September 30, 2011
Lower corn costs, elastic feed consumption and stubborn ethanol demand
Ethanol's rising returns and steeper demand curve means that that falling feed demand will not always translate into lower corn prices.
An eFeedLink Exclusive Commentary
by Eric J. BROOKS
If there's an invisible market hand keeping corn's price high, it is surely the growing, changing role played by ethanol. Defying early 2011 predictions of flat or falling output, US ethanol production has continued rising in the face of high corn costs, keeping CBOT corn futures at much higher price levels than was expected a year ago.

While the EU financial crisis pushed CBOT corn down by 20% in September, the price fall will likely only stoke higher demand for this grain. With corn's costs falling much faster than the price of oil, ethanol profit margins are improving even as livestock farmers struggle to find supplies at a reasonable cost. To understand what this means for the cost of feed, we examine what ethanol is doing to corn's price behaviour.
 According to the USDA's September World Markets and Trade report on grains, for the first time since the early 1970s, the US will account for less than 50% of world corn exports. This however, is not due to higher corn production growth, lower corn prices or superior corn yields anywhere elsewhere in the world: It is entirely the work of ethanol

The world that could have been

In 2001, America grew 252 million tonnes of corn. Approximately 15 million tonnes or 6% of 2001's corn harvest was made into ethanol, while 49 million tonnes was exported. That year, the United States supplied 64% of world corn exports.
In 2011, America will grow 317.4 million tonnes of corn. 127 million tonnes or 40% of the harvest will be turned into ethanol while only 42 million tonnes will be exported, which amounts to just 45% of world corn exports.
If nothing had changed and only 6% of this year's corn crop was turned into ethanol (as was the case in 2001), it would be a completely different world: Instead of 127 million tonnes of corn being turned into ethanol, only 19 million tonnes would be.
That would have freed up a whopping 108 million tonnes of extra corn. Take out the rise in the proportion of US corn eaten up by ethanol and this year's world corn exports zoom from an estimated 93 million to a jaw-dropping 201 million tonnes. America would have accounted for 74% of corn exports, corn's price would probably be below US$2.50/bushel -and food price inflation would never have happened.

The world the way it really is…

However, as ethanol becomes more economically viable on its own terms, even without government assistance, its demand for corn has become less responsive to high prices than that of livestock farmers. According to the latest studies, while livestock farmer's continue to react to higher feed prices in the same way, the way ethanol plants behave towards higher corn prices has changed. This of course, carries great implications for feed supplies, livestock production and profoundly impacts the cost of meat on your table.
This resilience, even expansion of corn demanded by US ethanol makers in the face of higher corn prices caught many analysts by surprise early last year. It accounts for much of this year's market rally and is one reason why, even with feed demand falling in the US and Europe, corn prices and consumption remain stubbornly high.

Why ethanol does not react to higher corn prices

There are actually two facets to this situation: Petrol refiner's ethanol demand depends on the price of oil and is the demand-pull factor for corn in ethanol. The cost-push factor comes from ethanol makers' corn cost. The overall impact on demand comes from the change in corn's cost versus the change in price of oil and petrol.
And over the last month, the price of crude oil (and petrol) fell by 7% while that of corn fell by 15%. With ethanol's corn's cost falling faster than petrol's selling price, this gives America's profitable ethanol producers even wider gross margins. Naturally, this encourages ethanol plants to ramp up their own corn purchases by enough to make up for the country's faltering feed demand.
The implication is obvious: This time around, lower feed demand may not cut the price of either corn or meat by that much.
But historically high oil prices are only one facet of ethanol's improved balance sheet. Compared to the 2007 to 2008 market rally, ethanol is simply more immune to the vagaries of either corn input costs or oil prices. Back then, UBS estimated that ethanol became profitable without government assistance at an oil price of US$85/barrel. Recently, Morgan Stanley estimated that ethanol's break-even-point without government subsidies had fallen to an oil price of US$75/barrel.
While there is uncertainty about exactly what corn price ethanol remains profitable, one thing is for certain: its profit margins are healthy and the recent price drop is giving them an incentive to step up their corn purchases.
Ethanol's estimated profit point is a point of contention: Conservative estimates such as that of Morgan Stanley, put ethanol's profitability point at US$8.77/bushel today; and at US$7.12/bushel if America's congress revokes fuel blending's US$0.45/gallon tax credit.
A more bullish assessment by Canada's Potash Corporation states that US ethanol is now profitable at any price below US$9.60/bushel or at US$8.00/bushel should its fuel blending tax credit is removed, concluding that, "at any corn prices below these levels, ethanol producers will have a positive margin."
Within a few months, USDA statistics will show how ethanol distillers behaved during the last several months of corn prices above US$7/bushel, and this will give us some more insight into which assessment of ethanol's break-even-point is more accurate.

Ethanol by-products keep output profitable at high prices

Finally, if ethanol's improving break-even point wasn't enough to keep its corn demand rising, the market for ethanol by-products is also becoming more profitable. For example, Tate & Lyle recently reported that, "We have seen a continuation of favourable market conditions for [ethanol] co-products and in the US we have locked in sales further forward to take advantage of unusually strong demand."
Similarly, for US ethanol's best known by-product, rapid DDGS export growth to Asia is tapering off but this is counterbalanced by rising shipments to Europe, where America's DDGS exports have doubled from last year's level.
With ethanol's break-even corn price falling, oil prices staying high, improving by-product prices and DDGS exports rising, this corn buyer segment is developing a remarkably strong immunity to high prices.

Microeconomic rationale behind corn's new price behavior

Moreover, increasingly insensitive demand for corn is also interacting with limited land arable area and higher populations. One makes corn's demand curve more steeply sloped and price insensitive. The other makes corn harvests less able to expand in response to higher prices.
As the accompanying diagram shows, this means that it takes much larger price increase than in the past to make corn harvests expand. It also means that a price increase cuts demand by less than in the past too.
With both supply and demand less flexible than before, this means that for the corn market to balance itself, it now has to undergo much larger price swings than in the past. Consequently, corn's rising price volatility is a two-sided affair: A higher world population and the exhaustion of new arable land are constraining supplies in the face of ethanol's demand insensitivity to higher prices.

With all these factors in mind, Morgan Stanley's more conservative forecast concluded that, "Ethanol remains an unlikely source of corn demand rationing, as blender and producer margins remain positive on both a spot and forward basis."

Indeed, with corn prices having fallen by some 20% from their late summer peaks, ethanol makers will probably take advantage of harvest time's softer prices to lock in additional supplies. This in turn should soak up any excess corn freed up by falling feed demand.

All this implies that today's corn market will not behave like the one of ten or twenty years ago. America's feed demand consumed 62.3% of 1981's corn harvest, 58.8% of 1991's corn harvest. But over the next ten years, feed demand's proportion of America's corn harvest fell from 58.9% in 2001 to a mere 37.6% this year.
In effect, the feed sector's once-dominant elastic corn demand is giving way to ethanol's increasingly inelastic corn consumption. This implies that in the future, corn consumption will be far less sensitive to change in prices. With price movements themselves causing corn demand to fluctuate by far less in the past, it will take much larger price swings to make corn's demand adjust to changes in supply.

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