The Profitability of Ethanol Production

Lately the number of newspaper reports about ethanol increased even faster than the price of corn. With that in mind, I'd like to take a closer look into the profitability of ethanol production.

Ethanol is produced through a chemical process using corn, natural gas and a lot of energy. The process has a certain conversion rate of corn to ethanol (for those who are interested: 2.8 gallons of ethanol per bushel corn) and a by-product widely called dry distiller that is used to feed animals.

Because the market share of ethanol compared to gasoline is still significantly lower, the price of ethanol is pegged to the price of gasoline. The pre-tax wholesale price of gasoline almost totally depends on the price of crude oil, and is roughly 50% of the retail price. At a current oil price (WTI spot) of $62, the pre-tax wholesale price is approximately $1.48. Considering a tax benefit of Ethanol compared to Gasoline of $0.51 per gallon (Volumetric Ethanol Excise Tax Credit), the current sales price of Ethanol most likely is $1.99.

Ethanol producers also sell the by-product to the market. The current market price for dry distiller (I was surprised myself to find a market price) is about $80 per metric ton and is expected to drop significantly as a result of an immense oversupply. Converting the production of the by-product to a one gallon of ethanol basis, the additional sales per gallon are $0.21, if the market price remains constant. This makes expected sales of $2.20 per gallon ethanol.

Now we have to consider the cost structure of ethanol production. As mentioned, the process producing ethanol involves corn, natural gas and a lot of electricity. For a reasonable production of ethanol an enormous amount of corn is required. At a current bushel price of $3.72, the per-gallon costs are $1.33. To minimize the transportation costs of corn, Ethanol plants are located in such prominent locations like Charles City, Iowa and Friesland, Wisconsin, just to name a few. Confirming my expectation by googleing them, these areas are dominated by agriculture, therefore minimizing the transportation distance. Transporting a bushel corn in this rural area costs about $0.40; therefore, we have transportation costs of $0.14 per gallon ethanol.

Adding costs for natural gas and electricity of $0.01 and respectively $0.07 per bushel, we can simply estimate the contribution margin of every bushel sold. Ethanol producers earn $0.46 per gallon ethanol sold. This is a margin of roughly 30%. Sounds like a good opportunity to me.

Some companies to play this industry are the more diversified Archer Daniels Midland (ADM) and pure play Verasun (VSE).

Disclosure: Author holds a long position in ADM

Comments

[mogapetto:]

I am not sure where an dhow you are coming up with natural gas cost of 1cent cost/gallon of ethanol. By all estimates, it takes 35000 BTU of heat to produce 1 gal og ethanol. At a cost of $8.20/mill BTU, this equates to 28.77 c/gal of ethanol. Similarly, it takes about 1kwh of electric power to produce a gal of the stuff and at $0.05/kwh, it is 5c/gal, making the total energy cost close to 34c/gal as against your 8c!! Also, where have you taken the enzme and other chemical costs into account? All that is another 15c/gal. Now do the math and you see the COGS is (1.56-8+34+15=1.96) and the contribution margin is 24c, less than 10%!! Not a great biz model to be crazy about!!

2007 Apr 27 10:18 PM

[Itsonlymoney:]

If i'm not mistaken the farmers used oil in the production of the corn in the first place so what is the real fuel advantage in the long run. Any surplus value could be the product of the continual mining of topsoil that will eventually give out as well. There has to be a better way to collect solar energy then by growing corn.

2007 May 11 01:39 PM