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Damn the ethanol and federal energy
policy forcing the market to choose between fuel or food and
livestock feed. Damn it and the havoc wrought by it. But it’s
only one of the macroeconomic forces—arguably one of the lesser
ones—bending commodity cost-price relationships that seemed set
in stone not so long ago.
As supplies of a commodity increase, the price is supposed to go
down, and visa versa. Yet, even with hefty corn harvests the
past two years, the price continues to march upward. Few
believed the market could sustain crude oil much past $70 per
barrel, but there it was marching past $100, then $120, then
$130. Bet on wheat topping $20 and plenty of folks would have
called you nuts even a year ago, but it reached that level.
Everything seems out of whack.
Corn prices go up, and calf prices remain historically high in
relative terms while the deferred live cattle contracts set new
records. There’s as much or more basis risk as there is price
risk, as distance-to-market and distance-to-feed spread the cost
of gain and cost of delivery from one region to the next.
In sum, you can’t manage what you
can’t see coming at you, and no one knows for sure what’s on the
horizon because so many forces are in play at the same time.
Call it a period of industrial
readjustment to a new commodity price plateau, with the economic
signals currently confounded in the cattle business by excess
cattle feeding and beef packing capacity, relative to cattle
numbers, as well as the worst financial crisis gripping the U.S.
economy in at least three decades.
Call it a mess. Anyone who tells
you they have the new market paradigms figured out is either
lying or wishing in blissful ignorance.
Ethanol as Driver and Scapegoat
There is no logical way to make sense of the federal
government’s willingness to choose fuel over food for national
security by subsidizing corn-based ethanol production.
There’s also no way to get around
the fact that these subsidies have increased demand for corn and
thus the price of it.
In June, the World Agricultural
Supply and Demand Estimates (WASDE) projected this year’s corn
crop at 11.7 billion bushels, based primarily on an estimated
yield decline of 6 bushels per acre below trend-line average due
to late planting, slow emergence and plant growth because of
widespread heavy rain and cooler than normal temperatures in the
Corn Belt. As such, the price of corn for the 2008-09 marketing
year was predicted to be $5.30-$6.30 per bushel.
With that said, vexing as it may
be, it’s hard to blame ethanol alone for the sustained run-up in
corn prices.
Bruce Babcock, director of the
Center for Rural Agricultural and Rural Development (CARD) at
Iowa State University testified before the U.S. Senate Committee
on Homeland Security and Government Affairs in May. It was at a
Hearing on Fuel Subsidies and Impact on Food Prices. Though
Babcock said added corn demand from the ethanol industry has
been a major factor in the doubling of corn prices in the last
20 months, he also pointed out that CARD research indicates
reducing or eliminating current subsidies for corn-based ethanol
production would have only minimal immediate impact on the price
of corn.
In that study, Babcock and Lihong
Lu McPhail, a CARD research assistant considered the individual
and collective elimination of the 51-cent-per-gallon blenders
tax credit, the import tariff tax on imported ethanol, and the
Renewable Fuels Standard, which specifies minimum biofuels
consumption levels for the U.S., mandating that usage increases
from 9 billion gallons in 2008 to 10.5 billion gallons in 2009.
McPhail and Babcock determined
that, “eliminating any one of the policies would reduce average
corn prices by less than 4%. Removal of all three programs would
decrease average corn prices by 14.5%. The reason why the
changes are relatively modest is that existing U.S. ethanol
plants will only shut down if their variable cost of production
is not covered.”
In his Senate testimony, Babcock explained, “Many people are
confused about the impact of federal ethanol policies. Much of
this confusion is seemingly caused by people assuming that
because government support was instrumental in bringing forth
the ethanol industry, then a withdrawal of support would get us
back to a time when the prices of corn, soybeans, and wheat were
less than half of today’s levels…
“The longer-term impact of a
change in federal biofuels policy depends crucially on the price
of crude oil and on the number of ethanol plants that come
on-line under current incentives. If we were to eliminate all
federal biofuels policies today, and future crude oil prices
support wholesale gasoline prices of $3.00 per gallon in the
future, then ethanol production over the next five years would
eventually increase to around 14 billion gallons, and corn
prices would be about $4.00 per bushel. A return of wholesale
gasoline prices to $2.00 per gallon would keep ethanol
production at about 10 billion gallons and corn prices would
fall to approximately $3.60 per bushel. In contrast, sustained
$4.00 gasoline prices would result in $5.00 corn, and 21 billion
gallons of ethanol.”
Similarly, Agriculture Secretary,
Ed Schafer explained in May that USDA expects food price
inflation this year to increase approximately 43% globally. “Of
that, we can identify 2 to 3 percent of that price increase that
is driven by biofuels,” said Schafer. “The majority of course is
energy, and the second largest piece, or about equal piece, is
the increase in consumption around the world which is using up
the production stocks.”
In summation, Babcock explained,
“There is no doubt that the growth of the ethanol industry is an
important factor in the run-up in agricultural commodity prices.
But this does not imply that a change in federal biofuels policy
would reverse this growth. If we continue to see crude oil
prices in excess of $100 per barrel, then there is little that
Congress or the EPA can do in the short run to significantly
reduce the price of corn short of an outright ban on producing
ethanol from corn.”
Don’t hold your breath.
The Oil Thing
Demand for distillate fuel (Including diesel and heating
oil) has declined 2% from the last quarter of 2007, according to
the Energy Information Administration (EIA). Yet, spot prices
for West Texas Intermediate Crude (WTI)—the basis for domestic
prices—skyrocketed from $113 to $133 per barrel in May. Though
it dropped back to $122 by the end of the month, it had climbed
to $138 by the end of the first week in June; nearby futures
prices for it the first week of June hovered around $132. The
average U.S. retail regular gasoline price June 2 was $3.97 per
gallon; $4.06 for blended gasoline.
According to EIA, in its June
Short term Outlook, the overall picture of strong demand and
tight supply is expected to continue.
All of that despite EIA
predicting U.S. consumption of liquid fuels and other petroleum
to decline 290,000 barrels per day this year, because of higher
prices and slower economic growth. Adjusting for increased
ethanol use, EIA analysts say U.S. petroleum consumption will
fall by 440,000 barrels per day this year.
According to EIA, “The
combination of rising consumption, further downward revisions in
the supply outlook for countries outside of the Organization of
the Petroleum Exporting Countries (OPEC), and low surplus
production capacity reinforce the perception that supply is
having a difficult time keeping up with demand growth,
accounting for much of the upward trend in oil prices.
Consumption in countries outside of the Organization for
Economic Cooperation and Development (OECD) continues to grow
rapidly, offsetting weaker consumption in OECD countries,
especially the United States.”
So, chalk rising prices up to
international demand growing faster than supply can accommodate,
just like the prices of other commodities like corn. “World oil
consumption is projected to grow by 1 million barrels per day in
2008,” says the EIA outlook.
In recent months some of the most pessimistic analysts have
predicted crude oil at $200 per barrel and gas prices at $7 per
gallon within four years.
Economic Woes at Home
Adding to the complexity of new demand-driven commodity
prices is the simmering U.S. economic malaise driven by the home
mortgage fiasco and resulting credit crunch, exacerbated by
commodity price inflation, chiefly energy and food.
“Most of the current economic
weakness can be attributed to two factors: the ongoing slump in
residential construction activity and the effects of higher
energy prices on consumer and business spending,” said Thomas
Hoenig, CEO and President of the Federal Reserve Bank of Kansas
City. In remarks to the Economic Club of Colorado in May, Hoenig
explained the dearth of new home construction had decreased
Gross Domestic Production by about 1% each of the past two
years, and that increases in oil costs will likely shave off
another percent.
“Another troublesome fact is that
accompanying the recent slowing of growth has been renewed
inflationary pressures. Prices for energy, food and other
commodities have soared over the past year,” said Hoenig.
“Overall CPI (Consumer Price Index) inflation has risen 4
percent from March of 2007 to March of 2008, and core CPI, which
excludes volatile food and energy prices, increased 2.4 percent
over the same time period.”
USDA’s Economic Research Service
projects an increase in the Consumer Price Index for food of
4.5-5.5% this year; that follows a 4.0% increase last year,
which was the largest single-year jump since 1990. While
uncomfortable here at home, global food price inflation has
spawned food crises for undeveloped nations. According to the
International Monetary Fund consumer food index, prices have
increased 45% worldwide since the end of 2006.
Hoenig continued, “It may seem somewhat strange for inflation to
be at these levels as the economy (domestic) is slowing, but the
inflationary pressures are not due primarily to domestic
factors. In fact, we are seeing significant increases in world
commodity prices and prices for imported goods, including goods
imported from China. Part of these increases are due to strong
economic conditions abroad, but part is likely due to the
sizable decline in the U.S. dollar over the past several years.”
Arguably, it’s the paradox of
growing inflation as the national economy limps along that has
led to headlines in the popular press trying to compare the
current financial crisis to that of the 1970s when a vicious
circle of rising inflation, rising wages and rising interest
rates entangled the economy, ultimately leading to price freezes
which led to even worse problems. What’s different this time
around is that wages haven’t been increasing and inflation has
so far been moderate enough that regulators haven’t yet started
to ratchet up interest rates (see Costs Up-Margins Down, page
24).
Incentive Takes Leave
In the meantime, cattle producers and others in the livestock
business have shouldered the brunt of commodity input inflation.
Net economics is obviously the
primary reason that cyclical herd expansion remains on hold. The
national beef cow inventory January 1 of this year was the
smallest in five decades. You can make a strong case that
inventory numbers will be down again January 1 next year.
Conversely, beef production remains nearly record high. That’s
another new force shifting the dynamics of the current cattle
cycle compared to the ones we’ve known traditionally. Fewer
cattle are needed to fill the beef pipeline and imports are
plugging the gaps.
That’s one reason deferred live
cattle futures prices appear so bullish. Cattle numbers are
tight and getting tighter as heifer feedlot placement and cow
slaughter continue ahead of a pace that would support expansion.
That, and the market is anticipating that sooner or later more
of the increased input cost will have to be passed along to
consumers, which adds to the inflationary pressures Hoenig was
talking about.
“There is an increased
probability of further slowing in the world economy, due to
recent financial market volatility and continued high energy and
input prices,” said analysts with the USDA Economic Research
Service in their most recent quarterly Outlook for Agricultural
Trade. “U.S. growth will slow in 2008 due to a sharp decline in
housing construction, financial market disturbances, and very
high energy prices. The U.S. banking system has provided
additional capital so farm operators should continue to get
commercial bank loans. Rising farm income and non-farm exports
will be growth areas in 2008.”
In some ways, it’s not that
commodity economics are bent in this new era of higher costs as
much as the fundamentals are working like gangbusters, though
governmental policies here and abroad are distorting the market,
prohibiting the market from finding its natural level.
Simplistically, in a global marketplace, for the first time in
history on a sustained basis, the U.S. faces competition from
international buyers with as much or more money in their
pockets.
“Overall, U.S. cow-calf producers
will see little if any near-term incentive to hold back extra
heifers for breeding herd re-building,” say analysts with the
Livestock Marketing Information Center. “In fact, many producers
will need to sell more heifers than normal to cover their out of
pocket costs.” |
