Markets & Finance

Effects of the Biofuel Boom


As biofuels become an economically competitive power alternative, life is changing fast for the whole agricultural sector

From Standard & Poor's Equity ResearchSky-high energy prices are having some far-reaching effects: As corn and other crops become increasingly important raw materials for biofuels, such as ethanol or biodiesel, the companies that make and process them are starting to act more like energy companies. And as more acreage is being planted with sugar cane, corn, and soybeans to make biofuels, other crops are being displaced, decreasing their supply and spreading the effect of high energy costs across a wide range of food products.

With global oil prices hovering around $70 per barrel, investment is pouring into the development of biofuel technology and facilities to produce it. Ethanol production now accounts for about 20% of the U.S. corn crop.

Reacting to Oil

Since biodiesel and ethanol are close petroleum substitutes, their prices track that of crude oil. Profits for companies that produce them, in turn, also react to shifts in oil prices. Archer-Daniels-Midland (ADM), the largest U.S. (and global) grain processor, now gets 25% of its operating profit from biofuels, including both ethanol and biodiesel, and its shares are being increasingly seen as an energy, as well as an agriculture, play.

"While we are a long way from all farm products being converted to biofuels, the biofuels that are being produced do act like energy products," says Joseph Agnese, a Standard & Poor's equity analyst. Right now, that relationship is benefiting many companies, he says, since biofuels are an important new source of demand. "We see significant earnings growth in 2007 from growing end-product demand for sweeteners and biofuels," despite risks caused by the rise in crop prices.

More demand for corn to produce ethanol, which is now blended with gasoline but has the potential to become its own motor fuel, helped push corn prices to a 10-year high in February. For grain processors like Archer-Daniels-Midland, Bunge (BG), and Corn Products International (CPO), however, higher corn prices cut into profits.

"Growing demand for the use of corn in ethanol has driven up the price of corn, an important raw material for both corn processors and meat producers such as Tyson [Foods] (TSN)," Agnese says. "There are already cases of profit margins being negatively impacted from the rise in corn prices over the past year."

Corn's Domino Effect

Trade groups representing beef, chicken, and pork producers, as well as the Grocery Manufacturers Assn., have started to voice opposition to taxpayer subsidies for biofuels like ethanol, and have succeeded in placing a limit on the amount of future ethanol production that can be derived from corn. Similar concerns are being expressed in Europe and China.

Higher corn prices raise the cost of raw materials for grain processors, but because ethanol producers are absorbing some of the industry's "wet milling" capacity—a milling technique that can be used either by food or ethanol producers—the value of end products such as cornmeal and vegetable oils has risen because of reduced supply. "The removal of wet milling capacity has helped Corn Products International pass along price increases and cover the cost of rising corn raw material costs," Agnese says.

Farm equipment makers like Deere (DE) are also feeling the effects of the biofuel boom. Higher crop prices are lifting farm income, translating into more demand for the tractors and combines that companies like Deere make.

S&P Equity Research believes there tends to be a positive correlation between crop prices and sales of farm equipment. S&P sees growth in the production of ethanol leading to increased demand for corn, which in turn is boosting prices of corn and, ultimately, cash receipts for farmers. S&P expects U.S. farm income to rise about 10% in 2007, and sales of farm machinery to grow at a similar rate.

Agnese believes there are limits to the increase in corn prices. Unchecked, the price of corn would "eventually increase to the point at which substitutes are viewed favorably, and an equilibrium will be reached with demand."

Scully is a reporter for Standard Poor's Editorial Operations.

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