The ongoing debate about the growing connections between food and energy has focused mainly on the influence on food prices of high energy prices and the diversion of crops into biofuel production. We are about to get our first real taste of the other side this relationship. There is a serious prospect that the direct and indirect effects of the current flooding in the Midwest will result in consumers paying even more for gasoline, due to disruptions in the corn ethanol supply chain. One estimate put the likely increase at 15%, or another 60 cents per gallon. The actual magnitude of the price spike will depend as much on the deftness of the federal and state governments in sizing up the change in ethanol supplies and issuing appropriate waivers, as on any action by the oil or ethanol industries.

Over the weekend I heard one reporter compare the flooding in Iowa to the aftermath of Hurricane Katrina, and it struck me that the impact on ethanol might be analogous to Katrina's on oil and gas production and refining output, though on a proportionally smaller scale. As a direct consequence of the floods, a significant fraction of Iowa's ethanol plants have been shut down. The impact on transportation systems has apparently been even more severe, with barge traffic stranded and a number of rail lines cut--thus restricting the means by which ethanol plants receive much of their feedstock and ship their product to market. These are short-term effects, similar to what happens when a refinery or pipeline problem disrupts gasoline deliveries. However, with total US ethanol inventories running at about 20 days of consumption prior to the flooding, a protracted outage could leave refiners and gasoline blenders short of ethanol for most of the summer, coinciding with peak gasoline demand.

The impact on ethanol production over the next year could also be significant, depending on how much of the corn crop has been lost. Compared to last year's 13 billion bushels, this year's corn crop was already predicted to be over a billion bushels smaller, even before the floods. With ethanol consumption mandated to increase from 6.8 billion gallons in 2007 to 9 billion gallons this year, ethanol's share of the smaller crop could rise dramatically, putting additional pressure on the price of corn and other agricultural products. That outcome is hardly pre-determined, though.

As I noted in a recent webcast (subscription required) on the US ethanol industry in which I participated with John S. Herold, Inc., ethanol output is driven by both economics and regulations. From a peak of nearly $3.00 per gallon, the "crush spread"--an indicator of ethanol plant margins derived from subtracting corn prices from ethanol rack prices--have recently fallen well below $1.00/gal. Based on Friday's CBOT July 2008 corn futures settlement at $7.07/bushel and ethanol at $2.799/gal., a crush spread of $0.28/gal. does not look sustainable. Ethanol prices must rise promptly, or ethanol output will fall, as higher-cost facilities are forced to shut down--or new plants delayed or canceled--pushing ethanol prices up later.

The knock-on effect on gasoline prices is harder to gauge, because of the uncertainties involved. In the best case, ethanol production might recover quickly and crush spreads rise by just enough to get ethanol plants back up to the 8.7 billion gal/year rate at which they were operating in March. Because gasoline contains no more than 10% ethanol, and with ethanol currently selling ex-distillery for as much as $0.50 per gallon less than the spot price of gasoline in the Gulf Coast before factoring in the $0.51/gal ethanol blenders' credit, the pump price of gasoline might go up by no more than a few pennies per gallon, or possibly not at all. But with several million acres of this year's crop already lost to the flooding, and the entire ethanol supply chain affected, including processing and distribution, that scenario seems wildly optimistic.

It is likelier that there simply won't be enough ethanol this year to meet the target of 9 billion gallons of combined production and imports set by the Energy Independence and Security Act of 2007. That goal looked like a stretch even before the floods, and the probable shortfall raises the odds that the EPA and states must ultimately agree to at least a portion of the ethanol blending waivers already requested by various states and municipalities, and preferably do so before the predictable ethanol supply crunch becomes a crisis. But even that won't be a panacea. With ethanol currently accounting for roughly 6% of the US gasoline pool, any shortfall must be made up by additional petroleum-based gasoline, which would come either from higher refinery runs--driving up crude imports and prices--or higher gasoline imports, in competition with demand from developing Asia. It seems ironic that an alternative energy program intended to make US energy supplies more secure might have the opposite effect, at least in the short run.

In a posting earlier this year concerning the food vs. fuel controversy, I suggested that our growing reliance on biofuels was introducing new linkages between two very complex, linked systems--food and energy. The results of these new interactions may surprise us, and one such surprise appears to be unfolding right now. That doesn't mean we shouldn't expand our use of biofuels, though there are ample reasons for caution with regard to food-based biofuels. But it does suggest that before we increase our reliance on these sources from 6% to the 20% or more contemplated by last year's Energy Bill, we need to learn much more about how this will work in the real world of floods, droughts, blights and all the other things that can impede the production of fuel from agricultural inputs.
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