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

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

Corn used for ethanol

Ethanol Capacity Plants Capacity Plants Capacity Existing bil. Gal. Construction bil. Gal bil. gal.= 4.5 bil. bu. of corn Source: RFA 5/8/2007

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

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

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 $

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

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.

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

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

Potential Supply and Consumption Balance Sheets for the U.S. Corn Marketing Year USDA WASDE : Expected Production : 10% Larger Production : 10% Smaller Production : 20% Smaller Production Supply (million bushels) Beginning Beginning1, Imports Imports Production Production10,53512,29013,51911,06110,784 Consumption (million bushels) Feed and Residual Feed and Residual5,8505,7505,8505,0904,450 Exports Exports2,2002,1501, ,600 Ethanol Ethanol2,1503,4003,5003,3003,060 Other Other1,3751,4001,4001,3601,260 TOTAL TOTAL11,57512,55012,90011,55010,370 Ending Stocks Ending Stocks , %5.5%12.1%4.0%4.0% Average Farm Average Farm$3.10$3.30$2.60$4.25$5.25 NOTE: USDA WASDE estimates for were released on May 11, 2007.

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

Long-run example Expect the long run wholesale price of gasoline to be $2.00 per gal 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. 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 below $3.50, firms enter market. If long-run price of corn is above $3.50, firms exit market. If long-run price of corn is above $3.50, firms exit market.

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

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

Why is entry/exit so important with ethanol and not other uses? 1. Long run equilibrium price has been well below $ Ethanol production will have a negligible effect on gasoline price, yet 3. It is a significant part (greater than 20%) of corn production

What adjustments will be needed to reach the new, $3.50 equilibrium 1. Depends on the elasticity of demand of other uses 2. Depends on the elasticity of supply of corn and other crops

Demand elasticities Assume the following price elasticities of demand: Assume the following price elasticities of demand: U.S. meat: -0.5 U.S. meat: -0.5 Exports = -1.0 Exports = -1.0 Industrial = 0.0 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. 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.

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

Supply response However, the effect will be much larger given long run supply responses 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 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 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 Soybean to corn price, for example, has fallen from 2.5 to about 2.0 this year for 2007 crops

Where does it end?? In my opinion, a high long-term oil price expectation dictates the corn price 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 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 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

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

Cost of Production of Biofuels from Alternative Feedstocks Feedstock sources Feedstock cost ($/gal) Based on $2.05 corn Opportunity Cost of Land for Producing Feedstock ($/gal) Non- Feedstock Cost ($/gal) Co-Product Credit ($/gal) Total cost ($/ gal) Corn – – 1.25 Corn Stover Switchgrass Miscanthus

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

Life Cycle Carbon Emissions Production phase KgCO 2 e/Gallon of Ethanol Biorefinery phase KgCO 2 e/Gallon of Ethanol Feedstock source Feedstock Displacement of alternative land use Net Sequestration Processing phase Co- product credit Total KgCO 2 e/ Gallon of Ethanol Corn Corn stover Switchgrass Miscanthus Gasoline*7.15 * Emissions from gasoline are calculated for a gasoline equivalent to a gallon of ethanol.

Sensitivity of Costs of Production to Crop and Carbon Prices Crop Prices $2/bu Corn; $5/bu Soybean $3/bu Corn; $5/bu Soybean $3.50/bu Corn; $7/bu Soybean Price of CO 2 ($ metric ton CO 2 ) Cost of Ethanol ($/gal 100E fuel) Corn Corn Stover Switchgrass Miscanthus

Some concluding “facts” Ethanol is here to stay at a significant level (in terms of corn use) for the foreseeable future Ethanol is here to stay at a significant level (in terms of corn use) for the foreseeable future Why? High oil prices; significant subsidies 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 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

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 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 The long term use of ethanol from corn will facilitate and encourage the development of other feedstocks

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

Some critical questions Long run price of oil? Long run price of oil?

 World energy consumption will increase 70 percent by  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 World Energy Outlook Economic growth in Mainland China is creating greater demand for automobiles, creating traffic and air quality problems.

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

Thank you!!