Seeking Alpha
Research analyst, alternative energy, long/short equity, commodities
Profile| Send Message|
( followers)  

Introduction

Corn ethanol producers and investors saw numerous reasons to celebrate in Q4 2011. Falling corn prices and rising petroleum prices suggested a more favorable crush spread for producers was on its way. The combination of a poor Brazilian sugar crop and a fall in the value of the U.S. dollar relative to the Brazilian real allowed U.S. corn ethanol producers to export a record volume of ethanol to Brazil. Initial industry concern over the possible loss of its $0.45/gal fixed subsidy at the end of the year dissipated as agricultural economists projected RFS2 RIN values to automatically pick up where any subsidy left off. The EPA began allowing the sale of up to 15% ethanol blended with gasoline (E15), a 50% increase over E10. Corn ethanol stocks responded accordingly: investors in companies such as Biofuel Energy Corp (BIOF), Pacific Ethanol (PEIX), and Rex American Resources (REX) experienced gains of 100-300% over the next six months.

REX Chart
(Click to enlarge)

REX data by YCharts

By July 2012, however, a very different picture has emerged. The aforementioned stocks have lost virtually all of their gains. Corn ethanol producers are shuttering plants, some of them permanently, in the face of losses of up to $0.20/gal.

What happened?

This article explores the perfect storm of events that has resulted in the rapid fall in corn ethanol's financial prospects. Specifically, it examines five primary causes: (1) corn ethanol's inability to economically compete with cane ethanol; (2) a strengthening U.S. dollar relative to the Brazilian real; (3) the expiration of the U.S. ethanol subsidy and tariff; (4) falling petroleum prices and rising corn prices; and (5) ethanol overcapacity.

Cane ethanol v. corn ethanol

Other things being equal, corn cannot compete with cane on an economic basis as an ethanol feedstock. Cane ethanol's inherent advantage can largely be attributed to differences in the harvest techniques for the two crops. Brazilian cane yields up to 150 metric tons of harvestable biomass per hectare (MT/ha) [1]. By contrast, Midwest corn yields of harvestable biomass are 12 MT/ha. In terms of fermentable sugars both crops are relatively equal, yielding roughly 4000 liters per ha (l/ha) [1]. That said, cane's superior process economics is attributable to the remainder of the difference in harvestable biomass. Cane growers harvest nearly the entire cane plant, resulting in a large quantity of leftover harvested biomass after the sugars have been fully extracted. This bagasse is combusted to produce electricity, which in turn represents a significant source of revenue that can even exceed that derived from ethanol [2]. Corn harvests just collect the grain-bearing ears and leave the stalks and leaves on the fields, depriving corn ethanol producers of a similar source of revenue.

The lack of electricity generation capability places corn ethanol at a disadvantage to cane ethanol in terms of both process economics and lifecycle emissions. The minimum fuel selling price of corn ethanol is estimated to be approximately 30% higher than cane ethanol [2, 3]. Cane ethanol's dependence on biobased electricity results in a lifecycle GHG reduction of 50% relative to gasoline, while corn ethanol only achieves a reduction of 20% due to its reliance on either natural gas or coal for power [4].

The real's falling value

The combination of U.S. efforts to fight deflation via quantitative easing and Brazilian efforts to fight inflation via high interest rates caused the dollar to fall sharply relative to the real between 2009 and mid-2011. By 2011 the dollar had been devalued enough to make U.S. corn ethanol economically competitive with cane ethanol in Brazil despite the latter's inherent advantages. This situation quickly reversed itself in Q3 2011 as Brazil cut its interest rates and imposed some controls on foreign capital inflows in an effort to devalue the real. By the end of the year U.S. corn ethanol had lost much of its currency advantage over Brazilian cane ethanol. This came at a very bad time for U.S. corn ethanol producers, as its domestic growth prospects were simultaneously sharply reduced by a loss of political support at home.

US Dollar to Brazilian Real Exchange Rate Chart
(Click to enlarge)

US Dollar to Brazilian Real Exchange Rate data by YCharts

Expiration of U.S. ethanol protectionist measures

For several decades U.S. corn ethanol production has been both subsidized by the federal government to varying degrees and protected from foreign competition by the imposition of a stiff tariff on foreign ethanol. While support for these protectionist measures fell during the Great Recession, it initially looked like Congress would slowly phase them out by 2016. Instead, Congress failed to take any action whatsoever and both the subsidy and tariff expired at the end of 2011 without any sort of replacement. The tariff had been obsolete since 2009 due to the fall in the value of the dollar and economists argued that RFS2 RINs would instantly make up the revenue difference caused by the expiration of the subsidy. For reasons they didn't foresee, this didn't happen.

Falling petroleum, rising corn prices

Corn ethanol's profitability is in large part determined by the prices of petroleum and corn. Petroleum prices heavily influence gasoline prices, which in turn determine the market price at which consumers are willing to switch from gasoline to ethanol consumption. Corn prices determine the minimum selling price for corn ethanol. 2012 has witnessed a 20% fall YTD in petroleum prices due to concerns over a slowing global economy. While the prices of agricultural commodities such as corn normally track closely to the price of petroleum, a major Midwestern drought during the summer of 2012 has caused a sharp rise in corn prices despite the fall in petroleum prices. Corn ethanol producers are finding themselves squeezed between rising input costs and falling output values as a result.

USO Chart
(Click to enlarge)

USO data by YCharts

Ethanol overcapacity

The RFS2's RIN credits are designed to insulate biofuel producers from just the sort of situation that corn ethanol producers are currently experiencing. RIN values are determined by the difference between a biofuel's production cost and market value; RIN values increase as feedstock prices increase (to compensate the producer for higher production costs) and decrease as petroleum prices increase (to avoid providing the producer with a windfall) [5]. (For more on the subject, please see my previous article on the RFS2.) RIN values could be expected to respond to the current macroeconomic situation by rising to the point at which ethanol producers at least break even. This is not happening, however, due to an important limitation in the RFS2: RIN values will only increase to the point at which they encourage enough production to fulfill but not exceed the RFS2 mandate. 14 billion gallons of ethanol is expected to be produced in 2012 even though the mandate only requires 13.2 billion gallons. RIN values are not needed to achieve the mandate for 2012 and they are therefore not changing to counteract producers' falling margins.

Conclusion

Ethanol producers are entering a "perfect storm" of economic, political, and weather conditions that is battering a normally resilient business structure. Investors in both dedicated ethanol producers like Pacific Ethanol and diversified agricultural conglomerates such as Archer Daniels Midland (ADM) have seen their investments substantially underperform the market in 2012 as a result. While all storms pass eventually, corn ethanol producers will continue to face substantial headwinds in both the short- and long-term. A slowing global economy will allow Brazil to continue devaluing the real via lower interest rates while encouraging a "flight to safety" that causes continued appreciation of the U.S. dollar. Current corn ethanol production capacity is 14.7 billion gallons while corn ethanol's mandate under the RFS2 is capped at 15 billion gallons, limiting domestic opportunities for growth. Finally, U.S. gasoline consumption is projected to decline over the next two decades, ensuring that the ethanol market will decline as well so long as public opposition to E15 prevents its widespread adoption (and that includes cellulosic ethanol as well as corn ethanol). In the face of a shrinking market, eroding public support, and a less-than-ideal product, corn ethanol producers may find that their current predicament is merely a sign of things to come.

References

[1] da Rosa, A. 2005. Fundamentals of Renewable Energy Processes, 1st ed. San Diego: Academic Press.

[2] Efe, C., Straathof, A., van der Wielen, L. 2005. Technical and economical feasibility of production of ethanol from sugar cane and sugar cane bagasse, B-Basic Internal Report, Delft University of Technology.

[3] Tao, L. and Aden, A. 2009. The economics of current and future biofuels, In Vitro Cellular & Developmental Biology - Plant 45: 199-217.

[4] Environmental Protection Agency 2010. Regulation of Fuels and Fuel Additive Changes to Renewable Fuel Standard Program - Final Rule, Federal Register 75(58): 14790.

[5] McPhail, L., Westcott, P., Lutman, H. 2011. The Renewable Identification Number System and U.S. Biofuel Mandates. Economic Research Service, Washington, DC.

Source: Corn Ethanol Producers Enter A Perfect Storm