Impact of Bio-fuels on Commodities Prices

Bryan Chan
November 9, 2011

Submitted as coursework for PH240, Stanford University, Fall 2011

In recent years, developed countries have increasingly sought to reduce fossil fuel consumption. This has been motivated by concern over the dwindling supplies of oil, the environmental damage caused by greenhouse gas emissions, and the security risks associated with depending upon unstable foreign countries for oil imports. [1] To help fill this void, countries have turned to various forms of bio-fuels, such as corn-based ethanol in the US and oil-seed based biofuels in Europe. In 2007, bio-fuels accounted for nearly 1.8% of the energy expended globally for transportation. Notable leaders in bio-fuel consumption are Brazil, where it accounts for 20% of transportation energy, and the United States, where the percentage was 3%.

Bio-fuels have received extensive government support. Many countries have set explicit targets for the percentage of energy used for transportation coming from bio-fuels, with the European Union targeting 10% by 2020. [1] In the United States, the federal government subsidized corn ethanol blending at a rate of 45 cents per gallon. [2] Including state and other auxiliary federal subsidies raises this subsidy to between $1.05 and $1.38 per gallon of ethanol. This is despite the fact that at current price levels for corn and oil, corn ethanol production in many cases would be profitable without subsidies. [3]

Despite the support, development of corn ethanol, the primary form produced in the United States, remains a work in progress. [4] The net energy balance ratio for corn-based ethanol is currently 1.3, meaning that for every 1.3 units of energy captured, 1 unit of fossil fuel energy had to be expended to grow and harvest the corn, and manufacture the ethanol. Put in a more global perspective, all the corn production in the world, if converted into ethanol, would only supply 6% of global oil demand, reducing fossil fuel emissions by 1%. [4] With current technology, corn ethanol is "basically a way to make cars run on coal and natural gas." [4] Other forms of bio-fuel are more promising; for example, sugar cane and palm oil have energy ratios of 8 and 9 respectively.

Another serious drawback exists as well. Given the spike in commodities prices that occurred in 2007-2008, many critics have wondered to what extent demand for agricultural commodities from bio-fuel production has driven up food prices. In the twelve months preceding March 2008, global food prices increased 43%. [5] Although this had a minimal effect on developed countries such as the United States, where the typical consumer spends less than 14% of income on food, the increases were felt disproportionately in the developing world, where a larger fraction of income is spent on food. In Africa, 43% of income is spent on food, with this percentage ranging as high as 70% for the most impoverished segments of the population. [5]

An initial glance at the data seems to support the validity of this concern. For example, as of 2007, ethanol demand for corn took up 25% of annual production in the United States, and 13% worldwide, which should clearly have an effect in driving up corn prices. [5] [6] Worldwide, two-thirds of increases in global corn production were used for ethanol production. [3] Second order effects would raise the prices of other similar grains, such as rice and wheat. Increased corn prices could lead to farmers dedicating additional acreage to corn, reducing supplies of rice and wheat, driving up prices. [7] Looking at price changes in the 12 months prior to March 2008 shows that wheat prices increased 123 percent, corn increased 37 %, and rice increased 36%. [5]

However, research on the effect of bio-fuels on food prices has yielded mixed results. Experts focusing on corn ethanol generally agree that some price increases have resulted. Some ethanol analysts estimated that using 2008 prices for corn, ethanol production resulted in corn prices being 20-30% higher than would otherwise be the case. [8] Edward P. Lazear, Chairman of the Council of Economic Advisors, attributed 13% of the 37% increase in corn prices in the year prior to May 2008 to ethanol production demand. [5] For grains in generals, studies have reached different conclusions on the effect of bio-fuel demand upon prices. At one extreme, Donald Mitchell of the World Bank attributed two-thirds of world food price increases between 2002 and 2008. [6] Another study found that 30% of food price increases between 2000 and 2007 were caused by bio-fuel demand. [7]

Others have argued for a more modest effect. For example, the World Food Organization, a division of the United Nations, concluded that freezing bio-fuel production at 2007 levels, as opposed to doubling production by 2018, would lead to 12% lower grain prices and 15% lower vegetable oil prices. [9] A similar study found that freezing at 2007 levels as opposed to reaching government mandated production levels by 2015 would lead to 14% lower corn prices. [9]

Alternative explanations for the boom in commodities prices are increased demand from middle-income countries and speculation/investment in commodities. The increased consumption demand theory holds that consumption from populous countries such as India and China drove up food prices, as consumers in those nations altered their diets to move up the food ladder towards a more western diet. [9] In reality, this was unlikely to be a primary driver of the price spike, as the World Bank noted in a 2009 report, since food demand for agricultural commodities did not change significantly during this period. [3] Similarly, supply shocks due to weather, although present, are unlikely to have been a major driver of the price boom. [9] Speculation in commodities may have played a significant role; in recent years investment managers have increasingly diversified into commodities, totaling $250 to $300 billion of holdings by mid-2008. Famed investor George Soros singled out commodities index trading, a particular method of investing or trading commodities, as being particularly destabilizing and "harmful in its economic consequences." [3] However, as with bio-fuels, the studies on the effect of financial speculation on commodities prices have been mixed.

The recent rise in commodities prices has also unveiled some other troubling developments in the food vs. fuel debate. The introduction of bio-fuels as a demand for agricultural crops has led to an increasingly tight relationship between energy prices and food prices; since higher oil prices mean that bio-fuels will be more profitable, higher oil prices lead to increased demand for bio-fuel crops and hence increased prices. At oil prices above $50, each percentage point increase in oil prices results in a 0.9 percentage point increase in corn prices. [3] There is a similar but less pronounced effect for wheat and soybeans.

In conclusion, research suggests that the increase in demand for agricultural crops resulting from bio-fuel production has had a significant effect on crop prices. While studies disagree on the extent of this effect, it is clear that bio-fuel demand played a role in the run-up of commodities prices earlier this decade, and results in some embedded premium in the prices of related crops, such as corn.

© Bryan Chan. The author grants permission to copy, distribute and display this work in unaltered form, with attribution to the author, for noncommercial purposes only. All other rights, including commercial rights, are reserved to the author.


[1] A. Ajanovic, "Biofuels Versus Food Production: Does Biofuels Production Increase Food Prices?" Energy 36, 2070 (2011).

[2] D. Juday, "A Mess We Made: The Biofuels Fiasco," CBS News (2011).

[3] "Global Economic Prospects: Commodities at the Crossroads 2009," The World Bank, 2009.

[4] C. B. Field, J. E. Campbell and D. B. Lobell, "Biomass Energy: the Scale of the Potential Resource," Trends in Ecology and Evolution 23, 65 (2008).

[5] "Testimony of Edward P. Lazear Chairman, Council of Economic Advisers," U.S. Senate Foreign Relations Committee Hearing on "Responding to the Global Food Crisis," 14 May 08.

[6] D. Mitchell, "A Note on Rising Food Prices," Policy Research Working Paper 44682, The World Bank, July 2008.

[7] M. W. Rosegrant, "Biofuels and Grain Prices: Impacts and Policy Responses," International Food Policy Research Institute, May 2008.

[8] S. Nelson, "Analysis - Ethanol No Longer Seen As Big Driver of Food Price," Reuters (2008).

[9] J. Baffes and T. Haniotis, "Placing the 2006/08 Commodity Price Boom into Perspective," The World Bank, Policy Research Working Paper 5371, July 2010.