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The Great Ethanol Debate

By Morgan Housel - Updated Apr 5, 2017 at 9:52PM

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Nobody likes $4 gas, but rapid inflation isn't cool, either.

You can't carry on a debate about the economy these days without two nagging points coming up: The price of oil is on a tear, and inflation remains a serious threat.

Of course, the increase in the price of oil is a telling sign of an inconvenient truth (no Al Gore cliche intended): Oil is finite; our appetite for it is not.

So when ethanol was introduced as a viable alternative, it wasn't any surprise that hallelujahs made their way around the country. Finally, we can free ourselves from the Middle East's abundance of black gold. Instead, we can use our heartland's trademark: corn.

If only ...
As the popularity of ethanol grew, the price of its main input, corn, mushroomed, doubling in price in just the past year. Farmers took advantage of the new price, clearing fields used to grow other crops to make room for -- you guessed it -- corn.

That price disruption has an ugly effect. The price of soybeans has climbed more than 20% to date. Wheat has more than doubled in the past six months. Some of the increase in commodities is from lower interest rates and speculators looking for an inflation hedge, but a good chunk of the runup stems from good ol' fashioned supply-and-demand imbalances caused by the ethanol crush.

Ironically, ethanol is hardly an energy savior. A study conducted by Cornell University and UC Berkeley found that corn-based ethanol required 29% more fossil fuel to produce than it provided in benefits, although it is worth noting that similar studies have shown contrary results. To grow corn, you still need tractors and fertilizer stuck in the petroleum age. Not efficiency at its finest. Why, then, is ethanol production so popular?

Insert anxious politicians here
Our buddies in Washington take a portion of the claim. The federal government has mandated that by 2022, 36 billion gallons of biofuel enter the marketplace. For perspective, last year we produced 7 billion. The heightened demand could result in big profits for ethanol producers such as Archer Daniels Midland (NYSE: ADM), Pacific Ethanol (Nasdaq: PEIX), and Bunge (NYSE: BG), particularly given the industry's massive subsidies, but might not turn out so hot for other sections of the global economy.

The rising prices of corn and wheat mean higher prices for animal feed, which increase the price of beef, which increases the price of milk, which increases the prices at Starbucks (Nasdaq: SBUX) ... and you get the idea. The rising price of one commodity spreads to other realms of the economy. Ethanol's outsized demand for corn does just that.

Don't add injury to insult
Before I continue, I'll clarify one point: Ethanol production isn't solely responsible for inflation worries. Many factors play a role in those. But let's face it, the economy needs all the help it can get. Federal Reserve Bank of Dallas President Richard Fischer recently noted that the Fed will battle inflation before it can tackle keeping the economy from recession. With so much effort going into ethanol for embarrassingly inefficient energy returns, why shoot ourselves in the foot to begin with?

And with banks such as Citigroup (NYSE: C) and Bank of America (NYSE: BAC) hanging on by their fingernails, the last thing we need is higher interest rates to fight inflation that in hindsight could have been easily prevented.

Or think about this: The United Nations estimates 852 million people worldwide don't get enough food to sustain a healthy life. To be sure, war, politics, weather, and location play a huge role, but having the price of food commodities surging to historic highs can only make this far worse.

That puts us between a rock and a hard place. With oil at historic highs and global demand galloping forward, the petroleum party won't last forever. But the consequences of corn-based ethanol don't forecast a rosy horizon. So what route are we to take?

Well, according to fellow Fool Toby Shute, lard and algae, of all things, could play a part. Alternative energy is vital and its development must be given priority. But jumping at every opportunity, as some have jumped at ethanol, is a short-sighted way to go. With every benefit comes a marginal cost, and ethanol's net result doesn't even add up to corn flakes.

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