March/April 2008

The Mess of Mandated Markets

Continued from page 1

By David Rotman

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Perhaps most obvious will be the impact on the price of corn--and, indirectly, of food in general. Since it became apparent that the biofuel standards would become law, the price of corn has risen 20 percent, to around $5.00 a bushel, says Bruce Babcock, director of the Center for Agricultural and Rural Development at Iowa State University. He expects that prices will probably stay around that level for at least the next three years. Because corn is the primary feed for livestock in this country, that means higher prices for everything from beef to milk and eggs. (Less than 2 percent of the nation's corn crop is eaten directly by humans; more than 50 percent feeds animals.) High corn prices could also make it harder to switch to cellulosic biofuels, because farmers will be reluctant to grow alternative crops. With the price of corn so high, says Babcock, "who is going to replace corn with prairie grass?"

At Purdue University, Wallace Tyner, a professor of agricultural economics, has calculated how different types of government policies, including the new mandated consumption levels, will affect the economics of corn ethanol. One of his most striking findings (though one that would surprise few agricultural experts) is that the fuel struggles to compete with oil on cost, in part because of extreme sensitivity to the commodity price of corn.

Because ethanol is generally blended with gasoline at a concentration of 10 percent, its market value is directly tied to the price of oil. But Tyner's analysis illustrates the complexity of the interplay between the markets for oil, corn, and ethanol. In the absence of government subsidies or mandates, according to his model, no ethanol is produced until oil reaches $60 a barrel. But with oil at that price, ethanol is profitable only as long as corn stays around $2.00 a bushel, which limits production of the biofuel to around a half-billion gallons a year. As oil prices increase, so does ethanol production. But production levels continue to be limited by the price of corn, which rises along with both the demand for ethanol and the price of oil (farmers use a lot of gasoline). Even when oil reaches $100 a barrel, ethanol production will reach only about 10 billion gallons a year if there are no subsidies; and even then, ethanol is profitable only if corn prices stay below $4.15 a bushel. If oil hits $120 a barrel, ethanol production will, left to market forces, reach 12.7 billion gallons--still more than two billion short of the federal mandate.

In other words, the federally mandated consumption levels mean ethanol will not, for the foreseeable future, be truly cost-competitive with gasoline. Indeed, says Tyner, setting the ethanol market at 15 billion gallons will mean an "implicit tax" on gasoline consumers, who will have to pay to sustain the high level of biofuel production. When oil costs $100 a barrel, the consumer will pay a relatively innocuous "tax" of 42 cents per gallon of ethanol used (the additional price at the pump will usually be only a few pennies for blends that are 10 percent ethanol). But at lower oil prices, the additional cost of ethanol will be far more noticeable. If oil falls to $40 a barrel, the implicit tax for ethanol will be $1.05 a gallon--or $15.77 billion for all the nation's gasoline users. "If the price of oil drops substantially, is Congress going to say, 'We didn't really mean it'?" asks Tyner. "It gets really messy."

The Mess of Mandated Markets

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