Ethanol, mandates, and drought: insights from a stochastic equilibrium model of the U.S. corn market

Mar 2008

The outlook for U.S. corn markets is inextricably linked to what happens to the U.S. ethanol industry, which depends, in turn, on the level of government subsidies and mandates.
Historically, corn price volatility was caused primarily by shocks to supply. Changing weather, pests, diseases, and land put into production all play their part in corn supply volatility. In recent years the volatility of the corn price has been influenced to a large extent by demand shocks as well. Demand shocks come primarily from changes in export demand, ethanol production, and the gasoline price. In the past few years the ethanol industry has expanded to become a significant buyer of corn. The future demand for corn for ethanol is difficult to estimate given the rapid growth of the industry. Thus, uncertain ethanol production capacity contributes to uncertainty about future corn demand. Integration between energy markets and agricultural markets and the high volatility in gasoline prices contribute to corn price volatility as well. At today’s volumes, integration flows one way: gasoline prices determine ethanol prices. Thus, low gasoline prices combined with high corn prices will squeeze ethanol plant margins. If an ethanol plant’s revenue cannot cover its variable cost, then the plant will shut down until margins improve. Least efficient ethanol plants will tend to shut down given heterogeneity in plant efficiency . The gasoline price and the corn price together determine the percentage of ethanol capacity that operates, and thus they determine the corn demand from ethanol production. Therefore, the stochastic gasoline price contributes to stochastic demand of corn from ethanol.
Two main questions in this study have been addressed. How will the continued use of corn for producing ethanol affect its price volatility, and how will Energy Independence and Security Act (EISA) affect the corn market? A stochastic partial equilibrium model to simulate the price variability of corn during the 2008/09 marketing year is developed. The model attempts to decipher the primary causes of uncertainty in the U.S. corn market in the midst of an increasing demand for corn as an energy substitute and new legislation.
These results indicate how integration of gasoline and corn markets has increased corn price volatility and that the passage of the expanded ethanol mandates in the EISA has had modest effects on corn prices.

By: L.L. McPhail, B.A. Babcock (Iowa State University)

 
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