Hogs Vs. Ethanol: Ethanol Wins!

US - The pork industry's concerns about higher corn prices from the extraordinary growth in corn demand for ethanol appears to be moving from speculation to reality.
calendar icon 19 October 2006
clock icon 13 minute read

Higher corn prices are expected to have at least two impacts in the coming year. First, market weights will likely drop, which is a positive for hog prices. However, this will be more than offset by the negative consequences of higher corn prices on costs

In addition to escalating costs, there is also some expansion, with the market herd up over 1 percent and the breeding herd up nearly 2 percent. This means pork production will rise by about 2 percent over the next 12 months. However, domestic pork supplies per person will only be modestly higher given growth in the U.S. population and continued growth in pork exports.

The pork industry will likely have growing concerns about the heavily subsidized ethanol industry. Those concerns are internal and external. Internal concerns involve how higher and more volatile corn prices will impact their businesses, including costs and returns. Corn availability may be an issue as well. External concerns include the federal ethanol subsidy which by itself enables ethanol users to bid an extra $1.38 per bushel for corn. This subsidy, by itself, represents a potential to increase corn prices by 67 percent compared to the $2.05 average corn price over the past eight years (1998 to 2005 crops). This and other favoritism to the ethanol industry is likely to place huge disadvantages on the pork industry and other corn users who are unable to gain substantial advantages from the use of distillers' grains.

In the face-off between hogs and ethanol over corn supplies, expect ethanol to win the battle at least for the next couple of years. Biofuels have so much momentum at this point that traditional corn users have little ability to slow that force for a few years. This most likely means that traditional corn users will have to adjust to these new realities. For some, survival may be at stake.

Family farms that still raise much of their own corn and also produce hogs will tend to be the least affected by the biofuels era. They will have available supplies of corn, a natural hedge between high corn prices and hog prices. If they own land, the federal ethanol subsidy and profits from ethanol will be partially capitalized into their land values. Those hog companies least likely to benefit are those who need to buy all of their corn on the open market. However, many of these are large companies that have better internal ability to manage these price risks through future/options; may have risk reducing benefits through integration; and have the internal knowledge to better manage supply risk through supply contracts.

The Numbers

The nation's market herd on September 1 was up 1.4 percent from year-previous levels. The inventory of hogs to come to market in the fourth quarter of this year and the winter were up about 1 percent. These numbers were consistent with the pig crop numbers from last spring and summer, which were up 1 percent as well.

The nation's breeding herd had expanded by nearly 2 percent, or 107,000 animals. Somewhat surprisingly, 65,000 of those animals are in the Eastern Corn Belt (ECB) states, with Indiana's breeding herd up 30,000 head, Illinois up 20,000, Ohio up 10,000 and Wisconsin up 5,000. The other area of expansion was the Plains states of South Dakota (+15,000), Colorado (+10,000), and Kansas (+10,000). In the Western Corn Belt (WCB), the expansion in Missouri (+15,000) was about offset by a decline in Minnesota (-5,000), with Iowa unchanged.

Has the ECB finally turned the corner on the declining portion of the nation's breeding herd? Figure 2 helps answer that question. The line represents the percent of the nation's breeding herd in the three largest ECB hog states: Illinois, Indiana, and Ohio. In the mid-1990's, these three states represented from 18 to 20 percent of the nation's breeding herd. That percentage hit bottom in 2003 at 14.5 percent, a decline of some three to 4 percentage points. The most recent numbers show the share of these three states has increased to 15.5 percent.

If the decline in the ECB has turned around, the reasons are not as easy to spot as the trend reversal. Probably the leading explanation is the expansion of processing capacity at an Indiana plant. That expansion slated for completion sometime in 2007 would require around 60,000 additional sows to produce the 1.25 million head of added capacity.

There also seems to be some interest in east coast producers moving closer to the traditional corn production areas. This may be stimulated by limited hog growth potential in eastern seaboard states such as North Carolina and by the growth of ethanol in the ECB. There is some feeling that getting closer to the distillers' grains will be advantageous compared to hogs located in the east or the southeast.

In addition, ethanol growth is the most robust in the WCB. Another hypothesis is that the large growth of corn use for ethanol in the WCB has increased corn prices there relative to the ECB. There is some empirical data that supports this idea. From 1995 to 2003, the USDA: NASS prices received by farmers data shows that Minnesota corn prices on average were $.28 per bushel lower than in Indiana. However, in the past two years, 2004 and 2005, that discount to Indiana has averaged only $.13 per bushel. Thus, Minnesota prices have increased $.15 per bushel relative to Indiana. The same holds true for South Dakota - a $.13 increase per bushel relative to Indiana in the two periods, and for Iowa - a $.10 increase in Iowa's corn prices relative to Indiana.

The current expansion in the ECB does not seem to be explained by changes in relative hog prices. ECB hog prices have continued to trade at a discount to WCB prices. In the most recent four calendar years from 2002 to 2005, ECB prices averaged about $.60 per carcass hundredweight lower than WCB prices. So far in 2006, that discount has been about $.50. Such a small change certainly does not explain the current growth in the ECB.

Pork Supply, Demand, and Prices

The inventory of market hogs that will come to market this fall and winter is up about 1 percent. The supply of market animals for next spring and summer will come from farrowings this fall (up 1 percent) and winter (up 2 percent). Marketing weights are expected to begin to drop below year-previous levels this fall and continue through next year due to much higher corn prices. Current forecasts are for carcass weights to be down by 1.3 pounds, or .6 percent.

Carcass weights are increasing about one pound per year on average, but corn prices are expected to be high enough to overwhelm the trend and push weights lower. The net effect is negative for hog producers as the enhanced hog price that results from lower weights will be much less than the impact of increased costs from higher corn prices.

Pork supplies are expected to be about 1 percent higher this fall and then nearly unchanged in the winter. The modest expansion in farrowings and increasing pigs per litter should move pork supplies nearly 3 percent higher for the spring and summer of 2007, see Tables 3 and 4.

Pork trade continues to be a positive demand factor. For 2006, pork exports are expected to reach 3.0 billion pounds, or about 14 percent of domestic production. Current forecasts from USDA are for exports to expand next year by an additional 4 percent. This is a sharp slowing of the growth rate from the 2003 to 2006 period when exports expanded by a compound annual rate of 20 percent. The major question will be if Asian pork purchases will hold up with U.S. beef once again flowing.

Hog prices averaged $52.40 per live hundredweight this summer. However, prices are expected to dip to the $45 to $48 range for quarterly averages this fall and winter. Prices for next spring and summer are expected to recover and average in a range from $48 to $52, see Table 5.

What About Corn Prices?

In the past 12 months U.S. corn prices averaged $2.03 per bushel. Futures markets at the close on October 13 were suggesting an average U.S. cash farm price of about $3.00 per bushel for the coming 12 months. If so, this means estimated hog production costs will rise from the very high $30s this past summer to about $45 by next summer.

These are scary times for hog producers. The best news right now is that hog prices are still expected to be above these costs over the next year, as shown in Figure 2. The bars in the figure are the price of hogs (live weight) and the line is an estimate of costs. This fall and winter, estimated costs rise to the $43 to $44 range and on to $45 by next summer. Expected returns, then, are only $2 to $3 per live hundredweight this fall and winter and $4 to $5 next spring and summer.

Of course, who knows where corn prices will actually be over the next year? How much could producers pay for corn? Given assumptions here, breakeven corn prices are about $3.50 per bushel this fall and winter and between $4.00 and $4.25 for next spring and summer. This assumes meal prices stay where they are now and that hog prices are as forecast

Ethanol and the Next Two Years for Hog Producers

Current estimates show that ethanol plants could pay about $5.50 per bushel for corn given current prices for ethanol, current prices for distillers' grains, and with crude oil at $60 per barrel. There will be little slow down in the building of ethanol plants if crude and ethanol prices stay near current levels, even if corn prices are bid to $4.00.

Hog producers should consider that the federal subsidy on ethanol adds about $1.38 per bushel to what an ethanol plant could pay for corn and still breakeven (this is based upon a 2.7 gallon ethanol yield per bushel and the $.51 per gallon subsidy rate). As an illustration, under current conditions, ethanol plants could pay $5.50 per bushel for corn. Without the federal subsidy, that would drop to about $4.12 per bushel. This is much closer to the breakevens for hog producers.

There are multiple points here, but one is that hog producers (and other corn users that cannot get substantial advantages from distillers' grains) may be grossly disadvantaged by the federal ethanol subsidy. A second point is that the federal subsidy is so large that three years of this subsidy by itself is equal to the entire cost to build the plant. This would be equivalent to telling a hog producer to build buildings and populate them and the federal government will provide a subsidy that is equal to the costs of construction and population over the first three years. The federal subsidy on ethanol is in the law until 2010.

Hog producers are one group that could consider providing information to policy makers and the general public of how ethanol subsidies are disadvantaging them, and distorting markets at the same time.

If the ethanol industry continues to receive these large subsidies, there is little to constrain the increase in capacity until corn prices are bid up to, or beyond, their breakeven levels. Of course, it is never clear just where this is because the single most important factor in the determination of ethanol producers' corn breakeven will probably remain the price of crude oil.

In addition to the federal subsidy, some states in the Western Corn Belt have state subsidies for ethanol production and have passed state renewable fuels standards. A number of states are also providing additional financial incentives for infrastructure and job training assistance.

It is not likely that corn prices will be going back to $2.00. For the last eight years from 1998 through the 2005 crops, the average U.S. farm price of corn was $2.05 per bushel. The new biofuels era provides little assurance of what corn prices will average over the next five years. Much higher and much more volatile prices can be expected with corn prices linked not only to livestock prices but to crude oil price instability.

There are likely some difficult days ahead for hog producers. Several thoughts come to mind. First, the industry needs to curtail all expansion in an attempt to avoid excess pork production at a time of sharply rising costs. Second, the industry has been through high corn prices before and can make some adjustments in terms of increasing protein levels relative to corn in rations, seeking all alternative feed sources that can substitute for corn, adjusting feeders and reducing feed wastage in feed systems, learning quickly how to feed distillers grains, cutting marketing weights, and culling low productive animals more quickly.

In addition, corn availability may become an increasing issue in the next two years. Ethanol plants and large companies that produce animals are already seeking ways to align with corn producers for supply. It is possible that by the 2008 crop, some of these end users will be offering supply contracts to assure supplies. Traditional family farms that produce their own corn for their hogs would appear to be at a substantial advantage in coming years.

Can hogs compete with ethanol in the longer run? The answer is probably YES as U.S. consumers will be buying both fuel and food. However, assuming corn prices will move to higher levels and be more volatile, there will likely be a period of adjustment that may involve substantial losses for about two years. This would be a period which would involve some liquidation of the breeding herd to reduce pork supplies sufficiently to increase retail prices and thus farm level prices. Over time, we know an industry must cover costs, so eventually hog prices will rise by enough to cover the higher and more volatile corn prices. Unfortunately, the beef sector will be better able to get positive value from the distillers' grains and thus retail pork and poultry prices will probably have to rise faster than retail beef prices. This is another factor that will be harmful to the pork and poultry sectors.

The next two years may be a period of great concern for the pork sector as higher feed prices cut or eliminate profits. This likely means most producers will want to be more risk averse by having more of their corn price risk booked ahead through forward contracts or through futures and/or options hedges. There will be some tendency to also forward price hogs as well. The concern regarding hog prices will be that a short corn crop in 2007 or 2008 could lead to much higher corn prices and cause a quick liquidation of hogs, driving those prices downward.

Overall, the goal may be to "assure survival over the next two years." Hopefully, by 2009, if corn prices move to a much higher plateau, the pork industry will have downsized sufficiently to drive pork prices to high enough levels such that they can afford the higher corn prices. In addition, by 2009 a better understanding of the need to balance crop usage between fuel and feed will develop. This may include some alteration to the federal ethanol subsidy.

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