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0108 PD: Ethanol production increases risk for dairy producers

W. Cris Lewis and Tyler Bowles Published on 21 December 2007

It is well known that dairy producers face a variety of risks. These include biological factors, adverse weather, unusually large variations in both output and input prices, competition from foreign producers, as well as general fluctuations in national and world economic conditions.

Changes in government policies, often seemingly far removed from the dairy industry, also can have significant economic effects on agriculture producers; the federal government ethanol development program is a case in point.

Under the guise of contributing to the goal of energy independence in the U.S., energy legislation signed into law by President Bush in 2005 essentially has two fundamental components:

1. It continues the subsidy of $0.51 per gallon of ethanol produced.

2. It requires that gasoline producers combine 7.5 billion gallons of renewable fuel (which will be primarily ethanol) with gasoline by 2012.

It is also noteworthy that there is a prohibitive tariff on imported ethanol, which essentially eliminates lower-cost Brazilian ethanol.

The first provision established an incentive (in the form of a subsidy) to produce ethanol and the second provides a market for the ethanol produced.

Several basic issues relative to ethanol production include the following.

1) Without the $0.51 per gallon tax-credit and mandate, little ethanol would be produced. It simply cannot be produced and sold competitively without the subsidy and mandated use.

2) It is not clear that the production and delivery of ethanol to gas stations does not require more energy per gallon than is contained in the ethanol itself. Generally, transportation is by truck or train because ethanol cannot be transported through low-cost gasoline pipelines.

3) Testing indicates that vehicle fuel economy is significantly lower for ethanol than for gasoline. Ethanol simply contains less energy per gallon.

4) The expansion of ethanol production has increased the price of feed grains and the variability in these prices. Essentially, a government program ostensibly designed to reduce dependence on foreign oil producers has increased the risk of being a dairy producer.

5) To the extent market conditions have allowed, some of the higher costs have been passed on in the form of higher milk prices.

6) Finally, in the western part of the corn belt, where irrigation is used (e.g., parts of Kansas and Nebraska), the increase in corn acreage and the development of ethanol plants, both of which require large quantities of water, is causing water consumption problems. The drawdown of underground water supplies is creating conflict among growers, states (i.e., Kansas and Nebraska) and water managers.

The data shown in Table 1* illustrates the expansion of ethanol production and the associated increase in corn and barley prices. Following the 2005 Energy Policy Act, the numbers of ethanol plants on-line has increased from 81 to 110 with 76 more plants under construction in 2007. Ethanol production increased 12.5 percent in 2006 over 2005 (from 3.9 to 4.9 billion gallons), and, as indicated above, the 2005 Act mandates a production increase to 7.5 million gallons by 2012. Obviously, the increase in ethanol production has increased the demand for corn, which largely explains the increase in the price of corn from $2.03 per bushel in June 2005 to $2.14 in 2006 and $3.51 in June 2007, despite a record 2007 crop. In addition, it appears that feed grain price variability also may have increased with the expansion of ethanol production.

It is instructive to quantitatively measure the risk faced by dairymen as a consequence of input price variability. The statistical measure known as the standard deviation is an excellent way to measure input price variability and the associated risk. This statistic approximately determines the average variability in prices over a given period.

Figures 1* and 2* show the standard deviation in the price of corn for every 12-month period from 1976 to mid-2007 and for barley for every 12-month period from 1990 to mid-2007.

Essentially, these graphs show the input price risk faced by dairy producers over these periods.

For corn, the average risk (i.e., the average value of the standard deviation) over the entire 18-year period is 0.212. With the production increases in ethanol in the past two years pushing up the price of corn, the standard deviation in 2007 has reached levels of almost 0.60 or three times the long-term average.

The recent input price risk associated with barley (as shown in Figure 2*) of more than 0.60 is higher than in any previous period in the past 17 years.

In summary, a program nominally structured to reduce the risk of dependence on foreign supplies of oil has had a variety of side effects, some of which probably were intended (e.g., a transfer of income and wealth to corn growers, especially the larger producers in the Midwest) and others that may not have been intended but certainly not unpredictable (e.g., increased input prices and input price risk for livestock producers and higher food prices for consumers). From an overall economic policy perspective, the government ethanol subsidy and production program probably has had net negative consequences for the U.S. economy; certainly it has conferred large gains on some and large costs on others. PD

Tyler Bowles Professor of Economics at Utah State University

Q. What prompted you to research the effects ethanol has had and continues to have on U.S. dairy producers?

There have been proposals in the context of the energy bill to dramatically increase the alternative fuels mandate to as much as 35 billion gallons. Aside from the absurd notion of politicians picking a number out of the air, such a dramatic increase in ethanol production would have dire consequences for the U.S. livestock and dairy industries.

Q. In your opinion, what can dairy producers do to help others realize the burdens they are bearing because of the current administration’s policy toward ethanol?

Historically, ethanol policy has been a political sacred cow. Recently, however, representatives of livestock and poultry interests, environmentalists, taxpayers and food groups are voicing opposition to an unchecked, aggressive ethanol policy. Dairymen need to be heard in this debate.

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