Earlier this summer I learned how inelastic ethanol policies affect the refining industry and consumers when I spoke with Charles Drevna, president of the American Fuel and Petrochemical Manufacturers. Unfortunately, the fuel pump isn't the only way ethanol affects your family budget. In a recent interview with renowned agricultural economist Dr. Thomas Elam, president of FarmEcon LLC, I turned my attention to the food-vs.-fuel debate in an attempt to answer one burning question: "How much does ethanol production contribute to rising food costs?"
The following three graphs from Dr. Elam's report Food Costs Are Eating American Family Budgets provide a powerful backdrop for the food-vs.-fuel debate. All are based on real-world industry data from inherently unbiased sources such as the U.S. Department of Agriculture and the U.S. Department of Commerce. What will they uncover about the controversial topic of ethanol production?
The trend was our friend
In 1950, the average American spent approximately 26% of his or her disposable income on food. Think about that. For every $100 leftover after taxes, individuals had just $74 to spend on non-food expenditures. Luckily, advances in agricultural production, logistics and transportation, and food availability have steadily lowered the amount of money spent putting food on the table. Food expenditures as a percent of disposable income fell to 20% by the mid-1960's, zoomed lower than 16% in the early 1980's, and ducked under 12% for the first time in history in 2000.
That's quite the trend, except for one thing: It's reversing.
Food prices are affected by many variables, such as input costs to farmland (energy, fertilizer, and the like), fuel prices, and selling prices for crops. There is no single cause and effect. Unfortunately, there's a mountain of evidence supporting claims that increasing ethanol demand is a major contributor to higher commodity prices of most major agricultural crops.
More land for biofuels, less for food
It's no coincidence that the ratio in the preceding graph begins to stray from the historical trend in 2006 and grows to its largest deviation in 2012 -- that's exactly the same time period the Renewable Fuel Standard, or RFS, was enacted and enforced. The RFS mandates how much ethanol and biodiesel must be blended into the nation's fuel supply each year. While biodiesel production can be non-competitive with food production, nearly 85% (by weight) of feedstock supplying the industry in July came from soybean and corn plantings. Ethanol is sourced virtually exclusively from corn.
What companies are driving this demand? Renewable Energy Group (NASDAQ: REGI ) supplies nearly 17% of the nation's biodiesel but has been adding feedstock flexible capabilities to all of its facilities. That means the company can switch between soybean oil, corn oil, tallow (animal fat), and yellow grease during times of food price volatility. One of REG's biggest goals is to not compete with the food industry, although that's easier said than done.
Meanwhile, the country's top four ethanol producers -- POET, Valero, Archer Daniels Midland (NYSE: ADM ) , and Green Plains Renewable Energy (NASDAQ: GPRE ) -- account for approximately 40% of all ethanol production. While Valero operates ethanol facilities primarily to hedge its fuel blending business the others operate vertically integrated agribusinesses in ethanol production, corn oil processing, and marketing and distribution. That doesn't necessarily alleviate the problem. Consider that Green Plains, the fourth largest ethanol producer listed, needs 280 million bushels of corn each year to produce 790 million gallons of ethanol.
Similarly, agricultural giant ADM processes about 912 million bushels of corn each year, or about 7.5% of the nation's annual crop. The company sells products to the food, animal feed, and ethanol markets, but the latter has given the greatest boost to the bottom line in recent years. ADM's corn processing business saw bioproduct sales increase 31% to $4.2 billion in the first half of 2013 compared with the prior-year period thanks to higher ethanol sales volumes and higher ethanol selling prices.
Why use corn? It's an extremely good source of the sugar dextrose, which is fed to yeast to produce ethanol. Waste biomass is returned to the market as dried distillers grains with solubles, or DDGS, which is primarily used as animal feed despite its lower nutritional value (making it an inadequate alternative to corn). Even when accounting for DDGS returned to the system and improving corn harvests, it's quite evident that ethanol demand is straining the system.
It's not as if everything we eat contains corn, so why is the crop so important to food prices?
How major crops respond to corn's dominance
One thing not evident from the preceding graph is that the amount of land dedicated to corn crops has generally increased in each year since the RFS. That mitigated some of the impact from the 2012 drought. However, it has also led to increased competition for land between the nation's most important crops, which has driven prices higher to make them more competitive with corn plantings. It's a vicious cycle.
Since these crops make up the foundation of the nation's food supply -- (they're inelastic) -- price increases are felt all the way up the value chain until consumers foot the bill. For instance, higher animal feed prices make poultry more expensive to raise for Tyson Foods (NYSE: TSN ) , which increases supermarket prices. Also consider that the company is vulnerable to such volatility for the several months it takes to grow its poultry. If it takes two months to raise a chicken, but feed prices spike at the one-month mark, then increased supermarket prices for chicken will lag by one month. It means consumers end up paying for increased crop prices several times for the same spike: once for direct cost increases on products without much market lag time (grains, vegetables, and the like), again for products with moderate lag time (poultry), and once more for products with greater lag time (cattle and pigs, which take up to 24 months to mature).
Foolish bottom line
Let's be clear: Increased demand for biofuels, namely ethanol, doesn't account for all of the increases in food prices since 2005. Dr. Elam estimates that 44% of the increase comes from higher prices for major agricultural crops, which evidence suggests are caused in large part to the RFS. I have historically been a supporter of a national biofuel program as long as it's grounded in reality. Unfortunately, it appears we have a lot of work to do before we can achieve that.
Fight back against higher food prices
Looking for ways to protect your family budget in the long run? The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.