Sunday, March 23, 2008

Economics of ethanol as a biofuel

By enacting the Energy Independence and Security Act of 2007, the US Government legislated into force a whole new economy in biofuels, whose consequences are bound to be felt for decades to come.

As David Rotman writes in the Technology Review, "the energy bill prescribes a minimum amount of biofuel that gasoline suppliers must use in their products each year through 2022. The new mandates, which significantly expand the Renewable Fuels Standard of 2005, would more than double the 2007 market for corn-derived ethanol, to 15 billion gallons, by 2015. At the same time, the bill ensures the creation of a new market for cellulosic biofuels made from such sources as prairie grass, wood chips, and agricultural waste. The standards call for the production of 500 million gallons of cellulosic biofuel by 2012, one billion gallons by 2013, and 16 billion gallons by 2022."

Economists are worried about the distortions such mandates will create in the agriculture and energy markets. Producing 15 billion gallons of conventional ethanol will require farmers to grow far more corn than they now do. And even with the increased harvest, biofuel production will consume around 45 percent of the U.S. corn crop, compared with 22 percent in 2007. Because corn is the primary feed for livestock in this country, that means higher prices for everything from beef to milk and eggs. High corn prices could also make it harder to switch to cellulosic biofuels, because farmers will be reluctant to grow alternative crops. Since it became apparent that the biofuel standards would become law, the price of corn has risen 20 percent, to around $5.00 a bushel.

Professor Wallace Tyner of Purdue University studued the economics of corn, ethano and oil, and finds that biofuels struggle to compete with oil on cost, in part because of extreme sensitivity to the commodity price of corn. In the absence of government subsidies or mandates, according to his model, no ethanol is produced until oil reaches $60 a barrel. But with oil at that price, ethanol is profitable only as long as corn stays around $2.00 a bushel, which limits production of the biofuel to around a half-billion gallons a year. As oil prices increase, so does ethanol production. But production levels continue to be limited by the price of corn, which rises along with both the demand for ethanol and the price of oil (farmers use a lot of gasoline). Even when oil reaches $100 a barrel, ethanol production will reach only about 10 billion gallons a year if there are no subsidies; and even then, ethanol is profitable only if corn prices stay below $4.15 a bushel. If oil hits $120 a barrel, ethanol production will, left to market forces, reach 12.7 billion gallons--still more than two billion short of the federal mandate.

Tyner claims that setting the ethanol market at 15 billion gallons will mean an "implicit tax" on gasoline consumers, who will have to pay to sustain the high level of biofuel production. When oil costs $100 a barrel, the consumer will pay a relatively innocuous "tax" of 42 cents per gallon of ethanol used (the additional price at the pump will usually be only a few pennies for blends that are 10 percent ethanol). But at lower oil prices, the additional cost of ethanol will be far more noticeable. If oil falls to $40 a barrel, the implicit tax for ethanol will be $1.05 a gallon--or $15.77 billion for all the nation's gasoline users.

Update 1
Here is an article about how the ethanol craze may be driving up food prices.

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