Commodities | Jul 23 2008
By Greg Peel
“Today we make a major step with the Energy Independence and Security Act. We make a major step toward reducing our dependence on oil, confronting global climate change, expanding the production of renewable fuels and giving future generations of our country a nation that is stronger, cleaner and more secure.”
So said President Bush after he successfully rushed legislation through Congress in December last year requiring automakers to increase fuel efficiency by 40% by 2020 and requiring oil refiners to increase their addition of ethanol from 6bn gallons in 2007 to 36bn gallons by 2020. In a parochial rush to reduce American fuel consumption – not for the sake of the planet but for the sake of reducing US dependence on oil supplies from its enemies – Bush had little idea what he was about to set in train.
While ethanol production had already been booming in the US with government support, the sudden surge in the oil price that was about to hit in 2008 sent the ethanol market into a frenzy. While the president had specifically added in the legislation that 21bn of the 36bn gallons of ethanol had to be produced from something other than corn, corn remained the most efficient source. And it was also an easy boon for farmers – they were producing corn anyway, so instead of selling to food producers they could now sell to ethanol producers and jump on the gravy train. It didn’t matter that the US – and a lot of the world – depended heavily on corn for both food for humans and food for animals to become food for humans. And furthermore, the common practice of “crop rotation” – which in the US is often in and out of corn and soybeans – could take a rest. It was corn, corn, corn all the way.
It might have been that this additional corn production would have put a dampener on the corn price, but given now both food and ethanol producers were fighting over corn harvests the opposite was true. And as the oil price headed for the moon, so, subsequently, did the corn price. The two became joined at the hip. Throw in massive flooding in the Mississippi valley, and corn prices skyrocketed. There were food riots in third world countries.
There was only one small problem with the president’s ethanol policy. Exactly how long did he expect ethanol-added fuel to remain a cheaper alternative? With the effect ethanol was having on the price of corn, soon the production of ethanol became a very expensive operation indeed. The rising oil price may have made ethanol more attractive but the corn price was having the opposite effect.
US based market trader Dennis Gartman highlighted this week a report from US FoodIndustryNews.com. It noted that VeraSun Energy, one of the country’s largest ethanol producers, had delayed the opening of three new ethanol plants because of “volatility in the market”. Citigroup has recently predicted that up to three-quarters of US ethanol plants would have to shut down as profits were turning to losses on the price of corn.
Gartman also notes that a dozen or more ethanol and other bio-diesel plants have declared bankruptcy in recent months not just because of input prices, but because they can’t find financing. The ramifications of the credit crunch have seeped beyond the financial sector into all corners of industry, and have not left the alternative fuel market unscathed. Moreover, the cost of building a new bio-fuel plant has skyrocketed along with everything else. Mr Jerry Taylor of the Cato Institute noted:
“I think the ethanol industry as a whole will have to re-examine its entire financial model and determine how it can make money. Many of these [ethanol] plants never met the objectives that they were designed and built to achieve.”
It is actually a lot cheaper to make ethanol from sugar cane. Sugar, unlike corn, has not been on a one-way price trajectory. However the sugar market in the US is tightly controlled, and the government puts a US54c per gallon tariff on imported ethanol. Brazil is the world’s major sugar source, and its ethanol industry has also been booming. And as corn ethanol has become ridiculously expensive, it has actually become a cheaper alternative for US oil refiners to pay the tariff and use Brazilian sugar ethanol instead.
Now we have had a major pullback in the price of oil. As to whether the pullback will continue it’s too early to say, and future prices remain a lottery given geopolitical and weather influences. But those aside, it appears as if we found the demand-destruction cap price for oil, at least for now. The same can be said, it thus follows, for corn ethanol, and thus for corn. As the oil price has fallen dramatically, so has the corn price.
So does this mean the US corn ethanol industry is back in business?
There must be a point of equilibrium at which oil, corn ethanol, sugar ethanol and other forms of bio-fuel, and indeed other forms of alternative energy, can reach. In the meantime we have seen a near hysterical overreaction following naive decisions. It is a warning to investors not to get swept up in the latest world oil solution.
The cost of producing an alternative energy source must, by simple definition, rise to match the cost of that which it is replacing. And the cost of that which it is replacing must also fall once alternatives are viable. While this process should occur only over a period of time, easily accessible commodity and financial markets allow for the sort of rapid bubble-and-bursts we have experienced recently. There is a potential that even the forced imbalance of an emissions trading scheme – which takes profits from carbon-producers and gives them to carbon-reducers – will simply be overcome as an inevitable longer term equilibrium is sought.
The lesson is that while there undoubtedly are opportunities in alternative energy investment, beware of jumping on a bandwagon that has already left.
