The Feed or Fuel Dilemma

When it comes to figuring out what is going on with corn these days, it is really pretty simple – it’s all supply and demand.
Corn demand is way up and supply isn’t.

When it comes to figuring out what is going on with corn these days, it is really pretty simple – it’s all supply and demand.
Corn demand is way up and supply isn’t. As to what that does, that too is easily determined and is the backbone of the economics revolution that began 231 years ago with Adam Smith.

The essence of early economics was unlimited demand versus limited supply. Smith and later economists calculated that the best way of allocating the limited supplies was through price, which Smith famously called the “invisible hand.”

The invisible hand is now furiously at work. In the past six months everyone has taken notice of the results of its actions and are busily trying to project what is to come.

Take the case of Iowa, the most prolific piece of corn-growing geography on the planet. For much of the past 15 years one of Iowa’s biggest concerns was disposing of all the corn it grew. Now, if all the targets are met, if the construction projects become reality and if government goals come to fruition, Iowa, the largest corn producing and exporting state in the U.S., will be importing corn. It will be importing not to feed the state’s massive hog herd, but to keep its ethanol plants running and the hogs will have to fend for themselves.

The reason for putting Iowa at the top of this story, instead of Ontario, is two fold. Iowa is the prime example of how quickly and dramatically the politics of ethanol are changing corn markets and grain markets in general. The other reason is that Canada is already a net importer of corn.

If analysts are right (and their analysis is based more on simple arithmetic than arcane farsightedness), and if politicians stick to their guns, soon virtually everyone will be trying to import corn for ethanol.

In a presentation in Guelph in late January, Dr. James Pierce, Coordinator of Monogastric Nutrition for Alltech said that 25 U.S governors have called for ethanol consumption to rise to 37 billion gallons by 2025. That level of ethanol production would consume 370 million tones of corn, but the U.S. only produces about 250 million tonnes

He said that the U.S. plans to open a new ethanol plant a week in the coming year and that estimate is considered to be very conservative by many observers. Others who have looked at the plans and the construction projects already underway estimate the U.S. will open two new ethanol plants every week in the coming year.

“Something will have to give,” Pierce said.

But we don’t have to wait until sometime later this year or until 2025 to see the impacts.

Corn prices have already surged to over $4 US a bushel, after hovering at around $2 for many years. Carry-in stocks of U.S. corn have fallen to about 25 million tonnes – half of last year’s level despite a very large crop – and if consumption and production remain at last year's level this year stocks of stored U.S. corn will fall to zero.

Internationally the same picture emerges. China, currently the third largest producer of ethanol (after Brazil and the U.S.) has suspended corn exports and is embarked on a significant expansion of its ethanol industry.

The China Daily reported in January that for the first time in China's history, grain prices are rising not due to a poor harvest or increasing demand but because of fuel prices.

To feed the China’s increasing appetite for energy, a huge amount of money is chasing corn, soy and wheat for biofuel production; and pushing up prices to record highs.

Wang Jinmin, a professor in agricultural products economics at the Chinese Academy of Agricultural Sciences, told the China Daily: “The rise in corn prices is a strong factor driving up the prices of other food products. And with its increasing role as a crude-oil substitute and environmentally friendly energy, prices are unlikely to drop in the long run.”

Analysts say that while industrial use only accounts for about a sixth of overall corn consumption in China, it is expanding at up to 15 per cent a year.

Ethanol is the main biofuel produced in China with output hitting 1.02 million tons in 2005 and corn accounting for 76 per cent of the raw material. The country plans to produce about 6 million tons of ethanol by 2010 and 15 million tons by 2020 in addition to 5 million tons of biodiesel.

The results are showing up on commodity markets.

On the Dalian Commodity Exchange corn prices jumped 19.5 per cent in the two months ending November, a 10-year high.
“We predict that agricultural products will be as hot as petroleum in the future,” a futures agent surnamed Wang from the Dalian Commodity Exchange told China Daily.

In Mexico the situation has already become dire, with tortilla prices jumping 14 per cent in two weeks. The Mexican government, faced with massive protests because the price surge was putting the price of this food staple beyond the reach of millions of poorer people, slapped a cap on the price of tortillas.

In terms of the broader international supply and demand picture world stocks fell 25 per cent last year. If consumption and production remain constant for three more years, stocks would be reduced to zero. But, as in the U.S., consumption is rising faster than production. In the last six years consumption has risen almost 18 per cent while production has risen 15 per cent.

Dan Basse, an analyst at Chicago-based AgResource, says with growing ethanol demand, refiners will have to battle with livestock owners for corn, driving up prices. “We’re going to have a food fight,” he says.

The prospect is so real that concerns have reached the U.S. Senate. Tom Harkin of Iowa, chairman of the Senate agriculture committee, says that the U.S. government must start funneling funds to research into other ways of producing ethanol, particularly from cellulose.

While research into producing ethanol from waste wood fibre, wheat straw and other feedstock is proceeding, it is proceeding slowly and it could be years before it becomes a realistic alternative, Dr. Pearse Lyons, founder and president of Alltech, said during the company’s recent lecture tour.

While Pierce estimates that the U.S. will open a new ethanol plant each week this year, others put the number of new plants higher.
Lester Brown of the Earth Policy Institute says that there are 110 ethanol plants up and running in the U.S., with 87 in the construction phase and another 200 in various stages of planning.

That would result in a dramatic surge in the already rapid growth of corn consumed by ethanol.

Five years ago ethanol consumed 706 million bushels of corn. That rose 41 per cent to 996 million bushels the next year, a further 17 per cent the year after that, 13 per cent in 2003, 13 per cent in 2004, 21 per cent in 2005 and 34 per cent in 2006.

The amount of corn used for ethanol in the U.S. more than tripled and now represents about 20 per cent of the U.S. corn crop, up from seven per cent in 2001 and is set, this year, to pass exports as the third largest use of U.S. corn. U.S. domestic use as a feed grain remains the top use and industrial uses comes in second.

Pierce said the 25 U.S. governors recently proposed a five-fold increase in U.S. ethanol production by 2025. To do that would require a third more corn than the U.S. currently produces. Even hitting the governors’ 2015 target would require a dramatic reallocation of corn supplies from feed and industrial uses to ethanol and exports would be a memory.

Bob Wisner and Phil Baumel, professors of economics at Iowa State University wrote recently that USDA supply-demand projections for the year ahead and trends through 2008 imply that the grain-livestock sector is entering an extended period of chronically tight corn supplies.

Projections imply that expanding demand for corn for ethanol processing will displace U.S. exports, but that is by no means certain, they said.

“A significant part of the displacement might be shifted to the U.S. livestock and poultry industries because of the ability of foreign buyers to bid aggressively for corn supplies.”

In their concluding comments they said: “the U.S. corn supply-demand balance is changing from one of chronic surplus production capacity to an extended period of tight supplies. If so, relatively high corn prices will be needed to allocate limited supplies among alternative users.”

They added that ethanol processor demand for corn is likely to be inelastic, reflecting government incentives and a relatively inelastic motor fuel market. “An inelastic demand requires large increases in price to reduce use when feedstock supplies are short.”
The situation is further complicated by China’s changing role in world grain markets, they wrote.

It is the widely held view that China is shifting from a large exporter of corn to an importer. If that happens, China would become a new market for U.S. corn. At the same time China’s corn customers would likely turn to the U.S. for supplies.

“This possible scenario raises the question of whether U.S. corn acreage can be increased enough to meet anticipated new sources of demand,” they said.

Meanwhile, corn has also become a bit of a darling among investors and speculators. The Globe and Mail recently featured corn as one of its investment stars. A recent analysis also showed that investment funds are now heavily involved in the grain futures markets.

The review showed that 20 per cent of corn futures and 50 per cent of wheat futures were held by investment funds. Since these funds are prohibited from taking physical delivery of the grains, the investments are based on the expectation that prices will continue to rise and that they will be able to sell their paper before the contracts mature.

On the spot market, corn prices have gone from just over $2 a bushel, where they have languished for years, to over $4 and many analysts fully expect prices to hit $5 US by this summer. If there is a production problem prices will be even higher.

Pearse Lyons said that the one certain thing in this market is that the ethanol plants won’t be driven out. Once the plants are up they will keep running.

Canada
Canada is the tail on the U.S. dog. It is later getting into the ethanol game and it is building plants at a slower pace, but that pace is quickening.

The Canadian Renewable Fuels Association says that extensive production of ethanol from grain will not detract from Canada’s ability to feed its own citizens and supply quantities of high-quality grains to export markets.
Canada typically produces just under 50 million tonnes of grain (wheat, barley, corn, oats, rye) annually, and exports about half of this. If all Canadian gasoline consumption (presently about 33 to 35 billion litres annually) contained 10 per cent ethanol, the maximum grain requirement would be eight to nine million tonnes. Canada would remain a major grain exporter, the association says.

But ethanol production is having an impact, particularly in Ontario, where corn is used as the feedstock. In Western Canada, wheat is the common feedstock.

Imports of corn are forecast to rise sharply this crop year as a result of strong demand for ethanol production and less barley supply. Carry-out stocks are forecast to drop by 30 per cent and the average Chatham price is forecast to rise by 30 per cent from 2005 to 2006, due to higher U.S. prices and lower domestic supplies.

There are currently three ethanol plants up and running in Ontario and another slated to come online in spring 2007. It is expected that imports of about 65 million bushels will be required to meet demand and this will stimulate local business.

As in the U.S., Canada’s ethanol industry has drawn significant government support.

The Canadian government initiated the Ethanol Expansion Program (EEP) in August 2003. The program provides capital assistance for plant construction and upgrades. The Canadian government has also committed to a five per cent average renewable content requirement in Canadian transportation fuel by 2010. An allocation of $118 million allows for a federal excise tax exemption of $0.10 per litre, support for research and development, and consumer awareness activities. 

The Canadian government projects that ethanol production will increase to about 2.74 GL by the end of 2010. Current ethanol production in Canada is estimated at 0.60 GL, but once the GreenField Ethanol Inc. and Husky Energy Inc. plants are fully operational in 2007, total ethanol production in Canada is expected to rise by more than a third to about 0.84 GL.

In addition to the federal program, several Canadian provinces are providing varying levels of road tax exemptions for ethanol-blended fuels and some have mandatory blending rates to encourage increased ethanol production. For example, the mandates for Manitoba, Saskatchewan, and Ontario are 8.5 per cent, 7.5 per cent and 5 per cent.

Implications for Canada's Agricultural Sector
Corn is currently the most important feedstock for ethanol production in Canada, just as it is in the U.S., Stan Spak, market analyst with Agriculture and Agri-Food Canada wrote in a recent report.

However, that is changing with the increased expansion of ethanol production in Western Canada, where wheat is the primary feedstock, he said. It is typically lower grades of wheat, (i.e., those that do not meet the higher standards required of milling wheat) that provide the main feedstock for ethanol production in Western Canada.

As Canada’s ethanol industry grows, it is likely Canadian farmers will be looking to incorporate higher yielding wheat varieties into their crop rotations, and plant breeders will be focused on developing higher yielding varieties of wheat for the non-milling market, he wrote.

Currently, about 1.0 Mt of corn and 0.5 Mt of wheat are used each year to produce ethanol annually in Canada.  If Canada meets its targret for increasing ethanol production 4.6 Mt of corn and 2.3 Mt of wheat will be required.

Canada currently uses more than 10 million metric tonnes of corn a year while producing less than nine million metric tonnes. Ontario produced a record 6.1 million tones in 2006 largely because of record yield of 150.5 bushels per acre. In Quebec production fell 21 per cent to 2.7 million tonnes.

The difference is covered off by imports from the U.S. The plan to almost quintuple corn used for ethanol could result in a “food fight” similar to what is forecast for the U.S.

The needed corn supplies could come from the U.S., but prices are rising and supplies tightening. The ability to increase Canadian corn production seems even more limited than in the U.S. because of agronomic and geographic factors. Simply put, there are limits on how far north you can go and there are limits on the amount of arable land.

In Canada, Ontario in particular, corn will be allocated by price as livestock producers and industrial users compete with ethanol producers for supplies. It must be noted that if production of ethanol reaches its 2010 target more than 90 per cent of Ontario corn could go to ethanol production.

In Western Canada, there are more than adequate grain supplies. However, most years feed wheat makes up a small percentage of harvested grain and in good crop years ethanol producers could be competing with export buyers and livestock producers for supplies.

In his report Spak says, “it is too early to determine with any accuracy what effect future expansions in the biofuels sector will have on the human food market, as biofuels compete for limited resources.” 

In other words, we’ll get to watch the very visible results of Adam Smith’s invisible hand as it works away at North American and world grain markets.