Thursday, August 2, 2012

Should the Ethanol Mandate be Temporarily Suspended?

There seems to be a big push to roll back the ethanol mandate, at least temporarily, due to the crop losses and high prices for corn, soybeans and wheat we're experiencing this year.  See, for example, Colin Carter and Henry Miller's Op Ed in the New York Times.

How much would a temporary suspension of the mandate affect prices?

As I write, the future price for corn delivered in December 2012 is $7.95/bu.  The price for delivery in December 2013 is just $6.30.  So, there is no incentive to store commodities, and inventories are very low.  So, any reprieve on the demand side will push directly on this year's price. With regard to prices, it would be equivalent to reducing the size of crop losses.  If we lose 1/3 of the crop from heat and drought, and we reduce demand by 1/3 by temporarily halting ethanol production, we'd probably go back to early-Spring prices of around $4-5/bu.

One problem with this back-of-the-envelope calculation is that ethanol production is unlikely to stop completely just due to a temporary suspension of the mandate.  There are shutdown and startup costs, and a 10% ethanol blend is firmly in place.  So prices probably wouldn't fall back that far, but they would fall a lot.

In fact, I wouldn't be surprised if speculation about a temporary suspension of the mandate is already  folded into futures prices, at least partly.  It's hard to know what the odds of a repeal might be, but the market knows it's not zero.  And the worse are crop losses, the greater the odds of a temporary  suspension.

What's more subtle and potentially more interesting is that temporarily repealing the mandate would set a precedent that would affect futures prices and inventory demand going forward.  It would be interesting to evaluate an ethanol policy with a "safety valve" that would relax the mandate in the event prices exceeded some threshold.  This kind of analysis is more difficult. Nam Tran, a grad student at NCSU, is working on it.  I'll post his results here if and when he has them.

(Cross-posted on GGG)

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