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Will a drought affect the price of ethanol?

Corn's Connection to Ethanol Prices

Ethanol production is already a multi-billion dollar industry with an economic ecosystem that includes farming, manufacturing, transportation and other sectors. Since so much money and so many jobs depend on this still-expanding industry, many people have studied the conditions that could benefit or harm the ethanol business.

One of the biggest concerns is what would happen if anything disrupted the supply of corn, a major feedstock for ethanol. Drought -- an unusually prolonged, extreme lack of rain -- poses one obvious threat.

In fact, a seminal study on the matter suggests a strong correlation between drought, low corn yields and higher ethanol prices. In that March 2008 study, Iowa State University researchers found that: 

  • Corn prices are "inextricably linked" to the U.S. ethanol industry, which depends on government subsidies and mandates to be competitive with other fuels.
  • A severe drought would boost corn prices so high that ethanol producers would have to idle their fuel production facilities.
  • Ethanol production probably would not meet federal requirements if a major drought took place.

[source: McPhail and Babcock]

Even as the government tries to encourage ethanol, farmers and corporations push back by lobbying Congress for special considerations. Here's a simplified look at some of that give and take: Alternative energy producers argue that they need price subsidies -- in other words, tax breaks -- on their output to compete in the marketplace with coal, oil and other entrenched fuels (all of which get their own taxpayer-funded subsidies). The government listened. The Energy Act of 2005 grants tax credits for an assortment of fuels, including a 51-cent per gallon tax credit for companies that make ethanol.

In addition, the Energy Independence and Security Act of 2007 (EISA) sought to stoke the farmers' demand for ethanol. Under EISA, the government requires fuel producers to introduce nine billion gallons of biofuel into the nation's fuel supply in 2008. What is biofuel? Biofuel is the catchall term for fuels that can be grown or renewed from biological sources, including ethanol, biodiesel and fuels refined from solid wastes.

­The EISA mandate ramps up expectations on fuel producers annually, culminating in a 36 billion gallon biofuels requirement in 2022­. The idea is to eventually make ethanol a significant portion of the U.S. transportation fuel supply. Policy makers say this will reduce the United States' dependency on foreign sources of oil.

Iowa State University researcher Bruce Babcock further told the U.S. Senate Committee on Agriculture, Nutrition and Forestry in August 2008:

­"Our decision to encourage expansion of biofuels production has changed the economics of agriculture by linking energy and feed markets. There seems little doubt that we will see biofuels production from corn and vegetable oil meet mandated levels" [source: Babcock].

Babcock's testimony, however, downplayed a contingency mentioned in the research paper he co-wrote earlier in the year. A severe drought, the paper said, would increase corn prices by 50 percent if fuel producers still had to meet the EISA biofuel mandate. That's because food manufacturers would be competing even more feverishly with fuel producers to buy corn.

Throughout most of recorded history, humankind has regarded droughts and other weather catastrophes as unavoidable "acts of God." But some scientists say we could be inviting severe and lengthy droughts upon ourselves. To find out why, go to the next page.