HardAssetsInvestor

Written by Julian Murdoch  |

November 09, 2007

Business As Usual

Details

Is the ethanol boom over? Not by a long shot. But the gold rush mentality is fading in the face of economic reality.

• Welcome to the real world
• Negative profit margins
• An industry grows up

Another month, another opportunity to navel-gaze the ethanol boom. Is the ethanol boom over? That’s what the flurry of articles in the Wall Street Journal and related publications would have you believe. Just as they jumped on the ethanol bandwagon en masse earlier this year, they’re jumping off now, with stories on ethanol plants gone idle and price drops across the board.

Is it true? Is the boom really over?

Not by a long shot.

But still, it has been an interesting ride this year. Let’s get a layer deep and see what’s really going on with ethanol.

What We Know

One thing is clear about the ethanol boom: Production is rising. This is no surprise. Production should be rising. At last count there are 131 ethanol plants in the U.S., with a current capacity of 6.923 billion gallons per year. Looking down the line, there are 10 plants that are adding capacity and another 73 entirely new plants under construction. Once all those projects are completed, there will be an estimated additional 6.567 billion gallons of capacity, well on the way to the much-covered 2012 target of 7.5 billion gallons, as called for in the Energy Policy Act of 2005.

But here's the interesting thing – all that capacity doesn’t seem to be getting sucked up by demand. Ethanol stocks continue to grow, creating a bit of a supply excess that has served to put a downward pressure on prices. The chart below showcases the rising stockpiles of ethanol – fuel just sitting around, waiting for a buyer.

 

You'd think with all the media hype and the high oil prices that we'd be using every drop of ethanol that comes out of the plants. But just like gasoline, it’s not that easy. The first problem is infrastructure. Ethanol is extremely corrosive in the presence of water, and specialized tankers (truck or rail) need to be used. This makes for one huge bottleneck in ethanol transportation. The supporting infrastructure just hasn't kept pace with all the new plants that are being built. Until that infrastructure is built up, the Midwest is going to be awash with supply, but that supply won’t make it easily to where it can be used.

The second important thing to understand is that most ethanol isn’t used pure – it’s blended into gasoline, mostly at a 10% ratio. That blending is important because it underlies the fact that ethanol demand is derivative of gasoline demand, and will be until we have the fueling stations and cars to support all-ethanol transport.

U.S. gasoline production has basically been flat for at least the last three years, and while the amount blended with ethanol is increasing, the bottom line is that we aren’t producing more gas at our refineries. No more gas, no more blending ethanol, no additional demand. Until the infrastructure builds up for pure ethanol or E85 gas replacements, the demand curve is somewhat limited by gasoline demand.

 

What about imports? In a word, gasoline imports are fickle and flat: Sometimes up, sometimes down, but basically hanging around a million barrels a day. Some in the industry say that those imports could be down around zero by 2020 if ethanol use continues to grow.

“U.S. demand growth for gasoline will average 1 percent through 2020, with U.S.-based ethanol ‘filling the gap,’" said John Waterlow, an oil analyst at Edinburgh-based Wood Mackenzie. "(Gas) Imports into the U.S. could fall to zero by 2020 should ethanol production rise at current rates."

That would add to demand for ethanol … if it happens. But we're talking millions of barrels a DAY for refining and imports, and millions of barrels a MONTH currently for ethanol production. The year 2020 and no gas imports seem a long ways away. But it is nice to dream.

Corn Supply

How much ethanol can we really make, anyway? If all current and planned capacity came on line all at once, there would be a total capacity of 13,458 billion gallons of annual ethanol production in the U.S. According to this report, that would mean that refiners would need 4.9 billion bushels of corn to keep the plants at capacity.

The USDA estimates that 2.125 billion bushels of corn were used during 2006-2007 for ethanol production. The latest forecast for 2007-2008 calls for 3.3 billion bushels of corn to be turned into ethanol. This number is less than previous, and with the cost of ethanol depressed ($1.82), it’s just not as fun a business as it used to be.

The good news, if you’re a refiner, is that it’s highly unlikely there will be a surprise price spike for corn in your future. Corn acreage will likely remain high for the foreseeable future since “everyone knows” the demand will be there.

Ethanol (AC, CBOT)

 

 

Where We Stand Today

Ethanol seems to be bouncing back from its low of $1.515 a gallon on Sept. 26, in part because of oil's climb through $90 and in part because of reduced production. At $1.515, the profit margin on a gallon of ethanol was minus 16 cents a gallon according to Bloomberg. At that point, the manufacturers made the only decision they could and cut production. It worked, and prices rose as production slowed. It’s not quite the cartel price manipulation of OPEC, but often times, basic supply and demand animal spirits trump collusion.

What does all this actually mean? It means that ethanol is growing up. The crazy red blush has come off the rose, and prices seem to be falling into a natural supply-and-demand pattern. Farmers aren’t planting based on NY Post headlines; they’re planting based on market conditions. Ethanol producers are making decisions based on real-world deliverable prices, and refiners are doing, well, they’re doing what they always do: fretting about spreads. It’s not boom-over. It’s business as usual.

Note: Data from http://www.eia.doe.gov/ except where noted.

 

Ethanol's Boom Stalling as Glut Depresses Price NY Times September 30, 2007
Ethanol in Chicago Rises on Reduced Production, Crude Surge Bloomberg October 29, 2007
Corn: A Little Breathing Room. Grain Price Outlook. University of Illinois Extension October 2007
Growing Ethanol Use May Eliminate U.S. Gas Imports by 2020 Bloomberg October 25, 2007
E85 Prices across the country
AAA Fuel prices