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Executive summary:

Corn ethanol margins have rebounded in 2013 due to falling corn prices relative to gasoline prices. The industry's performance YTD raises the prospect of continued growth in the future despite the pending arrival of the ethanol blend wall. Despite some recent evidence that E85 is being offered at a discount to gasoline, however, there is no evidence that E85 consumption has increased in 2013 relative to previous years. There will be little opportunity for industry growth until a sufficient increase in E85 consumption occurs.

One of my favorite aspects of contributing to Seeking Alpha is the rapid and constant feedback from commenters. The vast majority of these comments are very helpful as they force contributors to reevaluate our investing theses and, often, arrive at new ones. Compared to academia, where peer review can take up to a year and most of our audiences are supposed to know less than us (in theory, at least), SA helps contributors avoid the echo chamber situations that are all too prevalent elsewhere.

I mention this because I had a commenter on a recent article state that my outlook for growth in the corn ethanol industry was much too pessimistic (or "very doom and gloom," in the commenter's words). For more than a year now I've believed that the corn ethanol industry's future growth potential is very limited, and this conclusion has driven many of my other investment theses in the biofuels sector. This time is as good as any to reevaluate my position, particularly in light of the industry's recent media attention. I have no inherent bias against the corn ethanol industry and will readily change my thesis if ethanol producers' shares appear to be undervalued relative to current conditions and future growth prospects. After all, there should be no place for bias in the investment field.

Corn ethanol's headwinds

To quickly review, the U.S. corn ethanol industry experienced its first decrease in annual output last year since the 1990s (see figure) as the central U.S. endured its worst drought since the 1930s Dust Bowl. Industry margins turned negative and corn ethanol facilities were shuttered, sometimes permanently, as corn prices soared and gasoline prices remained flat. This fall in production occurred despite the presence of the revised Renewable Fuel Standard [RFS2], which requires increasing levels of annual consumption (the volumetric mandate) of four biofuel categories. The RFS2 is supported by a tradable compliance commodity/flexible subsidy called the Renewable Identification Number [RIN]. A RIN is generated whenever a gallon of biofuel is produced and remains attached to that biofuel until it is blended with gasoline or diesel fuel (depending on the biofuel type) for retail. The RIN is then separated at the point of blending and can either be traded to a third party or submitted to the EPA. Refiners are required to submit a sufficient number of RINs to the EPA at the end of the year to show that they are blending their share of the overall renewable volume obligation [RVO]. In theory, RIN prices operate as a function of feedstock costs and petroleum prices: they increase when feedstock (and operating) costs increase and decrease when petroleum (and biofuel) prices increase, thus ensuring that biofuel producers receive enough of a subsidy to meet the mandate. The one exception to this is when biofuel production exceeds the mandate for the year, at which point RIN prices fall to zero so as to prevent biofuel producers from receiving windfall profits. The corn ethanol industry suffered in 2012 not because of the drought, which would have caused RIN prices to increase enough under normal conditions to compensate them for their losses, but because corn ethanol production was outpacing the volumetric mandate. Since RIN prices weren't needed to subsidize production, producers quickly incurred losses until production fell.

US Fuel Ethanol Production Chart

US Fuel Ethanol Production data by YCharts

A second hurdle facing the industry is the fact that ethanol is a gasoline substitute and not a replacement. As an alcohol rather than a hydrocarbon, most vehicle warranties and fuel retailers do not permit the use of ethanol blends in gasoline that exceed 10 vol% ("E10"). This imposes a cap on ethanol blends (the so-called "blend wall") that is equal to 10 vol% of gasoline consumption. The exception is for specially-modified vehicles (flex-fuel vehicles, or FFVs) and retail stations that are capable of handling ethanol blends of up to 85 vol% ("E85"), although adoption of both has been quite low.1 Originally expected to increase for the foreseeable future, gasoline consumption is now expected to decline due to increased fuel economy, changing driving habits, and sustained high petroleum prices. This means that, so long as the E10 blend wall remains in place, the size of the U.S. ethanol market will shrink at the same rate as gasoline consumption.

Relatively little attention was paid to the issue of the blend wall until January 2013, when it became apparent that the 2013 corn ethanol RVO would meet or exceed the volume of ethanol's blend wall. RIN prices soared by 3,500% between January and July (see figure) as refiners and other obligated blenders scrambled to purchase corn ethanol [D6] RINs before the blend wall was actually hit, at which point it was feared that the market for additional ethanol would dry up. Soon there was an outcry from refiners owning insufficient blending capacity as their costs of compliance with the RFS2 greatly increased in response to higher RIN prices. Congress held hearings on RFS2 reforms in late July and, on August 5, the EPA announced that it would consider revising corn ethanol's volumetric mandate in 2014 down from its original volume due to the blend wall.

(click to enlarge)

D6 RIN prices in 2013.

Booming share prices

Set against this backdrop has been large increases in the share prices of some 1st-generation biofuel producers. Corn ethanol producers Green Plains Renewable Energy (NASDAQ:GPRE) and REX American Resources (NYSE:REX) (as well as biodiesel producer Renewable Energy Group (NASDAQ:REGI)) have greatly outperformed the S&P 500 index over the last year (see figure). It is one thing to be pessimistic about a struggling industry, but quite another to be pessimistic about the same industry when the share price of one of its leading producers has increased by 254% over the last year.

GPRE Chart

GPRE data by YCharts

Sharp-eyed investors will note that the share price gains have not been uniform across the industry, however; both Pacific Ethanol (NASDAQ:PEIX) and BioFuel Energy (NASDAQ:BIOF) have underperformed the market over the same period, particularly so in the case of the former. In a previous article, I discussed that a possible explanation for the divergence relates to blending capacity; blenders have captured most of the value of high RIN prices and both Green Plains and Renewable Energy Group own significant blending capacity. It is important to distinguish between ethanol production capacity and blending capacity because growth in the latter can only occur after growth in the former. In other words, benefiting from RINs via blending activities is only sustainable if the ethanol blend wall is overcome and producers are no longer limited by the E10 barrier.

Higher E85 consumption?

The simplest way of overcoming the ethanol blend wall is by convincing drivers to purchase FFVs and consume E85. I don't want to discuss why this hasn't happened to date since I've covered it elsewhere on SA, but suffice to say that E85 consumption up until now has not been sufficient to forestall the blend wall. Two of my colleagues at Iowa State recently published a paper advancing the position [pdf] that RIN prices in 2013 have been high enough to overcome the blend wall so long as they're used to offer E85 for retail at a discount. (I'll just say that I'm skeptical of the paper's conclusion because we wouldn't be having this discussion if past projections on E85 consumption had been accurate. The E85 demand curves that the profession used in the past greatly underestimated consumer opposition to fuel ethanol and I don't believe that the "new" demand curves are much of an improvement.) It didn't take long for the media and biofuels associations to pick up on this conclusion due to its potential policy implications. As I mentioned earlier, the EPA has raised the possibility that it will account for the blend wall in determining the 2014 corn ethanol RVO. If high RIN prices are spurring E85 consumption and thereby overcoming the blend wall (or at least pushing it to 85 vol% of gasoline consumption), then the problem is solved: under such a scenario the EPA won't need to change the original 2014 RVO and corn ethanol producers can begin to expand their capacity.

While this would make for an elegant solution to the industry's current problems, there is little evidence at present in support of it. Back in June, researchers at the University of Illinois Urbana-Champaign showed that the cost of E85 briefly exceeded its price in May, which would indicate that producers and blenders were using high RIN prices to discount E85's retail price. Unfortunately, the researchers used proprietary data so I can't update the chart to see if the gap persisted or widened as RIN prices further increased in June and July. Looking at other data makes me think that it has not and/or has been insufficient to spur increased E85 consumption. First, the Des Moines Register recently reported that E85 consumption in Iowa had increased by 43% in Q2 2013 on a QoQ basis. This is a very misleading figure, however, due to the seasonal variation in E85 consumption. EIA data shows that the daily rate of consumption of ethanol blends in excess of 55 vol% has doubled or even tripled between January and June since at least 2011 (D6 RINs were virtually worthless until January 2013). Furthermore, the EIA data shows that this consumption rate in 2013 is on pace to be the lowest since 2010.

Data from Minnesota, where the largest number of U.S. E85 pumps are located, shows that E85 consumption has peaked during the summer months every year since 2005, in some cases almost doubling between January and July. Furthermore, E85 consumption in Minnesota may have peaked in May; if true, then its maximum monthly E85 consumption in 2013 will have been significantly lower than in past years. One possible explanation for lower E85 consumption in 2013 is that blenders have been maximizing production of E10 in response to high RIN prices, taking ethanol away from E85 production. This would not be advantageous for the corn ethanol industry, however, as it would suggest the presence of a cap on ethanol consumption.

Falling facility prices

The second piece of evidence suggesting that drivers are not consuming more E85 in 2013 is that several corn ethanol facilities of varying ages and capacities have recently sold for pennies on the dollar (see table). In one case, the sales price on an installed capacity basis was as low as $0.03/gal; the highest was only $0.32/gal. This is hardly indicative of an industry that is on the cusp of significant growth, as an expectation of future returns would be captured by higher facility prices.

FacilityStateSale price ($MM)Capacity [MGY]Sales price ($/gal capacity)
Utica EnergyWI16500.32
NEDAKNE15500.30
New EnergyIN2.51000.03
Purified RenewableMN2250.08

Furthermore, the corn ethanol crush spread, which is one way of measuring product margins, is at its highest point since 2011 (see figure). If the corn ethanol industry really was on the cusp of profitable growth, then I would expect existing capacity prices to reflect this. The current spread of $0.96/bu (or $0.34/gal) would enable a facility purchaser to repay its capital expenditure in less than a year. Again, such pricing is not indicative of future growth expectations.

(click to enlarge)

Source: CARD (2013)

The export option

Finally, investors advancing the position that corn ethanol producers have strong growth potential often portray Brazil as a safety valve for the industry. FFVs and the requisite infrastructure caught on quickly in Brazil during the last decade and the country has managed to avoid the ethanol blend wall as a result. The Brazilian market is often proposed as an export opportunity for U.S. corn ethanol due to its lack of a blend wall, and such calls have been recently renewed in light of successive poor sugarcane harvests there. What is frequently forgotten is that such a measure would be temporary for two reasons. It would be temporary since corn ethanol is more expensive to produce than cane ethanol on an equal feedstock price basis. While corn is currently less expensive than sugarcane due to the poor harvest, this situation is unlikely to last for long. Second, even with the recent increase in sugarcane prices, U.S. corn ethanol would still be at a pricing disadvantage in Brazil itself due to the exchange rate between the two countries' currencies, which has seen the dollar appreciate by 43% against the real since late 2011. This translates into a high price for U.S. corn ethanol imported into Brazil, other things being equal.

US Dollar to Brazilian Real Exchange Rate Chart

US Dollar to Brazilian Real Exchange Rate data by YCharts

Conclusion

It has been proposed that high RIN prices will allow ethanol to overcome the blend wall if they are used to retail E85 at a discount relative to gasoline. While logical, this understates consumer opposition to fuel ethanol. While there is some evidence that E85 was offered at a discount beginning in May, there is no evidence that this has resulted in increased E85 consumption; if anything, current E85 consumption appears to be slightly lower than in past summers. While consumers might respond to lower prices by increasing their consumption of E85 and adoption of FFVs if given more than a few months in which to do so, evidence that this is happening will need to be available by November 30 at the latest if it is to affect the EPA's 2014 RVO determination. Until such evidence becomes available, I will remain bearish on the corn ethanol industry's growth prospects.

1 The EPA began to permit the use of blends of up to E15 back in 2011, although fierce opposition from fuel retailers, automakers, and drivers has prevented E15 from being made available outside a small handful of Midwestern retail stations to date.

Disclosure: I am long REGI, and I may initiate a short position in BIOF over the next 72 hours.. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Still No Signs Of Consumption Growth For Corn Ethanol