Crude oil and corn prices         

[June 06, 2007]  URBANA -- While ethanol-driven corn prices may be higher than historical averages, there is no reason to believe they won't be as volatile as in the past, said a University of Illinois Extension economist.

"Oil prices will have increasing impacts on corn prices," said Gary Schnitkey, U of I Extension farm financial management specialist. "Historically, crude oil prices have exhibited variability. Moreover, options contracts indicate that oil prices will be variable.

"This variability may cause more corn price variability than has occurred in the past. This variability may be further exacerbated by corn production risks and low levels of stocks, which may further contribute to corn price variability."

Schnitkey's report, "Crude Oil Price Variability and Its Impact on Break-even Corn Prices," was co-authored with colleagues Darrel Good and Paul Ellinger in the U of I Department of Agricultural and Consumer Economics. The report is available online at Extension's Farmdoc site.

For the 2006-07 marketing year, 2.15 billion bushels of corn, accounting for 11 percent of total U.S. corn consumption, will be used to make ethanol. More corn is projected to be used in ethanol production over the next several years. If corn remains the predominant feedstock, nearly 4.5 billion bushels of corn could be used annually in ethanol production beginning in the 2007-08 or early 2008-09 marketing years.

"Increasing use of corn in ethanol production holds the promise of increasing corn prices such that average corn prices in the future will be higher than average historical prices," said Schnitkey. "However, ethanol production may not reduce corn price variability. As corn use in ethanol production increases, corn prices will be more influenced by oil prices.

"Like corn, crude oil and gasoline are commodities and are subject to price swings as a result of supply and demand changes."

Once federal mandates for use of biofuels are reached, Schnitkey noted, ethanol's primary use will be as a substitute for gasoline. As such, the ethanol price will have to be competitive with the gasoline price so that consumers will buy ethanol-blended fuels.

"Because corn is the major production cost for ethanol, the price an ethanol producer will be willing to pay for corn, hereafter referred to as the break-even corn price, will be directly related to the ethanol price," he explained. "As the ethanol price increases, the break-even corn price increases. Moreover, ethanol price will be directly related to crude oil price.

"Therefore, break-even corn prices will be positively related to crude oil prices. As the crude oil price increases, the price of gasoline will increase, leading to higher ethanol and break-even corn prices. Conversely, decreases in crude oil price will lead to a lower gasoline price, a lower ethanol price and a lower break-even corn price."

The report includes charts and tables demonstrating the relationship among the prices and how to calculate the break-even corn price.

"Our report suggests that risk management will be of continued importance for farmers into the future," Schnitkey said. "Higher corn prices will lead to higher costs on grain farms, as cash rents and land prices adjust to those higher prices. Cost adjustments could lead to the same per-acre margins as before potential ethanol-induced commodity price increases.

"Given the same margins, farmers will still need to protect themselves against price declines."

[Text from file received from the University of Illinois Extension]