Corn Will Rise Despite Subsidy Woes

By Aaron Levitt | July 11, 2011 AAA

As energy costs continue to rise globally, alternative sources are back in vogue. While solar and wind energy have become market darlings, ethanol continues to be a point of contention within the renewable energy sector. Built on the back of controversial subsidies, the "fuel of the future" has enjoyed nearly 30 years worth of congressional support. However, with budget deficits ballooning, the U.S. government has taken to the task of cost cutting. Congress has set its sights on the nearly $6 billion in subsidies the ethanol industry receives each year. As a result, both the price of corn and many of the sector's leaders have seen their share prices fall since June. For investors, this drop in price for ethanol-related assets could be a stellar long-term buying opportunity. (For more on biofuels, check out The Biofuels Debate Heats Up.)

TUTORIAL: Commodities

Touching the Untouchable
Federal subsidies for corn ethanol have traditionally been off limits within Washington. After all, Iowa, which is right smack in the middle of the corn belt, holds the first nominating caucuses for the presidency. However, with the federal budget deficit growing at enormous levels, cutting the financial assistance makes more sense than appealing to voters. Overall, there is growing consensus that the sector has finally reached financial stability, thus making assistance unnecessary.

In June, the Senate voted to end two tax breaks for the ethanol industry, paving the way for more cuts. A new compromise spearheaded by Democrat Dianne Feinstein would end broad ethanol subsidies but preserve smaller tax breaks designed to help biofuels grow. The heart of the deal would repeal the Volumetric Ethanol Excise Tax Credit starting August 1. The credit gives blenders 45 cents for every gallon of ethanol they mix with gasoline, costing the U.S. Treasury about $400 million a month. Also to be cut would be the 54 cents per gallon tariff on ethanol imports.

Drivers for Higher Corn Prices and Ethanol Use Remain
Corn prices have fallen nearly 15% since June, when the proposals were first announced. However, many of the main drivers for higher corn prices and ethanol use remain in place. With oil prices touching nearly $100 a barrel, blenders have not needed the credits to make ethanol attractive. Wholesale ethanol prices are cheaper than gasoline in many markets, and producers have been beating government goals allowing for export. Falling corn prices have also spurred many emerging markets such as China to increase their buying for food production. Long-term trends for populations in these nations will only serve as a floor for corn prices.

Finally, the biggest reason corn prices won't suffer for long in the face of cut subsidies: many of the laws requiring the use of renewable fuels remain in place. Both the Energy Policy Act of 2005 and the Energy Independence and Security Act of 2007 require 36 billion gallons of annual renewable fuel use by 2022. These laws have been the key reason for the growth in ethanol production and consumption over the past few years. (To learn more about the energy sector, read Fueling Futures In The Energy Market.)

Buying the Dip
At this point, ethanol has established itself as a major part of the U.S. fuel supply. For investors, the decision to end subsidies could be a great buying opportunity for the long term. Here's how to position a portfolio for the change:

The long-term demand trends for corn remain intact as both livestock feed and fuel source. The Teucrium Corn Fund (NYSE:CORN) is still the easiest way for investors to bet on rising corn prices and consumption. The PowerShares DB Agriculture (NYSE:DBA) also includes a large weighting to corn.

In the new world of zero subsidies, investors may want to avoid pure-play ethanol firms like Pacific Ethanol (Nasdaq:PEIX) and BioFuel Energy (Nasdaq:BIOF) and focus on the leaders. Many top ethanol producers, like Valero (NYSE:VLO), Archer Daniels Midland (NYSE:ADM) and Bunge (NYSE:BG), are stable and profitable.

Finally, analysts at Itaú Unibanco (NYSE:ITUB) estimate that the U.S. market would become "more accessible" to Brazilian ethanol, allowing greater trade when prices are favorable. Sugarcane ethanol producer Cosan (NYSE:CZZ) could see greater demand for its products.

The Bottom Line
The decision to end ethanol subsidies could be seen as a game changer for the industry. However, many of the long-term fundamentals are still in place for the sector's growth. For investors, the recent crash in corn prices could be seen as a buying opportunity to add strong producers such as The Andersons (Nasdaq:ANDE) as well as corn to their portfolios. (To learn more about the corn market, see Investing Seasonally In The Corn Market.)

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