The Impact of Ethanol Production
oN Local Corn Basis
Kathleen Behnke
A Thesis
Submitted in Partial Fulfillment of the
Requirements for the Degree of
Master of Science
at the
University of Wisconsin
June 2010
Abstract of Thesis
The Impact of Ethanol Plants on Local Corn Basis
by Kathleen Behnke
As the United States searches for a sustainable source of fuel, corn-based ethanol has emerged as an early leader. Over the past decade, ethanol production has risen from 1.5 million gallons in 1999 to 10.6 million gallons in 2009. This growth was primarily fueled by the growth and expansion of starch-based ethanol plants. Accordingly, this resulted in increased demand for corn and today almost 35 percent of U.S. corn production is used for ethanol.
The aim of this thesis is to examine the impact local ethanol plants have on corn basis. The basis is the difference between the local cash price and the nearby futures contract price, and it accounts for variation in the supply and demand in the local market relative to the national market. It is predicted the entrance of an ethanol plant into a local cash market will increase corn demand, resulting in an increased cash price.
The data set contains cash corn prices from 153 grain buyers in eight different Midwestern states. The data ranges from Fall 1999 through Summer 2009. In addition to being affected by ethanol production, it is predicted basis is influenced to by the ratio of local to national corn production, transportation costs, storage opportunity costs, and seasonal factors. To estimate the impact these variables have on corn basis a spatial error component model is used, which accounts for both the spatial dependencies and panel data structure.
The empirical results were plausible and consistent with theoretical expectations. Results show that ethanol production in a 50-mile region of a county centroid has a small yet positive impact on local corn prices. The estimated impact of a 50 million gallon per year plant is a 0.425 cent per bushel increase in basis. These findings are smaller than the impacts found in previous work so the impacts were further investigated and shown to be consistent when directly compared to others’ findings.
This study concludes local ethanol plants do have a positive price impact; however the research also suggests the price impacts of ethanol production may be felt well beyond the county borders. Additionally, there is evidence the long-term price impacts are much less than the initial short-term price response.
Acknowledgements
I would like to express my gratitude to my advisor, Professor Randy Fortenbery, for his support and guidance during this study as well as my academic career. I would also like to extend thanks to Professor Steve Deller and Professor Brent Hueth for serving on my thesis committee. Additionally, I am thankful for the programming support I received from Professor Brian Gould.
I owe a special thanks to Kevin McNew and CashGrainBids.com for generously providing me with the data necessary for this project.
Finally, I would like to thank the professors, staff, and graduate students in the Department of Agricultural & Applied Economics for their support and assistance throughout this process.
Table of Contents
Abstract of Thesis
ACKNOWLEDGEMENTS…………………………………………………………….………iv
Table of Contents
List of Figures
List of Tables
CHAPTER 1: INTRODUCTION
1.1Rationale
1.2 Objectives
1.3 Scope of the Study
1.4 Organization of the Study
Chapter 2: Background and Literature Review
2.1 Background
2.1.1 Corn Background
2.1.2 Ethanol History and Policy
2.1.3 Ethanol Production Process
2.1.4 Ethanol’s Future
2.2 Literature Review
Chapter 3: Analytical Framework
3.1 Conceptual Model of Estimating Basis
3.2 Empirical Model
3.2.1 Panel Data
3.2.2 Spatial Methods
3.2.3 Spatial Panel Model
3.3 Data Sources
Chapter 4: Empirical Results
4.1 Model Validation
4.1.1 Hausman Test
4.1.2 Lagrange Multiplier Tests to Select Model
4.1.3 Tests for Spatial Error Correlation and Random Region Effects
4.3 Alternative Models
4.3 Parameter Estimates
4.3.1 Weights Matrix
4.4 Time Comparison
4.5 Comparison to Literature
Chapter 5: Conclusion
5.1 Summary
5.2 Conclusions
5.3 Suggestions for Further Research
Appendix A
Appendix B
Appendix C
APPENDIX D
Sources
List of Figures
Figure 1.1 Historical Ethanol Production …………………………………………………….…. 2
Figure 2.1 U.S. Corn Production………………………………………………………...…….….7
Figure 2.2 Percentage of U.S. Corn Production Used for Ethanol and Exports…………………..7
Figure 3.1 Corn Basis Map……………………………………………………………………....19
Figure 3.2 Average Annual Corn Basis………………………………………………………….20
Figure 3.3 Counties with Corn Price Observations…………………………………………...…29
Figure 3.4 Counties with Ethanol Plants…………………………………………………………29
List of Tables
Table 3.1 Summary Statistics ……………………………………………………………….…..31
Table 4.1 Alternative Model Specifications……………………………………………………36
Table 4.2 Model Estimates ……………………………………………………………………38
Table 4.3 Spatial Weight Variations……………………………………………………………..41
Table 4.4 Compare Monthly and Quarterly Data………………………………………………..43
Table 4.5 Compare Full Sample and Sub-sample Estimates…………………………………….47
Table 4.6 Ethanol Impacts…………………………………………………………………...….49
Table 4.7 Compare Full Sample and Sub-sample Estimates with Interest…………………...….51
Table 4.8 Ethanol Impacts with Interest………………………………………………………....53
Table A.1 Renewable Fuel Standard Program Mandates………………………………………..58
Table B.1 Ethanol Plants Included in the Sample…………..……………………………………59
Table C.1 Grain Elevators………………………………………………………………………..63
Table D.1 Summary Statistics by State…………………………………………………………..67
Table D.2 Summary Statistics by Year…………………………………………………………..69
1
Chapter 1
Introduction
1.1RATIONALE
More than decade ago the United States began an aggressive search to find a practical source of renewable fuel to meet our insatiable energy demands. Alternative fuels such as starch-based ethanol, cellulosic ethanol, and biodiesel are all considered to be potential solutions in a national effort to reduce gasoline usage by 20 percent over the next ten years (Bush, 2007). Corn-based ethanol emerged as an early leader due to the abundance of corn and the popularity of ethanol-gasoline mixes.
The national ethanol industry has expanded dramatically over the past 10 years. According to the Renewable Fuels Association (RFA), today there are more than 200 production plants with the capacity to produce almost 13.5 billion gallons. This is up from just 54 biorefineries with a production capacity of 1.7 billion gallons in 2000. The historical increase in production can be seen in Figure 1.1. RFA also reports the ethanol industry supported 400,000 jobs in 2009 and contributed $53.3 billion to the nation’s Gross Domestic Product (GDP). Furthermore,they calculate that despite the tax credit to ethanol producers the industry still contributed a tax surplus of $3.4 billion to the federal treasury.
The rise of ethanol in the US has been largely driven by government mandates, tax incentives, and the push to lessen America’s dependence of foreign oil. The government has supported the use of ethanol as a policy to reduce dependence on foreign oil since the 1970’s. In
Source: Renewable Fuels Association
the 1990’s it became popular to blend ethanol as an oxygenate in conventional gasoline to reduce smog. Ethanol production standards were set in place by the Energy Policy Act of 2005, and then updated as part of the Energy Independence and Security Act of 2007. Currently, ethanol production is scheduled to reach 36 billion gallons by 2022 and in the short-term there are plansto increase production by another 1.4 billion gallons in 2010. Furthermore, according to the 2010 Ethanol Industry Outlook, the 2009 production of 10.6 billion gallons of ethanol reduced the demand for oil by 364 million barrels.
These government mandates, coupled with the high crude oil prices, have pushed the biofuels sector to center stage in the discussion of future U.S. energy policy. However, this conversation must consider the implications of energy policy on the agricultural sector. Diverting corn and soy to produce ethanol and biodiesel has an impact on these commodity prices, which in turn affects many other factors in the traditional agriculture markets. Several economic issues are important to stakeholders in the both the ethanol and corn industries. Questions about the how much corn will be needed to continue the growth of the ethanol sector and how the increased demand for corn will affect prices on both a local and national level have increased in importance as the industry continues to expand.
1.2 OBJECTIVES
The ever strengthening relationship between the food and fuel markets clearly raises the question of how the biofuels industry affects the price producers receive for corn. The overall purpose of this study is to examine the magnitude of this impact at the local level and measure the extent to which the effect is maintained over time. To this end the specific objectives of are to:
- develop and estimate a spatial panel model of corn basis;
- assess the impacts of ethanol plants on the local corn basis; and
- determine if these impacts are consistent with the short-run impacts found in previous studies.
Objective 1 involves the construction and validation of a spatial error components model to analyze the impact ethanol production and other independent variables have on corn basis. Objective 2 requires the implementation of the model to estimate the impact local ethanol production has on local corn price. This study specifically examines the price impact of ethanol production within 50 miles of a county centroid. Finally, objective 3 compares the findings of this study to other work to determine if the impacts previously found are maintained in this more long-run setting.
While the topic has been studied before, this particular work is important because it increases both the scope and the depth of the data used. Additionally, by accounting for spatial dependencies and the panel nature of the data more validity can be given to the results. Most importantly, this study will provide greater understanding of the impact of ethanol production on local corn prices.
1.3 SCOPE OF THE STUDY
In order to estimate the impact of ethanol plants on local corn basis the study includes data from Illinois, Indiana, Iowa, Kansas, Minnesota, Nebraska, South Dakota, and Wisconsin. Together these Midwestern states account for more than 75 percent of the nation’s corn production (NASS) and are home to more than 70 percent of ethanol production plants (RFA) making them the ideal sample space.
To estimate basis changes over time the sample period ranges from October 1999 through September 2009. This allows for estimation from the beginning of the period of rapid ethanol plant expansion. The data is aggregated by season to account for the variation throughout the year. Overall, there are observations from 153 different locations and 40 time periods included in the sample.
1.4 ORGANIZATION OF THE STUDY
This chapter has presented the question this thesis addresses as well as objectives, and the general approach to the study. The next chapter provides a more detailed background of the problem and a literature review of the topic. Chapter 3 presents the analytical framework designed to measure the changes in basis, as well as the spatial-panel model needed to properly frame the question. Chapter 4 presents the empirical results and discussion and Chapter 5 concludes with the summary, conclusions, and suggestions for further research.
Chapter 2
Background and Literature Review
2.1 BACKGROUND
Before consumers are able to purchase starch-based ethanol at the pump there are many important production steps. The corn must be planted, harvested, and transported to market. Then the processing plant must buy inputs, produce ethanol, and send it to a blending facility before it can be distributed. This chapter begins by providing a background of the U.S. corn industry. It continues with a background of the ethanol industry, including an examination of government policies, production practices, and a look towards the future. This chapter will conclude with a review of the economic literature investigating the impact ethanol production has on corn prices and this study’s economic contribution.
2.1.1 Corn Background
Corn has been an important part of agriculture in the U.S. since it was first introduced from Central America. Not only is corn a food source for humans and animals, it can also be converted to sugar, starch, beverage, or fuel. Previously the low cost of substitute fuels limited the conversion of corn to ethanol, but in response to changing prices and regulatory conditions it has found a place as a source of renewable biofuel.
Figure 2.1: U.S. Corn Production
Source: USDA National Agricultural Statistics Service
Figure 2.2: Percentage of U.S. Corn Production Used for Ethanol and Exports
Source: USDA Economic Research Service
According to the Economic Research Service of the United States Department of Agriculture (USDA), national corn production has increased over the past decade due to greater demand. Figure 2.1 shows changes in production from 1990 through 2009. Production levels fluctuate in response to acres planted, weather conditions, and improved plant technology that allows for greater yields. Additionally, the USDA predicts higher net future returns to corn relative to other crops which provides an economic incentive to expand corn acreage in the coming years.
In 2009, 34 percent of national corn production went into ethanol production, 15 percent was exported, 41 percent fell into the category of feed and residual use, and the rest was used for food, sugar, seeds, or was carried over as stocks in 2010. Over the past two decades the relative shares of corn use have shifted, as shown in Figure 2.2. From 1990 to 2009 the amount of corn exported as percent of total production decreased by seven percentage points, despite an increase in total export volume. In contrast, corn used for ethanol as a percentage of total production increased from four percent to 34 percent, becoming the second largest use category. The growth rate in this category is expected to stabilize as fewer new corn-based ethanol plants are built, but the demand for corn in ethanol production will continue to be large.
2.1.2 Ethanol History and Policy
The use of ethanol has always been linked to the automotive industry. According to the U.S. Energy Information Association (EIA), Henry Ford built his first vehicle, the Quadricycle, to run on pure ethanol. However this automobile was quickly pushed to the side in favor of vehicles powered by gasoline, a less expensive alternative. This, coupled with the impending Prohibition, began America’s love affair with oil. Post World War II, the commercial ethanol market almost disappeared and did not begin to resurge until the oil crisis of the 1970’s (U.S. EIA).
As an effort to decrease dependence of foreign oil, the government has created policies to increase the use of ethanol fuel since 1978. The Energy Tax Act of 1978 provided a tax credit of $0.40 for every gallon of ethanol blended into gasoline at the 10 percent level. The number of ethanol plants began to increase and the Tax Reform Act of 1984 increased the blending credit to $0.60 per gallon. Despite these subsidies many of the new ethanol plants went out of business in the late 1980’s.
Additional support for ethanol came from the United States Environmental Protection Agency (EPA). As a response to growing air pollution in 1995, the EPA required an oxygenate be added to gasoline in ten major smog producing regions of the country. This mandated that gasoline be mixed with a 10 percent oxygenating agent. Initially methyl tert-butyl ether (MTBE) was the popular choice, but after groundwater contamination scares from MTBE, ethanol has come to dominate the market for oxygenates (EIA).
Another important component in the growth of the ethanol industry has been tax credits such as the Volumetric Ethanol Excise Tax Credit (VEECT) and the small ethanol producer credit. The VEECT was signed into law as part of the American Jobs Creation Act of 2004 and provided gasoline blenders a $0.51 excise tax credit per gallon of ethanol blended with gasoline. The 2008 Farm Bill reduced the credit to $0.45 and it is set to expire December 31, 2010. Additionally, the small ethanol producer credit provides an income tax credit of $0.10 per gallon for the first 15 million gallons of ethanol produced for plants with a capacity of less than 60 million gallons per year. Both of these credits have played an important role in encouraging growth in ethanol production and use.
To promote even greater ethanol utilization, the government passed the Energy Policy Act of 2005. It mandated the production and sale of four billion gallons of ethanol in 2006, with incremental increases resulting in production of 7.5 billion gallons in 2012. This legislation led to a huge increase in ethanol production and plants were quickly producing a much greater volume than the mandates required. As a response the Energy Independence and Security Act of 2007 updated the mandates requiring almost 13 billion gallons in 2010 and setting the target at 36 billion gallons in 2022. However, the directive specifies that only 15 billion gallons can be corn-based ethanol, the rest will be cellulosic and advanced biofuels. For a deeper look into the Renewable Fuel Standard see Appendix A.
The future expansion of the ethanol industry may depend on EPA’s approval of increasing the ethanol content in gasoline from 10 percent (E10) to 15 percent (E15). With RFAs current supply and demand predictions, if 100 percent of gasoline is sold as E10, by 2011 the supply of ethanol would exceed volume needed to create the E10 blend. According to Nurenberg of Ethanol Producer Magazine (2009), this blend wall will make it difficult to reach the Renewable Fuels Standard of 36 billion gallons by 2022. The EPA may allow E15 sometime later this year, but without a change the growth of the industry may be hindered by suppressed demand.
It should also be noted that ethanol production and use receives support from state governments. All of the states in the sample have some sort of program supporting biofuels and some even have their own renewable fuels mandates. Other programs include production tax incentives, plant loan assistance, blender’s tax credits, state money for ethanol research and promotion, and mandates for state fleets to shift to renewable fuels (International Institute for Sustainable Development, 2006).
2.1.3 Ethanol Production Process
Ethanol is a sugar-based bio-fuel that produces energy when burned. Though its energy content is less than that of pure gasoline, ethanol can reduce tailpipe carbon monoxide emissions by as much as 30 percent (RFA). This is a result of ethanol being composed of 35 percent oxygen, which results in more complete fuel combustion (RFA). Ethanol is commonly blended with gasoline at the 10 percent level (E10) to serve as an oxygenate. Furthermore, flex fuel vehicles can use E85, a blend of 85 percent ethanol and 15 percent gasoline.