WASHINGTON IS IN THE MIDST of a food fight--a "food versus fuel" fight to be more exact. At issue is the Energy Independence and Security Act that mandates the use of 36 billion gallons of biofuels between now and 2022. That schedule is known as the Renewable Fuels Standard (RFS). The concept of mandating 36 billion gallons (up from actual production of 5 billion gallons at the time, and a projected 7.5 billion gallons by 2012) was put forth by President Bush in his 2007 State of the Union speech; the Democratic majority in Congress passed it 10 months later in December 2007.
Now, halfway through 2008, there are regrets about the RFS--at least in some quarters. Governor Rick Perry of Texas--George W. Bush's former lieutenant governor--has asked for a waiver of this mandate. So has Jodi Rell, Republican governor of Connecticut (the state President Bush's grandfather once represented in the U.S. Senate). The way the law is written, states can petition for waivers based on economic harm to their state or region. Waivers won't come easy--it is the Bush administration that grants them, and everyone from the president down has publicly defended the biofuels policy.
So have a number of legislators. Iowa Republican Senator Charles Grassley is among the most vociferous. He's written letters to 13 Iowa companies that are members of the Grocery Manufacturers Association (GMA), a trade association lobbying for changes in the RFS, which has hired a public relations firm for their campaign. Grassley refers to GMA as the "Big Food" lobby. His letter states in part: "This smear campaign led by an organization of which you are listed as a member is harmful to an honest discussion and should be abandoned."
As for his contribution to intellectually honest and constructive discussion, Grassley was quoted by reporter Philip Brasher in the Des Moines Register saying: "If part of our problem is that the Chinese are going to eat meat and you've got to have corn and soybeans to feed the Chinese their meat, then why isn't it just as legitimate for the Chinese to go back and eat rice as it is for us to change our policy on corn to ethanol?" As this "let them eat rice" soundbite made clear, the debate over the food versus fuel issue is about as undignified as a full out real food fight at a summer camp cafeteria.
In trying to exonerate ethanol, its advocates point to a cheap dollar, the influence of speculators, high energy costs, to Chinese demand for meat and grain, to a short wheat crop in Australia, and other factors as causes of commodity and food inflation. To be sure, the commodity sector is caught in a bit of a perfect storm--and all of these factors and more have contributed to higher food prices. But that's no defense of the RFS's massive, mandated biofuels production, which remains the fundamental change that is driving the agricultural commodity markets.
Loose monetary policy does indeed cause speculative bubbles that can push up commodities prices. Investing in commodities--rather than securities--is the best hedge against inflation. That's why so many pensions and mutual funds are heavily invested in corn and soybeans and crude oil right now. But it takes a stretch of the financial imagination to argue that speculative investment is the primary cause of the commodity inflation--speculative institutional investors are putting their money where they see prices already going up. Agriculture and energy commodities have seen bull market runs and attracted investment fund money, but construction-based commodities, like lumber and copper have not. The difference? There is a demand for food and fuel; there is not for building materials. In other words, demand--not speculation--is still the primary driver of price. And the strongest and fastest growing demand for corn and soybeans is from the biofuels sector.
On the supply side, there indeed have been shortages of some crucial commodities around the world, especially wheat. But consider the curious role U.S. biofuels policy played here too. At the end of October 2007, the Australian Bureau of Agricultural and Resource Economics (ABARE) which is the repository of official agricultural statistics for Australia, the world's largest exporter of that wheat, announced it was lowering the Australian wheat crop estimate to 12.1 million metric tons (MMT), from the previous projection of 15.1 MMT. In the two weeks after that announcement, corn prices increased from $3.70 per bushel to $3.83 per bushel despite a record harvest. Why would corn prices rally on the news of a global wheat shortfall? Because ethanol users of corn needed next spring's acres to be kept in corn in order to meet ethanol's demand for feedstock.
A cheap dollar also pulls up prices through export demand. That is certainly happening now. Normally, $6.00 per bushel corn would not be exportable--the cost would be way too high. But with the dollar so devalued, exports continue. Indeed, total U.S. exports are up--a full 13 percent from the 2003-2007 average, which amounts to an extra 258 million bushels exported. Ethanol's use of corn, however, grew almost four times faster--by one billion bushels from last year to this. Overall, USDA projects exports will account for 2.1 billion bushels of corn this year, while ethanol will account for 4 billion bushels.
And what about the impact of the Chinese livestock and meat complex, alluded to by Senator Grassley? According to China expert, Darrell Ray, Director of the University of Tennessee's Agricultural Policy Analysis Center, "China has not been importing corn to grow her livestock industry. China continues to export more corn that she imports. With regard to grains, China has been taking care of China as if it were a planet on to its own, completely independent of what is happening elsewhere. . . . To attribute today's international grain prices to China essentially assumes that beginning two years ago the market decided there may be a need for China to become a net importer of some corn in the future, say 2012, and so bid-up the price of corn by double."
Finally, there is the skyrocketing cost of oil. Certainly, high oil costs push up the cost of producing corn, a very energy-intensive crop. Oil prices, however, are not keeping pace with the rate of increase in corn prices, believe it or not.
According to an authoritative study conducted by the Department of Agriculture in 2003, it takes 49,753 BTU's to produce a bushel of corn. That is inclusive of all energy inputs--from manufacturing and applying pesticides, to operating irrigation, to the energy used in providing custom labor work, etc. Considering that each barrel of oil has 5.8 million BTU's, it takes less than one percent (0.86 percent) of the total energy in a barrel of oil to make a bushel of corn. Even when oil hit $147.02--its record close on July 11--that amounts to $1.25 of energy costs per bushel of corn, which was priced at $6.39 on that same day.
Percentage-wise, that is roughly 19 percent of the cost of a bushel of corn. Relatively, that ratio is low compared that ratio over the past couple of years since the RFS was enacted. Look back to April 2006--immediately before the major influx of ethanol came on-line. Corn was $2.20 per bushel; oil was $69.44. That yielded a ratio of 27 percent of the price of corn being attributable to energy costs. Since November 2007, when oil broke $90, the ratio of energy costs as a percent of the price of bushel of corn has dropped from 23 percent to the high teens. In short, corn prices are rising faster than oil prices, and that renders doubtful the argument that energy costs are somehow pushing corn beyond its market worth.
In summary, monetary policy, energy costs, export demand, and exchange rates are all catalysts--and can be powerful in their role--but the fundamental longer term trend driving commodity market bullishness is the ethanol mandate. In 2001-2002, ethanol comprised about five percent of the corn crop use; in 2008-2009, because of the RFS, ethanol will comprise 33 percent of total corn use. Moreover, federal law mandates that the use of corn-based ethanol grow from the current nine billion gallons to 15 billion gallons--a 67 percent increase--over the next six-and-a-half years.
The market has seen spikes of high corn prices over the past 10 years, but the food processing industry (or the livestock industry) often absorb short run high price spikes in commodity prices. Ethanol, however, is driving corn prices for the long run--there is a minimum guaranteed demand for corn-based ethanol that will increase year over year for the next seven years, and will remain constant for at least another seven years after that thanks to the RFS. That upward pressure will get pushed into food costs for the long run.
Moreover, the worst is probably yet to come. Indeed, a majority of the corn that is in the food products and meat we are currently eating was purchased out of the crop harvested in the fall of 2007, at an average price of $3.50 to $4.00 per bushel. Most of what we will be eating next year will come out of a harvest that would be priced somewhere between $6.00 to $6.75--based on a normal harvest from this spring's planting. Once the flood damage to the Midwest is assessed, those prices could be significantly higher. Food and beverage prices in April 2008 were 10.18 percent higher than they were in April of 2005 before the RFS was implemented--and corn prices are still climbing.
A study entitled The Effects of Ethanol on Texas Food and Feed by the Agriculture and Food Policy Center at Texas A&M University (TAMU), often cited by the "ethanol-doesn't-cause-food-inflation" crowd because one of the conclusions is "this research supports the hypothesis that corn prices have had little to do with rising food costs," also avers "it would appear that this research supports the hypothesis that the transition in livestock prices and margins has yet to move through the system." In other words, the dramatic impact of record priced feed corn has yet to be fully felt by the consumer. The worst is yet to come.
Consider the meat sector--meat purchases alone account for more than two percent of the total Consumer Price Index (CPI). To date it has been the cattle feeding industry, the meat packing industry, and the rancher and cow-calf farmer absorbing the shock of record corn prices. Indeed, there is a large supply of meat on the market right now--in part, it is worth noting, because high corn prices have made it too expensive to keep beef alive on the hoof versus slaughtered and in the cooler. But as the current cold storage meat supply dwindles, the more expensively raised cattle will be harvested, and the retail impact will be felt.
Premier livestock analysts Len Steiner and Steve Meyer from the CME Group note one very key historic precedent: "the last major change in corn prices was followed by the first major change in food, meat and poultry costs since World War II." Corn prices back in 1973 jumped 67 percent over the previous year, establishing a new plateau--much as ethanol is driving food prices to a new, higher plateau now. Food inflation set a record that year, and continued rising an average of 8.2 percent from then to 1981 when it began to stabilize. Average food inflation the past 10 years has been 2.3 percent, by comparison; over the past 12 months, it has been 5 percent--since the implementation of the RFS, food inflation has been 8.67 percent.
The TAMU study is instructive in putting into context the various econometric machinations used in this debate. That study provides this caveat: A weakness of our approach is that the historical data are just that, and as such our measurements do not fully reflect the structural change that has been taking place in recent years. Indeed, economic modeling--more art than science to begin with--is a backward looking discipline. That is a problem, as biofuels have changed the commodity supply and demand balance as we know it. Indeed, what econometric model based on historical data could accurately predict and analyze the ramifications of record high prices coupled with a record large crop? That tandem has never happened before.
Moreover, corn has never faced a demand as inelastic as biofuel use. The law mandates the utilization of at least one in every three bushels of corn--no matter the price, no matter the overall supply available--for fuel feedstocks. And consider, the more inelastic the demand, the more impact on price, so goes the economic theory behind the model.
When Secretary of Agriculture Ed Schafer said in May, that the RFS "is not a major factor" in food inflation, he placed himself in opposition to some very fundamental principles of economics. When he said in June, "there is no evidence that we can find that changing the renewable fuels standard or moving away from corn-based ethanol production would make any difference in the price of food and foodstuffs in our country," one has to conclude they weren't even looking for such evidence.
Dave Juday is a commodity market analyst.