Structural shifts in agricultural markets caused by government mandates: Ethanol and the Renewable Fuels Standard

For many decades, demand for agricultural commodities has remained stagnant and its growth has been limited. In contrast, agricultural production continues to become ever more efficient by increasing output for stable or decreased inputs. Long-run profits have historically been near zero due to an ongoing relative equilibrium. But recent U.S. energy policy has changed to include a Renewable Fuels Standard (RFS), the goal of which is to boost domestic energy independence in an environmentally sound way. Most of the RFS in the near-term relies on the production of 15 billion gallons of ethanol made from corn. This has the effect of creating a new sector of demand for grain corn and subsequently supports rural economies.;Ethanol in the U.S. is primarily made from the starchy molecules in corn. One bushel of corn in a dry mill ethanol plant will produce approximately 2.7 gallons of ethanol and 17 pounds of dried distillers grains with solubles (DDGS) which can be used in livestock rations. A wet mill plant will produce other by-products. Ethanol can be used directly in the nation's fuel supply at limited levels of blending. Most cars in the United States can withstand the corrosive nature of ethanol in blends of up to 10% or more. But flex-fuel vehicles, which are able to operate on 85% ethanol are increasingly becoming available for sale and their use continues to grow.;Corn ethanol is a very complex issue when implemented on such a large scale as the RFS dictates. The amount of transportation fuel actually displaced by its use is a hotly debated topic. In any case, the large scale production of corn ethanol has created a firm link between agricultural markets and the energy sector. Ethanol is also an environmental issue. One of the primary goals of the RFS is to combat global warming and whether or not this is achieved it currently in debate. Aside from the climate change issue, there are other environmental ramifications tied directly to ethanol such as contamination, water use and land-use change.;Since the inception of the RFS, price volatility and uncertainty has never been greater. In the first half of 2008, prices for all commodities reached historically high levels. This raises the concern of the impacts with the RFS has on markets other than corn. The livestock industry and other grain markets have been affected to some degree by the RFS. This is in part due to the changing profile of the major trading participants in the commodity trading centers.;All of this is related to a structural change which has taken place in the agricultural markets as a result of the RFS. Historical relationships between price, supply and demand have adjusted and currently continue to adjust. The reasons for the adjustments are founded in economic theory regarding system-wide demand shocks. In this case, the demand shock is roughly a net 50% increase in the demand for corn by 2015 compared to the most recent decade. The adjustments which take place can be summarized by three periods. In period 1, the demand curve shifts outward, equilibrium is lost and higher corn prices are observed. In period 2, the market struggles to find a new equilibrium by increasing output. This period is marked by increased volatility and market participants over and under react to price signals until the new equilibrium is discovered. Period three is represented by the discovery of a relative market equilibrium at price higher than previously, but not as high as the initial demand shock.;Results from a fundamental analysis of the grain markets show that the expected market behavior has begun to take place and agriculture finds itself in period 2 of the changes described above. While most of the price changes and acreage shifts can be explained, the degree to which prices have increased are not fully explained. A change in trading center activities (Boards of Trade, etc.) may help to further account for the new prices. A survey of brokers shows that the behavior of commercial traders has significantly changed since RFS implementation. Volatility and uncertainty have ensued. (Abstract shortened by UMI.)...