“Usage mandates will drive the ethanol industry, even though profit margins have been narrow,” says James Mintert, Kansas State University agricultural economist. “When you mandate usage levels, you take economics out of the equation.”

Though the truth of that has been painfully obvious to cattle producers competing for grain with the millstone of federal ethanol subsidies tied 'round their necks, the ethanol industry also reaps the market illogic of artificial prices.

Ethanol gross margins - the difference between revenues from ethanol-plant outputs (ethanol and dried distillers grains and solubles) and the costs from variable inputs (corn and natural gas) - spiked at more than $3/gal. in summer 2006, says the Center for Agricultural and Rural Development (CARD). By that September, gross margins had already declined to roughly $1/gal. Today, the gross margin is around 75¢/gal., slightly higher than projections a year from now (Figure 1, page 78). Keep in mind, gross margin doesn't mean profit - it excludes components such as labor, maintenance and financing - only that a positive margin makes profit possible.

Even with crude oil in the spot market surging beyond $100/barrel and futures prices over $90, corn prices have swallowed much of the profit enjoyed by ethanol producers early on. That's why consolidation has been more active in the ethanol industry and some plans for new construction have been shelved.

It's not going away, though.

Mandate means high prices

The Energy Independence Security Act (EISA) that became law in December ensures incentive for expanded ethanol production, as well as incentives for advanced renewable fuels that will likely be difficult to entice without increased subsidies.

EISA mandates that 9 billion gals. of biofuel be used in 2008 (the bulk of it will be from ethanol). The mandate for corn-based ethanol is 13.2 billion gals. in 2012 and 15 billion gals. in 2015.

Bruce Babcock, CARD director and Iowa State University agricultural economics professor, estimates these mandate levels will require 16.2, 23.2 and 25.5 million acres, respectively, of corn acreage devoted to ethanol production. Babcock's estimates account for average yield increases and wet distiller's grains going back into ethanol production.

Last year's record crop came from 93.6 million acres, the most acreage in corn since 1944. Heading into this crop year, though, high prices for other commodities and their lower input costs compared to corn mean the odds are against that many acres going back into corn.

According to the Renewable Fuels Association, current U.S. ethanol production capacity stands at around 7.8 billion gals.; 4 billion gals. more capacity is projected in 2008.

Using a stochastic partial equilibrium model, which accounts for both randomness and probability, CARD researchers examined how Renewable Fuel Standards (RFS) defined by EISA, impact corn prices in their study, “Ethanol, Mandates and Drought: Insights from a Stochastic Equilibrium Model of the U.S. Corn Market.” According to Babcock, if both the EISA mandate and the current 51¢/gal. blenders tax credit for corn ethanol were eliminated, corn prices would decline about 22%.

Think about that. With Midwest new corn hovering around $5.30/bu. last month, that means it would still be $4.13 without the ethanol mandate and subsidy. Cowboy math says that's how much corn prices have increased due to global grain demand, fueled in part by the anemic dollar. Eliminating the blenders tax credit while maintaining the EISA mandate would decrease corn prices by only 2.3% in the CARD model.

Throw in a Midwest drought of 1988 proportions, and the CARD model has corn prices at $6.42 without the mandate, and $7.99 with the mandate.

Babcock explains competition for land ensures that providing an incentive to just one crop will increase the equilibrium prices of all.

“Corn and soybeans compete for the same acreage, so when energy prices are such that corn-based ethanol is stimulated, the price of soybeans must also increase if the farmer is to allocate some land to soybeans,” Babcock says.

More startling is the impact of the EISA mandate for biofuels production besides ethanol. EISA mandates that fuel producers use at least 36 billion gals. of biofuel by 2022 (no more than 15 billion gals. from corn-based ethanol). In theory, that means more pressure on feed stocks for other renewable fuels, and at least a cap on how much pressure the mandate can exert on corn prices. Reality looks vastly different, though.

In another recent CARD study, “Crop-Based Biofuel Production under Acreage Constraints and Uncertainty,” subsidy levels required to achieve EISA mandates for advanced renewable fuels are estimated at $1.97-$2.90/gal. for biodiesel and $1.55-$2.11/gal. for cellulosic ethanol.

“The new RFS results in much higher commodity prices than the baseline (see “Study parameters”). This suggests EISA cellulosic mandates that appear designed to avoid the feed-vs.-fuel tradeoff may actually exacerbate the situation, relative to a situation in which corn-based ethanol is allowed to expand,” Babcock says.

With new crop corn prices over $5/bu. and futures prices for soybeans more than $12, Babcock explains agricultural impacts will be staggering if they represent permanent price levels.

“Current prices imply that land rents in Iowa and the rest of the Corn Belt should increase by a factor of about 2.8, even after accounting for the loss of government payments, the higher production costs associated with increased demand for inputs and increased returns to management and machinery,” Babcock says. Use that same factor to increase land values from 2005 before corn prices took off, and Babcock says, “$5 corn and $12 soybeans could support average land values in excess of $8,000/acre.”

Supply/demand laws

It's difficult for livestock producers to make sense of an environment where higher prices lead to increased production and higher prices. Traditionally, increased production ultimately leads to lower prices.

Babcock points out EISA was adopted - and the lower RFS before it - at precisely the time global supplies of corn, wheat and oilseeds have been historically snug.

“An anticipated, slow ramp-up in grain production (global), combined with the need to meet new demand from biofuels mandates (global) is why Board of Trade prices are so high for the next three crop years,” Babcock explains.

World grain supplies will increase via acreage expansion, increased yield and investment in infrastructure ? the profit signals are too high for it not to occur. But, Babcock adds, “Demand expansion from U.S. and other countries' biofuel mandates is so large, it's likely that meeting food and fuel demand will require high-cost production practices and cultivation of lower-yielding acreage. In economic terms, this expansion of demand will push world agriculture up its long-run supply curve, which means future price levels will be permanently higher.”

For cattle producers, Mintert explains escalating feed costs are at the heart of the collapse in the price spread between cattle weight classes. He points to the difference between 500-600 lbs. steers and those weighing 700-800 lbs. (basis Kansas). The spread peaked near $20/cwt. in the summer of 2005; it bottomed out at about $7 last summer. More recently, Mintert explains the spread has rebounded to near $20 as strength in fall 2007 and winter 2009 live cattle futures prices have helped offset the impact of rising feedgrain prices.

Nearer term for cattle producers, Mintert emphasizes, “We'll see more price spikes, price volatility and higher average corn prices. We'll have to pay lots more attention to managing corn price risk than we have in the past.”

Study parameters

You can find the CARD studies mentioned in this article at www.card.iastate.edu.

The baseline parameters for CARD “Crop-Based Biofuel Production under Acreage Constraints and Uncertainty:” include pre-EISA policies, including 51¢ blenders tax credit for ethanol ($1 for biodiesel); average crude oil prices of $78.63/barrel; corn ethanol production capacity of 6.8 billion gals. annually; bio-diesel production capacity of 1.2 billion gals./year, and no cellulosic ethanol industry.