Biofuels Outlook and Challenges: A CME Webcast

By Kristina Zurla Landgraf   ISSUE 703 | MAR 2008

Whether you trade agricultural or energy futures or are just a consumer, biofuels trends are worth watching. Robert Wisner, Ph.D. former faculty member and extension economist at Iowa State University, gave his outlook for biofuels in a special CME Group Inc. Webcast presentation on March 25, 2008. He emphasized that it's important to remember biofuels are not just a U.S. issue, but the use of food for fuel and the search for alternative energy sources is impacting many markets and economies on a global scale.

Wisner said that while Brazil, the United States, Canada and the European Union represent the most rapidly growing biofuel industries, many other nations are moving toward increased use of biofuels too. The speed in which the industry is moving has created huge adjustments not only in the Midwest, but also in agriculture around the world, he said. Wisner even said some of his colleagues say it's the most dynamic development in agriculture perhaps since the invention of the steel plow. The changes affect the agricultural sector across the board, including plant breeding, the seed and fertilizer industries, crop handling, grain elevators, transportation, processing, and to livestock as well. Wisner said dramatic changes in crop rotations are taking place not only here in the United States due to the impact of biofuels, but also worldwide.

A double-digit rate of expansion in ethanol production means it is outpacing the infrastructure's ability to move ethanol to the markets. "We have challenges ahead, particularly in that we are close to the saturation point in the Midwest ethanol market, unless we see a lot more E85 stations and possibly movement to E20 and E30," Wisner said. Otherwise, he said the roughly 60 percent increase in production from plants under construction will have to be pushed out to the East, West and South, and there are infrastructure limitations including transportation, handling and blending.

Positive Ethanol Developments

The 2007 Energy Bill mandates specific levels of corn-based ethanol production, and later on, cellulose. Starting next year, some mandates for biodiesel production levels come into play. These mandates include penalties if not met across various sectors. Wisner said these mandates are not cast in stone, however. The EPA can lower mandates if there are serious economic problems meeting them.

There are also greenhouse gas emission requirements, which provide support to ethanol production. Among the developments aiding the movement of more ethanol out to market include a new Union Pacific rapid-receiving and unloading facility in Dallas (a large market that's opening up), a new ethanol shipping facility in northern Iowa, and an opening of the Florida market for ethanol, said Wisner. California has also developed its own greenhouse gas emission requirements that will create more ethanol demand there.

Last summer, Wisner said it was estimated that 41 countries were encouraging biofuels, and he suspects that's an understatement. The driving force is of course high crude oil prices. Wisner notes ethanol has been produced for motor fuel more than 30 years in Iowa, but as crude oil prices move higher and higher, there is more conversion of food to energy crops. Dependence on crude oil from unstable countries also represents an energy security issue. The U.S. imports 60-65 percent of its petroleum, which Wisner said represents "a tremendous negative impact on our balance of payments."

However, corn-based ethanol is just a first step, and only a partial solution to our energy challenges, said Wisner. It is not the only solution he said, adding that there are high risks to present it as such. Other fuel sources are needed, including municipal wastes, animal waste, forest production waste, and new crops.

Wisner notes "one of the rules of economics is that high prices are the best cure for high prices," and that will likely be the case for energy in time. He calls for new automotive technology, including hydrogen and fuel cells, more hybrid vehicles, new engine and vehicle designs, as well as increases in mass transportation usage and a diversification of energy sources, such as wind.

Key Determinants of Ethanol Industry Size

One of the key determinants of how big the ethanol industry will get is the price of grains, and inputs to producing them such as fertilizer. High grain prices are needed to cause farmers to expand acreage, but at the same time, can make ethanol less economically viable. Government mandates will also be important. If there is a crop shortfall due to weather problems, Wisner said production mandates may be lowered.

The U.S. 2007 Energy Bill mandates renewable fuels production of 4.7 billion gallons of corn-based ethanol in 2007, 9 billion gallons in 2008, 11.1 billion gallons in 2009, and 15 billion gallons in 2015. There is not yet a biodiesel mandate, but there will be in years ahead.

A big factor for agricultural market participants in dealing with these new dynamics includes the new "fund" traders that have had a growing presence in the markets. These represent index or hedge funds; large money-manager funds using commodities as a hedge against inflation and trading primarily on the long side, without an opposite position in the physical commodity. Whether these funds will stay in the markets, and what their impact will be aside from traditional participants remains a factor in price action, said Wisner.

A factor limiting the size of biodiesel in particular is that the economics of producing it are not particularly favorable, said Wisner. There is an upper limit on how high corn and soybean prices can go before it becomes unprofitable to use them as fuel sources. "We have to look at returns being generated for users," he said.

Wisner said currently, there is a small profit in processing corn to ethanol, but if corn prices increase 75 cents from corn's current level of about $5.50 a bushel (or even less), it becomes a situation of negative returns for ethanol production, and for hog and cattle feeders. "It may not shut down plants, but will slow plant expansion. There is a limit how much users can pay," he said.

Global demand will also impact the size of the industry. Wisner said China has three corn-based ethanol plants currently, and there has been talk China may shift from an exporter to an importer in corn. Everyone in China and India seems to be clamoring to trade their bicycles for cars, he said. If so, there is another layer of demand that will emerge before long.

U.S. Ethanol Expansion

According to DTN, a news and information provider, there were an estimated 171 plants in operation March 14, 2008, 74 were under construction, and of those, 35 have been under construction a year or more. In the next two to three months, about 10 more will come online, and planned plants number 341. Wisner noted a few are cellulose, but most are corn-based. However, he believes nowhere near all of those planned will actually be built. If they were, essentially the entire U.S. corn crop (about 13 billion bushels) would go to just ethanol processing. "That's not going to happen," he said.

Corn supplies (old crop) are adequate to meet this marketing year's demand, said Wisner. Last year, the corn crop saw a 24 – 20 percent increase in acres, which came from shifting land out from other crops. There was a 16 percent decline in soybean planted area, 29 percent in cotton area, 8 percent in non-durum spring wheat, and minor crops saw shifts as well. "That's not sustainable long-term, and we are looking for potential for extremely tight food supplies ahead if we don't get some of that acreage back," said Wisner. He presented some charts showing how much corn in terms of acreage and yield is needed to meet ethanol demand.

Do We Have Enough Corn?

Wisner said seed companies are optimistic about their new genetically modified crops and feel higher yields are attainable as these genetics are less sensitive to weather problems. He questioned where we will get the increased acres that are needed to produce these higher yields, however. "I suspect that as you look around the edges of large U.S. cities, you can see where acreage went, and it's not going back into crop production," he said.

We are looking at a huge surge in demand from a global perspective, he said. As prices come up in corn, Wisner said he expects to see more land clearing in South America, and a shift of pastures further north in Argentina to open the south up to row crops. More beef will be produced on forage, with livestock seeing a shorter time on feed.

If we see the U.S. ethanol plants under construction come on line, corn needs will dramatically increase. Wisner said the plants under construction would require corn supplies equivalent to 54 percent of U.S. global exports, and over three times the volume shipped annually to Japan, the largest U.S. export market and most dependable one. And that's just what's being built—not currently operating. The markets are going to have to adjust on the demand side and supply side, he said.

Wisner said several studies so far have concluded that ethanol has not been the major source of increased food prices in the U.S. so far, although that's not necessarily the case in other developing countries. And, we can "virtually guarantee an impact" on food prices ahead, he said. About 60-70 percent of the cost of dairy products, and poultry and pork, is feed. As corn prices have more than tripled in less than three years, it's easy to do the math on what should happen to food prices globally. Will there come a time when consumer pressure and food industry pressure cause a downsizing of ethanol mandates from the government? That's a question mark, said Wisner. And what if builders of new plants can't get the corn they need, due to drought or other factors limiting yields?

Wisner encourages traders and investors in these markets to think globally about all the major adjustments in the food and agriculture sector that lie ahead. Without policy change, ethanol will expand until it meets government mandates, or is unprofitable. As a consequence, grain markets will be explosive if weather problems occur and intensify the battle for food versus fuel. He also added that the options markets will be more important than in the past as risk management tools, particularly out-of-the money strike prices that can provide upward price protection.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.

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