How ethanol bites you in the wallet

Price inflation abroad

The effects of higher corn prices don't stop at the U.S. border. In fact, higher prices are hurting consumers in poorer countries more than more affluent consumers in the United States. Food price inflation is running higher in developing economies than in the United States, and in those countries food takes up a bigger part of the family budget. Food-price inflation was running at 6.2% in China in the first quarter of 2007 and 11% in India, for example. In the United States, food makes up only about 15% of the shopping basket that the U.S. Commerce Department uses to calculate the Consumer Price Index. In Thailand, food makes up 35% of that basket. In the Philippines, it's 50%.

The decision to promote corn-based ethanol as part of our national energy policy (if you can call it that) has imposed other costs on the economy, as well. Since ethanol is too corrosive to ship through existing pipelines, it has to be delivered from refinery to consumer by truck or rail. It's also necessary to ship corn to the ethanol refinery and, then to ship what remains after the starch has been extracted from the corn kernel to disposal sites or back to farms for use as feed. All of that extra hauling has put more pressure on U.S. rail lines that are already struggling with too much traffic running on too many single-tracked lines.

Where's the fertilizer?

And that 16% increase in the acreage planted to corn has also produced a big surge in U.S. fertilizer demand -- as much as an extra 1 million metric tons this year. (The shift from soybeans to corn also increases demand for fertilizer, since soybeans can fix nitrogen from the atmosphere and require less nitrogen fertilizer than corn.)

The supply to meet that extra demand won't come cheap, since nitrogen-based fertilizer prices are near record highs. Prices are projected to average $365 a metric ton in 2007, up from $270 a ton in 2006, an increase of 35%.

Much of that fertilizer will be imported, too. It takes natural gas to produce nitrogen fertilizers. High natural-gas prices have driven most U.S. producers out of the business, leaving nitrogen fertilizer production to countries such as Trinidad and Tobago, Russia and, surprise, Saudi Arabia. The U.S. Geological Survey calculates that in 2005 the United States imported 21% of the urea it turns into nitrogen fertilizer from Saudi Arabia and Qatar.

A game plan for investors

So where does this all leave investors?

• Buying the shares of farm-equipment makers, such as Deere (DE, news, msgs), since whatever its net effect on the economy as a whole, ethanol is clearly good for farm incomes.
• Buying the shares of fertilizer makers such as Potash Corporation of Saskatchewan (POT, news, msgs) and Yara International (YARIY, news, msgs).
• Buying the shares of agricultural commodity traders such as Archer Daniels Midland (ADM, news, msgs) that have the ability to arbitrage prices between commodities and geographies.
• Selling the shares of food-processing companies, such as Kellogg (K, news, msgs), Nestle (NSRGY, news, msgs), Hershey (HSY, news, msgs) and PepsiCo (PEP, news, msgs), that are getting squeezed by rising commodity prices for key ingredients such as corn, corn sweetener, milk and cheese. And staying neutral on ethanol producers themselves. Government subsidies for ethanol production have brought too many companies too quickly into the industry. A consolidation, fueled by high corn prices and bottlenecks in the distribution system that make it hard to get ethanol to market in many areas of the country, has just started.

And the technology questions still remain to be answered.

Brace yourself

Can the corn-based ethanol industry find a way to solve its corn-price problem by turning more of what remains after ethanol production into animal feed? (Currently, that "waste product," DDGS, or distillers dried grain with solubles, has too much oil to be easily digested by many farm animals.)

Will the technology for making ethanol from plant cellulose, such as the switchgrass so often mentioned by President Bush, evolve from test project to commercial viability any time soon?

Corn-based ethanol yields only marginally more energy (optimistically) than it consumes in production, and it requires so much corn that reaching the administration's lofty production goals is unlikely. Yet despite all its faults, corn-based ethanol is here to stay, at least for the next five years or so. The political logrolling that passes for energy policy in Washington -- you vote subsidies for ethanol, I'll vote subsidies for "clean" coal -- just about guarantees that.

So you might as well prepare your portfolio for the consequences.

Editor's note: A new Jubak's Journal is posted every Tuesday and Friday. Please note that recommendations in Jubak's Picks are for a 12- to 18-month time horizon. For suggestions to help navigate the treacherous interest rate environment, see Jim Jubak's portfolio of Dividend stocks for income investors. For picks with a truly long-term perspective, see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio. E-mail Jim Jubak at jjmail@microsoft.com.

At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: Archer Daniels Midland, Headwaters, PepsiCo. He did not own short positions in any stock mentioned in this column.

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