How Ethanol Is Eating Our Lunch

Demand for the corn-based fuel is resulting in higher prices for food and fertilizer.
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Ethanol is attractive as a solution to high gasoline prices because it promises a free lunch:

  • U.S. farmers would grow corn.
  • U.S. ethanol companies would turn the corn into ethanol.
  • U.S. consumers would go about business as usual.
  • And everyone in the U.S. would be less dependent on foreign oil producers.
  • But repeat after me: There is no free lunch.

So far, this not-so-free lunch has resulted in higher food prices and rising U.S. dependence on fertilizers produced by, you guessed it, foreign oil and natural gas producers.

The costs are just starting to work their way through the U.S. and global economies. But it's none too early for investors to revise their portfolios to take account of the costs of this free lunch.

On June 4, corn (No. 2 yellow, central Illinois) sold for $3.77 a bushel. A year ago, the price was just $2.25 a bushel. That's a 68% jump in price in a year. (The futures markets say prices will stay here, too, with corn for December delivery selling at $3.83 a bushel on June 4.)

The Price Connection

Soaring demand for corn from ethanol producers isn't the only reason for the price increase, of course. There's rising demand from export markets for corn to use as animal feed and for human consumption. And there's increasing demand for corn sweeteners from the food industry.

But there's no getting around the corn-ethanol price connection. Corn prices are up despite projections of a record 12.5 billion-bushel corn harvest in the U.S. this year -- because ethanol producers will eat up 27% of the U.S. corn crop this year, according to the U.S. Department of Agriculture. Corn consumption by ethanol producers is projected to climb to 3.4 billion bushels in 2007, up from 2.2 billion bushels in 2006, when ethanol producers consumed 20% of the corn crop.

Supplies would be even tighter if high corn prices hadn't deterred some buyers. Corn exports, the U.S. Department of Agriculture says, are expected to drop by 10% in 2007. And corn purchases for animal feed will drop 3%.

Corn's Conquest

The high price of corn has had a ripple effect on the price of other farm commodities too. With corn so profitable to plant, farmers have shifted acreage from soybeans, for example, to corn. In 2007, the acreage planted in corn will grow by 16% from 2006, while the acreage planted in soybeans will fall by 11%.

So it's not especially surprising that the price of a bushel of soybeans was up 36% as of June 4 from a year earlier. (Corn isn't just displacing food crops, either. In the southern U.S., the acreage planted in cotton is down 20% in 2007 as farmers switch to planting corn.)

And the ripples haven't stopped with the grain markets. The U.S. food industry is largely built on corn. It feeds the chickens, pigs and cows that wind up on our dinner tables. It's the source of the sweeteners in everything from soda to cookies to bread. And it's processed into starch for use in candies, soups, cake mixes, baked goods and, in the general economy, into plastic, paper, adhesives and textiles.

So if the price of corn is up, you'd expect the price of everything to be up. And so it is. If you grilled steak on this past Memorial Day, it cost 5.5% more than a year ago, according to the U.S. Labor Department. Think you can escape by barbecuing chicken? Forget it. Whole chickens cost 7.7% more than they did in May 2006.

Milk and cheese are up, too, since corn makes up the bulk of a dairy cow's diet. Milk prices are up about 3% from a year ago, or about 10 cents a gallon, according to the U.S. Department of Agriculture. But higher costs could push up the price of a gallon of milk by an additional 40 cents in the next few months to a national average of $3.78 a gallon.

And those annual rates of increase understate the spike in prices so far in 2007. In the first quarter of 2007, raw milk prices were up 23%, for example.

So far in 2007, food inflation in the U.S. is running at an annual rate of 6.7%. If that rate holds for the entire year, that would be the fastest rate of increase in food prices since 1980.

Hit in the Breadbasket

The effects of higher corn prices don't stop at the U.S. border. In fact, consumers in poorer countries are being hurt by higher prices more than more-affluent consumers in the U.S. Food price inflation is running higher in developing economies than in the U.S., and in those countries food takes up a bigger part of the family budget.

Food-price inflation was running at 6.2% in China in the first quarter of 2007 and 11% in India, for example. In the U.S., food makes up only about 15% of the shopping basket that the U.S. Commerce Department uses to calculate the consumer price index. In Thailand, food makes up 35% of that basket. In the Philippines, it's 50%.

The decision to promote corn-based ethanol as part of our national energy policy (if you can call it that) has imposed other costs on the economy as well. Since ethanol is too corrosive to ship through existing pipelines, it has to be delivered from refinery to consumer by truck or rail.

It's also necessary to ship corn to the ethanol refinery and then to ship what remains after the starch has been extracted from the corn kernel to disposal sites or back to farms for use as feed. All of that extra hauling has put more pressure on U.S. rail lines that are already struggling with too much traffic running on too many single-tracked lines.

Growing Fertilizer Costs

And that 16% increase in the acreage planted to corn has also produced a big surge in U.S. fertilizer demand -- as much as an extra 1 million metric tons this year. (The shift from soybeans to corn also increases demand for fertilizer, since soybeans can fix nitrogen from the atmosphere and require less nitrogen fertilizer than corn.)

The supply to meet that extra demand won't come cheap, since nitrogen-based fertilizer prices are near record highs. Prices are projected to average $365 a metric ton in 2007, up from $270 a ton in 2006, an increase of 35%.

Much of that fertilizer will be imported, too. It takes natural gas to produce nitrogen fertilizers. High natural-gas prices have driven most U.S. producers out of the business, leaving nitrogen fertilizer production to countries such as Trinidad and Tobago, Russia and, surprise, Saudi Arabia. The U.S. Geological Survey calculates that in 2005 the United States imported 21% of the urea it turns into nitrogen fertilizer from Saudi Arabia and Qatar.

Game Plan for Investors

So where does this all leave investors?

  • Buying the shares of farm-equipment makers, such as Deere (DE) - Get Report, since whatever its net effect on the economy as a whole, ethanol is clearly good for farm incomes.
  • Buying the shares of fertilizer makers such as Potash Corporation of Saskatchewan (POT) and Yara International.
  • Buying the shares of agricultural commodity traders such as Archer Daniels Midland (ADM) - Get Report that have the ability to arbitrage prices between commodities and geographies.
  • Selling the shares of food-processing companies, such as Kellogg (K) - Get Report, Nestle, Hershey (HSY) - Get Report and PepsiCo (PEP) - Get Report, that are getting squeezed by rising commodity prices for key ingredients such as corn, corn sweetener, milk and cheese. And staying neutral on ethanol producers themselves.

Government subsidies for ethanol production have brought too many companies too quickly into the industry. A consolidation, fueled by high corn prices and bottlenecks in the distribution system that make it hard to get ethanol to market in many areas of the country, has just started.

And the technology questions still remain to be answered.

Brace Yourself

Can the corn-based ethanol industry find a way to solve its corn-price problem by turning more of what remains after ethanol production into animal feed? (Currently, that "waste product," DDGS, or distillers dried grain with solubles, has too much oil to be easily digested by many farm animals.)

Will the technology for making ethanol from plant cellulose, such as the switchgrass so often mentioned by President Bush, evolve from test project to commercial viability any time soon?

Corn-based ethanol yields only marginally more energy (optimistically) than it consumes in production, and it requires so much corn that reaching the administration's lofty production goals is unlikely. Yet despite all its faults, corn-based ethanol is here to stay, at least for the next five years or so. The political logrolling that passes for energy policy in Washington -- you vote subsidies for ethanol, I'll vote subsidies for "clean" coal -- just about guarantees that.

So you might as well prepare your portfolio for the consequences.

New Developments on Past Columns

"

Don't Fool Yourself: It's a Cheap-Money Economy": Yields on the 10-year Treasury note have climbed past 5% recently, and the stock market has stumbled. So what's the big deal about a 5% yield on the 10-year Treasury note, anyway? This is still, historically, a low interest rate on the 10-year note. Yields were well above 6% as recently as 2000 and spent all of 1999 well above 5%.

But it's not 5% per se that worries the stock market. It's the possibility that interest rates will move through 5% on their way to 6% or higher. That's a problem for this stock market, and stock investors, because this rally has been built on a belief that 1) earnings growth will pick up in the second half of 2007, and 2) that the

Federal Reserve

would lower rates or at least keep them steady for the rest of the year. With interest rates climbing, even without any action by the Fed, one of those beliefs is currently being tested.

At the time of publication, Jim Jubak owned or controlled shares of Archer Daniels Midland. He does not own short positions in any stock mentioned in this column.

Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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