It's not easy being a farmer, especially since the economics of farming ensure an ever-present dilemma. If farmers' crops do well, then there's usually a glut on the market, and so the prices they get are relatively low. When prices are high, it's usually because their crops haven't done well, and so they don't have as much volume to reap the benefits. Even with government subsidies, it's a hard life for many farmers, so it isn't surprising that children and grandchildren in farming families often leave the family business for a less stressful life.
Given the generally gloomy long-term outlook among farmers, any news of a way for rural communities to attract and retain money, people, and profitable businesses is welcome. Because of this, the recent push for decreasing reliance on imported oil in favor of renewable energy resources, such as corn-based ethanol, have farming communities in a new state of optimism. A recent report from the Federal Reserve Bank of Kansas City evaluates the potential for new investment in ethanol production to transform the countryside and reinvigorate the economy of rural America.
The economics of rural towns
Much of the optimism over ethanol has to do with the way that rural communities survive economically. In some ways, small town economics resembles the economics of international trade among countries. Small towns often have limited resources and must obtain many of the goods and services they need from outside their communities. However, because residents need an ongoing source of income in order to make a living, small towns rely on the modest success of their local businesses to keep money within the local economy and to bring in new money from elsewhere.
Ethanol production meets a lot of the challenges involved in attracting and retaining money within a rural community. The promise of a local ethanol plant can attract outside money from investors across the country. The process of building and maintaining such a plant creates new jobs, many of which have salaries that are much higher than typical jobs available in rural communities. Plants also attract new workers from outside the community, which increases interest in local real estate, potentially raising real estate prices and increasing the tax base on which local governments depend. For local farmers, an ethanol plant can represent a new market for their crops, one that doesn't require expensive long-haul transportation to major grain markets. In addition, the availability of fuel for their farming needs has led many farmers to form co-operative ventures to build ethanol plants of their own.
Effects on other farming operations
However, ethanol production can also have negative effects on other parts of the economy. First and foremost, investment in corn-based ethanol promises to divert a significant amount of each year's corn crop away from use in consumer food products, as well as cattle feed and other animal products. According to the Fed report, about 20% of the overall U.S. corn crop was used in ethanol production in 2006. As you might expect, increased demand for corn led to higher prices; in 2006 alone, corn prices rose about 50%.
Furthermore, the focus on corn plays a key role in the decisions that farmers make in selecting crops. As demand grows, more farmers may choose to grow corn instead of other crops, which may in turn lead to shortages and higher prices for other commodities. Higher corn prices will increase costs for feedlots and cattle ranchers who rely on grain to feed their livestock. Higher costs for food production will likely work their way through to higher consumer prices. While these factors may be offset if ethanol production succeeds in lowering fuel costs, it's difficult to predict how the economics will play out.
Making ethanol profitable
In addition, ethanol production suffers from some of the same uncertainties that any other business faces: In order to be profitable, the revenue from selling the final product must pay for the costs of the raw materials needed to make it. While rising prices may be good for corn farmers, the profitability of the ethanol plants themselves is hurt by high corn prices. Furthermore, the process of making ethanol requires a stable supply of natural gas, which shows volatile price movements as well. Meanwhile, on the revenue side, the price of ethanol can swing widely; according to the Fed report, ethanol prices have swung between $1.20 and $4.20 per gallon in just the past 18 months. As a result, profit margins are subject to the whims of these prices, and a huge profit margin in one year might be followed by greatly reduced profits or even losses in the next.
It's too early to tell whether increased ethanol production will succeed in its mission to reduce dependence on foreign oil and to revitalize rural America. Initial excitement over public offerings from ethanol-related companies such as Pacific Ethanol (NASDAQ:PEIX), Verasun Energy (NYSE:VSE), and Aventine Renewable (NYSE:AVR) has largely dried up as oil prices have fallen from their peaks last summer. Nevertheless, the emphasis on renewable energy in the latest State of the Union speech makes it likely that ethanol production will continue to be an interesting place to invest in the coming years.
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Fool contributor Dan Caplinger has gotten a firsthand look at how rural communities find ways to survive economically. He doesn't own shares of any of the stocks mentioned in this article. The Fool's disclosure policy is automatically renewable.
