Having spent a lot of time analyzing U.S. agriculture and prognosticating on what will happen next, my bottom line assessment is that the heady returns of the last few years are probably over, but the fears of the most pessimistic among us are probably overblown as well. Simply put, Midwest American agriculture is likely entering the early stages of a cyclical correction.
Note that I reference the Midwest because the biggest boom (bubble?) has been in row crop agriculture in the Heartland (especially corn and soybeans), largely as a result of the ethanol boom.
Drivers Of The Ethanol Boom
Ethanol is at the core of the situation in which American agriculture finds itself today. Many people have asked me what drove this ethanol boom. In my view it was a unique combination of both private and public support to both supply and demand for ethanol:
- The U.S. government supported ethanol demand through RFS, blender subsidies, the phase-out of MTBE in gasoline and R&D support for ethanol research.
- The U.S. government further supported domestic supply of ethanol through tax credits on biofuel facility construction and imported ethanol tariffs.
- Private industry supported the demand for ethanol through the expansion of hybrid and flex-fuel vehicle fleets as well as the overall growth of the greentech investment industry.
- The supply side of ethanol was supported by the ag industry (which had a large supply of cheap corn) due to both productivity (GMO corn) and favorable weather. The private equity and banking sectors supported supply through large quantities of cheap credit.
The net effect of this public and private support to ethanol was a surge that resulted in some 200 ethanol plants operating in the U.S. consuming 30% to 40% of the corn crop.
As a result of the ethanol boom, the price of corn jumped from the average price of $2.37 over the 35-year span from 1970 to 2005 to a much higher range between $4 and $7.50 a bushel, about two to three times the historical average. I have heard ethanol supporters claim that ethanol has had no effect on corn (or food) prices. My only question is: What are you smoking? Of course ethanol has raised corn prices! A primary reason corn ethanol is so strongly supported by corn growers (and many others in agriculture) is precisely because it has had the effect of creating a solid demand (price) floor under the commodity.
We all know in agriculture that commodity prices are set by the marginal demand in the market. The ethanol boom created demand for 5 billion bushels of corn, most of which was met with new production. This demand for corn not only drove corn prices to new heights, but also raised the entire commodity crop complex (which after all has to compete with corn demand to get acres). I find it somewhat amazing that anyone could argue with a straight face that adding 40% incremental demand to a commodity crop would not affect the price. Anyone who could seriously advance this argument clearly flunked Economics 101.
By the way, I am not saying that higher corn demand and higher corn prices are bad for American agriculture. In fact, I think they are good for American farmers and American agriculture. Higher prices not only support farm income but also support the investments in emerging technologies that are crucial to increasing agricultural productivity to meet the burgeoning demands of feeding 9 billion people by 2050 without massive subsidies. Corn prices of $2/bushel would simply not support this investment. But we need to quit arguing that ethanol has had no impact on the price of corn or food — that is patently false and just embarrassing. Instead, let’s embrace that enhancing the profitability and productivity of agriculture is essential to building the capacity to feed the world in the future.
Oil Arbitrage
One unintended consequence of the ethanol boom is that we have created an arbitrage situation with oil. Since crude oil is converted into gasoline and ethanol derived from corn is a substitute for gasoline, resulting in a direct correlation between oil and corn prices. This helps agriculture when oil prices are high, but when oil prices decline (global recessions, fracked natural gas competition) it can put downward pressure on ag prices.
The Effect Of Monetary Policy
Another related effect is that of monetary policy. The U.S. government has been printing money at the rate of $85 billion per month for the past few years and has been using monetary policy to lower the relative value of the dollar, which supported higher commodity prices. With the focus on “tapering” all the talk in Washington right now, it’s possible we could see a stronger dollar, which could have a negative impact on commodity prices.