Every farmer who pays for gas or diesel fuel is frustrated with rising petroleum prices and its impact on the expense side of a farm budget. But a new economic forecast from the University of Illinois says every farmer may soon be even more frustrated that the variability in petroleum prices is impacting the revenue side of a farm budget. Literally, the oil industry will control your cash coming and going.

It doesn’t matter whether it is the income or expense side of the balance sheet, there will be a line item attributed to ethanol impact, say Illinois agricultural economists Darrel Good, Gary Schnitkey, and Paul Ellinger in a new Farm Economics Facts and Opinions Newletter.

More than two billion bushels of the 2006 corn crop will be refined into ethanol, and that is expected to more than double by sometime in 2008. This has created a demand market unknown previously, and will push prices above historical averages. But as the other shoe drops, the ethanol demand may not reduce the variability in corn prices. As corn moves from a supply driven price to a demand driven price, it becomes more closely linked to the price of oil. That is the result of ethanol, which will soon be a replacement for petroleum, and priced in lockstep with petroleum. Early in the ethanol era, advocates told farmers they had an oil well in every corn field, and the Good/Schnitkey/Ellinger analysis indicates the economic consequences of that may come true. With ethanol priced equivalent to petroleum, the ethanol refiner will have a breakeven price that can be offered for corn. As the ethanol price increases (along with higher crude oil prices) that breakeven price will also increase. Unfortunate, the converse is also true.

The economists examined the ethanol industry and calculated two breakeven prices for corn. One allows operational costs for an ethanol refiner to be covered, and the second allows all refining costs to be cover, which would encourage expansion of the ethanol industry. To put those numbers in perspective, there has to be an economic link connecting the price of crude oil with the wholesale price of gasoline, and with the price of ethanol. The wholesale price of gasoline will be less than retail prices, because marketing margins and various federal, state, and local taxes have to be added. With current crude oil prices around $65 per barrel, that translates to a $2.14 wholesale gas price and a $2.14 (coincidentally) ethanol price. The economists found, “The gasoline and ethanol prices are equal only at a $2.14 price. For gasoline prices below $2.14, the equivalent ethanol price is above the gasoline price. For gasoline prices above $2.14 per gallon the ethanol price is below the gasoline price.” The breakeven corn price would be $5.62 to cover operating costs and $5.07 to cover all costs. “Currently, corn prices are around $3.50 per bushel, indicating that ethanol production currently is profitable. Current price forecasts suggest that corn prices will exceed break-even prices; therefore, there are incentives to expand ethanol production.” But they warned not to expect $5+ corn prices, just because the ethanol industry could pay that amount.

From 1986 through 1999, the low average crude oil price meant that ethanol was costly as a fuel source, since production costs were higher. Given that the break-even corn price was below the average corn price, ethanol production as a gasoline substitute was unprofitable say the Illinois economists. And they add, “Currently, the profitability of ethanol production and ethanol use of corn stems from high crude oil prices. At present, future markets point toward crude oil prices averaging $65 per barrel over the next several years.” While a decline in crude oil prices will cause the breakeven prices to drop, the economists looked at the futures and options market for crude oil and found that $65 is about the average expected over the next five years. They say, “Break-even corn prices will not necessarily equal corn prices that farmers will receive; however, the linkage will become more direct as ethanol constitutes a larger use of U.S. corn. The above analysis suggests that crude oil will not lead to more stable corn prices. Rather, dependence as a fuel source will cause corn to have more variable prices.”

Summary:
Cornbelt farmers have worked hard to promote ethanol and now that the corn market has benefited from that action, there may be some consequences of corn prices being more closely linked to the variability in the price of oil. As ethanol becomes more of a substitute for gasoline, its price will be parallel to that of wholesale gas and crude oil, creating a breakeven price that ethanol refiners will be able to pay for corn. Currently, crude oil, wholesale gas, and ethanol prices are high enough to allow profitability in refining ethanol from $3.50 corn. However, those profits diminish if corn prices climb above $5 or if oil prices decline.