The drought is going to cause extraordinary damage to corn yields this summer, which is going to destroy ethanol. But the damage may be mitigated by eliminating our use of ethanol - which we don't need.
It's been a while since we've seen the "food vs fuel" debate concerning ethanol vs. gasoline. The issue largely went away when the recession hit, as the price of gasoline tanked and sent more than 50% of the ethanol players into bankruptcy. (Most of the small players were wiped out, and several of the larger ones didn't last either). After that, ethanol faded from the public spotlight… as though it was somehow embarrassing to kick a wounded animal, or as though it were unworthy to continue to level attacks against the industry now that it's suffered.
The truth should be quite surprising to many based on the media focus: While the companies went bankrupt, the infrastructure was still built, and the only impact bankruptcy had was to affect ownership in fully functioning refineries and blending stations all across the Midwest. Actual production ramped up continually through 2008-2009, gaining 7.5 [Mbbl] in monthly production from July 2008 to July 2010 - a nearly 40% increase during the same time period when the product value plummeted below feedstock costs, and rampant bankruptcies ensued.
But the ethanol crash in 2008-2009 was based solely on product value. There was still a rapidly growing agricultural yield to provide for growth in the industry, so new players who were able to acquire the infrastructure in a steal had no problem keeping production high and expanding rapidly.
The coming crash for ethanol will be based on tightening supply of feedstock, which is a vastly different situation that was faced in 2008-2009, and will need to be considered in a different light.
The first thing to quantify is the extent of the drought facing the U.S. at this time.
The 2012 Dust Bowl:
As of July 17, a total of 63.9% of the contiguous U.S. is in some state of drought, while another 16.2% of the contiguous U.S. is abnormally dry. This is the worst drought in at least 55 years, and possibly the worst drought since the dust bowl of the 1930's. The development of the drought has introduced a new term to the broad discussion of climate: "flash drought". But the critical region to focus on is the Midwest and the High Plains - the "corn belt". As of July 17, the states most critical to corn production showed the following:
Corn production rank
% of the total 2011 U.S. corn for grain production
% of the state suffering drought conditions:
% of state suffering severe drought conditions
Using the above data, we can very roughly estimate that >80.3% of the total U.S. corn crop is under a condition of "drought" or worse, while >68.8% of the total U.S. corn crop is suffering under "severe drought" or worse. Corn is a water intensive crop, and is therefore threatened by drought to a greater degree than many crops.
The above should make clear that we are in for an extremely tough corn crop. 1234 counties have already been designated as disaster areas, with more to come. The U.S.D.A. characterizes >40% of the nation's corn crop in poor to very poor condition, and that is going to worsen as the summer continues.
It's not just the rain, it's the heat.
Please indulge a very brief physics lesson here:
There's some confusion in the broad discussion - at least from some opinion writers who only look at rainfall data and are far removed from the farmlands - about how devastating this drought really is. The root problem here stems from the vapor pressure of water. We think of water boiling at 100 C, and remaining in liquid state until boiling temperature has been achieved. But what actually occurs is water is constantly in the atmosphere (humidity) to some extent based on temperature, and is constantly evaporating from the ground until that concentration is achieved.
The concentration of vapor in the atmosphere is based on the vapor pressure of water - which is temperature dependent (at 100 C the vapor pressure exceeds atmospheric pressure). I've provided the chart in which I've gone through the exercise of converting temperatures to Fahrenheit and vapor pressures to "maximum percent concentration"… and, based on an estimate of a 6 C temperature drop per km (typical is 6.5 C/km, but I was assuming high humidity, in which case elevation based temperature drops are not as steep), I went ahead and roughly estimated the total amount of water that the lowest 3 km of atmosphere is capable of absorbing, or "holding" per acre before reaching saturation. (The water vapor is lighter than air and gradually "lifts" into the upper troposphere, so the atmosphere is constantly drying out and evaporating more water from the land, plant masses, and bodies of water in an attempt to maintain saturation.) The units here are "thousands of gallons per acre".
I went through this brief exercise to explain the following: every ~2 degrees [F] of temperature increase, the atmosphere can and will absorb an additional ~6% of water. Therefore, if the temperature is 96 degrees rather than 90 degrees, the atmosphere will attempt to evaporate or contain an additional ~15,000 gallons of water from the land. If the temperature is 100 [F] rather than 90 [F] then there will be an additional ~31,000 gallons absorbed by the lower 3 km of atmosphere per acre of land.
An inch of rainfall over an acre of land is ~27,000 gallons, so having two days where the temperature is 96 rather than 90, or having a single day where the temperature is 100 rather than 90, has a general impact on the land similar to reducing rainfall by an inch. (Of course it doesn't work that way exactly, but this is a useful generalization.)
The takeaway here is that the intense heat wave at the end of June/beginning of July served to bake dry the nation's corn supply, and entering into late July/early August with such a large broad region of drought conditions is a very bad sign - with little likelihood that matters will turn for the better during the traditional hottest period of the year. It will take something akin to a genuine miracle in order for much of the crop that is currently under severe drought to be saved in August. Even if there is actually some rain every evening (which is doubtful, because the moisture is not there to rain out), the additional heat of August will still be drying the fields more than a light rainfall will replenish them.
So what about ethanol?
We are certainly going to lose 38% of the corn crop, and we are likely to lose more. That's clear.
Corn is already spiking to ~$8/bushel and that's going to climb as the crops will continue to worsen.
This means we also have the certainty of a catastrophic season for ethanol due to feedstock costs being too high rather than due to product values being too low.
Ethanol has never been an industry that has had to stand on its own, but this year the blending credit that offered $0.45/gallon for refineries that mix ethanol into the fuel was allowed to expire. So cost is cost, for the first time in the fledgling industry's history.
Only 2.8 gallons of ethanol can be produced from a bushel of corn. If corn is selling for $8/b, then the corn feedstock alone costs $2.85/gallon, before any other consideration is given to energy, O&M, amortized capital expenses, and distribution.
The current wholesale price of gasoline is $2.71/gallon in the New York harbor and $2.61/gallon at the Gulf coast. That's gasoline that is ready to go: properly isomerized to the right octane and cetane ratings, and ready for your vehicle. Current regulations maintain that this gasoline must be purchased from the harbor or the oil refinery and blended with some lower energy density ethanol that is now going to be extremely expensive.
Ethanol has, in the past, consumed ~40% of the nation's corn crop. This number is quite similar to the current projection of the amount of the corn crop that is likely to be ruined by drought. At the same time, recent drilling trends point to a rapid increase in domestic oil production, and current political trends point to a tremendous glut of petroleum threatening to collapse global oil prices sometime soon. The following two charts were taken from previous articles that I had published (linked above), but they bear repeating:
We are clearly producing more fuel then we have in over a decade, fuel production is growing rapidly, and drilling rigs are rapidly shifting from NG to oil, which will only serve to increase domestic oil production more rapidly.
In light of this, it stands to reason that for THIS HARVEST we don't need the corn for fuel as badly as we will need the corn for food (and cattle feed). Why can't we let the cars burn gasoline for a year while we recover from this year's dust bowl?
Nationalize Ethanol refineries?
Of course without the mandates for ethanol blending requirements, the ethanol refineries will again face bankruptcy. However, most of these facilities will face bankruptcy even with the regulations in place. It may be time to face the facts that an industry based on agriculture cannot be maintained without government intervention. For ~70 years, farmers were able to maintain sufficient diversity of crops and market stability due to federal subsidies, loan guarantees, quotas and forced rationing, and other USDA meddling; but this is a commodities market where - when left solely to market devices, boom years would lower the value of all crops, then bust years would come along and destroy farms that are harmed by weather. Market forces serve to kill the industry, but it's a vital industry that cannot be allowed to be killed.
When the rush for ethanol began (through machinations ranging from production tax credits, ethanol blending credits, tariffs, blending mandates, tax credits for flex-fuel vehicles, CAFÉ standard overrides for flex-fuel vehicles, grants for ethanol pumps, stimulus funds for additional pipelines, blending allowance upgrades, grants for researching enzymes.. etc…) this offered a new way to help support farmers and support agricultural prices without just paying farmers to leave fields fallow.
Since then the ethanol industry has thrived and grown at a rate that traditional energy will not match.
During most of the 2000's when global oil supply and global oil demand were near matched, the additional input from ethanol served to keep the balance better restored, and served to keep oil prices far more stable than they would have been without the then ~700,000 [bbl/d] of ethanol being pumped into the system.
So there was two societal needs that were heavily funded and incentivized by society… a need to help support the agricultural industries from experiencing depressed prices due to excessive bounty, and a need to get more fuel into the system more quickly than the oil and gas industry could ramp up alone.
Now the needs of society are reversed: fuel is plentiful and food is facing a critical shortage. So the only options are to harm society by keeping in place those incentives or to remove those incentives and ensure the total destruction of an industry that there is little doubt we will have need of again.
It seems the best option here would be to purchase the ethanol refineries from the industry and mothball them all for one year. Then, assuming next year we do not have a severe drought that destroys more than 40% of the U.S. crop, we can restore the ethanol plants back to their current function. It could be absolute serendipity that we happened to be growing 40% of our food with no intent to eat it, as ~40% of the crop is currently being destroyed. If we think about ethanol in this light, it becomes far more useful to society than if we only consider it as a lesser-quality fuel. Clearly there is more benefit in paying for farmers to grow corn-for-ethanol then there could ever be benefit in paying farmers to leave land fallow… and there's far more money for farmers with the ethanol payments as well, but in times of severe crop destruction - as we are facing now - the potential benefit to society of having started the season by planting nearly twice as much food as we intended to consume becomes quite useful…
This will also serve to reduce the impact of the coming massive glut of oil facing the world markets which are already reaching record commercial storage levels.
In future seasons where a major oil disruption occurs or 3rd world growth exceeds expectations and oil prices are through the roof, having the infrastructure that is capable of sustainably adding more than 1 [Mbb/d] additional fuel to the supply might be heavily appreciated…
But that is not the case today. I'm sure that most Americans would vastly prefer having meat to having higher priced fuel of lesser quality. Ethanol cannot stand on its own without government involvement… fine. Whether the ethanol industry is nationalized, bailed-out, or just left to die in order to be scooped up by some other daring companies, the one thing that shouldn't happen this year is to use blending regulations to prop up an unnecessary industry that is consuming a vital and (for this year) limited resource.
Let the cars use gasoline.
Political reality: The reality of the situation, however, is that God is credited with agricultural prices while politicians are credited with fuel prices. So it is highly unlikely that any move will be made concerning regulations that will increase the price of gasoline and decrease the price of corn (over the course of a year, the loss of 1 Mbb/d of ethanol will certainly take its toll on gasoline inventories).
This is even more likely due to the tea party's influence in reducing spending - regardless of merit. The regulations don't require additional taxes, they merely require additional spending on food, which again will likely be attributed to God, not congress.
I believe that with the coming harvest we will see corn prices spike to over $10/b before November, while as noted before the oil and gasoline prices face a glut deluge and will likely drop significantly whenever Iran yields. But soon after the election I expect most state and federal regulations concerning ethanol blending requirements to be lifted, and the ethanol industry is already tightening - a process which will continue throughout the next three months. Then corn prices will ease a little and gasoline prices will begin to climb again.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am part of a small group working on a novel renewable fuels synthesis process. There are, in some people's minds', some form of competition between fuels synthesis and other alternative fuels - such as ethanol. I believe this notion to be bizarre, as ethanol is physically limited by land acreage from ever being a significant portion of the global hydrocarbon market... there's plenty of room for all here.