Agriculture to Energy

This is the first in a series of posts on this subject. Today I'll talk about the general situation. Next post I'll fill in a trade or two.

For the last couple of years the prospect of of using crops for alternative energy has been thought of as a "game changer". The potential added demand for the crops is so large as to dwarf traditional food uses. According to many, there are not enough acres in the world to satisfy this demand. Grains and sugar go to ethanol, oilseeds to biodiesel, etc. Not only is this economic, but the political powers around the world are almost always protective of their farmers and agribusiness. So once the capacity for ag to energy has been put in place, it will get used. In other words, capacity growth is a one way street. Therefore we will get pretty much a permanent bull market in this ags (baring a fall in energy prices, which I don't believe).

I missed out on the initial bull market in ags; I was concentrating heavily on the energy markets and didn't want to increase my risk. Now that many of them have settled back (from a 0% pullback in bean oil to about 20% in corn to over 50% in sugar), I want to look at them again.

The first thing to remember is obvious, but it bears mentioning: food is essential to mankind. The most important goal of an economy is to get enough for people to eat. So if alternative energy starts impacting people's diets, it will be reduced. We saw a little of this in Mexico last year. Of course prices are made on the margin, so the energy demand will provide a floor in surplus times. But if energy demand starts cutting in food, it will be dealt with.

Second, the economics of ag to energy are not nearly as clear cut as commonly believed. For example, the process that produces ethanol from corn also produces byproducts that are used for animal feed and compete with oilmeals.

Third, many of these processes are definitely not economic. I won't bore you with the detailed numbers, but according to the analyses I have seen, all US processes require government subsidies/tariffs/tax breaks to work. (My sources are internal financial plans of some of the projects going up.)

What this means is that many of these schemes are subject to considerable political risk. A change in government policy to be less pro-ag could decimate them (and take the floor out from the corn market). Remember that the Democrats are likely to get full control of government in '08. Sure, higher oil prices would bail things out, but if you believe that - just buy oil.

So I'm a skeptic on a lot of this. However there are a few areas where this does make some sense, and we get some pretty good trades. Tomorrow I'll talk about sugar and later about biodiesel.