Bloomberg.com
02-09-07
Ethanol's Corn-Fed Boom Holds Hidden Costs: Higher Food Prices
By Peter Robison
Feb. 9 (Bloomberg) -- Arturo Esquivel shakes his head as he pays 10 pesos (90
cents) for tortillas in Mexico City, two- thirds more than a year ago. He'd be even
angrier to learn that Chicago bond analyst Philip Adams's SUV may be to blame.
The General Motors Corp. Yukon XL sport-utility vehicle runs on ethanol, a fuel
made from the corn that also influences the cost of Esquivel's tortilla, feeds the
chickens, pigs and cows raised for consumption worldwide and sweetens soft
drinks.
Demand for corn as the raw material for an alternative vehicle fuel is creating
unintended consequences throughout the global food chain. Midwest corn
growers are commanding prices not seen in a decade: the crop surpassed $4.20
a bushel Jan. 17, almost double its September price. Yet farmers who raise
livestock are seeing feed costs soar, and companies from Tyson Foods Inc. to
Coca-Cola Co. are warning of higher prices. Even environmentalists say using
more corn will have drawbacks.
``We are seeing the most dramatic, fast-moving changes in Midwest agriculture
in at least half a century,'' says Robert Wisner, an economics professor at
Iowa State University, in Ames.
Hog farmers, cattle ranchers and poultry producers are among those in the $125
billion U.S. livestock industry losing money. The U.S. Department of Agriculture
says the cost of American staples such as pork and chicken may increase 6
percent at current corn prices. The fallout is especially severe in developing
countries, including China. Mexican President Felipe Calderon is pressing tortilla
makers to cap prices.
`Making Life Harder'
``It is making life much harder for those of us who make the minimum,'' says
Esquivel, 38, a maintenance worker in paint- splattered overalls who earns the
equivalent of $6.03 a day.
Prices of the white corn that go into Mexican tortillas are indexed to yellow corn
traded in the U.S. and used in ethanol plants, says Antonio Ochoa, vice president
of Latin America at R.J. O'Brien and Associates Inc., a futures brokerage in
Chicago. ``Every time corn here goes up, it is going to have a direct impact on
tortilla pricing,'' he says.
This isn't what Americans like Adams, senior bond analyst for Gimme Credit
Publications Inc. in Chicago, had in mind when they bought ethanol-capable
vehicles.
Detroit-based GM and other carmakers say the alternative- fuel cars are a way to
support American farmers and reduce the country's dependence on foreign oil.
President George W. Bush pledged in his Jan. 23 State of the Union address to
boost use of renewable fuels almost fivefold through 2017, primarily relying on
ethanol.
The benefits haven't been obvious to Adams, 52. His 2004 Yukon can run on
either gasoline or a blend of 85 percent ethanol mixed with gasoline. Adams says
he's filled his SUV with ethanol only once because the nearest station that sells
the fuel is six miles (10 kilometers) from his home in Wheaton, Illinois.
``It was probably a mistake,'' Adams says of the purchase.
Gates, Goldman Sachs
The combination of federal subsidies and high gasoline prices has led to
unprecedented interest in ethanol, a grain alcohol derived from the energy-rich
starches in plants.
Microsoft Corp. Chairman Bill Gates, British billionaire Richard Branson, New
York-based investment bank Goldman Sachs Group Inc. and California venture
capitalist Vinod Khosla are all investors in the industry.
Its growth rests partly on the 2005 Energy Policy Act, which requires that 7.5
billion gallons -- 5 percent -- of the nation's annual gasoline consumption come
from renewable fuels by 2012. Exxon Mobil Corp. and other refiners get a 51cent tax refund for each gallon of ethanol they blend with gasoline.
Ramping Up
Already, 113 ethanol distilleries are operating and an additional 77 are under
construction, with potential capacity of 11.8 billion gallons, according to the
Renewable Fuels Association, a Washington-based trade group backed by
ethanol producers, including Archer Daniels Midland Co. of Decatur, Illinois.
Record output of 4.9 billion gallons of ethanol last year accounted for 2.8 percent
of the U.S. fuel supply. That was triple the 1.6 billion gallons produced in 2000,
and made the federal tax subsidy worth $2.5 billion. While Bush touts the
potential to make ethanol from wood chips or grass, corn is still the cheapest
U.S. option. All but eight of the 190 distilleries planned or under way use corn.
The injection of new demand for ethanol is reshaping America's farmlands. Last
year, 20 percent of the U.S. corn harvest went to make ethanol -- a figure that
may rise to half within two years if all the new distilleries are built, says Iowa
State's Wisner. The U.S. is the largest corn grower and exporter, accounting for
almost 40 percent of the world supply.
Corn Inventories Fall
The Agriculture Department predicts that by Sept. 1 U.S. farmers will have less
corn on hand than at any time since 1996, when inventories were their lowest in
50 years and prices rose above $5 a bushel. The department says global
inventories this year will be their lowest since 1978. Corn futures for March
delivery closed at $3.9975 a bushel on the Chicago Board of Trade on Feb. 8,
compared with a 10-year average of $2.34 a bushel.
Wisner says so many farmers now are planting corn that it's tightening supplies
of other crops. Prices of soybeans, another component of animal feed, have
jumped 41 percent since September. Soybeans are in more demand as a biofuel
too. The Agriculture Department estimates that 13 percent of U.S. soybean oil in
2007 will be used for biodiesel, an alternative fuel derived from vegetable oils.
Webster City, Iowa, pig farmer Gene Gourley isn't happy about the extra
competition for his main feedstock. Feed makes up 60 percent of the costs at the
farm where he and his brothers raise 60,000 pigs a year. He says their typical
profit is $3.50 per pig, yet they're spending $18 more to feed each one. ``It
doesn't take rocket science to see we just went into the red substantially,'' says
Gourley, 43.
Leaner Profits
Meat producers from Nebraska to Texas are suffering. Commercial feedlots lost
an average of $163.17 a head in January, their worst month since at least 1974,
according to the Livestock Marketing Information Center, a research group in
Lakewood, Colorado, that's backed by the industry. A year earlier, they had
average profit of $5.07 a head.
Pilgrim's Pride Corp. in Pittsburg, Texas, the largest poultry processor, has lost
money in four consecutive quarters.
Tyson Chief Executive Officer Richard Bond said during a Jan. 29 conference
call with analysts that ``significant'' price increases are on the way, without saying
how much. Over time each $1-a-bushel increase in corn may push up U.S.
consumer prices of pork and chicken about 3 percent, Agriculture Department
chief economist Keith Collins told a Senate committee Jan. 10.
`Food Versus Fuel'
``As the food-versus-fuel debate unfolds, we must carefully consider the negative
unintended consequences of over-using grains,'' Bond said.
Economists and environmentalists are divided about the issue. Some say the
strain on supplies shows the uncertainty of relying on crops for fuel and highlights
other negative environmental consequences, from deforestation to overuse of
chemical fertilizers.
An ``epic contest'' is brewing between the world's 800 million motorists and the 2
billion poorest people, who spend as much as half their income on food, says
Lester Brown, director of the Earth Policy Institute, a non-profit environmental
group in Washington. He says food won't be affordable to the poor if prices move
in tandem with a limited commodity like oil.
China's Corn Problem
``The price of grain is moving upward toward its oil equivalent value, and I don't
think we've yet grasped the significance,'' Brown says.
The top planning agency in China, the world's No. 2 corn grower, demonstrated
its concern in December when it halted construction of ethanol plants without
state approval. Corn futures on the Dalian Commodity Exchange jumped 25
percent in 2006 as soaring demand swallowed a record harvest and analysts
forecast China may soon become a net corn importer. The nation's Ministry of
Agriculture said Jan. 26 that it couldn't rule out the possibility of grain shortages.
Some economists say it's only a matter of time before world corn production
catches up and point out that U.S. food prices are near historic lows as a portion
of expenditures. Americans spent 9.9 percent of their disposable income on food
in 2005 compared with 22.1 percent in 1949, according to the Agriculture
Department.
``You'll notice that steak got more expensive, or bacon just went up, but the total
dollar increase in your spending on food won't be huge,'' says John Lawrence,
extension livestock economist at Iowa State University.
`Bumps in Prices'
Supporters of ethanol dismiss the idea of a tradeoff between gas tanks and
stomachs. ``We ultimately have the resources to continue to produce for food
and energy,'' says Bruce Rastetter, CEO of Iowa Falls, Iowa-based Hawkeye
Holdings Inc., the third-biggest U.S. ethanol processor. ``It doesn't mean we
won't have bumps in prices along the way.''
People have been making ethanol, also known as ethyl alcohol, for centuries. A
199-proof form was sold as moonshine during the U.S. Prohibition era. It's made
by pulverizing corn kernels and mixing them with water to create a mash that is
fermented and distilled. Ethanol was first used as a motor fuel by American
inventor Samuel Morey in 1826. Later, Henry Ford designed some of his early
cars to run on either gasoline or ethanol.
Since 2002, refiners have used ethanol as the main blending additive in gasoline,
replacing a carcinogenic substance known as MTBE. They add ethanol in a
concentration of about 10 percent. GM is also ramping up production of vehicles
that can run on E85, the 85 percent mixture. It says half its annual vehicle
production will be E85- or biodiesel-capable by 2012.
Boom Towns
The boom is transforming places like Heron Lake, Minnesota, a town of 773 once
known for some of the state's best duck hunting.
The $97 million Heron Lake BioEnergy plant, backed by a group of local farmers,
is scheduled to start producing 50 million gallons a year of ethanol next month.
Construction crews finished the skin of a giant cooling tower this week. Trestles
for a rail loop that will carry 200 grain cars are going in on dusty fields east of
town.
Heron Lake hasn't been this busy since the 1950s, says Mayor Bill Wurdeman.
He's investing in a new grocery store to replace one that shut three years ago.
Families are renting spare rooms to some of the 200 construction workers in
town, because every apartment is taken. Wurdeman jokes that he's also stopped
thinking about closing the city-owned liquor store.
'Spark We Need'
``We're hoping this is the spark we need to start growing,'' says Wurdeman, 50.
The benefits haven't been unalloyed. Larry Liepold, who raises hogs in the area,
near the Iowa border about 130 miles south of Minneapolis, invested $28,000 in
the plant with family members. Now he's anxiously watching feed costs.
``If prices hang on for three, six, nine months at these levels, that's where largescale pain is going to come,'' says Liepold, 45, who sells 2,500 hogs a year to
Tyson and Greeley, Colorado-based Swift & Co.
Even industry heavyweights aren't immune. Springdale, Arkansas-based Tyson,
the world's largest meat processor, said Jan. 29 that profit in its poultry business
fell 41 percent to $73 million in the fourth quarter because of higher corn costs.
Beverage Industry
Other links in the food chain are also feeling the effects of rising demand for
corn-based ethanol. Corn syrup accounts for about 10 percent of the costs for
bottlers of soft drinks made by Atlanta-based Coca-Cola and PepsiCo Inc. of
Purchase, New York.
Prices usually drop after a big harvest like the one in 2006. Instead, for the first
time in memory, corn syrup prices are rising for two consecutive years -- up more
than 20 percent in 2007 after scattered increases of 5 percent to 20 percent the
previous year, says John Sicher, publisher of the industry journal Beverage
Digest.
``We as an industry are facing unprecedented issues on cost,'' John Brock, CEO
of Atlanta-based Coca-Cola Enterprises Inc., Coke's chief bottler, said at a Dec.
11 conference in New York.
The company raised North American prices as much as 4 percent in October.
Prices may rise 5 percent in 2007, Morgan Stanley analyst Bill Pecoriello wrote in
a Nov. 12 report. The company declined to comment on pricing.
Crop Size
The main uncertainty is how much corn American farmers can grow -- and how
many acres it will take.
Last year's crop was the third-largest in history, 78.3 million acres (31.7 million
hectares). To keep corn stocks from shrinking to zero over the next two years,
the U.S. must add 12 million more acres, Credit Suisse analyst David Nelson
wrote in a Jan. 17 report. In addition, use of animal feed must drop 14 percent
and U.S. corn exports must decline 35 percent.
The result, according to Nelson: A ``massive'' liquidation in U.S. meat production
and a shift to lower-cost suppliers in Brazil.
Collins, the Agriculture Department economist, told the Senate last month there's
no reason for alarm. He said there are several ways to meet increased demand
for ethanol, ranging from boosting yields with drought-resistant strains of corn to
tapping land now held in reserve. About 36 million acres across the U.S. are
covered by a conservation program that pays farmers $1.8 billion a year in an
effort to restore native grasses and control soil erosion.
Nelson estimates 4 million to 7 million acres of the reserve are viable for farming.
Subsidies Shrink
Growers point to other benefits: Higher commodity prices prompted the
Agriculture Department to estimate Jan. 31 that it will reduce support payments
for farmers to $13 billion in fiscal 2007, from $20.2 billion in 2006.
``The good news is it's driving down the cost of the Farm Bill,'' says Curt Watson,
a fourth-generation farmer who grows corn, soybeans and sugar beets in
Renville, Minnesota. ``Energy provides a bit more diversity on the farm.''
For all the excitement, ethanol share prices haven't taken off as expected. One
reason: After soaring to more than $77 a barrel in mid-July, oil prices have
dropped back to about $60 a barrel. The rising cost of corn is another factor,
cutting profit margins. Many ethanol refiners become unprofitable once corn rises
to $4.50 a bushel, according to analysts at the commodity fund Krom River
Partners LLP in London. That's just 50 cents more than yesterday's price.
Ethanol Shares Tumble
Shares of Fresno, California-based Pacific Ethanol Inc. -- whose largest
stockholder is Gates -- have sunk to less than $20 from more than $40 in May.
Aventine Renewable Energy Holdings Inc. of Pekin, Illinois, has dropped 60
percent from its initial public offer price of $43 in June. Goldman Sachs had a 2
percent stake as of September. Hawkeye, backed by Boston buyout firm Thomas
H. Lee Partners LP, postponed a planned IPO in September.
Venture capitalist Khosla, who helped start Santa Clara, California-based
computer company Sun Microsystems Inc., remains bullish. His Khosla Ventures
has invested an undisclosed amount in two corn-based ethanol plants and seven
other biofuel projects.
``I'm not changing my plans at all,'' he says, predicting the eventual emergence
of as many as five major biofuel companies, each with annual sales of $10 billion
-- compared with $12 billion for the entire industry in 2006.
``It's about five new Googles in this business,'' Khosla says. ``That's how you
should frame it.''
'Crack That Code'
Better technologies aren't far away, says Dan Reicher, president of New Energy
Capital Corp, a private-equity firm in Hanover, New Hampshire, that has stakes
in three corn-based ethanol plants. The firm is part of a group that won a $10
million grant from New York state in January for a pilot project to make
``cellulosic'' ethanol from wood residues.
``Once we crack that code, it will be extremely attractive, from both an
environmental and an economic standpoint,'' says Reicher, an assistant
secretary in the U.S. Department of Energy from 1997 to 2001.
The breakthroughs can't come soon enough, because making ethanol with corn
carries its own environmental drawbacks, according to a June 2006 study by
researchers at the University of Minnesota in Minneapolis. They found that there
may even be a net increase in greenhouse gas emissions if more acres are
devoted to growing corn.
The crops have to be irrigated, plowed with tractors, doused with nitrogen
fertilizers and transported to ethanol distilleries, which power their machinery with
natural gas or coal. Croplands are less effective than forests or grasslands in
absorbing carbon dioxide, the heat-trapping gas blamed for global warming. Most
U.S. croplands have lost one-third of their carbon, the Agriculture Department
estimates.
`Dead Zone'
Nitrogen is a potent greenhouse gas, too, says University of Minnesota research
associate Jason Hill, one of the study's authors. When it's sprayed on crops,
some is discharged into the atmosphere and some washes down the Mississippi
River basin into the Gulf of Mexico, where it's blamed for forming an oxygendepleted ``dead zone'' the size of New Jersey.
``There's an awful lot we need to know before we plunge headfirst into biofuels,''
Hill says.
Different Options
With so many uncertainties about ethanol, economists like Iowa State's Wisner
say the U.S. would be wise not to shortchange investments in hybrid-electric cars
and hydrogen fuel cells. He says crops may be stretched thin in years of bad
weather or disease.
``It adds an element of volatility -- and really the weather does become the makeor-break factor in whether you satisfy demand,'' says Geoff Cooper, a
spokesman for the National Corn Growers Association in St. Louis.
Others argue for gasoline conservation as the backbone of energy
independence.
Adams, the Chicago bond analyst, says it's the choice he eventually made for
himself. Last year, he bought a Toyota Motor Corp. gas-electric hybrid SUV that
gets 30 miles to the gallon. His wife ferries their kids around in that, and he drives
the Yukon only 4 miles a day.
``It's a trial-and-error, messy, long-term process,'' Adams says. ``When it's time
to replace your gas guzzler, you search into your soul and ask, `How big a
vehicle do I need?'''
To contact the reporter on this story: Peter Robison in Seattle at at
robison@bloomberg.net .