Ethanol, “you ought to be in pictures!”

When California announced in June that all gasoline sold in the state must contain a 10% ethanol blend by late 2009, the corn-based fuel quickly became an even bigger star in the nation's most populated state — one that has some 25 million cars and trucks.

This boost in demand for corn is just one of the many firsts for corn growers. Consider, for example, how ethanol now links corn prices to energy prices. It used to be that weather and export demand drove corn prices. Now, ethanol prices follow oil prices, hitching farmers' fortunes to a new cart.

War in Iraq, corn yields in Iowa and weather on the Gulf coast — all impact ethanol production and profits. Anything that can cause oil or grain prices to fluctuate will shake up ethanol plants, what they can market fuel for and what they can pay for corn. Oil prices still have the biggest influence on ethanol prices. And they rub off on corn, too.

Continuation of the 51¢ government incentive for ethanol is another factor. But oil “is the major driver” in determining ethanol prices, says Chad Hart, Iowa State University (ISU) ag economist and part of a recent ISU study that examined the impact of the biofuels industry on grains.

“Higher oil prices are certainly a strong signal for more ethanol production,” says Hart. “Corn prices have a secondary effect on ethanol prices.”

Chris Hurt, Purdue University Extension ag economist, concurs. “Clearly the energy value in ethanol is much more valuable when crude prices are high,” he says.

With some 120 ethanol plants in operation and 80 or more under construction, ethanol production is expected to increase dramatically. The nation produced more than 4.9 billion gallons of ethanol in 2006 and projections are for 5.6 million or more this year, according to the Renewable Fuels Assn.

USDA says future plants in the works could increase production by another 6.2 billion gallons. That's close to the government's 12-billion-gallon target in 2012.

Rick Brock of The Brock Report, Milwaukee, WI, and market analyst for The Corn and Soybean Digest, says “there is a 50% correlation between ethanol stock values and crude oil prices, while the correlation with corn prices is only about 15%.”

Hart says that in the ISU study, which was released in May, economists looked at the impact of ethanol prices after a $10/barrel increase in oil prices.

In January, when oil prices were in the $50/barrel range, April Chicago Board of Trade (CBOT) ethanol futures were about $1.80/gal. When oil prices escalated into the low and mid-$60 range, ethanol futures approached $2.40. In mid-May, when crude oil was at $62, ethanol futures were about $2.20.

Oil prices bumped the high $60 level in May and parts of June. They topped $69 on June 18, again after Middle East tension flared. Ethanol futures remained above $2.14 and were expected to continue on the upswing.

“We determined that the industry could handle all of the ethanol we could throw at it,” says Hart.

With no end in sight for high oil prices, near-term ethanol demand and production should remain strong. More fuel for higher prices came when the California Air Resources Board ordered the 10% ethanol rule to begin Dec. 31, 2009. That would almost double ethanol demand in California, which last year used about 1 billion gallons, nearly 20% of the total consumed nationwide.

“We're really looking at how quickly the ethanol industry will grow in the next few years and whether it will hit the demand bottleneck,” says Hart. “Right now, if we converted the whole country to a 10% blend, the ethanol demand would jump to 15 billion gallons. Then, do we look at E85 or E15, E20 or other combinations? I think we will face that issue in the next three to four years.

“If sufficient demand for E85 from flex-fuel vehicles is available, corn-based ethanol production is projected to increase to over 30 billion gallons per year with the higher oil prices in the long run,” says Hart.

It's hard to be happy about $3-plus gasoline. But it if helps keep corn above $3 or even $4/bu., that could be better mileage for the bottom line of corn growers.

Continue reading on ethanol and oil prices on page 2 >

“Because corn is the major production cost for ethanol, the price an ethanol producer will be willing to pay for corn will be directly related to the ethanol price,” says Gary Schnitkey, University of Illinois agricultural economist.

He's co-author of “Crude Oil Price Variability and Its Impact on Breakeven Corn Prices,” through the Illinois farmdoc program. “As the ethanol price increases, the breakeven corn price (for an ethanol plant) increases,” he adds.

“Moreover, ethanol prices will be directly related to crude oil price…. As the crude oil price increases, the price of gasoline will increase, leading to higher ethanol and higher corn prices. Conversely, decreases in crude oil price will lead to a lower gasoline price, a lower ethanol price, and a lower corn price,” he says.

Competition from foreign ethanol will continue to pressure U.S. production. “Over 50% of Brazil's sugarcane production is going into ethanol,” says Joe O'Neill, senior vice president of marketing, New York Board of Trade (NYBOT), which handles sugar futures contracts. “Most of the world's ethanol is produced from sugar, which has had a big impact on our sugar contracts.”

While NYBOT's sugar contracts have seen heavy trading, its ethanol futures contract, which trades in 7,750-gal. increments, has been dormant. This spring there was no trading at all. “Liquidity hasn't materialized in that contract, but we expect it to be more active in the near future,” says O'Neill.

Meanwhile, CBOT ethanol futures have seen trading, but very little. Trading is based on 29,000 gal. per contract, equivalent to one railcar or two 5,000-bu. corn contracts. But in May, open interest was only about 1,000 contracts, compared to a record-setting CBOT total commodity open interest of 10 million contracts. A Chicago Mercantile Exchange ethanol contract trades in 30,000-gal. increments.

Brock says the demand for corn for ethanol will continue to escalate because many ethanol producers “don't care what they pay, they just need the supply of corn. Large producers (like Cargill and ADM) often must go ‘door to door’ to obtain contracts for corn grain handlers and growers,” he says.

He adds that the $4 billion in subsidies paid to ethanol producers “could double when all the proposed ethanol plants are online” and continue to fuel a growth in rural wealth.

In the long run, Hart sees greater emphasis on other crops to yield ethanol. “We see the development of cellulosic ethanol,” he says. “At a recent conference in Mexico, we heard from a lot of other countries that are also working to increase biofuels production with crops other than corn. We're all trying to find out if there's a way to reduce our energy needs through the crops we produce.”

Adds Hurt, “It's clear that the ethanol industry cannot continue to grow on the use of the corn seed as a feedstock source for more than a few more years without hitting huge constraints including extreme competition of corn use for food.

“The hope is that cellulose-based ethanol can then pick up the biofuels cause in the 2010-2012 time frame. What we do know is that biofuels are somewhere between a ‘big deal’ and a ‘revolution’,”he says.