The Impact of Biofuels on Agriculture

Don HofstrandAgMRC Renewable Energy Newsletter
June 2008

  Don Hofstrand                                                                          
  Co-director, Ag Marketing Resource Center
  Iowa State University Extension

U.S. agriculture is going through one of the biggest changes in the last 100 years.  Essentially, it is changing from a “surplus” production capacity industry to a “deficit” production capacity industry.  This is a huge paradigm shift for individuals and businesses involved in production agriculture. Many of these changes are positive for the industry, but there are also challenges.

One of the primary drivers of this change is the entrance of the agricultural sector into the energy industry. Instead of serving just one master (food production) agriculture will be serving two masters (food and fuel production).  Although the actual role agriculture will play in supplying energy is still uncertain, a significant contribution by agriculture will require a major change in the agriculture sector.  Below are some of the impacts this change may have on the agriculture sector.

Corn ethanol is the first phase of agriculture’s entrance into the energy industry.  Other linkages between agriculture and energy will follow.  We will examine the following topics in more detail in future articles.

Industry in its Infancy

The biofuels industry is a new player on the business landscape.  Typical of industries in their infancy, the biofuels industry will evolve rapidly in coming decades.  Corn ethanol is the first phase of the biofuels evolution.  Other phases will follow.  So, the biofuels industry should be examined, not only as it exists now, but how it will look in the future.

Technology and innovation will create a cascade of changes and improvements.  Breakthroughs in production processes will improve efficiency and reduce costs.  New production methods will emerge that utilize an increasing array of feedstocks.  New uses for bi-products will be developed.  Transportation and logistics bottlenecks will be resolved.  Environmental impacts will be reduced.

In future articles we will track these changes.

Commodity Business

Corn ethanol production (as with other biofuels) is a commodity business requiring the purchase of commodity corn and the sale of commodity ethanol. A characteristic of commodity industries is that production capacity is expanded until profits are driven to a minimum. Corn ethanol is probably no exception. Ethanol production capacity will continue to expand until either the price of ethanol is driven down, the price of corn is driven up, or both. Only when rates of return are no better than investment returns in the rest of the economy will ethanol expansion stop.  We can already see the impact of this through higher corn prices.

In future articles, we will track the expansion of corn ethanol and other biofuels in relationship to their demand, mandated usage and availability of feedstocks.

Meeting the Demand
Can we increase the U.S. crop production capacity to meet the expanding demand posed by biofuels while still meeting the needs of the food industry?  In other words, can we serve two masters - food and fuel?  U.S. agriculture has never been challenged to see how much it can produce.

There is little doubt that we can increase crop output over the coming years. Some of the ways production will increase are listed below.

    • Trend line increases in corn yields will continue. Many analysts believe the rate of increase will be higher.
    • Improved crop genetics will increase the amount of corn produced on marginal lands. The corn growing region of the U.S. will expand, especially into the Great Plains. Improved hybrids with shorter growing season requirements, reduced disease stress during dry conditions, and drought tolerance are all being touted by the seed industry.
    • Conversion of some CRP land and other grassland areas to crop production.
    • More research funding will focus on increasing agriculture’s production potential through improved inputs, cultural practices, etc.
    • Increased usage of tile drainage to increase productivity. Higher grain prices will provide the financial incentive.

Will these and other factors be sufficient to meet the emerging energy demand while maintaining our commitment to food, feed, exports and conservation? In future articles we will track and analyze these and other factors to assess their impact on agricultural productivity and the environment.

A Rising Tide Lifts All Boats

“A rising tide lifts all boats” is often used in economic circles to indicate that a growing economy benefits all people.  This concept can also be applied to grain production. Stated differently, a “rising corn prices lifts all grain prices.”  This is because high corn prices are not caused by a limited supply of corn acres. Rather, high corn prices, over the long term, are caused by a limited number of total cropland acres.

Corn genetics are expanding the geographic area on which corn be produced. However, if we have more acres of corn, it means we have fewer acres of something else. And a shortage of the other crop will drive up the price of that crop. Expanding corn acreage in the Corn Belt will reduce soybean acreage. Reduced soybean acreage will drive up the price of soybeans. Higher soybean prices will expand soybean acreage in other areas like the Great Plains. Expanded soybean acreage will compete with wheat and other grains.

Currently there are a number of bullish factors impacting U.S. grain production.  Poor crop conditions in many parts of the world are pushing up wheat prices.  The decline in the value of the U.S. dollar is stimulating foreign demand for our grains.  The rapidly expanding economies in other parts of the world (e.g. China and India) are stimulating this demand further.  So, many factors in addition to bio-fuels are creating a bidding war for limited U.S. grain supplies.
In future articles we will address these issues.

Impacts on the Livestock Industry

Higher feed prices are putting intense pressure on livestock profits. Economic theory tells us that higher feed prices will eventually be translated into higher meat prices. Because the demand for meat is relatively unresponsive to price changes (inelastic), consumption will not drop precipitously as price increases. However, the transition period will not be pretty.

There is concern that the biofuels industry will cause a reduction in livestock production in the heart of the Cornbelt, especially for hogs and poultry. Although distillers grains is a feed by-product of the ethanol process, the total feed supply is reduced sharply. For every pound of corn that goes into the ethanol process, only one third of a pound comes out as distillers grains.

However, in the long-term, ethanol and livestock may find ways to co-exist. Research into the use of distiller’s grains as livestock feed is yielding interesting results. It indicates that distillers grains can comprise much more of the cattle ration than previously believed.  Research is also being focused on using increased amounts of distillers grains in hog and poultry rations. These changes provide hope that the feed industry and the ethanol industry can co-exist and thrive.

In future articles we will explore the potential for the ethanol industry and the livestock industry to co-exist.

Farmland, the Limiting Resource

The scenario I describe above appears to be of great benefit for grain farmers. However, that is not necessarily the case. Profits accrue to the limiting resources in agriculture. Farmers are not the limiting resource, farmland is. We can see this by the line-up of farmers that develops every time a tract of land comes up for sale or rent. Because land is the limited resource in producing grains, it becomes the residual claimant of profits. Farmers bid aggressively to expand their land base and farmland rental rates rise to the point where grain farmer’s profits are reduced to levels in existence before the grain price rise. Rising rental rates and expectations of future increases are quickly capitalized into land values. So the biggest beneficiary is the land owner. Granted, many farmers are both farm operators and land owners. However, over half of the land in Iowa is rented, often from an out-of-state landowner.

We will track the monthly profitability of the industry and how these profits (losses) are distributed among the biofuels producer, farm operator, input supplier and farmland owner.

Climate Change and Carbon Emissions

A powerful new factor has entered the economic calculus of the supply and demand for renewable fuels.  Over the past year the dangers of greenhouse gas emissions have been confirmed.   So biofuels are being called upon to achieve a reduction in both our dependence on foreign oil and the carbon footprint of transportation fuels.  How this will be achieved is uncertain at this time.  More research and analysis are required to adequately address this issue.  In addition, some mechanism is needed to put a price on carbon (and other greenhouse gases) so the marketplace can reflect the importance of these emissions.

Regardless of the actions taken to reduced greenhouse gas emissions, the earth will continue to warm over the next 30 years.  How will this impact the ability of the U.S. and international agriculture to produce food and fuel is unknown.

This newsletter contains the first of a series of articles on climate change and its impact on agriculture and renewable fuels.

A New Set of Players

The increased profitability of agriculture, including bio-fuels, is attracting a new set of players to the agriculture sector.  These players, including finance, technology, venture capital and others, will be competing with us for a piece of the action.  We will no longer have the agriculture sector just to ourselves.  So we must garner new skills to effectively compete.

In the new environment described above, U.S. agriculture’s place on the national and international stage will become much more pronounced.  Agriculture and the decisions made in the industry will come under intense scrutiny.  Our detractors will be more powerful and more forceful.  To be successful, we will need to learn how to effectively navigate and function with this new prominence.  It will require a new set of skills.

In future articles we will provide information and analysis on issues like the current debates about food versus fuel.

Crop Price Volatility

In this new environment, grain prices will be influenced by both food and energy demand factors. The demand from the food sector is relatively stable. Changes in demand are driven by changes in population, consumer incomes and consumer tastes and preferences, all of which change slowly. A stable food industry has led to relatively stable crop prices over recent decades.  By contrast, the energy industry is going through a period of monumental change, leading to uncertainty and rapid changes in supply and demand conditions. This will lead to volatile energy prices which in turn will lead to volatile grain prices.

As the energy industry’s dependence on bio-fuels increases, the impact of the energy industry on bio-fuels will increase.  A whole new set of factors will have a direct impact on grain prices. Crude oil pricing decisions by Saudi Arabia, Venezuela, Russia and other exporting countries will have a direct impact on U.S. grain prices. Terrorism and other crude oil supply disruptions will impact grain prices.

We will track the price relationships between the agriculture and energy sectors and assess the key price drivers of the renewable energy sector.

History of Little Significance

People often use historic prices and past experiences for making decisions relative to the future viability and profitability of agriculture and the bio-fuels industry. However, by all indications, we have entered a new era in agriculture. Where it will take us no one knows. But we do know that agriculture’s future will probably not look like its past.  So looking into the rear-view mirror will probably not provide much value for predicting the future.  In fact, reliance on the rear-view-mirror may lead to erroneous decisions.