Consequences Of A Farmland Bubble, And Who Gets Hurt When It Bursts?

by: Robert Wagner

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Executive summary:

  • The EPA's push to encourage ethanol usage has resulted in an "Ethanol Bubble" that threatens the entire farming industry.
  • Changes to the EPA's RFS2 mandate and waning political support may provide the catalyst to pop the "Ethanol Bubble."
  • The popping of the "Ethanol Bubble" will have a catastrophic impact on the farming industry.


The previous record setting highs for corn have driven farmland into the stratosphere. Last year headlines were rife with claims of a "farmland bubble."

The Kansas City Federal Reserve said irrigated cropland in its district rose 30% in 2012, while the Chicago Fed reported a 16% increase. And despite the drought in Iowa last year, farmland prices have nearly doubled since 2009 to an average of $8,296 an acre. Prices in Nebraska have also doubled during the same period.

Some of that price increase may be due to economic factors like higher yields, but corn yield per acre hasn't doubled since 2009. According to Purdue University, corn yields have increased by about 14% over that time period. I can't link to the graphic in that article, but here is one that isn't as current but shows the trend. 2012 was a drought year so ignore the last data point. The point is, crop yield increases can't explain all of the price increase in farmland prices.

While crop yields haven't increased enough to justify the increase in farmland prices, operating costs haven't been decreasing, in fact, fuel, seed and fertilizer prices have been near record highs. At the time that article was written last month it cost $4.94 to make 1 bushel of corn.

Research by Iowa State University shows that the cost of planting corn following corn (seeds, chemicals, etc.) per acre has bumped from $201.62 (2006) to $376.81 (2012) making the cost per bushel go from $3.40 to $4.94 in those six years. University of Illinois reported that non-land costs (fertilizer, seed, pesticides, drying, storage, crop insurance, machinery, and overhead costs) surged 92% from $302/acre to $581. Although they aren't measured on identical criteria, the trends show similarity.

At the same time, the article claims that corn was trading at $4.49 on the CME. If that analysis is correct, farmers are losing money on every bushel of corn they grow. Losses won't pay off $1/2 million combines/tractors and $8k/acre farmland.

Thursday, the CME Group's new-crop Dec. '14 corn price is $4.49. Specifically, the highest listed expense in ten input items, is corn seed at $264 per bag (185 bu. per acre rate).

So, it's easy to see why the farmer is most concerned about the future of seed costs.

One bright spot is that corn ethanol margins have been strong, but that is largely due to falling corn prices and a likely temporary market anomaly called the "blend wall" that has disrupted the pricing of D6 Ethanol RINs.

The main reason farm prices have been forming a "bubble" is because of ethanol, and the problem with that concept is the same problem with the affordable home concept. Government programs have detached the markets from reality.

This graph shows how farmland began its meteoric rise back in 2005. The Index took a pause along with everything else due to the 2008 crisis, but it rapidly rebounded to new highs.

(Source of Image)

It isn't a coincidence that 2005 had a single quarter with a return of 22.78%. The large gain was made the quarter after the Energy Policy Act of 2005 passed, mandating the future usage of ethanol in fuels. Back then, Congress was pushing for more ethanol. The reason the bill was so bullish is that it established the groundwork for the EPA's RFS and later RFS2 program that increased ethanol usage from under 4 billion gallons in 2005 to an effective mandate of 13.8 billion gallons in 2013, and a possible peak mandate of 15 billion gallons in the future.

(Source of Image)

During that time corn production increased.

(Source of Image)

And more importantly, corn acreage has exploded. Corn acreage was 80 million acres in 2000, and was predicted to reach a modern record on 97 million acres in 2013.

If realized, corn will represent the highest planted acreage in the United States since 1936 (102 million planted acres) and for soybeans the fourth highest acreage on record. Corn growers intend to plant 97.3 million acres in 2013, up for the fifth consecutive year, slightly higher than last year and 6 percent higher than in 2011. With expected returns for corn historically high going into 2013.

While 17 million may sound like a lot, it is even more important because farmland is relatively fixed. We don't manufacture land, there is simply a fixed amount of it, and it must be divided between all the different uses. While the 17 million acres includes previously unfarmed land, the rest comes out of reduced production of other crops. What once was a tomato patch now is a corn field. Fewer tomatoes, more corn, higher prices for both.

As farmers rushed to find new places to plant corn, they wiped out millions of acres of conservation land, destroyed habitat and polluted water supplies, an Associated Press investigation found.

Five million acres of land set aside for conservation - more than Yellowstone, Everglades and Yosemite National Parks combined - have vanished on Obama's watch.

Landowners filled in wetlands. They plowed into pristine prairies, releasing carbon dioxide that had been locked in the soil.

Sprayers pumped out billions of pounds of fertilizer, some of which seeped into drinking water, contaminated rivers and worsened the huge dead zone in the Gulf of Mexico where marine life can't survive.

Because farmland is relatively inelastic, it is the most dangerous kind of market for the Government to tamper with. Inelastic markets behave like "squeezing" a balloon, and when you squeeze one area, an unintended consequence bulges out somewhere else. With the introduction of the Energy act of 2005, and the EPA's RFS and RFS2 program, the farming market has been totally distorted. Crop prices increased, corn and soybean production increased, production of other agricultural products decreased, feed prices increased, beef prices increased, farm prices increased, farm equipment prices increased and farm expenses increased. Higher food prices largely due to the RFS2 program combined with a drought was claimed as the catalyst for the Arab Spring uprising that toppled Egypt and almost put it in the hands of the Muslim Brotherhood. I doubt the EPA discussed this possible outcome with the State Department before they implemented the RFS2. This misguided EPA policy could have resulted in a broader war in the Middle East.

In a year of protests in the Arab world, high food prices helped to make oppression, corruption and poverty under autocratic leaders even more intolerable.

"Prices are so expensive," said one protester about Egypt's leaders. " What shall we do right now? We have to stay until they are gone and give a chance to others who can satisfy our needs."

Because of the numerous flaws and unintended consequences of the EPA's RFS2, the program has attracted critics from all sides.

As I've mentioned before, anytime you have Paul Krugman agreeing on "demon ethanol" (his term) with such a diverse group as the Huffington Post (above), the Manhattan Institute, the Wall Street Journal, Reason Magazine, the Cato Institute, Investor's Business Daily, Rolling Stone Magazine, the Christian Science Monitor, the New York Times, John Stossel, The Ecological Society of America, the American Enterprise Institute and the Brookings Institution, the Heritage Foundation, George Will, and Time Magazine, you know that demon ethanol has to be one of the most misguided public policies in U.S. history.

Ethanol has the same problem the industrial and mining unions have. They all rely on the Democratic Party for support, but the Democratic Party is attempting to form a coalition of completely diametrically opposed groups, so someone has to be thrown under the bus. President Obama has already demonstrated where his allegiance lies when he decided to sacrifice coal mining and pipeline building jobs to appease the environmentalists. The problem is, environmentalists are beginning to turn on ethanol.

Cracks have already begun to form in the once formidable ethanol political fortress wall. For the first time in its history the EPA blinked last year on the RFS2 and proposed a cut to the ethanol mandate and keeping the soybean oil intensive biomass based diesel volume mandate unchanged. Given the 2013 biodiesel production was 1.7 billion gallons when the mandate was 1.28 billion gallons, keeping the mandate at 1.28 billion gallons is effectively a cut.

To make matters worse, ethanol is a first generation biofuel, and the RFS2 is designed to make corn ethanol obsolete. What the Government giveth it can taketh away. Already the US imports sugarcane ethanol from brazil and other countries. Once again I wonder if the EPA is consulting the State Department when it is having such an impact on trade policy. This misguided EPA policy could result in a trade war.

By contrast, the EPA has previously said that some 666 million gallons of Brazilian sugar cane ethanol would be needed to fulfill the advanced biofuel requirement in 2013.

"It will be a shame for all the countries that are developing ethanol markets, not just for Brazil," Nastari said.

Other Latin American countries, which are seeking greater production of ethanol for domestic use and for export, could see the EPA's action as a "red light", said Plinio Nastari, president of sugar and ethanol consulting firm Datagro.

The United States typically takes up to 80 percent of Brazil's ethanol exports.

These trading partners have invested huge sums of money to satisfy the US' EPA RFS2 mandate. I doubt they are real happy when the EPA starts changing the rules in the middle of the game. While not directly related to the EPA's RFS2, the recent Biodiesel Tax Credit Bill introduced by the Senate specifically excludes imported biodiesel from participating. I would imagine that was largely done to offset the EPA's decision not to boost the biodiesel mandate for 2014.

The change also ensures the credit benefits domestic producers. The old law allowed blenders to receive the credit for blends that included foreign-imported biodiesel.

It appears that the Senate leans more National Socialist whereas President Obama and the EPA seem to lean more towards the World Socialist. Current policies are abandoning free market solutions, and the focus is more towards empowering a central authority over vast ranges of our economy and society. Once highly independent and proud farmers now go cup in hand to the government begging for programs to keep them alive, or should I say thriving. They act as if farming didn't exist before the USDA was formed.

A Depression-era program intended to save American farmers from ruin has grown into a 21st-century crutch enabling affluent growers and financial institutions to thrive at taxpayer expense.

Gains in farming however have been largely artificial due to the EPA's RFS2 program propping up the demand for corn and soybeans, and driving up the price of food, farming costs and farmland. That was never the intent of the EPA's RFS2, but those are the unwanted and unintended consequences. Because it simply doesn't make sense to burn food while people are starving in this world, the RFS2 transitions out of food based feedstocks and towards cellulosic/non-food feedstocks. When that happens, blenders can get ethanol from sources other than corn, and buy renewable diesel instead of biodiesel.

Because of the "nested" structure of the RFS2 and the "blend wall" issue, 2013 will likely represent the peak of corn based ethanol production. The reason is the "blend wall" effectively produces a cap for ethanol demand, above which additional production simply results in a wasteful surplus of ethanol. The "blend wall" is determined by the amount of gasoline sold in the US, not by some artificial quota set by the EPA. Blenders will blend up to 10% or E10, and simply don't have the desire or infrastructure to go much above that. You would have thought the EPA would have set a target of 10% of US fuel consumption instead of a hard and fast number, but obviously they can't think of every possible negative outcome from their ivory towers, sometimes we just have to learn the hard way from their mistakes.

Why this "blend wall" issue most likely created a peak for ethanol demand in 2013 is because D6 Ethanol RINs are the least valuable and least flexible of RINs. Production of other biofuels in the RFS2 program can satisfy "obligated parties'" RFS2 mandate. As more biodiesel, renewable diesel, sugarcane ethanol imports, advanced biofuels, cellulosic biofuel and cellulosic diesel get produced the excess RINs they generate can be used to satisfy the D6 RIN requirement. Corn ethanol doesn't have a specific volume target or RVO under the RFS2, it is the default biofuel from which other biofuels are intended to replace. While the above chart shows an RFS2 ethanol target of 15 billion gallons for 2022, that is a "plug" number to make the numbers fit. It is entirely possible, but not likely, that imports and expansion of other biofuels could completely replace corn based ethanol by 2022. If that were to happen the impact on farm prices and profits could be catastrophic. It is literally like the ARM Mortgage crisis all over again, only this time the EPA created the mess, not Fannie and Freddie.

Great strides are being made towards cellulosic and other advanced biofuels, and as more of the larger players become interested the more likely ethanol will be replaced by other biofuels. Dupont (NYSE:DD) is even developing a cellulosic product that can be used in place of ethanol and produced in existing ethanol plants.

After the success of a demonstration-scale facility in Tennessee, DuPont is now nearing completion of a commercial-scale cellulosic ethanol production facility in Iowa. By the end of the year, the facility should be operational with expectations to produce 30 million gallons of fuel ethanol from corn stover feedstock.

DuPont's interest in advanced biofuels spreads beyond just cellulosic ethanol into less traditional bio-based fuels like propanediol and biobutanol. The company's Butamax endeavor into biobutanol production is in collaboration with BP, with plans to use the fuel in place of ethanol for gasoline blending.

The major advantage of biobutanol over ethanol is its higher blending percentage given current regulations. It is not clear how detrimental the proposed changes to the Renewable Fuel Standard (RFS) would be to biobutanol, but it remains an intriguing opportunity given the ability to produce the fuel at already existing ethanol production facilities.

Because the development of the cellulosic biofuels industry has been slower than expected, it is unlikely that excess production of other biofuels will completely eliminate the market for corn based ethanol any time soon. In my opinion, Congress will eliminate the corn ethanol mandate long before the cellulosic fuel industry has the capacity to do so. Ethanol is being attacked from all sides, and it is an extremely unpopular and environmentally unfriendly fuel. Many extremely powerful groups are now calling for the elimination of the ethanol mandate. You know corn ethanol is in trouble when this fuel was sold as an "environmentally friendly" fuel and the Senator from California is leading the charge to eliminate it. Some in the Democratic Party appear to have identified who gets thrown under the bus, and it isn't Sierra Club.

(Reuters) - A group of 10 U.S. Senators introduced a bipartisan bill on Thursday to eliminate the corn ethanol mandate, arguing that current law raises the cost of food and animal feed and damages the environment.

The bill, introduced by Dianne Feinstein, a California Democrat; Tom Coburn, an Oklahoma Republican; and eight cosponsors, faces an uphill battle as many lawmakers from agricultural states support the Renewable Fuel Standard (RFS) that dictates that rising volumes of ethanol made from grains, including corn, be blended into motor fuel.

While the bill may face an uphill battle, the war for ethanol is far from being won. Ethanol is now being attacked as a threat to the "environment." Being safe for the "environment" was the basis of its support. The tactics used against "Big Oil" and "Dirty Coal" are now being turned towards "Big Dirty Ethanol." The following quote also highlights the theory I outlined above about how other biofuels can replace corn based ethanol. The message to ethanol is clear, and it is the same message sent to the coal industry.

"I strongly support requiring a shift to low-carbon advanced biofuel, including biodiesel, cellulosic ethanol and other revolutionary fuels. But a corn ethanol mandate is simply bad policy," Feinstein said in a statement.

In reality, the true market for ethanol is up to about 3-4% of the US fuel supply. Up to 4% ethanol is needed as an "oxygenator" of the fuel, and blenders will buy it simply because they have to. Above 4% ethanol then has to compete with gasoline on its own merits up to 10%. Above 10% ethanol starts to create real problems for the infrastructure, engines and car warranties, so potential ethanol usage is near what was produced last year, and can only realistically increase if fuel consumption increases.

That chart is dated, and when published gasoline actually cost less than ethanol. Today that dynamic has changed, gasoline now costs far more than ethanol, so blenders are buying ethanol based upon its economics not regulatory requirements. Ethanol is simply cheap right now and currently trades at a full $1 less in some months, or a 30%(+) discount to gasoline. Ethanol has 2/3rds the energy content of gasoline so they are basically at parity.

The price of corn ethanol includes a D6 RIN per gallon. That has helped ethanol margins and encouraged production. Without the RFS2 and the embedded D6 RIN, margins wouldn't be so high. Taking away the D6 RINs from corn ethanol and expanding the target volumes for cellulosic and/or advanced biofuels could cripple domestic corn based ethanol production. Currently the ethanol operating margins are $0.47 and D6 RINs trade at $0.55. Ethanol producers are basically making a RIN for every gallon they produce. Take away that RIN and they have no reason to produce. It is worth noting that ethanol made from non-corn sources can get 1.5x or more D5 RINs provding an incentice for blenders switch away from corn based ethanol.

How does all this tie together? Easy, much like the National "affordable housing" initiative resulted in a mortgage bubble that once burst nearly sent the world into a depression and devastated home prices and the homebuilding industry, the EPA's RFS2 has created a similar situation in the farming industry. Much like the mortgage industry was built upon a house of ARM cards, the farming industry is based upon a house of RIN cards. The industry is being artificially inflated, and the vultures and Hyenas are beginning to circle. I wonder if the EPA consulted the Federal Reserve before it created this bubble? The Federal Reserve is the one almost certain to get the blame once it pops; they took the blame for the bubble Fannie and Freddie created.

Almost the entire farming industry is being propped up by ethanol. Farmers have leveraged up paying top dollar for farmland, equipment and supplies to produce corn, nearly 40% of which is used for ethanol production. That leverage requires hefty margins to pay off, and those margins are almost totally the result of the RFS2. Even the RFS2 margins can still collapse as is happening right now in the biodiesel industry.

(Source of Image)

If Congress pulls the plug on the EPA's RFS2 ethanol mandate, the likely result would be an immediate collapse in the price of corn, followed by lower prices of other crops as production shifts away from corn. The problem is, without the food based biofuels EPA RFS2 mandate there is excess capacity in the farming industry. Currently that excess capacity generates incomes used to pay for costly inputs, costly equipment and very costly farmland mortgages. A repeal of the ethanol mandate would be catastrophic to the farming industry, but making catastrophically bad decisions isn't new for Washington. Peter Schiff made his name "calling the mortgage crisis."

During the early 2000s I worked far away from Wall Street and we were always discussing what was going to happen when the rates increased given that everyone had leveraged up with ARMs. There were many many many people that understood the terrible risks that were injected into the market, not just Peter Schiff. Peter just had the biggest megaphone. The problem is, once the party gets started, the only way to stop it is to get Congress to agree action is needed, and Congress is famously known for "not acting until the iceberg is hit."

Unfortunately people like Peter Schiff are off tilting at windmills trying to "End the Fed," hype gold and debating the "Bitcoin." If Peter Schiff deserved his title as an economic prophet, he would be focused on the Mortgage Crisis 2.0, the bursting ethanol bubble and pending collapse of the farming industry, not trying to explain why gold is better than "Bitcoin." If Peter Schiff misses the farming industry collapse it will simply prove that occasionally a blind squirrel will find an acorn and even broken clocks are right two times a day. Ironically, I agree with Peter Schiff on the "Bitcoin," but that issue pales in comparison to the consequences of a possible farming industry collapse.

A repeal of the ethanol mandate would likely have a significant impact upon:

  • Farm Equipment makers like John Deere (NYSE:DE) and Caterpillar (NYSE:CAT)
  • Seed producers like Monsanto (NYSE:MON)
  • Fertilizer companies like Agrium (NYSE:AGU) and CF Industries (NYSE:CF)

Midwestern banks will suffer after they did in the last farming crisis, as detailed in this 1985 article:

Of 889 "problem banks" the Federal Deposit Insurance Corporation was watching at this writing, 37 percent held a high degree of farm loans, according to an FDIC spokesman. Most are in the rural Midwest. In the last half of 1984, 22 farm banks failed; in the past year and a half, 11 production credit associations have gone under.

Ethanol producers like Green Plains Renewable Energy (NASDAQ:GPRE) and soy bean oil based biodiesel producers like ADM (NYSE:ADM) will also likely be harmed.

Food processors like Tyson (NYSE:TSN) and Hormel (NYSE:HRL) may actually benefit form the lower meat and feed costs. And companies like DD with corn based ethanol replacements may also benefit.

Companies focused on the 2nd generation biofuels like Renewable Energy Group (NASDAQ:REGI), Syntroleum (NASDAQ:SYNM) and KiOR (NASDAQ:KIOR) would all likely benefit.

Consumers like me that haven't purchased a steak from a store in 3 years will surely benefit.

Those benefits however most likely won't make up for the costs that will fall on the farmers. Almost certainly the farmers will bear the greatest cost if and when the ethanol bubble bursts. If and when that happens farmers will no longer be able to pay the inflated mortgages with their now deflated margins and underwater farmland mortgages.

In conclusion, just like the 2008 mortgage crisis, the Government has manufactured another bubble, and recent events may result in it being burst. Back in 2006 Democrats took the Congress and promised a new direction and to go after the energy industry, and they did. Oil prices bottomed almost immediately and never looked back...until the inflation fears they generated drove up the rates on ARMs, triggering the mortgage crisis.

We will energize America by achieving energy independence, and we will begin by rolling back the multi-billion dollar subsidies for Big Oil.
H.R. 6, "Creating Long-Term Energy Alternatives for the Nation Act." passed 264-163, Jan. 18th, 2007

Democrats were right, they were about to take America in a new direction, only as we now know, it is a very wrong direction.

During the 2006 elections, House Democrats promised to take our country in a New Direction, that a Democratic Majority would bring the change that our country so desperately needed. House Democrats wasted no time and within the first 100 hours can now stand united to say that we have kept our promise to the American people. Our successes are just the beginning. We have opened the 110th Congress with a tone that will continue throughout, which is one of cooperation, consensus and compromise that will see beyond party lines. Now, House Democrats are setting our sights beyond the first 100 hours to make America safe and strong for the future.

In reality, oil prices and inflation spiked after that election and the resulting mortgage crisis nearly destroyed the global economy.

My intent however isn't to bash one political party or another, it is to simply to call people's attention to the fact that Government actions, often done with the best of intentions, can have disastrous results. After all, the Democrats promised to "stick it to Big Oil" and save the world from its global warming causing toxins back in late 2006 early 2007. Right now we are witnessing the potential intentional popping of another bubble, the "Ethanol Bubble." Both parties are joining the effort, and I would imagine they will eventually succeed. If and when they do succeed, investors and farmers should be prepared to protect themselves. This article is an attempt to get the conversation started and afford investors time to prepare. Hopefully my fears are unwarranted and America finds a way to smoothly transition from first generation food based biofuels to second generation cellulosic/non-food based biofuels - only time will tell. If history tells us anything, however, that is highly unlikely. I would imagine that only after the ethanol mandate is repealed will Congress realize all the unintended consequences that they didn't think of before they acted. If you want a great case study to examine, watch the movie "Too Big To Fail," it makes that concept crystal clear.

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.

Disclosure: I am long SYNM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own calls on REGI.

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