Ethanol, Mandates, and Drought: Insights from a Stochastic Equilibrium Model of the U.S. Corn Market

Lihong Lu McPhail, Bruce A. Babcock
March 2008  [08-WP 464]

The outlook for U.S. corn markets is inextricably linked to what happens to the U.S. ethanol industry, which depends, in turn, on the level of government subsidies and mandates. We develop a stochastic partial equilibrium model to simulate outcomes for the corn market for the 2008/09 marketing year to gain insight into these linkages. The model includes five stochastic variables that are major contributors to corn price volatility: planted acreage, corn yield, export demand, gasoline prices, and capacity of the ethanol industry. Our results indicate that integration of gasoline and corn markets has increased corn price volatility and that the passage of the expanded ethanol mandates in the Energy Independence and Security Act (EISA) has had modest effects on corn prices. Model results indicate an expected average marketing year price of $4.97 per bushel and a price volatility of 17.5% without the 10 billion gallon EISA mandate but with maintenance of the $0.51-per-gallon tax credit. Imposition of the mandate increases the expected price by 7.1% and price volatility by 12.1%. The effects of the mandate are modest, as ethanol production would average 9.5 billion gallons without the mandate because of high gasoline prices. The mandate is binding with a probability of 37.8%, which indicates that an additional tax or subsidy will be needed to ensure that the mandate is met. High corn prices caused by drought can cause the mandate to bind. Fixing 2008 corn yields at extreme drought levels increases expected corn prices to $6.59 per bushel without a mandate and to $7.99 per bushel with the EISA mandate. An average additional subsidy of $0.73 per gallon of ethanol would be needed to ensure that the mandate is met in this drought scenario. Elimination of the current blenders tax credit would result in the mandate not being met in all cases. On average, a subsidy of $0.41 per gallon would ensure that ethanol production is at least 10 billion gallons in the 2008/09 marketing year.

Keywords: EISA mandate, ethanol, price volatility of corn, stochastic equilibrium.

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