Ethanol: Facts, Fiction, and Questions

1. Ethanol: Facts, Fiction, and Questions Robert Hauser University of Illinois May 2007

2. Crude Oil Prices, Cushing, OK WTI Spot Price, Jan. 2, 1986 – Nov. 21, 2006

4. Corn used for ethanol

5. Ethanol Capacity PlantsCapacity Existing 118 6.09 bil. Gal. Construction 87 6.43 bil. Gal. ----------------------------------------------- 12.52 bil. gal.= 4.5 bil. bu. of corn Source: RFA 5/8/2007

7. Ethanol production cost per gallon • Non-corn cost at 12% ROE: $0.89 • Corn cost at $2 - $4/bu: $0.73 to $1.45 TOTAL COST: @ $2 corn -- $1.62 per gal @ $4 corn -- $2.34 per gal

8. Revenue from Ethanol Production • Ethanol value based on: • Substitute for gasoline (67% BTU) • Federal government subsidy • Other subsidies • DDGS value • CO2 value • Octane booster • Oxygenate • Meets RFS requirement

9. Effects on break-even gasoline price Corn price/bu $2.00 corn $4.00 corn Ethanol cost: $1.62 $2.34 Co-products $1.39 $1.90 Subsidy $0.88 $1.39 Additive value $0.58-$0.88 $1.09-$1.39 BTU inefficiency $0.86-$1.31 $1.62-2.07

10. With versus without subsidy $2 corn $4 corn $1.62 eth$2.34 eth With subsidy $0.86-$1.31 $1.62-2.07 Without subsidy $1.62-$2.07 $2.38-$2.83 ---------------------------------------------------- $80 crude oil => $2.61 wholesale gasoline $60 crude oil => $1.98 wholesale gasoline $40 crude oil => $1.36 wholesale gasoline

11. Perspective The effect of the federal government tax credit subsidy, under the assumptions used here, has the same effect on the break even gasoline price as changing the market price for corn from $2 per bushel to $4 per bushel.

12. Monthly Farm Price of Corn in Illinois, January 1960-September 2006

14. Corn price expectations:short versus long term Short term: depends mostly on U.S. supply • Current expected 2007 production: 12.3 bil bu • Probability of a 10% or more negative deviation: 19% • Probability of a 10% or more positive deviation: 13.5%

15. Potential Supply and Consumption Balance Sheets for the 2007-08 U.S. Corn Marketing Year

16. Long term corn price expectation • Oil price • Additive value of ethanol (RFS, octane, oxygenate …) • Ability to increase 10% mixture • Trade barriers • Non-feedstock cost of ethanol production • Non-ethanol corn demand – domestic feed, industrial, export, carryover, … • Domestic and foreign supply responses

17. Long-run example • Expect the long run wholesale price of gasoline to be $2.00 per gal • With subsidy, no additive value, and a 12% return on equity, this implies that the “break even” corn price is $3.50 per bushel. • If long-run price of corn is below $3.50, firms enter market. • If long-run price of corn is above $3.50, firms exit market.

18. Why is entry/exit so important with ethanol and not other uses? 1. Long run equilibrium price has been well below $3.50

19. Monthly Farm Price of Corn in Illinois, January 1960-September 2006

20. Why is entry/exit so important with ethanol and not other uses? • Long run equilibrium price has been well below $3.50 • Ethanol production will have a negligible effect on gasoline price, yet • It is a significant part (greater than 20%) of corn production

21. What adjustments will be needed to reach the new, $3.50 equilibrium • Depends on the elasticity of demand of other uses • Depends on the elasticity of supply of corn and other crops

22. Demand elasticities • Assume the following price elasticities of demand: • U.S. meat: -0.5 • Exports = -1.0 • Industrial = 0.0 • If feed is 25% of retail price and ethanol causes a 50% increase in feed costs then the resulting 12.5% increase in meat price causes a 6.25% reduction in meat consumption.

23. Demand effects, ceteris paribus • Corn exports (at unitary elasticity) falls by 50% • Virtually no effect on industrial use • The feed and export demand implications represent a 13.5% diversion away from traditional uses to ethanol • Represents about 11 million acres

24. Supply response • However, the effect will be much larger given long run supply responses • In the short run, the least-cost way of using more corn for ethanol is not through fewer hogs or exports, but through fewer soybeans, cotton, and wheat • Requires market adjustment in both long run price level and relative price • Soybean to corn price, for example, has fallen from 2.5 to about 2.0 this year for 2007 crops

25. Where does it end?? • In my opinion, a high long-term oil price expectation dictates the corn price • There will be a movement up the non-ethanol demand curves for corn (mostly feed demand domestically and abroad), causing substitution of land • The form of this substitution world wide will depend on supply responses in those parts of the world that can add crop acres, perhaps Brazil and the Ukraine

26. Other factors determining the new state of equilibrium • U.S. subsidy policy – very important • RFS level -- ?? • 10% ethanol versus …? • Tariff policies – important but unlikely to change • Breakthroughs in cellulosic technology. That is, reducing the cost of making ethanol from fiber as opposed to starch

27. Cost of Production of Biofuels from Alternative Feedstocks

28. Alternative feedstocks • We know little about cellulosic processing, transportation, or production costs • Implication here is that energy costs could make big difference in its absolute advantage • Valuation of carbon may also make a big difference

29. Life Cycle Carbon Emissions * Emissions from gasoline are calculated for a gasoline equivalent to a gallon of ethanol.

30. Sensitivity of Costs of Production to Crop and Carbon Prices

31. Some concluding “facts” • Ethanol is here to stay at a significant level (in terms of corn use) for the foreseeable future • Why? High oil prices; significant subsidies • Under reasonable assumptions, the effect of the current subsidies is the make the break-even gasoline price for $4-corn ethanol the same as the break-even price for $2-corn ethanol without subsidy

32. Concluding facts, continued • The resulting higher price of crops will get incorporated into land values, meaning that land owners will be one of the biggest winners. • The long term use of ethanol from corn will facilitate and encourage the development of other feedstocks

33. Fiction • The demand-driven increases in crop prices will lessen the demand for farm income support • Ethanol will add significantly to the “security” of U.S. energy market • The use of cellulosic feedstocks is “right around the corner.”

34. Some critical questions • Long run price of oil?

35. World Energy Outlook • World energy consumption will increase 70 percent by 2030. • Transport accounts for 60% of growth in oil consumption. • 70 percent of energy demand growth outside OECD countries • 1/5 of demand growth will be in Mainland China. • 18 cars per 1000 persons in Mainland China--800 in US Economic growth in Mainland China is creating greater demand for automobiles, creating traffic and air quality problems.

36. Some critical questions • Long run price of oil? • Subsidy policies? • 10% to xx?% ethanol? • Long run equilibrium crop adjustments? • Cellulosic technology?

37. Thank you!!