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Midwest Drought Hits Gas Pump as Ethanol Prices Rise

08/10/2012 | 02:16pm US/Eastern

--Drought is pushing up prices for corn and ethanol

--Government being asked to waive ethanol requirements

--Fuel costs subtracts from money spent on wider economy

The U.S. motorist standing at the gas pump is seeing the effects of the drought ravaging corn production, and that's not good for the economy.

Prices for ethanol, largely derived from corn and accounting for 10% of the gasoline consumed by U.S. drivers, have jumped by nearly one-third to $2.60 per gallon since May because of worries about hot, dry weather that has baked most of the country since June. Nearly all of the ethanol consumed in the U.S. comes from corn, production of which will fall to the lowest level in nearly two decades due to the drought, the U.S. Department of Agriculture said Friday.

The increase in ethanol prices helped spark a 16-cent jump in the national average gasoline price in July--the biggest increase for that month on record--to $3.45 per gallon. Four cents of that increase are attributable to ethanol, said Michael Green, spokesman for the American Automobile Association, a consumer travel group.

"If ethanol prices had not increased as a result of the drought, there would not have been a record increase in the price of gasoline for July," Mr. Green said.

For the overall economy, the increases in ethanol and gasoline prices come at a bad time for a nation trying to work its way out of an economic slowdown.

The normal household spends about 4% of its income on gasoline and fuel, according to federal Bureau of Economic Analysis. Every few extra cents spent on gasoline is money not spent in the wider economy, said Richard Hastings, macroeconomic analyst at Global Hunter Securities.

"I would definitely be concerned about the prolonged, elevated nature of gasoline and energy spending," Hastings said. "It's impacting the spending on the service economy."

Back at the gasoline pump, crude oil prices, which rose in July and account for 62% of the cost of gasoline, do have a bigger impact on overall prices than ethanol does. So do refinery outages. A fire at Chevron Corp.'s (>> Chevron Corporation) refinery in Richmond, Calif., Monday raised the spot price of gasoline in the San Francisco Bay area by as much as 35 cents during the week.

But the severity of the drought and the resulting rise in corn prices could start to hit harder at the pump. If corn prices remain at current levels, ethanol prices could rise another 20 cents to $2.80 a gallon, said Michael McDougall, senior director at brokerage firm Newedge.

The rising influence of ethanol on gasoline prices underscores the impact of federal biofuel mandates to lower consumption of fossil fuels. Federal law requires that 13 billion gallons of ethanol be blended into the national fuel supply in 2012, and that mandate will increase to 15 billion in 2015. Currently, biofuel makers are trying to increase the average level of ethanol content of a gallon of gasoline to 15% from 10%, but the measure is opposed by automakers and fuel refiners, who say it could damage engines. It's also opposed by some who say the environmental benefits of corn-based ethanol are dubious.

The fact that large quantities of corn--nearly 30% of the crop--end up as fuel is also contributing to the price increase. Livestock owners, pressured by rising feed prices, have asked the U.S. government to waive the ethanol requirement for a year. The U.S. Environmental Protection Agency is working closely with the Department of Agriculture to keep an eye on crop yields, a White House spokesman said Friday.

Corn futures have shot up 60% since closing at $5.10 a bushel on June 15, around the time when the effect of the drought became evident. Ethanol prices haven't risen as quickly because of a production glut that brought stocks of the fuel to a record high of 23 million barrels in March, according to the U.S. Energy Information Administration. But that glut is subsiding as the high cost of feedstock has made production unprofitable. Experts say ethanol prices will rise rapidly as the glut works itself out.

"If corn prices stay high, eventually ethanol prices will catch up," said Bill Day, spokesman for Valero Energy Corp. (>> Valero Energy Corporation), the largest U.S. refiner by processing capacity and one of the biggest ethanol producers in the country.

The U.S. average retail price for gasoline was $3.67 on Friday, according to AAA's Daily Fuel Gauge report, up 4 cents from a year earlier.

--Jared Favole contributed to this story

-Write to Ben Lefebvre at ben.lefebvre@dowjones.com

Subscribe to WSJ: http://online.wsj.com?mod=djnwires

Stocks mentioned in the article : Chevron Corporation, Valero Energy Corporation
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