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Is Ethanol a Boon or Drain on Our Economy?

Posted on: Tuesday, 19 August 2008, 03:00 CDT

By Byrge, Joshua A Kliesen, Kevin L

Renewable energy In 2005 and 2007, two pieces of energy-related legislation with potentially far-reaching consequences became law. A key feature of these bills was a federal mandate to substantially increase the production of ethanol over the next two decades. These bills were aimed at reducing U.S. dependence on foreign-produced petroleum and at addressing global climate change.

Even before the federal mandate, ethanol production had been increasing rapidly since 2000. Some of this can be traced to the sharp rise in crude oil prices, which is a derivative of the rapid growth in developing nations like China. At the same time, food prices have begun to rise sharply, which is sometimes attributed to higher prices for corn, the primary ingredient in ethanol.

What are the costs and benefits of the ethanol boom, and is increased production of ethanol the primary cause of rising food prices?

According to the Renewable Fuels Association, ethanol production has increased by an average of almost 22 percent per year from 2000 through 2007. Over this period, the number of ethanol plants more than doubled, to 134. By January 2008, industry capacity stood at 7.9 billion gallons per year. According to the RFA, when all current building projects are completed, total capacity will exceed 13 billion gallons per year.

The surge in ethanol production can be attributed mainly to three factors: higher crude oil prices; federal production mandates and tax incentives given to ethanol producers; and the use of ethanol as a fuel oxygenate to replace methyl tertiary butyl ether, which was phased out in 2006.

Ethanol produced in the U.S. is derived mostly from corn. Hence, the primary consequence of an increase in the demand for ethanol as a gasoline fuel additive is an increase in the demand for corn. With the federal government mandating a five-fold increase in ethanol production by 2022, it seems inevitable that an increasing share of the nation's corn crop will be devoted to ethanol production. The prospect of higher corn prices-and the prices of other commodities, as more acres are devoted to corn production-has raised the specter of a food-fuel debate.

According to the U.S. Department of Agriculture, the percentage of the domestic corn supply used to produce ethanol has increased from less than 5 percent in 2000 to 22 percent last year. The USDA's latest long-term projections indicate that nearly 5 billion bushels of corn, or about 31 percent of total projected supply, will be used to produce ethanol in 2017. At the same time, the USDA projects that the price of corn in nominal terms will fluctuate between $3.50 per bushel and $3.80 per bushel. Although this is considerably less than prices seen currently, it represents a substantial step-up from the roughly $2.25 per bushel average price seen from 2000 to 2006.

For farmers, higher crop prices eventually lead to higher land prices, which has already occurred. At the same time, higher crop prices increase the cost of producing beef, pork and poultry.

Critics of the U.S. ethanol mandate argue that this increase in commodity prices has led to increased food prices worldwide. In the U.S., the Consumer Price Index for food and beverages increased by more than 4.5 percent last year, following an average increase of 2.5 percent from 2000 to 2006. This trend has continued into this year. Researchers, such as C. Ford Runge and Benjamin Senauer, professors of economics at the University of Minnesota, argue that increased biofuel production will lead to even more significant price increases for consumers in poor and less-developed nations, where food expenditures are a larger portion of consumer incomes. These concerns were also recently noted by officials from the United Nations and the International Monetary Fund.

However, in the U.S. the percentage of the corn crop used to produce food for humans is projected by the USDA to decline only from 9.6 percent of total supply in 2007 to 9.4 percent of total supply in 2017. In effect, to compensate for the increased ethanol production, the USDA assumes that corn yields will continue to increase and that there will be no major drought. The latter assumption might be crucial, given the projected decline in buffer stocks over time. Without adequate inventories (or imports), a major drought would probably cause a sharp increase in corn prices.

Another important, but often ignored, reason why higher raw commodity prices cannot fully explain the rise in food prices is that the commodity component of the consumer's food bill is relatively small. Over time, the farmers' average share of total consumer expenditures for domestically produced food has dropped measurably. This share averaged about 33 percent during the 1960s and 1970s, fell modestly to 26 percent during the 1980s, and then has averaged about 20 percent since the 1990s.

Greater use of ethanol would make a dent in the demand for oil, albeit a pretty small dent. (Using all corn grown in the U.S. to produce ethanol would replace only 12 percent of the gasoline used for transportation in the U.S.) Moreover, many experts contend that burning ethanol will lower greenhouse-gas emissions.

Congress has begun to promote cellulosic ethanol, which could produce 250 percent more ethanol per acre than corn. Of the 36 billion gallons of biofuels required by 2022-and nearly all of this is expected to be ethanol rather than biodiesel-16 billion must be from cellulose. One key source of cellulose is switchgrass, which is considerably cheaper to produce. However, as a recent academic study found, the infrastructure to support ethanol from switchgrass is "virtually nonexistent," and the U.S. Department of Energy's National Renewable Energy Laboratory has probably underestimated the costs of producing cellulosic ethanol by as much as 37 percent to 191 percent.

Obviously, significant improvement in technology will be necessary to bring this form of ethanol to market. Moreover, if the 2022 mandate is met, the combination of corn and cellulosic ethanol produced in that year will be "energetically" equivalent to roughly 21 billion gallons of gasoline (15 percent of the gasoline used for transportation in 2005). In short, crude oil will remain the dominant source of motor fuels production.

One way to partly meet the federal mandate would be to remove the federal import tax. This would allow imports of ethanol from Brazil, which is the world's second-largest ethanol producer. According to a recent report by the Congressional Research Service, Brazilian ethanol enjoys a significant cost advantage relative to U.S.- produced ethanol. Moreover, since Brazilian ethanol is made from sugar cane, allowing increased imports from Brazil would lessen the potential supply pressures on U.S. feed grain production noted above.

Joshua A. Byrge and Kevin L. Kliesen are economists with the Federal Reserve Bank of St. Louis. This article appears in expanded form in the July 2008 edition of the bank's publication, The Regional Economist.

Source: Northwestern Financial Review

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