Part 1: Uncharted waters
Managing a beef cowherd in today's corn environment is like sailing uncharted waters. Ranchers' past experiences may not be of much value.
Previous run-ups in corn price were supply driven (Figure 1). In years of short corn supplies, ranchers just had to cope with high prices for a year or less until the next good crop brought prices back down. Most ranchers didn't change marketing practices; they just tightened their belts temporarily.
What's different today is the run-up in corn price is demand driven — driven by mandates for corn-based ethanol production. Thus, even with a record crop in 2007, corn prices went up even more in early 2008.
Ranchers often ask me how long it will be before “normal” prices for corn return. But corn prices won't soften as long as this increased ethanol demand is present, and that demand is going to last for several years. The real economic question ranchers should be asking is: “What business changes should I make to cope with increasing corn prices over the next several years?”
Little hope from cellulose
While cellulose-based ethanol is seen as one remedy to the increased corn demand, that technology isn't projected to be feasible until sometime after 2012. The bottom line is that corn prices probably will never return to the pre-2007 era.
Impact of market forces
Thus, the current increased demand for corn is projected to last well into the next decade, and ranchers must learn to manage their operations in the face of substantially increased costs-of-gain beyond the ranch gate.
One silver lining is thought to be economical co-products from ethanol production, which many people are counting on to lower feedlot-gain costs. While co-products are excellent feeds, only about 30% of the diet can be replaced with co-products.
In addition, ethanol-related co-products are now being priced off corn price — sometimes 90%, 95% or even 100% plus of the price of corn on a dry matter basis. Plus, co-products are now being exported — again priced relative to corn.
In both cases, the economic advantage of feeding co-products is being bid away. I know of one animal scientist who no longer recommends feeding ethanol co-products for this very reason.
In fact, the era of $2, or even $3, corn and low-priced co-products is probably gone. Low cost-of-gain diets (traditional or co-product) for cattle beyond the ranch gate are gone for this decade and beyond.
Another factor is that for 30+ years, the beef industry operated in an era of government farm programs that generated a corn surplus. This surplus corn was stored in government- or farmer-held corn reserves, and the program effectively generated a corn price floor and a corn price ceiling.
However, that era ended in the 1980s with a change in the farm bill. There's no longer a government- or farmer-held corn reserve, and corn prices are now allowed to move up and down with market supply and demand forces. The result is any hint of a short supply or increase in demand will move the market — often dramatically.
Figure 2 illustrates the impact of the new market forces on U.S. futures-market corn prices. Ethanol's rapid increase in demand for corn started in late 2006 and is projected to increase into the next decade. While the rate of demand growth in 2009-10 may not be as aggressive as 2007-08, corn demand isn't projected to come down before 2015.
Figure 2 illustrates how corn prices surged in late 2006 in response to the boom in ethanol-plant construction in 2007 and 2008. This demand surge has generated $5+ corn futures prices for May 2008 through December 2010.
Figure 3 depicts existing ethanol plants and those under construction. The extremely favorable economics of ethanol-plant investments caught the attention of New York investors and a large number of ethanol plant investment projects rapidly ensued. The resulting run-up in corn price forced a few projects to be suspended or cancelled in early 2008. The latest number I've seen is 18 plants now on hold.
So what does this suggest for corn prices for the rest of this decade? One possible answer might lie in what the average ethanol plant could pay for corn.
Markets are typically known for overreacting, both up and down. While many suspect the corn-futures market has already overreacted, the sobering fact is the price of ethanol rises with the price of gasoline. Today's $100+/barrel oil and projected $3-$4 gasoline will certainly drive up ethanol prices. And as ethanol price goes up, so does the breakeven price that ethanol plants can pay for corn.
Economic theory suggests that after an ethanol plant is built, it will continue to operate as long as it can cover variable costs, at least in the short run. Fixed costs don't have to be covered in the short run.
Table 1 suggests that with $2.35 ethanol, the average plant can pay up to $7.50/bu. for corn and still cover variable costs. These same plants can even pay $6.10/bu. of corn and still cover variable costs, plus interest, depreciation and taxes.
Another study I reviewed in late March concluded a $4 average corn price in the 2007-08 corn-marketing year, and possibly $5.75 in the 2008-09 period. Both studies suggest we may not yet have seen the top in corn price.
The bottom line is feedlot cost of gain will increase substantially for the rest of this decade and beyond. Corn prices won't come down anytime soon, and will continue to put post-weaning profits under severe economic pressure. Clearly, this isn't a time for ranch production/marketing as usual.
Harlan Hughes is a North Dakota State University professor emeritus. He lives in Laramie, WY. Reach him at 701-238-9607 or [email protected].