Impact on Corn Market if Ethanol Expansion Stops
AgMRC Renewable Energy Newsletter
Robert Wisner, Biofuels Economist, Agricultural Marketing Resource Center
Last month, we looked at the potential U.S. corn supply-demand and price situation if the ethanol expansion had stopped at the capacity level of 2004-05,instead of expanding by the additional 2.78 billion bushels of corn that USDA projected in September would be processed into ethanol in the current marketing year. We concluded that, if the expansion had stopped in 2004-05, the crop sector of U.S. agriculture almost certainly would be struggling with excess production capacity, low prices, and large government expenditures to support agriculture. This would have reduced the pressure on the livestock and poultry sectors, but also would have been accompanied by reduced rural economic growth that occurred as hundreds of millions of dollars were invested in ethanol plant construction. Under that scenario, the farm machinery industry would not have seen the demand surge it has experienced and the fertilizer and seed corn industries also would have seen significantly less growth.
This month, we are looking at the potential corn and soybean supply-demand balance if the ethanol expansion stops when current plants under construction are completed. This scenario address questions that are very important to the livestock and poultry industries, ethanol plant managers and merchandisers,investors, grain producers, grain elevator managers, lenders, the farm input sector and others.
Plants under construction
At the end of September2008, the Renewable Fuels Association reported additional plant capacity under construction that will create a demand for approximately 700 million additional bushels of corn. Some of that capacity will come on line in the next few months. Most of it should be on line within the next two years. Returns for new plant construction have changed dramatically since the last half of 2006,when large returns brought a surge of investments and new plant construction.
Current ethanol profitability
Ethanol returns at this writing are near or below break-even, depending on the plant location. That is due in part to the recent extreme pressure on U.S. and global financial markets, and crude oil prices that have declined by over 50% from their early summer high. Lower crude oil prices have produced a sharp decline in wholesale gasoline prices and created downward pressure on ethanol markets since early summer. Other contributing factors include sharply increased plant production costs and concern that as the average U.S. ethanol blend in retail gasoline approaches 10%, ethanol prices will weaken further. Corn prices have declined sharply since mid-2008 but the lower feedstock cost for ethanol plants has been offset by lower ethanol prices.
Ethanol prices in early October were still drifting slightly lower, and showed large variability from state to state. Rack (wholesale) prices reported by Axis petroleum in early October varied as much as a $0.24 per gallon between Iowa and Nebraska, with Iowa having the lower prices. A price range of that size creates a variation in the value of processing corn into ethanol of $0.67 per bushel. The prices of distillers grain also were higher in Nebraska, adding another $0.17 to the value of corn processed into ethanol in that state versus Iowa.
The higher ethanol price in Nebraska may reflect California’s preparation to increase its required ethanol blending level from 5.7% to 10% of retail gasoline supplies, starting in 2009. California has decided to increase its required ethanol blending level in an effort to reduce greenhouse gas emissions. Nebraska has lower transport costs to that market than Iowa. Whether California’s new regulations will go into effect will depend partly on a recent legal challenge by a petroleum firm. If the California regulations go into effect, other states may follow suit, thus reducing pressure on ethanol prices as the average U.S. blend approaches 10%.
Another uncertainty relating to California is whether a substantial part of its increased ethanol demand might be supplied by Brazil. Brazil produces ethanol from sugar cane at a substantially lower cost than U.S. corn-based ethanol. When Brazilian supplies are imported into the U.S., importers must pay a $0.54 per gallon tariff. Part of the $0.51 blending credit may be passed back to importers through ethanol prices, especially in times or locations where U.S.supplies are tight. If the importers themselves are blenders, a larger portion of the $0.51 blending credit could be considered an offset. These processes thus may offset a portion of the import tariff, with the amount depending on market conditions. Without the tariff, the U.S. government might to some extent subsidize the Brazilian ethanol industry.
In 2009, the blending credit will be lowered to $0.47 per gallon, thus leaving at least $0.07 of the import duty that is not offset. Brazil may at times have a freight cost advantage over Midwest shipments to California and in some cases may be able to avoid the tariff by dehydrating ethanol in countries that are part of the Caribbean Basin Initiative. Its competitiveness also fluctuates with exchange rate changes.
Corn demand for current ethanol production
The Renewable Fuels Association placed existing ethanol plant capacity at10.7 billion gallons on September 30, 2008. At the current industry average corn to ethanol conversion rate of approximately 2.8 gallons per bushel, the end-of-September 2008 rated capacity creates a demand for approximately 3.82billion bushels of corn. With favorable returns for ethanol production, demand for corn for ethanol could be eight to ten percent higher than this rated capacity. At this writing, trade source estimates for August 2008 ethanol production plus the U.S. Energy Information Agency (EIA) data for production through July suggest that corn use for ethanol in the 2007-08 marketing year was about 2.973 billion bushels. October 10 USDA estimates place corn use for ethanol in 2007-08 at 3.0 billion bushels, with corn use for ethanol to reach4.0 billion bushels in the current marketing year. Most newer plants have the ability to produce ethanol at as much as 20% above rated capacity.
How Fast Will Yields Increase
There are differing views on how rapidly corn yields will increase in future years. Figure 1 shows the U.S. average corn yield since 1960 along with USDA’s October estimate for the 2008 crop and several long-term trend lines. The best fitting trend line is based on 1960 to 2007 yields. We also include trend lines for the following years:
- 1970 to 2007
- 1980 to 2007
- 1990 to 2007
- 1995 to 2007
For our medium-yield projections in the balance sheet, we use the 1990 to2007 trend line. Note that the 1990 to 2007 and 1995 to 2007 trend lines are tilted slightly more upward because of low yields during the early part of the periods and an exceptionally high yield in on year, 2004. Only one year since2002 has shown a yield equal to or above the 1995 to 2007 trend line. With the1990 to 2007 trend line, one year since 2002 has been above the trend and one has approximately equaled it. The rest of the years were below trend.
Promising new corn genetics along with new soybean varieties that increase yields modestly are being developed by the seed industry. Some analysts believe these new genetics will soon cause an accelerated uptrend in yields and a further decrease in sensitivity of yields to unfavorable weather. If so, that would ease tightness in corn supplies beyond what is shown in Table 1 medium yield columns. The higher yield column could reflect this type of scenario.
Some estimates in the seed industry exceed those in our high-yield columns shown in our balance sheet, but it is important to keep in mind that the greatest response will be in the best soil areas. Responses to new technology outside these areas maybe somewhat less and must be factored into the national average yield. We also have included low-yield scenarios on our web site to reflect modestly adverse weather but not extreme years such as the droughts of the 1980s or the 1993extreme flood year.
Other factors affecting the national average yield
A leveling off of ethanol production would over time require less corn-following-corn acres. Agronomic research at Iowa State University and the University of Illinois has shown yield reductions versus corn after soybeans. Corn planted after corn the previous year also requires more fertilizer than corn planted after soybeans. Fertilizer availability and cost under some scenarios could become yield constraints.
A University of Illinois study and agronomic research at several universities indicate that a trend toward earlier plantings also has contributed significantly to higher yields. With many Midwest producers now starting to plant corn in mid-April, logic suggests this source of increased yields has about run its course.
Future yields also will depend heavily on the price and availability of fertilizer, especially nitrogen. In the last three years, the cost of fertilizer has increased dramatically in response to increased U.S. corn acres and expanding demand in India, China, South America, and other areas. As plant populations per acre increase to take advantage of new genetics, adequacy of fertilizer supplies becomes critical for fully capturing the crop’s yield potential
Corn supply-demand if ethanol production levels off
Corn supply-demand projections are shown with ethanol production leveling off when the current plants under construction are completed is shown in Table 1. Plants are assumed to operate at rated capacity. Detailed projections with varying yields and key assumptions are also available. With ethanol production growth leveling off in about two years, we would expect tightness in corn supplies to gradually ease as the U.S. average corn yield continues its long-term upward trend.
In Table 1, data for the 2004-05 through 2007-08 September-August marketing years are from the USDA NASS and ERS. For 2008-09, they include the USDA October 10 production estimate and our updated projections of use through August2009. As noted last month, ending carryover stocks are a major influence on corn prices. Our 2008-09 projections place potential August 31, 2009 U.S. corn carryover stocks at 1.149 billion bushels. Stocks at that level represent 4.7weeks utilization. Our 2009-10 through 2010-11 medium-yield projections show carryover stocks approximately stabilizing at 4.3 to 4.8 weeks utilization for the next two years. Modest increases would be likely in 2011-12. Corn acreage also would be likely to stabilize, starting in 2011. The leveling off of corn processing for ethanol would allow projected domestic corn feeding and exports to gradually increase. Exports will be affected by a number of possible developments, including some likely increase in production in South America and a potential shift of China from a net corn exporter to a net corn importer. China has been a major corn exporter for most of the last two decades. However,its livestock and poultry industry growth has out paced its growth in corn yields and production. China has a large potential to increase corn yields overtime, but many analysts doubt it will be able to increase yields rapidly enough to avoid shifting to a net corn import position.
Figure 2 shows very tentative projections of U.S. corn production and utilization to 2013, based on the yield trend used in Table 1 and a leveling off of corn processing for ethanol. These projections represent a normal-weather scenario. As U.S. corn yields increase, domestic corn feeding and exports would expand modestly in response to gradual easing of tight supplies. Production,with favorable weather, would gradually rise above total utilization, allowing a modest increase in carryover stocks. While we are reluctant to project prices that far into the future with the current turmoil in global financial markets,we would expect inflation-adjusted corn prices to trend gradually lower. The projected demand also would allow some corn acres to be shifted back into soybean production.
Impact of Ethanol Mandates
Current corn and energy market conditions point to a potential leveling off of corn processing for ethanol at approximately the level projected here. However, this may not be a realistic scenario when U.S. government ethanol blending mandates are included. Last year’s energy legislation mandates that corn starch-based ethanol supplies from conventional technology must reach 15billion gallons annually by 2015. If the industry expansion levels off after current plants under construction come into operation, U.S. production would fall short of the mandate by approximately 2.32 billion gallons or 15%. If production reached the mandated level, it would require an additional 800million bushels of corn, thus tightening corn supplies beyond what we project. The gradual easing of corn supplies would likely then be delayed by at least two years from the time-frame we show here.
The 15 bil. gal. mandated level of ethanol production would require 800 mil.bu. more corn than if the expansion stops now. This would delay the easing of corn supplies and prices at least two years beyond the time-frame shown here.
If U.S. ethanol supplies fall below the mandated level, enforcement mechanisms in the legislation create processes that would allow ethanol processors to bid whatever price is necessary to obtain the required corn. At the same time, these mechanism would permit higher costs to be passed on to consumers even though retail ethanol prices might be higher (in dollars per energy-equivalent units) than gasoline. One condition allowing U.S. corn-based ethanol production to fall below the mandated level would be if the shortfall were filled by imports from Brazil. That possibility cannot be ruled out. Brazil is continuing to expand its ethanol production capacity and is developing infrastructure that will lower the cost of its exports. A leveling off of U.S.corn-based ethanol production after current plants under construction come online would modestly reduce but not eliminate the sensitivity of corn prices to widespread adverse U.S. or foreign weather. With severely adverse weather over a large area of the Midwest, we would expect corn prices to rise enough to reduce domestic livestock feeding and possibly increase ethanol imports.
The current economic environment of the U.S. corn-based ethanol industry is strongly discouraging additional investment in new plants. Ethanol prices have declined in response to sharply lower crude oil and gasoline prices than at their peak. Although corn prices also have declined, the combined changes in the energy, corn, and distillers grain markets have pushed returns for new plant investments into negative territory. Rising construction costs also are part of this picture. In addition, the plant investment outlook for the corn-based ethanol industry, as in most other sectors of the economy, is greatly clouded by the turmoil in U.S. and global financial markets.
These market conditions, if not overridden by government mandated higher production levels, will set the stage for a gradual easing of corn supply tightness. Barring adverse weather, that easing would become most noticeable starting in about the 2011-12 marketing year. We would expect a leveling off of corn processing for ethanol along with a continued upward trend in U.S. corn yields to allow a gradual increase in domestic corn feeding and modestly increased corn carryover stocks within about three to four years. U.S. corn exports might also increase modestly, depending on how rapidly foreign production expands. Brazil and Argentina are the non-U.S. areas with the greatest potential to expand production, although some increases can be expected in the Ukraine, parts of Africa, China, and other areas. Rapid growth in Chinese demand for meat and its declining grain stocks suggest that country may soon shift from corn exporter to importer. If so, its import needs could be a factor in modestly increased U.S. corn exports.
A leveling off of U.S. corn processing for ethanol would reduce but not eliminate the sensitivity of corn and soybean prices to adverse weather. With the corn-based ethanol production expansion halting, gradually increasing corn yields would set the stage for some corn acres to shift back into soybeans, thus helping to ease the tightness in soybean supplies.