February 23, 2007

A 1970s-type Stagflation Threat
Special Report

My good friend, Don Coxe, has got me thinking about the potential inflation pressure coming from the super surge in corn prices, reflective of the ethanol production plans of the U.S. and other G-7 countries. Don is recommending a reduction in bond exposure, as he increases exposure to stocks to "build positions in agricultural, gold, base metal, and energy stocks". If you haven't already read this month's Basic Points, "Baubles, Bangles & Needs" (February 20), I suggest you do so. Don is always a provocative thinker and he is often at the forefront of new developments. I think (fear) he might be on to something.

If the production of ethanol actually materializes to levels anywhere near plans, the surge in corn, soybean and sugar prices could well continue and be sustainable. This means the cost of producing meat and poultry spikes as just a first-round effect and corn exports fall sharply. The price of farm land in the U.S. and Canada has already begun to rise meaningfully and the Kansas City Fed survey of manufacturing in the Tenth District shows a strong rebound in February, with price indexes increasing for the second consecutive month due largely to rising food prices. (The Tenth District encompasses Colorado, Kansas, Nebraska, Oklahoma, Wyoming, northern New Mexico, and western Missouri-only part of the American Corn Belt).

There is a lively debate about the efficacy of ethanol in the scientific and business community. It takes a good deal of energy to produce ethanol from any source; ethanol is less fuel efficient, as it takes 25% more ethanol than gasoline to drive a given number of miles. As well, there is a question just how much corn, switch grass, sugar or other bio-material is realistically available to produce sufficient ethanol to markedly reduce U.S. dependence on Middle East oil. Moreover, ethanol is corrosive if it comes in contact with oxygen. The infrastructure needed for ethanol to replace gasoline in a major way is expensive and yet to be built. Any mix of fuel that includes more than 10% ethanol technically requires a retooled auto engine. Brazilians in the 1970s began producing and purchasing alcohol-fuelled cars, only to abandon them when oil prices plunged.

Nevertheless, the Congress, White House, and the American public love the idea of ethanol; so grain and seed prices are surging.

Politics

The U.S. Congress passed an energy bill in 2005 that mandated the doubling of alternative-fuel use by 2012 to 7.5 billion gallons a year. Then President Bush raised the ante in his State of the Union speech in January by seeking a boost to 35 billion gallons a year by 2017. That would be a huge jump from where they are now: an estimated 4.9 billion gallons were produced in the U.S. in 2006, according to the U.S. Renewable Fuels Association, a trade group representing the ethanol industry. In 2000, 1.6 billion gallons were produced. The U.S. has 112 active ethanol plants, another 77 are under construction and 7 are being expanded, according to the trade group. Big companies such as Archer Daniels Midland Co. and smaller startups and farmers have jumped in on the ethanol-driven corn rush.

According to the Canadian Renewable Fuels Association (CRFA), fuel ethanol can also be made from bio-materials such as crop residues (straw, corn stover, etc.), forestry wastes (sawdust, etc.), municipal solid waste and recycled newsprint. Temeco Enterprises, a pulp and paper producer in Quebec started in 1991 to produce ethanol from forest waste. Terra Grain Fuels Inc. of Regina is currently constructing an ethanol plant near Belle Plaine, Saskatchewan that is designed to produce approximately 150 million litres of ethanol annually from corn or wheat. They are committing to use locally grown wheat to assist in creating a profitable wheat market in Saskatchewan. CRFA argues that fuel ethanol makes sense for many reasons, particularly its benefits for Canadian agriculture. The farm lobby in North America is one of the strongest ethanol advocates.

Food versus Fuel Means Rising Prices

There is a critical balance of food versus fuel, not only for U.S. and Canadian livestock farmers and food consumers, but for a larger global economic order. The U.S. heartland is to corn what the Saudi Arabian desert is to petroleum. The U.S. produces 40% of the world's corn and is the largest global supplier. There is no alternative to U.S. corn yet, but Brazil and Argentina have increased their corn crop substantially, and the decline in the U.S. dollar has offset some of the rise in corn export prices for now.

Newly affluent and emerging middle classes in developing countries-who in turn bring more political stability to the developing world-have for the past two decades demanded better diets in terms of protein-meat, milk, and eggs. That demand has been met in no small part because of U.S. corn.

Early this month, it was reported that some 75,000 unionists, farmers and leftists in Mexico marched to protest price increases in basic foodstuffs like tortillas. Poor Mexicans rely on tortillas-made from corn meal-as an inexpensive dietary staple. In Southern Africa, 'mealie', a hot porridge-like food made from corn is also a staple. Corn meal is called mealie meal and it is used to make bread and other baked goods. And many other poor people in many other places rely on other foodstuffs made from corn.

The average corn price in August 2006, at the end of the last crop year, was US$2.09, but when current and prospective ethanol capacity hit the 8 billion gallon level, corn prices started a bull trend, still in place. On January 23, the day of the State of the Union speech when the President introduced his plan for renewable energy, corn was $4.09 per bushel, and it is currently about $4.13 per bushel. Many analysts expect $5.00 per bushel before this is over. Putting this in context, for the past ten years, the average price has been $2.05 per bushel; in only three years have corn prices ever topped $3.00 per bushel. The all-time record-high season-average corn price is $3.24 per bushel in 1995/96-a year that saw many ethanol mills shut down because of too high corn prices.

But now, the use of ethanol is mandated by law, and as such price does not necessarily impact demand. Instead, the burden of record corn prices falls on the livestock and meat sector-typically the economic engine of the rural and farm economy. The U.S. National Cattlemen's Beef Association, the National Turkey Federation, the National Chicken Council, and the U.S. pork producers are predicting not only rising costs and prices of their products as many producers lose money-but herd reduction is inevitable. The U.S. is a large net-exporter of chicken and pork. With the surge in price, these exports will no doubt dwindle, driving the U.S. dollar down further.

Many food products will be impacted. For example, Maple Leaf Foods Inc. is warning of more job cuts and price hikes for meat, animal feed and possibly bakery products to cover the increased cost of wheat and corn caused by the demand for ethanol. The food processor announced yesterday a fourth-quarter loss of $11.6 million, from a year-ago profit of $18.2 million, after $44.9 million in restructuring charges and other costs. The major Canadian exporter, already reeling from annual losses of about $100 million caused by the strong Canadian dollar, has been grappling with rising grain prices. These increase the price of meat production, making consumer price increases in bakery and meat products inevitable.

And as more land is dedicated to planting corn, other commodities and food products-from wheat to tomatoes-could be in shorter supply, therefore bumping up their prices, too. Tyson Foods Inc., the world's largest meat producer, warned on Jan. 29 that rising costs would be passed on to the consumer as it discussed the potential risks of the ``dramatic rise'' in corn prices. Expect more of these announcements. Even products sweetened with high-fructose corn syrup-like Coca-Cola and other soft drinks, candy, snack foods, ketchup and myriad other products-are now more expensive to produce and consumer price hikes are in the works. Corn starch is also an important additive in many products from Chinese food to gravy. Should consumer food prices rise 10%, discretionary income could start to slide in the coming months. Food prices are a much larger proportion of the budget of low-income households than higher-income folks, so the lower-income quintiles will be disproportionately hurt. Their marginal propensity to consume is higher too, so their reduced discretionary income will slow retail sales, particularly at Wal-Mart and other stores that cater to this market segment. This could have a powerful macroeconomic effect.

Moreover, there is a shortage of motor fuel feed stocks. Much of the renewable fuels on which the Bush plan is based are assumed to be from cellulosic biomass (learn this term, you will be hearing a lot about it-in this case, it is corn stalks). Today, there is no ethanol commercially produced from cellulosic biomass feedstock in the U.S. The only existing cellulosic ethanol plant in operation is a test facility in Canada, where they produce about 84 gallons per ton. Unless the technology and efficiency change dramatically in the next ten years, there still will be no incentive to use cellulosic ethanol over corn-based ethanol. And, there just isn't enough corn potentially available to satisfy the demand coming from production of ethanol, let alone for food. Furthermore, there is nothing secure about fuel based on the corn crop, which can be wiped out by drought, insects or floods in any given year.

Government Subsidization

In addition, making money on ethanol has become increasingly difficult as corn prices surged at the same time that oil prices fell to an 18-month low a few weeks ago. The spread between the sales value of finished fuel ethanol-which is tied to gasoline prices-and the price of corn is getting squeezed fast. Such slim profit margins have started worrying investors, who not so long ago were giddy over ethanol-linked stocks. VeraSun Energy Corp., for instance, was among the hottest stock offerings in 2006, but in the last two months, shares in the South Dakota-based company have slid more than 30%, despite the President's call for higher ethanol mandates. Archer Daniels Midland, America's largest food processor, just reported a 20% gain in its fiscal second-quarter earnings, but that was achieved by raising its selling prices for ethanol, starch and sweeteners to help offset higher corn costs.

All this surely won't be lost on politicians who have been pumping up ethanol's virtues. The U.S. federal government already supports producers with a tax subsidy of 51 cents per gallon of ethanol, which totals about $2.5 billion a year, and it's possible that will rise if the profitability issue doesn't improve. A U.S. government-imposed tariff of 54 cents a gallon also put a floor under ethanol prices by making imports more expensive. In Canada, the CFRA is asking government for further subsidization of biofuel R&D and other supports to assure the profitability of the nascent industry.

Potential Macroeconomic Effects

This means that more taxpayer dollars could go toward ethanol production, at the same time that taxpayers are footing bigger bills for food. Most informed people seem to know that ethanol is not a panacea for all our environmental ills. Nor is it a replacement for U.S. Middle East oil imports. The President's renewable energy plan will arguably never be fully implemented.

But, what concerns me is that the biofuel-induced surge in some commodity prices might have broader, unintended effects on markets and the global economy. If this were to go too far or last too long, the potential macroeconomic implications could be serious: inflation, higher interest rates, food shortages, falling U.S. exports, widening U.S. current account and federal budget deficits, and a rapidly depreciating U.S. dollar-in other word-stagflation.

We last experienced stagflation-a slow-growing, high-inflation economy-in the early 1970s, the last time the biofuel bandwagon rolled by.