Written January 2010

Gregory McKee, PhD                                                                                                   
Department of Agribusiness and Applied Economics
North Dakota State University

Gary W. Brester, PhD
Department of Agricultural Economics and Economics
Montana State University

Joel Schumacher, MS
Department of Agricultural Economics and Economics
Montana State University

This report was funded by the AgMRC.



Abstract:

The ethanol industry in the Upper Great Plains (Minnesota, North Dakota, South Dakota, and Montana) is supported by a combination of Federal and State subsidies.  Federal subsidies have recently been reduced, and some State Legislatures in the Upper Great Plains are considering reducing their subsidies as well.  This report analyzes the economic effect of removing State subsidies on the profitability of ethanol production, local corn prices, and corn producer well-being in these states.  In practice, State subsidies are relatively small.  However, given recent marginal profitability levels, the elimination of State subsidies could cause older, smaller plants to cease operations.  We consider the effects of closing 8 plants in the Upper Great Plains on corn prices and find that prices at these locales could decline between $0.05/bushel and $0.18/bushel depending upon location, and by about $0.01/bushel at some regionally adjacent ethanol plants.  As a result of these price changes, corn producer surplus would decline by $9.4 million which is approximately 0.25% of the total value of corn production in the four-state region.

Key words: ethanol, subsidy, basis, equilibrium analysis, returns over variable cost

Economic Impacts of Eliminating State Ethanol Production
Subsidies in the Upper Great Plains

Section 1.  Introduction

The U.S. ethanol industry has received subsidies from Federal and State governments in recent years.  Federal ethanol tax credits were first established by the Energy Tax Act of 1978 and remain the most significant subsidy for the ethanol industry.  In recent years, the value of this subsidy has ranged between 1/3 and 1/6 of per gallon ethanol prices.

State subsidies are generally smaller than Federal subsidies.  In addition, many State incentives are not directly tied to ethanol production levels (The Economist, 2007).  The ethanol market has matured significantly in the past decade with the construction of many new ethanol production facilities and the expansion of older facilities.  Many States competed with each other to attract these new facilities, and many used a variety of state-based incentives as a competitive advantage to this end.

All subsidy programs represent a transfer of income from taxpayers to the recipient of the subsidy.  Recently, legislatures have considered reducing ethanol subsidies because of budget deficits or changes in policy goals.  For example, the Federal Ethanol Tax Credit was reduced from $0.54/gallon to $0.51/gallon between 2005 and 2007.  In 2007, the U.S. Congress voted to further reduce this credit to $0.45/gallon as of January 2009.  In addition, a recent report suggests that the tax credit may no longer be needed to stimulate ethanol production because of the maturation of the industry and the possibility that sufficient production capacities will be available to meet the goals of the Federal Renewable Fuels Standard (GAO, 2009).  States are also considering reducing their subsidy programs.  For example, the Minnesota Legislative Auditor suggested ending subsidies for the state's corn-based ethanol industry.

In this report, we calculate the likely economic impacts of reduced State ethanol subsidies in Minnesota, South Dakota, North Dakota, and Montana.  For purposes of this report, these states are collectively referred to as the Upper Great Plains (UGP).  We first provide an overview of ethanol and corn production in each State and associated subsidy programs.  We then calculate the likely impact on ethanol producers of the removal of State subsidies.  To the extent that this action may cause some ethanol plants to cease production, we then estimate these effects on local corn prices and production.  Finally, we calculate changes in producer surplus as a measure of changes in corn producers’ economic well-being in this region.

Section 2.  State Ethanol Subsidy Programs in the Upper Great Plains

This section provides an overview of State ethanol subsidy programs for Minnesota, South Dakota, North Dakota, and Montana.

2.1.  Minnesota

Minnesota has 21 ethanol production facilities with a combined annual production capacity of over 1 billion gallons (see Appendix 1).  Minnesota provides ethanol producers a $0.20/gallon subsidy for ethanol produced by facilities which were operational as of June 30, 2000.  Such facilities are eligible to receive subsidy payments for 10 years.  Payments are limited to $3 million per facility annually.  About one-half of Minnesota’s facilities qualify for the subsidy.  The program is scheduled to end on June 30, 2010.

Minnesota mandates that all gasoline sold in the State must be blended with ethanol to encourage ethanol consumption.  Minnesota also supports ethanol consumption through a grant program that offsets E85 (i.e., gasoline containing 85% ethanol) fuel infrastructure costs.  Furthermore, Minnesota’s retail fuel excise taxes are lower for E85 gasoline ($0.142/gallon) than for E10 (i.e., gasoline containing 10% ethanol) gasoline ($0.20/gallon).  Nonetheless, E85 sales are a small component of total gasoline sales because its use requires specially-engineered equipment including gas pumps, engines, and distribution infrastructure.

2.2.  South Dakota

South Dakota has 15 ethanol production facilities with a total annual production capacity of over 900 million gallons (see Appendix 1).  The State offers a production incentive of $0.20/gallon to ethanol producers.  However, the program includes several constraints that limit subsidy expenditures.  For example, the subsidy payment can only be applied to 416,000 gallons/month (5 million gallons per year) per facility.  In addition, total State expenditures on this program cannot exceed $7 million/year.  Commercial facilities eligible for this subsidy in 2008 received between $0.005/gallon to $0.03/gallon depending on facility size.  Only plants that were operational prior to 2006 are eligible for this program.

South Dakota collects lower retail excise taxes on ethanol-blended gasoline relative to non-ethanol blends.  Non-blended gasoline is taxed at $0.22/gallon.  Ethanol blends below E85 are taxed at $0.20/gallon, while E85 (or higher) blends are taxed at $0.10/gallon.

South Dakota also supports expansion and construction of agricultural processing facilities by refunding certain sales, use, and excise taxes on construction expenditures.  These subsides serve to lower the capital cost of facilities.  However, fixed costs contribute a relatively small portion (often less than 10%) of total ethanol production costs.

2.3. North Dakota

North Dakota has six ethanol facilities with a total annual production capacity of over 300 million gallons (see Appendix 1).  Two of these are older and somewhat smaller facilities, and both have been shutdown periodically in recent years.  North Dakota offers an ethanol production incentive based on ethanol and corn prices.  The program began in 2003, but ethanol and corn prices did not trigger payments until 2007.  The program consists of two parts.  The first part reduces the price of corn used by an ethanol plant by providing a $0.001/gallon subsidy for every one cent that corn prices exceed a pre-established threshold price (currently $1.80 per bushel).  The second part of the program reduces this subsidy by $0.002/gallon if ethanol prices exceed a pre-established threshold (currently $1.30 per gallon).  Only facilities built after July 1, 1995 are eligible, and total statewide program expenditures cannot exceed $1.6 million annually.

North Dakota also provides indirect support for biofuel production.  Grants of up to $5,000 are offered to fuel retailers to offset the installation of ethanol-compatible fueling pumps.  A partnership with the Bank of North Dakota provides grant funds to help reduce interest rates for biofuel production facilities and some other biofuel-related operations. 

2.4.  Montana

Montana does not have any commercial ethanol production facilities at this time.  However, several incentive programs exist for potential ethanol producers.  The key incentive is a $0.20/gallon production subsidy.  This subsidy is only available to plants that use a certain percentage of Montana-produced agricultural commodities as feedstock.  The program limits individual facility payments to $2 million annually, and $6 million over the life of a facility.

Section 3.  Ethanol, Corn, and By-product Production in the Upper Great Plains

3.1.  Ethanol Production in the Upper Great Plains

The U.S. ethanol production industry has expanded rapidly over the past decade.  The impetus for this expansion has been threefold.  First, many States have banned the use of methyl tertiary butyl ether (MTBE) as a gasoline oxygenate.  Because oxygenated gasoline burns cleaner and reduces engine emissions, legislation requires that oxygenated gasoline be used in certain cities as a means for reducing air pollution.  MTBE was historically used as the preferred additive by blenders because it was relatively inexpensive and easily transported.  Recently, MTBE has been detected in groundwater in some regions of the United States.  Although research has generally found that inhaling MTBE poses a significant human health hazard, the effect of MTBE-contaminated drinking water on human health is not well-documented.  Nonetheless, many States enacted bans on the use of MTBE as an oxygenate and ethanol became the preferred gasoline oxygenate.  Second, the 2005 Federal Renewable Fuels Standard (RFS) provided targets for increased biofuel production.  The targets have generally been met by increases in the production of ethanol.  The RFS and accompanying Federal subsidies have encouraged the development of ethanol plants.  Third, some States have also subsidized ethanol production and/or implemented programs to encourage ethanol consumption.

Figure 1 shows that ethanol production was almost non-existent in 1981, and was less than 1 billion gallons in 1992.  By 2000, ethanol production had grown to only 1.6 billion gallons.  In 2008, ethanol production exceeded 9.2 billion gallons.  Currently ethanol production capacity exceeds 10 billion gallons, and may increase if Federal targets outlined in the 2007 Energy Independence and Security Act (which amended the RFS) are to be met in the future.

Figure 1.  U.S. Ethanol Production, 1981-2008.



The four-state UGP region is a significant producer of ethanol.  Although Montana lacks ethanol production facilities, the other three states produced over 2.2 billion gallons in 2008.  This represented approximately 24% of total U.S. ethanol production (figure 2).  During the past year, South Dakota was the fourth largest producer of ethanol and Minnesota was the fifth with each producing approximately 1 billion gallons or 11% of U.S. production.  North Dakota produced 233 million gallons of ethanol in 2008, and was the 11th largest producing State.

3.2.     Corn Production in the Upper Great Plains

Most U.S. ethanol production facilities use corn as a feedstock.  In 2008, approximately 3.4 billion bushels of corn was used to produce ethanol in the United States.  This represented almost 30% of the 2008 U.S. corn crop.  Increased demand for corn raised prices from less than $2/bushel at the turn of the decade, to more than $4/bushel over the past two years.  In response to increased corn demand, U.S. corn production increased from approximately 10 billion bushels in 2000 to over 12 billion bushels in the past year (figure 3).

Figure 2.  Minnesota, South Dakota, and North Dakota Ethanol Production
     Relative to U.S. Production, 2008.




Figure 3.  U.S. Corn Production, 1981-2008.

Figure 4 presents 2008 corn production in Minnesota, South Dakota, North Dakota, and Montana.  Minnesota is the largest corn producer of the four States with approximately 1.1 billion bushels.  South Dakota produces approximately one-half as much corn as Minnesota (about 550 million bushels).  North Dakota produces approximately 285 million bushels of corn per year, while Montana is a minor producer with an average of about 5 million bushels in each of the past two years.

The four-state region produced approximately 17% of the U.S. corn crop in 2008 (figure 5).  Figure 6 shows that Minnesota’s corn production represents about 10% of the U.S. corn crop.

3.3.    Ethanol By-product Production in the Upper Great Plains

UGP ethanol plants produce a significant amount of dried distillers grains and solubles (DDGS) as a by-product of dry corn milling.  DDGS are primarily used as livestock feed in either a wet or dry form.  Although some variability exists among plants, modern plants produce 2.8 gallons of ethanol from a bushel of corn.  The four-state region used approximately 1.1 billion bushels of corn in 2008 to produce ethanol.  Assuming that 18 pounds of DDGS are produced from each bushel of corn, the region also produced approximately 11 million tons of livestock feed. 

Figure 4. Minnesota, South Dakota, North Dakota, and Montana
    Corn Production, 1999-2008.



Figure 5.  Minnesota, South Dakota, North Dakota, and Montana Corn
      Production as a Percent of U.S. Production, 1999-2008.



Figure 6.  Minnesota, South Dakota, North Dakota, and Montana Corn
           Production Relative to the U.S. in 2008 (Percent)

 

Section 4.  Effect of Changes in State Subsidy Programs on Financial Performance
           Associated with Ethanol Production

A simulation model was used to determine the potential effect of reductions in State ethanol subsidies on ethanol plant-level returns over variable costs and profits.  An economic model developed by Hofstrand (2008) was adapted to production conditions in the UGP.  The model accounts for variability in ethanol, corn, natural gas, and by-product prices.

A model is created for a typical, large 100 million gallon per year (MGY) plant, and another for a typical, small 30 MGY plant.   Both models assume new construction of dry milling ethanol plants and the production of DDGS and carbon dioxide as by-products.  Each plant is assumed to have a useful life of 15 years.

The economic model for a 100 MGY plant maintains the same construction cost and efficiency assumptions used by Hofstrand (2008).  We assume construction costs of $2.26 per gallon, the production of 2.8 gallons of ethanol and 18 pounds of DDGS per bushel of corn, and consumption of 30 ft3 of natural gas, 0.9 KwH of electricity, and 3.5 gallons of water per gallon of ethanol produced.  The initial variable and fixed costs of ethanol production, exclusive of corn and natural gas inputs, are $0.47/gallon.

The economic model for the 30 MGY plant assumes construction costs of $2.26 per gallon of ethanol, the production of 2.6 gallons and 17 pounds of DDGS per bushel of corn used, and the consumption of 38 ft3 of natural gas, 1.15 KwH of electricity per gallon, and 4.4 gallons of water per gallon of ethanol produced (Wu, 2008).  The initial variable and fixed costs of ethanol production, exclusive of corn and natural gas inputs, total $0.55/gallon.

The baseline models use averages of corn and ethanol prices for Minnesota, North Dakota, and South Dakota for the period January 2005 through July 2009.  Average annual corn price observed in each state was used for 2005-2008; monthly prices were used between January and July 2009.  Weekly data on ethanol prices in Iowa were used for the January 2005 to March 2007 period.  Ethanol prices for South Dakota were used between April 2007 and July 2009.  Based on observed subsidies per gallon paid to ethanol producers in the UGP, which is affected by the number of plants and funding limits in each State, we assume an average State subsidy of $0.05 per gallon (see Appendix 2).

We first consider whether ethanol plants in the UGP are able to generate returns over variable costs.  Firms that are unable to generate positive returns over variable costs will cease to operate.  In the 100 MGY and 30 MGY plant models, returns were positive between January 2005 and December 2006, but were negative on average between January 2007 and July 2009 (figure 7). 

Between January 2005 and December 2006, the average observed ethanol price for the UGP was $1.94/gallon, while simulated variable costs were $1.23/gallon for the 100 MGY plant and $1.38/gallon for the 30 MGY plant (figure 7).  Thus, both simulated facilities were able to generate positive returns over variable costs during this time period.  Returns over variable costs for the 100 MGY plant averaged $0.63/gallon, and $0.46/gallon for the 30 MGY plant.  Between

Figure 7.   Ethanol Plant Returns over Variable Costs with State Subsidies, 2005-2009.
 

January 2007 and July 2009, however, simulated average returns over variable costs for the 100 MGY plant declined to $0.13/gallon, and to -$0.06/gallon for the 30 MGY plant. 

The effects of removing State production subsidies vary by facility size.  Some, but not all, 100 MGY plants qualify for State ethanol production subsidies.  For those plants that qualify, the removal of a $0.05/gallon subsidy reduces profitability, but would not cause returns over variable costs to be negative.  For 30 MGY plants, however, the loss of State production subsidies would have caused returns over variable costs to be even more negative, and more frequent, during the October 2007 to August 2009 period (figure 7).  Thus, it is likely that some smaller plants could cease operations in response to the loss of State subsidies.

The profitability of ethanol production depends on plant size.  Profits for ethanol producers were greatest in this simulation during 2005 at $0.55/gallon for the 100 MGY plant, and $0.34/gallon for the 30 MGY plant.  Between 2006 and 2008, average simulated profits declined to $0.09/gallon for the 100 MGY plant and -$0.17/gallon for the 30 MGY plants.  Simulated profits were negative in 2009 regardless of plant size.  Figure 8 illustrates simulated profits for these two plant sizes over the most recent five years.  These results indicate that ethanol production at the 100 MGY plant was profitable in most years, but was almost always unprofitable for the 30 MGY plant even with the inclusion of State subsidies. 

Figure 8.  Total Profits for Investor-Owned Ethanol Plants with State Ethanol
         Subsidies, 2005-2009.




The effects of reducing State ethanol production subsidies may differ depending upon the ownership structure of ethanol plants.  Both agricultural producers and non-producers have made substantial investments in ethanol production facilities (The Economist, 2007).  Consequently, positive and negative changes in corn producer well-being could be larger when ethanol plants are producer-owned if profits occur in both sectors.  It is also possible, however, that profitability in one sector could serve as a diversification strategy against lower profitability in another if the two are inversely related.  In addition, it is possible that vertically-integrated firms may have lower transactions costs which could also affect profitability.  Furthermore, it is likely that a vertically-integrated ethanol plant is likely to consider both the profitability of ethanol plant operations and that generated by the corn production of its owners when making management decisions.  Investor-owned firms, however, are not likely to consider the latter.

Therefore, we calculate the total profits of vertically integrated ethanol plants (i.e., those owned by corn producers).  Figure 9a shows the total profits to corn and ethanol producers for all five years.  Corn production profitability is calculated as the difference between corn price and per bushel corn production costs including inputs and cash rents (Duffy and Smith, 2008).  These differences are converted to profits (or losses) with respect to per gallon ethanol production, and

Figure 9a.  Total Profits for a 100 MGY Producer-Owned Ethanol Plant
       With State Ethanol Subsidies and Corn Production, 2005-2009.



Figure 9b.  Total Profits for a 30 MGY Producer-Owned Ethanol Plant
                    With State Ethanol Subsidies, 2005-2009.

 
 
then summed with profitability presented in figure 8 (which shows simulated ethanol production profits for investor-owned plants).  Figure 9b indicates that total profits for farmer-owners of either a 100 MGY plant or a 30 MGY plant were positive between 2005 and 2008, but negative in 2009.

These results hold whether or not State subsidies are included.  During 2005-2009, average annual total profits for farmer-owners of 100 MGY plants were $0.31/gallon of ethanol, and $0.08/gallon for farmer-owners of 30 MGY plants.  The total profits generated from vertically integrated corn and ethanol production (figures 9a and 9b) can be compared to profits generated from ethanol production alone (figure 8) for 100 MGY and 30 MGY plants.  With the exception of 2005 for which corn production profits were negative, simulated total profits from vertically integrated corn and ethanol production are greater than those for investor-owned plants obtained from ethanol production alone.

Together, these results indicate that smaller ethanol plants using older technology are most likely to be affected by the loss of State ethanol production subsidies.  Plants of this capacity probably experienced zero or negative returns over variable costs and negative profits more frequently than larger plants.

Section 5.  Changes in Corn Basis Using a Spatial Equilibrium Model

A potential shutdown of ethanol plants would cause changes in local corn supply and demand conditions.  Specifically, some local corn prices would decline in response to the loss of local markets.  These lower prices would cause some producers to reduce corn production and increase the production of alternative crops.  In addition, other nearby markets would experience an increase in corn availability which would lower prices in those markets.

Cash Grain Bids, Inc. uses spatial arbitrage models to help cash grain traders pinpoint regional buying and selling opportunities.  Cash Grain Bids, Inc. collects daily grain bid prices from elevators, feedlots, terminals, ethanol plants, and other key buyers.  The data encompasses more than 3,400 markets and 17 commodities dating back to 1996.  Their spatial arbitrage models consider price differences across markets, and also rail, barge, and truck shipping network systems and rates.

A spatial arbitrage model of grain trade in the UGP is used to estimate the impact on local/regional corn prices if one or more ethanol plants ceased operations.  The model provides a framework for assessing the impacts of localized structural changes on cash grain markets.  The model estimates the extent of price impacts and measures the spatial diffusion of these impacts across markets in response to production shortfalls, disruptions in grain transportation flows, and changes in the demand for corn.

Given the information presented in Section 4, we presume that 8 smaller, older plants (those with capacities less than 30 million gallons/year ethanol plants in Minnesota, South Dakota and North Dakota) may close in the absence of State subsidies.  For these 8 plants, the model considers supply and demand conditions that would exist at other plants that continue to operate within a

Figure 10.  Ethanol Plants in the Analysis.




200 mile radius of each of the shuttered plants (65 in total).  These plants serve as the basis for corn demand and price competition as shown in Figure 10. Note that it may be the case that other plants were closed at the time of our analysis. Our analysis, however, only models those changes associated with a loss of State ethanol production subsidies. Other plants may be closed for other reasons.

Using an historical database of cash prices, all cash markets within a 200-mile area of the 73 total markets (896 cash markets) were identified.  Daily price data from these 896 markets were collected from January 1999 through December 2008.  From these daily values, average prices for each location were computed.

To assess the impact of potential ethanol plant closures, the model was first solved assuming that all 73 plants in the UGP remained in operation.  The spatial equilibrium model adjusted each plant’s corn price as needed to draw the necessary grain supplies needed to maintain plants at full capacity.  Corn supplies are assumed to be provided by nearby elevators based on regional corn production.  The relative price of corn at each elevator, adjusted for transportation costs, dictates which markets ultimately deliver corn to each ethanol plant.  Each plant must ultimately raise prices to attract enough corn so that it can operate at full capacity.  This procedure produces an estimate of the price of corn at each ethanol plant based upon market shares obtained from various sources.

From this baseline, the model was solved a second time but with only 65 operating plants in the analysis.  This second model assumes that 8 plant closures occur because of a loss of State subsidies.  Of course, corn prices decline at closed plant sites because of associated demand losses.  Some nearby ethanol plants also experience declines in corn prices because, as purchasers of corn, they face fewer competitors.  Comparing these lower prices to the baseline model provides an estimate of corn price impacts resulting from the 8 plant closures.

Table 1 presents estimated price declines at each plant site that closes because of the loss of State subsidies.  In general, corn prices are lowered by between $0.05/bushel to $0.18/bushel.  Along with direct corn price reductions at each closed plant, minor spill-over impacts occur at nearby ethanol plants.  However, these were generally small -- about $0.01/bushel.

The map presented in figure 11 illustrates the estimated impact from plant closures in the region. The results illustrate that areas with the most significant impact occurred where:  (1) plants closed in relative proximity of each other, and/or (2) limited competing plants in each area were not available to serve as a demand buffer. Since there were no changes in Central North Dakota and Wisconsin, these areas are not shown on the map.

Section 6.  Corn Producer Surplus in the Absence of State Ethanol Subsidies

The economic well-being of some corn producers would be negatively affected by the elimination of state-level ethanol subsidies.  One method of measuring this reduction is by calculating changes in producer surplus.

6.1. Producer Surplus as a Measure of Producer Well-Being

The shutdown of an ethanol plant reduces corn demand at that particular location.  Corn that was used “locally” must now be transported to more distant locations.  Thus, the local corn basis widens as the difference between a terminal market price and a local price increases.  The decrease in local corn prices causes producers to reduce corn production and increase the production of other crops.  In addition, lower corn prices are realized for corn that continues to be produced in such areas. 

Figure 11.  Corn Price Impact from Plant Closures.

 

The concept of producer surplus can be used to estimate the impacts of a reduction in local demand on corn producers.  Producer surplus refers to the phenomenon that, at any given market price, some (but not all) producers would be willing to produce corn even if prices were lower than those currently offered by the market.  Essentially, aggregate producer surplus is the difference between an industry’s total revenue and the total variable costs of producing a product.  Note that this is not synonymous with profit because measures of profit must necessarily include costs which do not vary with output (i.e., fixed costs).  Decreases in producer surplus represent an aggregate reduction in the economic well-being of producers within a sector of an industry.

Figure 12 illustrates this concept.  Assume that the local supply of corn (S0) represents local corn producers’ willingness to produce corn at various prices.  Furthermore, let the D0 represent the demand for corn by a local ethanol plant.  The existing local equilibrium corn price and quantity are represented by P0 and Q0, respectively.  Current producer surplus is represented by the areas A and B.  The size of these areas can be calculated using simple algebra and geometry for any given P0, Q0, and slope of S0 which is determined by the own-price elasticity of supply of corn.

If a local ethanol plant ceases operations, then the local demand for corn is reduced from D0 to D1.  The new local equilibrium corn price declines to P1.  The difference between P0 and P1 represents a decline in the local price (i.e., a widening of the basis).  At the new equilibrium price (P1), a smaller amount of corn is produced (Q1) as some producers substitute away from corn production into other crops.  The new producer surplus is then represented by area B.  Consequently, the change in corn producer surplus caused by the shutdown of a local ethanol plant is measured by the difference between areas A+B and area B. 
Estimates of total producer surplus are not particularly relevant as they are a function of selected research methodologies.  However, the model presented in Figure 12 can be used to effectively measure changes in producer surplus associated with changing economic conditions.

Figure 12.  Producer Surplus Losses Resulting from a Reduction in Local Demand.




6.2. Estimating Changes in Corn Producer Surplus in the Upper Great Plains

Our modeling strategy uses estimates of changes in local corn prices obtained from Cash Grain Bids, Inc. and described in Section 5.  The closure of 8 plants in the UGP region will reduce local corn prices at each site from $0.05/bu to $0.18/bu depending upon plant location.  Additional “spillover” effects would occur at 6 additional plants in that local prices at each would decline by $0.01/bushel.  Therefore, we use Cash Grain Bids, Inc.’s estimate of long-term corn prices at each of the 14 affected plants as P0 for each plant.  Furthermore, we assume that Q0 is the amount of corn that is demanded by each plant if they are operating at full capacity.  For smaller plants (those less than 30 million gallons of annual capacity), we calculate corn usage based upon a conversion rate of 2.6 gallons of ethanol per bushel of corn.  For larger plants, we use a conversion rate of 2.8 gallons of ethanol per bushel.  The reduction in basis is then applied to P0 to arrive at a new lower price (P1) at each plant location.  The price P1 represents a corn price that producers face after the loss of a local ethanol plant or because of additional corn availability at nearby plants.  The new equilibrium quantity (Q1) is calculated for each plant using the slope of the supply function (S0) which is based on a short-run, own-price elasticity of supply of corn estimate of 0.57 combined with the new lower price of P1 (Babcock, 2008).  This process is repeated for each of the 14 affected plants.

The approach results in an estimated loss of corn producer surplus of approximately $9.4 million.  This represents a reduction of about 0.25% of the total value of corn production in the four-state region.

Note that at least some of this producer surplus would be transferred to providers of transportation services.  That is, although corn production is estimated to decline by about 2 million bushels in this region, the demand for transportation services for the remaining production will increase as corn is transported to more distant locations.

6.2.1.  Changes in Corn Producer Surplus in Minnesota

The loss of State ethanol subsidies could cause some plants in Minnesota to experience negative returns-over-variable costs for extended time periods.  Based on age, size, and plant efficiencies, it is possible that 5 Minnesota ethanol plants may cease operations.  In addition, the spillover effects of these shutdowns could slightly reduce corn prices at two additional plants.  The combination of these effects would cause a reduction in Minnesota corn output of 1.2 million bushels which is a 0.1% decrease in total corn production for the state.  Lower corn production and local prices would reduce Minnesota’s corn producer surplus by $5.7 million.  This represents 0.19% reduction of the total value of Minnesota corn production.

6.2.2.  Changes in Corn Producer Surplus in North Dakota

The loss of State ethanol subsidies could cause 2 North Dakota ethanol plants to cease processing operations, and the reduction in demand for corn by these plants would have a small, negative effect on the price of corn at one other North Dakota plant.  The combination of these effects would cause a reduction in North Dakota corn production of 400,000 bushels which is a 0.14% decrease in total corn production for the State.  Lower corn production and local prices would reduce North Dakota’s corn producer surplus by $1.8 million which represents 0.23% of the total value of the state’s corn production.

6.2.3.  Changes in Corn Producer Surplus in South Dakota

The loss of State ethanol subsidies could cause the shutdown of 1 South Dakota ethanol plant, but would not lead to additional spillover effects on corn prices at other regional plants.  The shutdown would reduce corn production in South Dakota by 240,000 bushels which is a 0.04% decrease in total corn production for the State.  Lower corn production and local prices would reduce South Dakota’s corn producer surplus by $1 million (which is 0.07% of the total value of South Dakota’s corn production).

6.2.4.  Changes in Corn Producer Surplus in Iowa

The loss of UGP state-level ethanol subsidies could cause spillover effects on corn prices at three ethanol plants in Iowa.  That is, these plants would have less competition for regional corn inputs, which would lower corn prices at those plants.  In turn, Iowa’s corn production would decline by 150,000 bushels (a negligible amount of the State’s 2008 production of 2.2 billion bushels).  Lower corn production and local prices would reduce Iowa’s corn producer surplus by $700,000.

6.3.  Summary

The elimination of State ethanol subsidies could cause plants with relatively high cost structures to experience negative returns-over-variable costs.  Firms that are unable to recover variable costs of production will cease processing operations.  The least efficient ethanol plants (those that are using the oldest technologies or with the least scale economies) are most at risk of halting production operations in response to the potential loss of State subsidies.  The elimination of State ethanol subsidies would certainly affect profit margins of all plants, but probably not to the extent that they would cease operations.  In addition, a few plants may be able to offset some of these losses if the shutdown of some plants increases available corn inputs to those remaining in the market.  These latter plants may be able to purchase corn inputs at lower prices if “local” corn demand declines.

We have identified 8 plants that could potentially be at risk of shutting down.  In addition, another 6 plants may benefit from slightly lower corn prices resulting from these shutdowns.  Corn producers who previously supplied the shutdown plants would experience lower corn prices of $0.05 to $0.18/bushel depending upon location, and about $0.01/bushel for those who supply 6 other plants that continue operations.  As a result, corn production in the UGP would decline by about 2 million bushels (or 0.1% of 2008 corn production) as some producers switch from corn production to alternative crops because of lower local corn prices.

Section 7.  Summary and Conclusions

The U.S. ethanol industry receives a variety of subsidies from Federal and State governments.  State ethanol production subsidies have generally been smaller than Federal subsidies and range from less than $0.01/gallon to $0.20/gallon depending upon State and location.  Some State subsidies also target infrastructure development.  The ethanol market has matured significantly over the past decade.  Coupled with recent State budget deficits, some State legislatures have considered reducing ethanol subsidies.

We investigate the likely economic impacts of reduced state ethanol subsidies in the Upper Great Plains (UGP) region (i.e., Minnesota, South Dakota, North Dakota, and Montana).  The UGP region is a significant producer of ethanol.  Although Montana lacks ethanol production facilities, the other three States produced over 2.2 billion gallons in 2008.  This represents approximately 24% of total U.S. ethanol production.  During the past year, South Dakota was the fourth largest producer of ethanol and Minnesota was the fifth with each producing approximately 1 billion gallons or 11% of U.S. production.  North Dakota produced 233 million gallons of ethanol in 2008, and was the 11th largest producing state.  Montana does not have any commercial-sized ethanol production facilities.

Most UGP ethanol production facilities use corn as a feedstock.  Minnesota is the largest corn producer of the four states with approximately 1.1 billion bushels.  South Dakota produces approximately one-half as much corn as Minnesota (about 550 million bushels).  North Dakota produces approximately 285 million bushels of corn per year, while Montana is a minor producer with an average of about 5 million bushels in each of the past two years.  The four-state region produced approximately 17% of the U.S. corn crop in 2008. 

Each State in the UGP offers a variety of ethanol production subsidies, infrastructure development incentives, and consumption encouragement.  State subsidies range from less than $0.01/gallon to $0.20/gallon.  However, per gallon subsidies are often lower in practice than as stated in legislation because of restrictions on annual total State expenditures for specific programs.  Although difficult to quantify, it appears that the effective State ethanol subsidies in the UGP are approximately $0.05/gallon.
 
We use a simulation model to calculate ethanol profitability for two plant sizes -- 100 million gallons per year and 30 million gallons per year.  Smaller plants generally have older technology and have been unable to maintain returns over variable costs over the past two years.  Any firm that cannot generate enough returns to offset variable costs will cease operations.  Although State subsidies are generally small, reductions or elimination of such support could cause smaller, older ethanol plants to cease operations. These plants also have negative profits and profitability, making them unattractive investments for corn producers or other investors.

Eight plants were identified that could be at risk of shutting down in the UGP if State subsidies were eliminated.  A spatial arbitrage model is used to calculate the effects on corn prices in local and nearby areas as a result of these closures.  The model indicates that local corn prices could decline by between $0.05/bushel to $0.18/bushel depending upon location.  In addition, 6 nearby markets would experience declines in corn prices of $0.01/bushel.  Lower prices would reduce corn production in the UGP by a minor amount as some producers would increase their production of alternate crops.

Perhaps a larger issue involves the potential reduction of Federal ethanol production subsidies.  These subsidies have already declined from $0.54/bushel to $0.45/bushel.  Budgetary or policy changes could cause further reductions.  The loss of a significant portion of these subsidies could cause larger, newer production facilities to struggle to generate positive returns over variable costs.  Of course, if some plants shut down, ethanol prices may increase to those plants that have low enough cost structures to continue production.  But, one would expect significant reductions in national corn prices and local basis changes as the result of such a restructuring.  The modeling approach outlined above provides a methodology for considering the economic impacts of further reductions in Federal ethanol production subsidies.

Section 8.  References

Anon. “The Craze for Maize; Iowa’s Ethanol Economy.” The Economist, May 2007. Downloaded September 2009.

Babcock, Bruce A. “Distributional Implications of U.S. Ethanol Policy.”  Review of Agricultural Economics. 30,3(2008):553-542.
Duffy, M. and D. Smith. “Estimated Costs of Crop Production in Iowa-2009.” December 2008.  Iowa State University Extension Publication FM-1712.

Hofstrand, D. “Tracking Ethanol Profitability.” Agricultural Marketing and Resource Center,  January. Ames, IA, 2008.

Seeley, Tina. “Ethanol May Not Need its US Tax Credit, GAO Finds.” URL: http://www.bloomberg.com/apps/news?pid=20601103&sid=a1DXs3SIS8Jo#. Downloaded December 2009.

State of Minnesota Office of the Legislative Auditor. “Biofuel Policies and Programs.” April. St. Paul, MN, 2009.

U.S. Government Accounting Office. Biofuels: Potential Effects and Challenges of Required Increases in Production and Use. August. Washington DC, 2009.

Wu, M. “Analysis of the Efficiency of the US Ethanol Industry 2007." Center for Transportation Research, Argonne National Laboratory. Presented at Renewable Fuels Association, March 27, 2008.