THE RISE IN CRUDE OIL PRICES STIMULATES ETHANOL-RELATED DEMAND FOR AGRICULTURAL COMMODITIES

Worldwide interest in ethanol fuel

With crude oil prices reaching historically high levels, the global prospects for ethanol fuel use are growing. Ethanol production, derived from starch and sugar crops such as sugar cane and cereals, expanded by 53 percent from 30 billion litres in 2000 to about 46 billion litres in 2005. It is expected that world ethanol consumption will reach 54 billion litres by 2010, accounting for about 1 percent of world oil consumption (which is estimated to exceed 5 151 billion litres by 2010 according to the World Energy Council [2005]). Apart from concerns over high oil prices, the growing interest in ethanol fuel has other notable motives. These include: the need to diversify energy sources, the desire of many countries to meet their greenhouse gas abatement targets under the Kyoto Protocol, and the need to stabilize commodity prices and cut down on agricultural subsidies in line with WTO provisions. Thanks to advances in technology and policy incentives, the ethanol fuel industry is no longer restricted to a few countries (i.e. Brazil, Japan and the United States) but is building momentum in other parts of the world, including China, India and Thailand. The increase in ethanol use has the potential to create a substantial demand for energy-related agricultural products, and to further impact on commodity markets.

Ethanol policies

In general, countries use market regulation, through mandatory blends with gasoline and tax incentives to support ethanol fuel production and consumption. Mandatory blend ratios range from 5-10 percent (China, Thailand) to 20-25 percent (Brazil). Additional support is provided through credits for storing ethanol, a lower excise tax on ethanol fuel than on gasoline and investment concessions for new plant construction. Most cars produced today can run on low-level blends, while high-level mixes and pure biofuel require small engine adjustments. In Brazil, the dominant producer and consumer of ethanol fuels in the world, the national ethanol programme (PROALCOOL) began in 1975 with the aim of reducing the country’s oil import bill. Two institutions played a vital role in implementing the national ethanol programme. The Institute of Sugar and Alcohol (IAA) controlled sugar and ethanol production and exports through a production quota and fixed purchasing price of ethanol, while Petrobas controlled domestic ethanol sales and distribution. Inadequate ethanol supply and demand management caused serious market disruptions in the early 1990s. Consequently, the Government made radical policy changes over the 1997/1999 period. In 1997, the price of hydrated ethanol was liberalized, followed by anhydrous ethanol in 1999, Petrobas’ distribution monopoly was abolished and subsidies to ethanol blend gasoline producers were reduced. The Government no longer exercises direct control over ethanol production and exports, but sets the ethanol to fuel blend ratio, and periodically provides support in the form of purchases and sales from ethanol strategic reserves.

In the United States, the second largest producer of biofuels, a variety of federal and state-level incentives, including excise tax exemption and subsidies, exists for mostly maize-based ethanol fuel. In addition, ethanol is likely to be one of the main beneficiaries of the Renewable Fuels Standard (RFS) provision, part of the recently adopted United States Energy Bill. The RFS did not provide any liability protection for the use of MTBE (methyl tertiary butyl ether), an octane enhancer in gasoline which is banned in several states and considered a main substitute for ethanol.

In the EU, where the biofuel market is dominated by biodiesel produced from vegetable oils, ethanol accounts for about 20 percent of the biofuel market. France and Spain are the main producers. In 2003, the EU issued a directive for the use of renewable transport fuels with established targets and guidelines. It set the share of renewable fuels in total transport at 2 percent, rising to 5.75 percent by 2010. An additional directive allowed member states to exempt biofuel from fossil fuel taxes. EU member states were also given the flexibility to design tailor-made energy policies to achieve target guidelines. In France, the Government set production quotas along with tax incentives for biofuel production. In 2005, a progressive tax rate was implemented on petrol distributors to encourage blending biofuels with gasoline. Similarly, Spain, the largest EU producer of ethanol, together with Germany, Italy, Portugal and Sweden all provided either partial or full exemptions from excise duties applied to petroleum products, along with laws to encourage biofuel production.

India’s bioenergy programme was intended to create an alternative to sugar producers in the face of depressed prices. In 2002, the Sugar Development Fund was revised to include provisions on ethanol use. The Government approved the sale of E5 (5 percent blend with gasoline) across several states, and introduced a Rs 0.75 excise duty exemption for ethanol sales. The Government of China also provides subsidies for ethanol production, and mandates the use of E10 ethanol blends in several provinces. Tax incentives also apply in Thailand to promote the use of E10 fuel mixes, while Australia, Canada and Japan provide investment and production subsidies, under certain conditions. Currently, most countries have high importation tariffs on biofuel to make imported fuel uncompetitive with domestic supply.

Impact of rising oil prices on ethanol-related demand for agricultural commodities

Normally, when crude oil prices increase, two main factors affect agricultural commodity markets. First, the production costs for the crop increase; under competitive conditions, this leads to a contraction in supply and hence raises commodity prices. Second, depending on the economics (including government incentives) of biofuel production, the increase in oil-based fuel prices provides an incentive to biofuel producers to expand production, which in turn expands demand for agricultural feedstock crops causing prices to increase further. At the same time, the expansion in biofuel supply may also be dampened by the parallel rise in commodity prices. The overall net impact on commodity markets will depend on the degree of increase in biofuel prices relative to the increase in total crop production cost. Recent analysis has shown that the effect of oil prices on production costs is comparatively much stronger than that on increased demand for biofuel related commodities, partly because the world share of bioenergy in total transport fuel consumption and the existing production capacity of biofuel remain relatively limited (Agricultural market impacts of future growth in the production of biofuels, OECD, Paris [2006]).

 

The impact of oil prices is likely to be greatest, however, for commodities that constitute an important source of demand for bioenergy. The best example of this is that of sugar (from sugarcane), which is currently the most economic of significant feedstock crops. In the case of sugar, there is evidence of a strong co-movement between crude oil and sugar prices. A standard statistical test examined whether a long-run relationship exists between these two prices and if so, how strong it is. The results showed that such a relationship does exist and it is much stronger than the price links between other seemingly unrelated commodities. In addition, it was established that signals from the oil market are transmitted much faster to the sugar market than in the reverse direction, leading to the conclusion that on average, sugar prices tend to follow oil prices. Figure 35 illustrates the linkage between oil and sugar prices while Table 11 shows the parity prices between sugar and oil, based on a simulation of the oil-sugar price relationship.

Table 11. Estimates of parity prices between sugar and crude oil

The co-movement between sugar and crude oil prices has developed mostly because of the strong link between ethanol and sugar production in Brazil, the world’s largest sugar producer and exporter accounting for about 38 percent of world exports and 19.5 percent of production. The growing number of Brazilian flex-fuel vehicles which can run on any combination of gasoline and ethanol directly influences the demand for ethanol. As consumers react to the relative price differential between ethanol and gasoline, any increase in the price of gasoline stimulates demand for ethanol, reduces sugar exports and raises world sugar prices. Similarly, a decline in crude oil prices would result in reduced ethanol consumption, a greater diversion of sugar volumes onto the world market, and a downward pressure on world sugar prices. At the world level currently, it is estimated that about 15 percent of sugar crops are converted into ethanol rather than sugar.

Prospects for expansion of biofuel production

With existing technologies, production of ethanol from sugarcane and from maize has been the most economic compared with ethanol from other feedstocks, and with biodiesel from vegetable oils. However, if crude oil prices remain high, incentives to produce both ethanol and other biofuels from different feed-stocks will increase further. This may benefit many developing countries that produce sugarcane or which have excess supplies of cereals or vegetable oils, particularly countries that are landlocked and import energy.

The emergence of carbon trading programmes in accordance with the ratification of the Kyoto Protocol may also enhance the competitiveness of biofuels, particularly ethanol, in comparison to fossil fuels. Since ethanol consumption results in a significant reduction in carbon dioxide emissions, users can obtain carbon credits that can be sold to large polluters, leading to a reduction in the costs of producing ethanol while increasing that of fossil fuels. Several countries have already advanced carbon-trading programmes, including Japan and the EU, and it is likely that similar carbon trading schemes will emerge around the world.

It is important for many resource-constrained developing countries wanting to produce biofuel to assess the cost of drawing resources away from food and feed production against the expected benefit from lower crude oil imports. For example, the OECD study of the impact of oil prices on bioenergy production looked at the resource requirement in terms of land. It estimated that the EU would need to convert about 70 percent of its agricultural land to provide 10 percent of its energy need, while the United States, Brazil, and Canada would require about 30, 3, and 0.3 percent of agricultural land, respectively. The rate of such conversion varies across countries and is dependent on feedstocks used to produce bioenergy and per capita transport fuel consumption: the higher the latter, the greater the land requirement, given current technology. In the long run, technology advances and productivity gains could allow the use of less land per unit of energy produced. It should be kept in mind that technological advances may also permit the production of biofuels from cheaper feedstocks such as ethanol from cellulose-based feedstocks, such as stalks, woody materials and leaves. This could allow more ethanol to be produced at a lower cost, and at the same time, reduce the market impact on food commodities.