Wednesday, December 19, 2007

Recent perspectives on Ethanol - policy, prices and trading

Given the emphasis placed on renewable fuels in the new Energy Act (signed today by President Bush, albeit with great concern for proper credit allocation), I thought it might be useful to cover some recent biofuels-specific reading I’ve done in the past few days. The past year has seen an increasingly polarized and political debate (although not necessarily along party lines) between ethanol advocates and critics, and sometimes it can be difficult to wade through the morass.

Typically I find some of the most insightful postings coming from my old boss Nathanael Greene, a biofuels expert at the NRDC (see for example here, here and here). His most recent post, describing some of the behind-the-scenes efforts in developing a sustainable renewable fuels standard, is no exception:

My main area of involvement was the renewable fuel standard, which increased and extends the existing standard from requiring 7.5 billion gallons of renewable fuel by 2012 to requiring 36 billion gallons by 2022. As importantly as the number, the bill adopts the first ever global warming performance requirements and strict protections for sensitive lands… …On the bill specifics, the 36 billion gallon requirement includes 21 billion gallons of advanced biofuels, which are defined as renewable fuels other than ethanol produced from corn starch. 16 billion gallons of the advanced biofuels requirement comes from cellulosic biofuels, which are produced from plant material such as switchgrass or wood chips.

The bill requires all of the biofuels to h
ave lifecycle greenhouse gas emissions at least 20 percent less than gasoline. The advanced biofuels must all have emissions at least 50 percent less, and the cellulosic biofuels must have emissions at least 60 percent less. Importantly, we won wording changes that make the definition of lifecycle emissions broad enough to capture both the direct and indirect emissions caused by land-use change. …we also won clear parameters for sustainable sourcing of biofuels feedstocks that guard against the loss of native forests and prairie. These provisions also protect threatened, imperiled, and endangered species and public lands.
Well-planned and intelligent climate policy requires multi-stakeholder engagement (i.e. industry lobbyists and environmental groups, and all parties in between). At the risk of sinking into Dr. Phil territory, future climate and energy legislation must include the lessons of the past, needs of the presents and goals of the future. As Nathanael puts it:
So a small, but important step for Congress and the US towards real climate policy, a big step on biofuels policy, but still just the first steps in what will be a long march

Unfortunately, the debate over ethanol referenced above won’t be helped by articles such as one found in yesterday’s NYT, with the attention-grabbing (and simplistic) headline “Food and Fuel Compete for Land”:
For years, cheap food and feed were taken for granted in the United States. But now the price of some foods is rising sharply, and from the corridors of Washington to the aisles of neighborhood supermarkets, a blame alert is under way.

Among the favorite targets is ethanol, especially for food manufacturers and livestock farmers who seethe at government mandates for ethanol production. The ethanol boom, they contend, is raising corn prices, driving up the cost of producing dairy products and meat, and causing farmers to plant so much corn as to crowd out other crops.

The results are working their way through the marketplace, in this view, with overall consumer grocery costs up roughly 5 percent in a year and feed costs up more than 20 percent.
While I don’t want to blame the reporter for the editor’s choice of headline, it essentially becomes a “he said/she said” piece, with no clarity or counter beyond the talking points.

I contrast that with a WSJ piece I kept from over the weekend. While this article focuses on the fact that price of rice is at a 20 year high, it also provides a solid economic framework to explain the extremely high prices of all staple foods around the world. More importantly, the reporter doesn’t assume that corn-derived ethanol should receive most of the blame. Instead a more nuanced view emerges: (bullets added by me)
  • The global commodities boom that has lifted prices of everything from gasoline to gold is now elevating rice -- a staple food for half of the world -- to its highest level in nearly 20 years.
  • Rice's surge has complex consequences for the global economy….the ubiquitous grain is suffering poor harvests and tight supplies in some of the biggest rice-exporting and rice-consuming nations, just as demand grows in places like India and the Philippines.
  • The higher price is a boon for some farmers and investors. But at the same time, it is expected to contribute to a protracted bout of food-price inflation for the foreseeable future…
  • …Soaring prices are drawing myriad investors into the market. On the Chicago Board of Trade, the number of bets outstanding on rice futures contracts recently reached a high -- a basic sign that more traders see a chance to make money on rising prices...
  • … The story of rice echoes that of nearly all commodities, whether petroleum, copper or wheat. Prices for many commodities are surging thanks to booming demand from emerging economies like China…
  • ...Rising oil prices also make it costlier to grow and ship rice and other grains -- which, in turn, drives up food prices...
  • …Grains have been trading at or near historic highs partly because of a combination of growing demand for biofuels -- such as ethanol made from grain -- as well as a rising global population, which means more mouths to feed in the developing world.
  • In addition, the weaker dollar has helped to boost global rice prices, as most rice is traded in dollars. In Thailand, the world's largest rice exporter, the price of long-grain rice has increased nearly 20% since last year, according to Nathan Childs, senior economist at the Department of Agriculture.
I’m not ignoring the fact that using corn for ethanol can have some impact on global food prices, but it is important to keep in mind that high oil prices, changing developing world food consumption habits, an increasing population, a weaker dollar, low harvest yields and speculative commodity trading are all impacting both the demand and supply of staple foods (and thus their price).

Another good article on the boom in price of another staple (wheat) is here:

Finally, I’ll close on what I found an interesting footnote, showing that either the US Department of Agriculture isn't immune to the same simplifications. Despite describing multiple fundamental reasons underlying record high farm incomes, only one seems to matter – “Biofuels lead to all-time record farm income in the United States”: (actual report here)
The United States Department of Agriculture's Economic Research Service (ERS) has released its annual Agricultural Income and Finance Outlook, showing that the biofuels revolution that has swept the US has led to net farm incomes reaching an all-time high. ERS is forecasting net farm income to reach $87.5 billion, up $28.5 billion from 2006 and exceeding the 2004 record…. …The value of crop production is expected to increase by $30.5 billion in 2007, the largest annual increase since 1984.

Direct government payments in 2007 are expected to decline by $3.7 billion from 2006. Farm production expenses are forecast to rise to a record-level $254.2 billion in 2007. Average net cash income for U.S. farm businesses is projected to be $66,100 in 2007. This represents a 21-percent increase from 2006 and would be 23 percent higher than its most recent 5-year average.
Of course, much of this revenue will pass to large agribusiness, as opposed to smaller family farms.
While rural residential farms made up more than 6 out of every 10 U.S. farm operations in 2006, they are expected to account for less than 10 percent of U.S. net value added in 2007....Farm operations with $1 million or more in gross sales are few in number yet are expected to be the source almost half of U.S. agriculture’s net value added in 2007. While these farm operations represented less than 2 percent of farm operations in 2006, they are expected to account for more than half of U.S. livestock value of production and almost 43 percent of crop value of production in 2007.
Still, from an investment perspective, the U.S. farming industry is booming. Just one example – the Market Vectors Agribusiness ETF (AMEX: MOO) is the first ETF composed of companies that are primarily involved in the agricultural business and looks to track the performance of the DAXglobal Agribusiness Index (DXAG) Launching this August, it’s risen 25% in the past three months:

With the recent energy legislation, and macro-forces showing few signs of retreat, the U.S. agriculture business may prove a vibrant and growing industry over the next decade.

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