MarketNotes
How Corn Became an Energy Play
There has been a lot of media coverage on governments' rising concern over greenhouse gases and the importance of finding and bolstering use of alternative (non-fossil based) fuels. Numerous governments – including Ontario's – are mandating the use of ethanol as a gasoline additive. And ethanol is made from corn, sugar and wheat – traditional "soft" commodities.
Ethanol, also known as ethyl alcohol or grain alcohol, is the current alternative fuel of choice. A recent (January 10, 2007) article in the Wall Street Journal entitled "Ethanol Bandwagon Picks Up Speed" noted that Gov. Schwarzenegger mandated fossil fuel-limiting regulations to be written by 2008 – and let the markets decide how to abide by them; ethanol is a front-runner in that race. On the same day of the WSJ article, 37 U.S. governors proposed tax incentives for ethanol use, about 2 years after the 2005 proposal that President Bush endorsed.
The numbers are staggering. The original proposal was for 7.5 billion gallons of ethanol to displace gasoline in automotive fuel by 2012; the new proposal tightens the timeline to 2010 and increases the target to 12 billion gallons, then to 15 billion gallons by 2015 and then to 37 billion gallons by 2025. In the year 2025, approximately 25% of U.S. gasoline consumption will have been replaced by ethanol.
Given that ethanol facilities or converters can get about 2.8 gallons out of each bushel of corn (the rate has been inching upward over the last 10 years), that means 13.2 billion bushels of corn would be required. From 1930 to 2003, productivity of corn acreage increased from 20.5 bushels per acre to 151.2 bushels per acre, and productivity is expected to continue to increase by about 1.5 bushels per acre per year. By 2025, that equates to between 184.2 and 223.9 bushels per acre – or 59.0 to 71.7 million acres. We'll take the mid-point at 65.4 million acres.
Approximately 16% (one-sixth) of U.S. arable land would be devoted to fuel rather than food.
What are the implications?
Reduced farmland available to other crops
In 2006, it's estimated that 11.11 billion bushels of corn were produced on U.S. farms, up about 3% per year since 2000, and that means a greater proportion of farmland is being devoted to corn production. Indeed, Credit Suisse sees U.S. corn acreage (for food, feed and ethanol) rising from 78.6 million acres in 2006 to 83 to 85 million in 2007. In 2006 about 20% of the corn crop was used in ethanol production; this is forecast to rise to 30% this year and 38% in 2008. The increased focus on corn comes at the expense of diminished soybean and cotton planting, among other crops.
More expensive livestock feed
In addition to manufacturing ethanol, ethanol facilities produce something called DDG (distillers dried grain, a co-product used as animal feed). One bushel of corn becomes 2.8 gallons of ethanol and 17.8 pounds of DDG. It is simply added to ground corncobs for feed. However, soy is also used for feed and with less of it available (less acreage dedicated) there could be less supply of livestock feed. DDG is only a coproduct of ethanol production, and more feed can be generated from a pure feed-conversion process. That means less livestock feed is being produced per acre of arable land. Already the pull of corn to other uses has raised corn prices and higher corn prices translates into higher feed prices. Combined with less land available for production of other animal feed crops (soy), the overall impact on livestock feed prices is significant.
More expensive beef
Higher feed prices means lower beef production, as producers quickly market cattle (getting them off their hands in order to limit the feed bill). The Department of Agriculture's monthly cattle-on-feed report showed that the U.S.'s largest feedlots placed 7.6% fewer cattle into their feeding pens during November 2006, compared with the previous year. Further, the animals were lighter. Consequently, there was less overall beef production and higher prices. The same trends exist for pork and poultry. And, since ethanol producers can outbid livestock producers due to energy prices, tax breaks and subsidies, there is little livestock producers can do, short of lobbying.
Conclusion
Corn has become an energy play for the 21st century, but the growing demand for corn for ethanol production is having a domino effect on other soft commodity prices (livestock, soy and cotton, for starters). Given these emerging trends, is there a way for investors to benefit? Invest in corn, because ethanol production is mandated by the U.S. government and corn is the U.S.'s fodder for it. Invest in soy, cotton and other crops that will likely be displaced by corn because with decreasing supply, their prices can be expected to rise. Invest in cattle and pork as those downstream commodities could face dwindling and pricier feed inputs resulting in lower production and higher prices.
The ONE Financial CASH+ Breakfast Notes provide exposure to soft commodities, including livestock, corn, soy, cotton and numerous others. And they do so with the security of 100% principal protection and the benefit of a tax efficient, variable quarterly income stream.
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