The big price build-up: are you ready?

The US economy is just now showing signs of revival, and already we are seeing signs of runaway oil and grain prices that may bring unwanted inflation and dangerous instability hardly before the recovery has had a chance to add jobs.

I used to have a car like this – an old Mustang – that at end of life could hardly get running before it was overheating. It was easier to trade in the car than trade in the economy, but what are we all to do? How are we to prepare? And, now that the global biofuels industry has soared to more than $50 billion in annual revenues and is a lot more than just a niche industry, how should the industry respond.

As if CEOs, investors, policymakers and, well, all of us, didn’t have enough to keep us awake at night, here are some fundamentals to keep a sharp lookout on.

1. Ethanol prices going up, up, up.

From a low of 1.61 per gallon (at the Nebraska racks) in December 2008, and remaining as low as $1.62 per gallon in July 2010, rack prices hit $2.47 in November, and the January contract at the CBOT is at $2.305 per gallon, with a $2.11-$2.25 range in the contracts for the rest of the year.

2. Oil prices going up, up, up.

After hitting a low in the upper $60s per barrel in June, oil jumped to over $90 per barrel in December and closed at $88.38 earlier this week. Now, T. Boone Pickens tell the National Journal that oil prices will spike to as high as $120 per barrel in 2011, and will translate at gas prices jumping over $4 per gallon in the US.

3. Grain and oilseed prices going up, up, up.

Corn prices hit a bottom near $3.20 a bushel in September 2009, and now we are now looking at $6.11 per bushel for corn in the July 2011 contract, as of this week. Concerns over a poor harvest in Argentina are making pessimists on the availability of corn supply. Wheat, which bottomed at under $4.50 last spring, is now over $8 per bushel for the 2011 contracts. Soybeans, which were in the $8 range in late 2008 and as low as $9.30 last summer, are now at $13.82 for the January CBOT contract.

Here are some possible scenarios to think about.

1. Deja vu all over again.

Grain prices spark “food vs fuel” debate about the role of ethanol in spiking demand and prices, while the soaring fossil fuel prices make Big Oil a lot more interested in recovering oil while good times last from their marginal proved reserves by investing in new upstream exploration, than investing in biofuels. Could it happen? It surely did in 2008. Industry trade associations are forewarned and forarmed this time around – so don;t expect something as simplistic as the Grocers Manufacturing Association’s scare campaign to get traction on Capitol Hill, but keep a sharp lookout all the same.

2. The Battle of the Bulge.

Congress is looking at the job numbers and the deficit, and is going to want easy credit and lots of stimulation from the Fed to grow the tax base and the prosperity base. The Fed, meanwhile, is going to be looking nervously at the inflationary pressure brought by high oil prices – traditional measures are to establish tight credit, rein in inflation, and risk more job losses by choking out the inflationary pressure.

Herein is the puzzle. Traditional recessions are cyclical, caused by soaring confidence and demand – reigned in, when they start to trigger inflation instead of growth – by Fed action. The 2008 recession, however, was structural in nature, not cyclical.

What’s a structural recession? “The more serious class of recessions are “structural”. A structural recession is more than a crisis of confidence. It occurs when a deep, underlying problem in an economy can no longer be denied.”

What is the deep, underlying problem. In a word, dependence on oil, throughout the economy, and a weak US manufacturing base. There is more oil than corn, on a cost basis, in a box of Corn Flakes.

“If you are what you eat,” Michael Pollan once wrote, “what you are is corn.” Close, but not quite on the money. If you are what you eat, what you are is a barrel of oil.

3. Investor flight.

There’s little in this world that deflates investor interest faster than the prospect of long-term cycle of recession-followed-by-choked-off-recovery. The inability of Africa to provide its own energy and manufacturing base – with trade deficits causing by energy imports causing fundamental devaluation of the currency, making imports (such as manufacturing) impossible to afford – is a long-term “bad” that the US economy is slowly but inexorably centering on.

The complexity here is that energy is expensive – simply on the basis of its massive scale – and the bill for converting over the US from oil to something else is in the trillions, not the billions. Its difficult to see how foreign investment is going to play a role – for one, the US government is leery of selling off US farm assets to foreign control – and it is difficult to see how the US is going to aggregate even a meaningful portion of the required capital.

4. Long-term dollar decline.

The more the US imports, the more the trade deficit grows, there’s pressure on the dollar to devalue. That makes oil prices rise in the US (as they are dollarized), but prices do not rise (necessarily) as fast elsewhere because the rise in prices can be offset by the increased value of, say, the Euro against the dollars. Example, if oil goes from $60 to $120, while the Euro doubles against the dollar from $1.35 to $2.70, US consumers face doubled oil prices, while Europeans see no change at all, because the currency change offsets the oil price rise. A simplistic example, of course – but illustrative of the potential for the US to get completely out of competitive position in trade.

5. Solutions now, please.

In a world of fast-rising oil, grain and oilseed prices, a switch from oil to ethanol or soy-based biodiesel is not, in itself, a miracle cure – even if the economy could facilitate such a switch, which it lacks the infrastructure base to do, in any case, limited as we are to an ethanol blend wall at E10. Advanced biofuels offer options because they base off of alternative feedstocks, such as municipal waste, algae, and forest or ag residues.

But the US has moved slowly in investments to scale these technologies – for goodness sakes, not one of the Bush era cellulosic ethanol DOE grants has resulted yet in a completed plant operating at the proposed scale (Range is running, but at lower volumes, POET and Abengoa are constructing, BlueFire is financing, the others appear to be DOA).

With hard ceilings on growth in the form of permitting and construction timelines, production volumes are locked in at a maximum in the hundreds of millions of gallons for the 2011-12 period. The earliest we can see a real breakthrough in volumes, that is volumes that are significant to the economy, is 2013 – that’s a lot of potential suffering at the pump for the overburdened US consumer. We’re likely to hear a lot more grumbling about the evils of corn ethanol in a price buildup than the role of advanced biofuels in remediation, for the time present.

6. De-linkage from oil.

We’re going to hear a lot about this one. The theory goes, if you get off oil, you get out of the boom-and-bust impact of swinging prices (and we’ve seen swings from $140 in 2008 to $35 in 2009, and $90 now, and that’s price volatility of the first magnitude). Here’s the tough part – you have to make sure the alternative feedstock doesn’t immediately track oil, as soon as it is linked to energy. At $120 oil, forest waste is worth something in the range of $160 per ton in terms of the total aggregate value of the energy that can be produced by a cellulosic ethanol process – even higher if ZeaChem hits its 135 gallons per ton target when it reached scale. Though the capital and operating costs of aggregating and processing that waste into energy consumes some of that value, what’s to stop forest waste prices going to Pluto, except for long-term contracting?

And as several Digest readers have pointed out, what’s the incentive for a biofuels producer to price renewable gasoline at $2 per gallon when there’s demand out there at $4 per gallon? Ultimately, increases in supply will cool off prices, but transformation restructuring of prices would require biofuels at massive scale.

7. The customers of oil get real.

Chemical companies have been dabbling in biofuels and renewable chemicals. Dupont, for example, has a series of joint ventures, but in almost every case they see their role as the early-stage investor and technology licensor – beyond demonstrations of technology, they do not see themselves as an investor for scale. Dupont Danisco Cellulosic Ethanol and Butamax are two manifestations. And DuPont is one of the real visionaries – companies like BASF and Dow are participating as investors at even more anemic levels. Smart folk at those companies – they simply don’t see the payback, given their costs and sources for capital.

8. Watch natural gas prices.

No matter what happens to oil, keep a sharp lookout on gas prices. If those start to rise – and fast – you will see a wholesale change of sentiment among investors, as it will choke off hope that CNG or LNG vehicles offer an alternative to biofuels and oil, and that chemical companies can avoid the impact of a long-term price increase in oil.

The bottom line for biofuels.

These are tricky times. Careful messaging is called for. The specter of food vs fuel will rise again, unless the industry convinces the public that a box of Corn Flakes has more oil than corn. The specter of investor flight is real. But the overriding concern should not be oil prices – it is gas prices. If those spike, oil & gas investors are going to be completely consumed exploring their marginal production alternatives, but policymakers and chemical companies are going to see a lot more that they like in bioenergy.

Job #1 for the biofuels industry: Get Ag off the Dope (oil)

Get oil out of the production of farm goods in the United States – and, well, everywhere. Farmers need to eat their own dog food, as the saying goes. That will start the de-linkage process. That means fertilizer, and diesel. Until that happens, crop and residue prices will simply track oil.