US Drought Reignites Ethanol Debate

Once again economics and politics are colliding as the ongoing drought, the worst in 50 years in the United States, has reignited the debate about ethanol. The debate centers on whether is makes sense, at a time of food shortages globally, to turn corn into fuel. The U.S. ethanol industry uses roughly 5 billion bushels of corn annually, or about 40 percent of the U.S. crop.

Already strains in the industry are showing thanks to high corn prices in excess of $8 a bushel. Not to mention stagnant demand for fuel and the expiration of some subsidies which ended in December. Output of ethanol from producers has fallen to the lowest levels seen since October 2009.

The slowdown in the ethanol industry has already affected the producers. One of the largest producers of ethanol (with a capacity to refine 1.7 billion gallons a year), Archer Daniels Midland (NYSE: ADM), recently reported poor earnings. The company said it lost money on ethanol thanks to already-high inventory levels, weak fuel demand and low inventories of corn. Another large ethanol maker, Valero Energy (NYSE: VLO), also recently reported negative ethanol profit margins citing the same reasons as ADM. Both companies have shut down some ethanol producing plants in the Midwest.

Many organizations, including the United Nations, have asked the U.S. to waive government mandates for ethanol usage this year. The mandates will ensure that more than 13 billion gallons of ethanol will be used this year, no matter the price of corn. Also asking the government to suspend for a year its mandate for ethanol use are members of the U.S. livestock and poultry industry. Animal feed is the second biggest use for corn, behind ethanol. It accounts for about a third of corn usage, so the two industries are in competition for scarce, high-priced corn.

The livestock and poultry industry will suffer with falling profit margins because of the soaring price of corn for animal feed. Meat prices at the grocery store will rise, hitting consumers hard. Larry Pope, CEO of meat producer Smithfield Foods (NYSE: SFD), warned that U.S. meat prices will rise by “significant double digits” in the near future if nothing is done about the high corn prices.

But at least Smithfield Foods has done a decent job of hedging corn prices into 2013. Some of their peers such as chicken producer Sanderson Farms (Nasdaq: SAFM) have not done a good job of hedging corn. And this is important since animal feed makes up 55 percent of the company's cost of goods sold. Sanderson estimates that for every 30 cent jump in corn, it raises the cost of producing a pound of chicken by a penny. Doesn't sound like much, but it is important when you're working on the thinnest of profit margins. No wonder its stock has tumbled by about a fourth over the past few months.

The key question for meat producers and other consumers of corn is whether the government will waive, at least temporarily, its mandate for ethanol fuel. The answer is almost certainly no! In an election year, no politician in either party will want to risk losing votes in key Midwestern farm states where the ethanol program is very popular.

So other users of corn have best be prepared for even higher prices (unless the weather improves) by hedging as much corn as they can. For investors, it means continuing to invest into exchange traded funds (ETFs) such as the Teucrium Corn Fund (AMEX:CORN) which is up more than 40 percent since June. The ETF offers investors unleveraged direct exposure to futures for corn without having to open a futures trading account. The fund is set up in a unique way so as to reduce the effects of contango and backwardation. For specific information on how Teucrium does this using three different futures contracts, please visit Teucrium's website at www.teucrium.com.   This article originally appeared on the Motley Fool Blog Network. Make sure to read all of my articles for the Motley Fool at http://blogs.fool.com/tdalmoe/.