott, Hurt, and Tyner 2 examined the causes of commodity price increases and noted that a falling dollar combined with rapidly declining world stocks-to-use ratios since 2000 set the stage for the price increases. While both of these factors would have resulted in somewhat higher commodity prices, the unprecedented price increases in commodity prices were likely triggered by two events and further fueled by a third. The triggering events were a short wheat crop in 2007 and the large expansion in U.S. ethanol capacity illustrated in Figure 1. Export restrictions put in place by some key exporting countries in response to rising prices likely exacerbated the price increases, particularly for rice and wheat. It is not possible to apportion the causes of the price increases shown in Figure 5. But clearly, U.S. ethanol expansion and U.S. ethanol policy are not solely responsible for the changes in commodity prices seen recently. Gathering insight into the effects of ethanol expansion and ethanol policy on the prices of commodities requires some 2 What s Driving Food Prices? Farm Foundation Issue Report, July

8 modeling efforts combined with scenario analysis. Let s start with the impacts of the Energy Independence and Security Act (EISA). Impact of the New Energy Bill On December 6, 2007, the U.S. House of Representatives passed its version of the new energy bill, which was later combined with a Senate version of the bill and was signed by President Bush on December 19. Early December was an important time for commodity prices because the House indicated for the first time that it would include an expanded Renewable Fuels Standard for corn ethanol and a new mandate for biodiesel. On December 1, the price of December 2009 corn was $4.15 per bushel. By January 14, this price had increased to over $5.00 per bushel. The price of November 2009 soybeans increased from $9.51 to $12.40 per bushel over the same period. Corn ethanol use is mandated to grow from 9 billion gallons this year, to 13.2 billion gallons in 2012, and to 15 billion gallons in Accounting for the distillers grain that replaces the corn that is used to produce ethanol, and the expected growth in average yields, this level of production will require 16.2, 23.2 and 25.5 million acres of corn, respectively, to be devoted solely to ethanol production. It seems that when it became clear that the new mandates would become law, farmers and buyers of corn and soybeans knew that future demand for corn would grow dramatically and that higher prices would be needed to induce the required switch in acres. When Will Prices Come Down? As stated earlier, Congress adopted new corn ethanol and biodiesel mandates during a time when world supplies of corn, wheat, and oilseeds were tight. Thus, markets quickly responded by signaling the world s farmers to increase production. This is how commodity markets traditionally work. High prices signal that more production is needed. Hence, high prices are their own worst enemy because increased investment in production capacity and increased production will inevitably result in lower market prices. The temporary nature of high prices is well known to corn, soybean, and wheat farmers. Over the last fifty years there have been only two corn price increases that have 7

9 been sustained for more than two years. The first was from 1973 to 1975 when a combination of short crops around the world and increased export demand dramatically increased prices. The second was from 1979 to 1984 when high corn prices were sustained by supply controls, government-defended floor prices, and drought. Farmers in the United States and around the world have always been able to out-produce the market and government policy. Farmers have a strong incentive to continually adopt cost-reducing and yieldenhancing technologies. Thus, even when prices are low, agricultural supply tends to increase as farmers seek out the seemingly never-ending advances in seed technology, improved pest management, and more productive machinery. When prices are high, farmers have the added incentive to bring more land into production and to plant the crops that bring the greatest economic return. Because farmers have traditionally produced ingredients that are turned into food, the demand for farm products reflects characteristics of the demand for food. World food demand depends primarily on population and income, both of which expand predictably and slowly. When production of food ingredients outstrips the growth in food demand for more than a year or two, prices inevitably decline. The resulting price declines can be large because food demand is quite insensitive to price. There really is only so much food any person can eat. Unceasing supply increases combined with slow and predictable demand growth have resulted in a seemingly inexorable long-run trend of falling inflation-adjusted agricultural prices intermixed with one or two years of high prices caused by unexpected supply disruptions. In agriculture, as with most other commodities, it has not been a question of if price bubbles will burst; it is only a matter of when they will burst. The traditional story of supply eventually outpacing demand and causing farm prices to drop has been historically valid because demand for agricultural commodities is primarily determined by demand for food. But now that agriculture is supplying a significant portion of the nation s fuel, it faces a different type of demand. Simple supply and demand charts will show how this new demand will affect commodity prices. Figure 6 shows the traditional story of the impact of technological progress on the price of farm products. A new yield-increasing or cost-reducing technology shifts the 8

10 agricultural supply curve to the right. Because food demand is price insensitive, a small shift in supply causes a relatively large change in price. Thus, the small change in market-clearing quantity from Qo to Qn causes a large drop in market-clearing prices from Po to Pn. Figure 7 shows that an increase in demand for agricultural products because of biofuels will increase market prices, both with and without technological change. But if the price sensitivity of demand does not change, then technological progress will eventually cause market prices to drop significantly. However, there are strong reasons to think that the price sensitivity of demand by the biofuels industry for agricultural feedstocks is much different than the price sensitivity of food demand. Consider the demand for ethanol as a substitute for gasoline in the U.S. fuel supply. The Environmental Protection Agency (EPA) allows gasoline blenders to use up to 10% ethanol by volume in their blends. Pressure is building by the ethanol industry to induce EPA to allow up to 15% blends. If EPA allows the increase, then blenders will voluntarily blend about 21 billion gallons of ethanol if the BTU-adjusted price of ethanol is less than gasoline. To a rough approximation, at this price, ethanol is a perfect substitute for gasoline. Being a perfect substitute combined with having a small share of the market means that the price of ethanol will not drop rapidly as more ethanol is produced. This, in turn, means that the price sensitivity for corn as a feedstock is much lower than for corn meeting feed demand. The impacts of a more price sensitive demand for corn is shown in Figure 8. 9

11 Original supply Supply with higher yields Po Pn Food Demand Qo Qn Figure 6. Impact of Technological Progress on Price and Quantity if Agriculture Supplies Food Original supply Supply with higher yields Po Pn Food plus Fuel Demand Qo Qn Figure 7. Impact of Technological Progress on Price and Quantity when Aggregate Demand Increases 10

12 Original supply Supply with higher yields Po Pn Food plus Fuel Demand Qo Qn Figure 8. Impact of a Supply Shift when Demand Is Price Sensitive The impact of technological progress with a price-sensitive demand is now much different. A shift in the supply curve now causes a relatively large change in quantity (more of the crop is used in biofuels) and a relatively small change in price. If this is the type of demand facing biofuel crops, then the long-term prospects for the prices for such crops and for crops that compete with them for land is much brighter than we have seen historically. After all, if biofuel feedstocks get too inexpensive relative to gasoline and diesel, then new investment will take place that increases industry capacity, which in turn will increase the demand for the feedstocks, which will boost their prices. Only until the volume of biofuels reaches a much larger proportion of our transportation fuel demand will the demand for feedstocks once again be long-run price sensitive. The price sensitivity of demand for feedstocks in the short run will be quite high if the biofuels industry is operating at or near capacity because it takes time to expand demand by building more plants. But, given the ability to build more plants, and given the regulations and the automobile fleet that can use the biofuels, long-run demand for feedstocks will be quite elastic. 11

13 The Long-Run Price of Corn In the foreseeable future, the price of corn and land-competing commodities will not fall significantly so long as current ethanol policies are kept in place. The reason is that maintenance of the $0.45/gallon blender s tax credit, the EISA mandates, and the ethanol import tariff will ensure continued strong demand for corn. Strong demand for corn will increase the price of soybeans and other crops that compete with corn for land. The key factor determining the price of corn after the 15-billion-gallon ethanol mandate is met is the price of ethanol. A simple supply and demand analysis of three future scenarios provides insight into whether we can expect corn prices to fall. The scenarios are as follows: 1. Elimination of the $0.45 per gallon subsidy given to wholesale buyers of ethanol, the wholesale price of gasoline is $2.50, and ethanol is valued at its energy value. 2. Continuation of the $0.45 subsidy, $2.50 gasoline, and ethanol valued at its energy value. 3. No ethanol subsidy, $2.50 gasoline, and ethanol valued at par with gasoline value. The critical difference between these scenarios is the price of ethanol at production levels in excess of 15 billion gallons. In the first scenario, the additional ethanol will have to compete with gasoline without subsidy, which implies an ethanol price of $1.67 per gallon. This translates into an ability to pay for corn of about $3.12 per bushel. The second scenario adds a $0.51-per-gallon subsidy, which makes the ethanol price equal to $2.18 per gallon and an ability to pay for corn equal to $4.52. The last scenario assumes that automobile manufacturers and blenders optimize fuel pumps and car engines so that fuel mileage does not decrease with ethanol, which implies an ethanol price of $2.50 per gallon and an ability to pay for corn equal to $

14 Price of Corn ($/bu) Corn Supply Curve for Ethanol Demand for Corn by Ethanol Producers Supply Scenario 1 Scenario 2 Scenario Billion Gallons of Ethanol Figure 9. Long-Run Price of Corn under Three Scenarios When the ability of ethanol producers to pay for corn (indicated by the demand curves in Figure 9) in excess of the mandate is less than the price of corn needed by U.S. corn farmers to supply the required corn to meet the mandate (indicated by where the supply curve in the figure intersects 15 billion gallons), then the mandate will bind and the supply price of corn will be $4.00 per bushel. This is what occurs in Scenario 1. If some combination of market demand or additional subsidy to ethanol drives the ability of ethanol producers to pay for corn to above $4.00 at 15 billion gallons, then the mandate will not bind, the long-run price of corn will be greater than $4.00 per bushel, and corn ethanol production will exceed 15 billion gallons. This occurs in Scenarios 2 and 3 when corn supply meets corn demand at 21.5 and 31.5 billion gallons, respectively. The longrun corn price is determined solely by ethanol producers ability to pay for corn in these two scenarios. Note that if the 15-billion-gallon mandate is eliminated, then under Scenario 3, the price of corn will fall to just above $3.00 per bushel. 13

15 Challenges to the U.S. Ethanol Industry The link between agricultural commodity prices and crude oil prices is good news for farmers if crude oil prices stay high. But this link requires a vibrant ethanol industry that is capable of expanding when profitability is high and contracting when profits go negative. The industry faces a number of near-term challenges that could prove troublesome for agriculture. The first problem that will have to be overcome is that we are fast approaching a limit to how much ethanol can be used in our gasoline blends. The EPA allows only 10% blends to be used for cars that are not flex-fuel. Given that it is not practical for the entire U.S. gasoline supply to be blended with ethanol because of transportation bottlenecks, we will likely approach the 10% blend wall within a year or so. Once we hit this wall, the price of ethanol will fall dramatically and production will be scaled back to mandated levels. The industry is lobbying hard for the U.S. government to reconcile their 10% blend rules with a 15-billion-gallon mandate that would violate the 10% rule. There are two ways this policy contradiction can be reconciled: (1) increase the allowable blend percentage; and (2) increase incentives for car manufacturers to produce flex-fuel vehicles. The second potential problem is the concern that linking agricultural prices to energy prices will significantly increase the price of food. One answer to this is to conduct some rather simple arithmetic. Approximately 24% of land devoted to U.S. feed grains will be devoted to ethanol production if the mandated corn ethanol production level of 15 billion gallons is reached in Because the United States accounts for approximately one-third of world feed grain production, the U.S. ethanol industry accounts for roughly 8% of world feed grain supplies. The impact of the industry on feed prices depends on how producers in the rest of the world respond to increasing prices. If the rest of the world s producers increase production by 1% for each 4% increase in price, and the world s use of feed grains declines by 1% for each 4% increase in price, then after all is said and done, feed costs will be 16% higher than they would be without ethanol. The increase in feed costs will primarily affect the cost of raising livestock, except in those countries where people directly consume corn, barley, and grain sorghum. 14

16 A 16% increase in the price of feed grains does not mean that food prices will increase by 16%. For one thing, much of the food that we eat is not affected by feed grain prices. Meat, dairy products, and eggs are the primary food items that will be affected because feed costs make up a significant portion of their costs of production. Of course, increases in feed costs will not affect other production costs and they will not affect costs beyond the farm. The proportion of the price of pork, beef, milk, eggs, and chicken accounted for by feed costs is shown in Figure 10. Multiplying this proportion by the 16% increase in feed prices gives the resulting increase in consumer prices caused by ethanol (see Table 1), assuming that all increases in feed costs are passed along to consumers. As shown, the direct impacts of ethanol on U.S. food prices are likely to be modest. 35% 30% 25% 20% 15% 10% 5% 0% Pork Beef Milk Eggs Chicken Figure 10. Proportion of Retail Price Accounted for by Feed Costs 15

17 Table 1. Food Price Impacts from a 16% Increase in the Price of Feed Change in Retail Price Caused by Ethanol Pork 2.1% Beef 2.5% Milk 3.8% Eggs 5.1% Chicken 3.2% The third problem facing the U.S. corn ethanol industry is whether its product will be judged as contributing to a reduction in greenhouse gas emissions. It is clear that the production of corn and corn ethanol has lower greenhouse gas emissions than burning an equivalent gallon of gasoline. But what is not clear is if the response of farmers overseas to higher market prices caused by diversion of U.S. corn into ethanol production will cause new land to be plowed up. If so, then the carbon released from the tillage of new land should be counted against corn ethanol s reduction in greenhouse gas emissions. Given moves taken by California, the EPA, and Europe to adopt greenhouse gas performance standards for corn ethanol, it is an open question whether corn ethanol will be judged to meet the evolving standards. If it cannot meet the standards, then the link between energy markets and agricultural markets could be broken. 16