HardAssetsInvestor

Written by Brad Zigler  |

May 20, 2008

Are We At The Bottom Of The Ethanol Barrel?

Details

Managing editor of HardAssetsInvestor.com Brad Zigler examines the viability of meeting the U.S. 2022 biofuels mandate.

• The squeeze is on
• Factoring the corn crush equation
• Have ethanol producers' fortunes turned?

 

One of the best scenes from the 1980s hit film "Back to the Future" was the setup for its sequel: Doc Brown drops banana peels and beer - can and all - into the Mr. Fusion Home Energy Reactor that powers his time-traveling DeLorean before zooming off for future adventures.

According to the script, Mr. Fusion was supposedly created in 2015. Don't bank on that actually happening, though. The best we can hope for, with our present technology, is to turn corn into ethanol for blending in motor fuel. Or turning kitchen grease into biodiesel. No banana peels or cans of Budweiser.

The U.S. government has mandated that 36 billion gallons of biofuels be produced domestically by 2022, of which 15 billion gallons will be ethanol. That's more than a twofold increase from present-day production levels. Plainly, the Feds are in a hurry to get to the future.

The trouble is that U.S. ethanol production relies upon corn. And that, some say, is putting the squeeze on corn supplies. About a quarter of the domestic corn crop is now diverted to ethanol production.

For ethanol, it's all about the squeeze. Corn is squeezed - "crushed" in industry parlance - into the fuel additive, and by-products, at a growing number of plants throughout the nation's growing region. Ethanol refining starts out a lot like booze making. Corn is first ground, then mixed with water and enzymes, before being cooked to break down the corn's starches into sugar. The mash then goes into fermentation tanks where yeast converts the sugar to alcohol and carbon dioxide. The resulting alcohol is filtered out and the solid remnants dried into an animal feed known as distillers' dried grains and solubles (DDGS).

The reliance on corn as a feedstock has turned out to be a liability for ethanol-minded investors. Between 75% and 80% of the variable cost base in ethanol production, not surprisingly, is the input cost of corn. Corn, as HardAssetsInvestors.com readers know, has been on a tear, rising 31% so far this year after a 16% hike in 2007.

Every 10-cent increase in the bushel price of corn, in fact, equates to a 5-cent loss in the corn crush margin.

Corn Crush?

The corn crush measures the difference between the sales proceeds of finished fuel ethanol and the price of its corn feedstock. With current technology, one bushel of corn can be converted into 2.75 gallons of ethanol. To determine the potential refining profit, the prices of finished ethanol and corn must be rationalized. Ethanol, like the gasoline with which it is blended, is priced in dollars per gallon while corn is priced by the bushel. To reduce ethanol to corn terms, multiply the ethanol price by 2.75. The feedstock corn price is then subtracted from the converted ethanol price to obtain the crush margin:

 

Corn crush = [(Price of ethanol x 2.75 ) - Price of corn]

 

Using this method, you would have priced the corn spread between $8.42 and 53 cents over the past year. The wide spot was June 2006 when corn was cheap at $2.35 a bushel. Ethanol sold for $3.94 a gallon back then.

Margins bottomed out in September 2007, wrung by a double whammy of a 61% collapse in ethanol prices and a 58% bump up in corn prices.

Though corn prices continued upward to the $6 level, the corn crush actually improved as ethanol prices head upwards to top $2.60 a gallon. The crush is now over 96 cents.