Ethanol’s effect on rising corn prices

October 19, 2010

By Will Van’t Veld
Economist
ATB Financial

William Van't Veld

William Van’t Veld

CALGARY, AB, Oct. 19, 2010/ Troy Media/ – In the summer of 2008, the price of corn had risen to a high of $US 6.6 per bushel – a 110-per-cent increase over where it had been just nine months prior. The rise led to riots in many developing nations as the price of staple foods soared.

In North America, debate raged over whether or not ethanol should play a role in energy and environmental policy, viewed as the principle drivers of the increase. That debate ended when corn prices subsided, but with the price back in the $US 5.50-6.00 per bushel range, issues could resurface.

Weather causing havoc

Weather conditions have been causing havoc on agricultural production this year. Drought conditions this summer in Russia dramatically cut the wheat harvest by nearly a third, and caused governments in the affected countries to impose export controls. Given that corn and other feed grains can be used as substitutes for wheat, one would have expected some moderate upward pressure on corn prices. However, recently it became apparent that adverse growing conditions in the U.S. mid-west, while not nearly as dramatic as those in Russia, were not ideal and this really pushed corn prices up.

Typically, the less-than-ideal weather conditions in the mid-west wouldn’t have warranted any significant mention. In fact, the USDA expects less than a four-per-cent drop in the corn harvest this year as a result of weather conditions. Yet, even though Russian wheat production fell by over 30 per cent, the rise in corn prices has been more dramatic than the rise in wheat.

The discrepancy is partly due to the high concentration of corn production, with nearly 50 per cent of the world’s corn supply being grown in the U.S. mid-west compared to only eight per cent of the world’s wheat supply being sourced in Russia. The other issue is the one alluded to earlier: ethanol.

Ethanol can be made from a variety of sources, including wheat, but corn is the dominant feedstock used in its manufacture. Increasingly, acreage in the U.S. is being devoted to corn, with total production up 37.5 per cent since the ’97-’98 season, but that hasn’t been enough to compensate for rising demand, which is up 57.6 per cent. Currently, about half of U.S.-produced corn is used for cattle feed and the other half for human consumption, seed and industrial use. Industrial use really equates to ethanol production, and this represents 77 per cent of non-animal feed demand. The drop in production will also reduce inventory levels, which could make corn prices even more susceptible to adverse growing conditions in the coming years.

Alberta farmers stand to benefit from the rise in corn prices. Grains and oilseeds typically see their prices bid up as North American livestock farmers move to substitute away from the high cost of corn. At the same time, livestock farmers in Alberta will benefit from a large supply of local grains that have been downgraded due poor growing conditions in many regions of western Canada. (Farmers elsewhere in North America might not be as lucky.)

Canola producers will benefit

Alberta canola producers will benefit as canola oil (and other oilseeds like soybeans) tend to move in tandem with corn prices, all of which can be substituted for each other in the production of many food products.

If food producers and livestock farmers believe higher corn prices will be the norm, they’ll raise prices or curtail output, which could lead to food price inflation. Wheat price inflation is less dangerous, as inventory levels remain healthy and it is unlikely that wheat production will be hit two years in a row.

The situation with corn is completely different. Each year more corn is being diverted to ethanol production, meaning crops have to increase just to keep pace. This leaves corn highly sensitive to any drops in production.