While inflationary expectations began to register in the US Treasury market in late 2005, it would seem that the vast majority of commodity prices ended the year without much of an inflation premium. Early in 2005. the airline and auto industries saw escalating prices as a result of energy costs, but as the year progressed the housing and construction industries saw their cost structure explode due to material shortages resulting from the destruction from the US Gulf Coast hurricanes. ln early September the US chemical industry suggested that its costs were expected to rise by $107 billion over 2004. According to a DuPont economist, every $1 per barrel increase in crude oil prices could result in chemical company costs rising by $2.6 billion and that every $1 per MMbtu increase in natural gas prices would effectively raise their costs by $3.7 billion. While most of 2005's global food production was spared the sharp escalation in costs brought on by soaring oil prices and rising fertilizer costs, we suspect a much different picture for 2006. ln addition to row crops being presented with sharply higher costs for fertilizer and energy, there are also expected to be indirect impacts from soaring oil and chemical costs on inputs like fungicides and pesticides. As if the aforementioned issues weren't enough of a burden for commodity producers, the threat of bird flu looks likely to increase costs significantly in the poultry industry. Most US poultry operations are already indoors and therefore are less prone to infection from migratory birds. However, much of the world's production that remains outside may have to be brought under cover to lower that risk, which would certainly increase production costs. While the world has already experienced the impact of mad cow and swine flu, it is becoming clear that "simple" low tech production of many commoditics could become a thing of the past, as the world is forced to move toward more sophisticated and safer production methods. Therefore, in addition to rising cyclical costs (labor, financing, fuel. insurance) we also suspect that these new "special" production costs will become a permanent fixture which could result in overall production capacity shrinking. While high transportation and soaring energy prices add a further complication to the upcoming production situation, the most alarming development is that a number of commodities are seeing their demand base explode in the wake of a FOOD VERSUS FUEL CONUNDRUM.
While the direct impact of Hurricanes Katrina and Rita will probably only be felt for months it is possible that the increased frequency and strength of the storms is just in the beginning phase of a typical cycle. Even more concerning is the argument that global warming is set to cause an intensification of the hurricane season, which would seem to have long ranging implications for US energy supply. While soaring oil prices were already in the process of opening up the door for alternative fuels, we suspect that the 2005 hurricanes solidified oil prices at significantly higher levels, and that will probably serve to accelerate the integration of ethanol, bio-diesel and sugar based alcohol within the world energy equation. While structural limitations are sure to restrict the rapid expansion of these alternative fuel sources. We suspect that an offshoot of the sharp 2005 energy price gain will be a growing global awareness of the need to diversily energy supply and to decentralize both sources and distribution and that the demand from the energy sector will continue to seriously draw on corn, soybean oil and sugar supplies. In the not too distant future, it will be clear that the energy market is having a tangible impact on a host of food markets. The other, more definitive impact of the 2005 hurricanes could be an increased inflation pressure, as prices for oil, copper, lumber, base metals and a host of building materials were all given an added lift as a result of the extensive damage from the storms. When one considers the 2004 tsunami, the US hurricanes and the earthquake in Pakistan, it certainly seems like the demand for base commodities will continue to run at a very hot pace. Furthermore, with both food and energy prices ratcheting higher, it could be a difficult task to avoid spiraling inflation.
The surge in crude oil prices to over $70/barrel in 2005 is likely to have a positive price influence for corn, sugar and soybean oil, as green fuel production and consumption are likely to accelerate. Most studies were showing that crude oil prices above $40-$45 would be high enough to establish incentives for new investments and for an accelerated mixing of green fuels with fossil fuels in order to stretch available supply. Certainly the 2005 hurricane season illustrated the US dependence on foreign oil, but it also showed the need for expanded refinery capacity in the US. After years of slow development, the industry seems ready for accelerated usage of ethanol and bio-diesel as a way to augment gasoline and diesel supplies in the US.
In addition to the surge in energy prices, the Energy Bill that was passed by Congress in 2005 should go a long way in reviving confidence in the future of ethanol production and also help boost (or even jumpstart) the production and usage of bio-diesel fuel. Excise tax credits provide incentives for distributors to blend bio-diesel into diesel fuel and help reduce the cost to the consumer.
ETHANOL With unleaded retail prices surpassing $3.00 in 2005, 10% ethanol blend gasoline selling at about 10 cents below unblended gasoline at many Midwest locations and 85% blend selling as much as 50 cents lower, it is clear that ethanol has garnered a foothold. In the past several years, it has been a rare occurrence for the ethanol blends to sell at a discount to straight unleaded, and ethanol has struggled to get the retail price advantage that would appear to have been possible for quite some time. ln other words, distributors have been in a position to sell ethanol blends at a discount but have not done so. However, with corn prices down and retail gas prices up sharply, the price differential could widen quickly, and there could be a significant economic incentive for consumers to buy ethanol blends and for distributors to sell more blended gasoline. Ethanol production in the US was expected to expand to 8 billion gallons by 2012, which was a goal set by a US Senate committee before the recent surge in energy prices. However, the Renewable Fuels Association indicates that with new facilities coming on-line, ethanol production could reach 7.36 billion gallons as early as 2008. Wirh trade perceptions last spring that the petroleum industry was resisting ethanol blending, claims for such sharp production increases over the next few years come into question. However, given the surge in crude oil prices over $70.00 in 2005, the growth pace projected by the market last year was probably still too conservatlve. Brazil is the world's largest ethanol producer, and that country already blends 25% ethanol into its gasoline for fuel. Monthly new sales of flex-fuel vehicles in that country exceeded normal engine vehicles for the first time in the spring of 2005 and was up from 20% of the new car sales in the prior year. As a result, ethanol consumptlon is increasing there at a dramatic rate. Brazil is expected to produce nearly 16 billion litres in 2006 and hopes to be exporting 8-10 billion per year in the next few years.
Brazil's exports of ethanol are growing and are expected to double in the years just ahead with special interest from Japan, lndia and the US. Other countries are also shifting to ethanol blended gasoline. Japan has a voluntary 3% blend, and they imported 149 million liters of ethanol from Brazil in 2004. Brazil exported a total of 1.8 billion litres of ethanol in 2004. If Japan were to make a 5% blend mandatory, they would need to import about 3 billion litres per year or 16% of Brazil's 2001 production. Thailand has mandated a 10% blend beginning in 2007.
BIODIESEL With over half of the cars in Europe running on diesel fuel, bio-diesel usage there is likely to surge in the months just ahead. About 32% of Europe's rapeseed crop in 2004 ( 15.1 million tonnes) was used for bio-diesel, and rapeseed represents about 80% of the bio-diesel market. Many European countries are expected to reach a goal of blending 5.75% bio-fuel by 2008, ahead of their 2010 goal. Europe is expected to replace 2% of its fuel consumption with renewable fuels this year. Global demand for bio-fuel was 2.5 million tonnes last year and is expected to grow about 25% per year. The surge in energy prices will only accelerate the growth. The major obstacle to increasedb io-dieselp roductioni n Europe will be that oilseed crushing pace is already near capacity and growth in consumption in the next several years will likely come from imports of other vegetable oils, such as palm oil. Malaysia is ramping up efforts to produce and export bio-diesel and could also increase palm oil exports to Europe and other world users. With palm oil trading at a significant discount to other oils, palm oil prices may be the first to find a fundamental "floor" price, as the energy component provides underlying support.
Current US bio-diesel capacity is about 220 million gallons and is expected to reach 320 million gallons by the spring of 2006. Production in 2002 was only about 25 million gallons, but the new tax bill and tax incentives for 2005 and 2006 are significant, and production in 2005 is expected to jump to at least 125 million gallons. New construction of refining facilities and significant economic and legislative incentives should boost 2006 production towards 270 million gallons, and we would not be surprised to see it climb to 400 million gallons or more in 2007. It takes about 7.3 pounds of soybean oil to produce 1 gallon of biodiesel, so the US is likely to use 912.5 million pounds of soybean oil to produce bio-diesel in 2005, 1.97 billion pounds in 2006 and possibly 2.92 billion pounds by 2007.
IMPACT ON COMMODITY PRICES CORN: For the 2005/2006 season, the US is expected to use 1.5 billion bushels for ethanol production. A number that could double in the next two years. Ending stocks are projected at 2.2 billion bushels for this season after a crop of 10.86 billion bushels. While 2.2 billion bushels may be seen as "comfortable," total usage is projected at 10.76 billion bushels, and if ethanol production continues to grow, total usage will be over 12.5 billion bushels in just two years unless usage in other areas drops. As a result, it will become increasingly more difficult for the market to avoid significant tightness.
SOYBEAN OIL: The US is likely to use 912.5 million pounds of soybean oil in 2005 for bio-diesel production. With much of the usage in the second half of the year. Usage is expected to jump to near 1.97 billion pounds in 2006 and possibly 2.92 billion pounds in 2007. Ending stocks for the current year are projected at 1.496 billion pounds. In order to mix 10% biodiesel across the country, it would take about 18 billion pounds of soybean oil as compared with production this year of 18.1 billion pounds.
SUGAR May 2006 sugar futures are already up 24% since the May lows. World sugar production is about equal to usage for this season, and a recovery of production in India and Thailand in the next few years could boost world production. However, usage is growing rapidly in Asia, especially China. Brazil is the world's largest producer of sugar and uses nearly 50% of its sugar cane crop to make ethanol. Brazil's ethanol usage is accelerating rapidly, and traders are concerned that if that trend continues and exports accelerate as well, a much larger percentage of the cane crop will be used for ethanol production and sugar production and exports will decline.
