A few weeks ago I described how corn ethanol producers have entered a perfect storm of economic, environmental, and political conditions that is causing substantial losses within the industry. Describing the past doesn't require much courage, however -- you don't put your reputation on the line until you start making forecasts. So, with the results of James Shaw's study on the negative correlation between Seeking Alpha forecasts and stock performance firmly entrenched in the back of my mind, this article provides an overview of the conditions that the ethanol industry can expect to encounter over the next several years.
U.S. Market Outlook
As the chart below shows, U.S. ethanol producers have had an incredible run in the 21st century. This was due to strong government support, first in the form of a large subsidy for every gallon of ethanol blended with gasoline (the VEETC) and now in the form of the RFS2, which effectively serves as a flexible subsidy (i.e., it only has value when ethanol consumption falls short of a mandated volume, thereby preventing windfall gains at taxpayer expense). While a combination of bipartisan popular opposition and Congressional inaction resulted in the expiration of the VEETC at the end of 2011, the RFS2 is currently designed to operate until 2036. While the RFS2 mechanism for subsidizing biofuel production is rather complex (see my previous article on the topic for more details), it bases the subsidy's value on the profit margins necessary for the industry to produce a certain volume of corn ethanol: It increases in value when industry conditions are negative and falls in value when industry production satisfies the mandate, in theory falling to zero when production exceeds the mandate (in practice it will always be worth at least $0.01-$0.02/gallon to cover transaction costs).
Click to enlarge images.
The primary cause of the industry's current troubles is overproduction; specifically, 14 billion gallons per year of corn ethanol production when the mandate only requires 13.2 billion gallons per year for 2012. The RFS2 subsidy for corn ethanol is almost worthless as a result ($0.049/gallon at the time of writing), barely exceeding transaction costs. This is despite an incredibly poor industry environment resulting from high feedstock costs and relatively low petroleum prices; the subsidy would be much higher if U.S. corn ethanol production was below the mandated volume.
Corn Ethanol and the RFS2
Optimists might (correctly) point out that the RFS2 volume mandate increases annually and excess production in 2012 doesn't necessarily mean excess production in 2013, even if production doesn't fall. While true, the current level of corn ethanol production exceeds the mandated volumes even in future years. Here are the mandated volumes through 2015:
|Year||Corn Ethanol Mandated Volume|
|2012||13.2 billion gallons per year|
|2013||13.8 billion gallons per year|
|2014||14.4 billion gallons per year|
|2015||15.0 billion gallons per year|
Source: EPA 2010.
At current production rates, the RFS2 won't begin subsidizing corn ethanol production again until 2014 at the earliest. Worse, that's only based on actual production; corn ethanol capacity is 14.9 billion gallons per year. Note that I don't include volumes beyond 2015; this is because the RFS2 permanently caps corn ethanol's mandate at 15 billion gallons per year. In other words, the opportunity for future industry growth under the RFS2 (i.e., through at least 2036) is limited to one additional midsized corn ethanol facility. After that, capacity will equal the mandate's volume cap. While I do expect to see some production mothballed this year due to the extremely negative industry environment, it is unlikely that this fall in production will equate to a fall in capacity. Corn ethanol's growth prospects under the RFS2 are very limited.
The Blend Wall
The RFS2 just applies to subsidized corn ethanol production, so it is possible in theory for corn ethanol production to exceed 15 billion gallons per year if unsubsidized production is profitable. This is where ethanol's inherent shortcomings as a transportation fuel must be accounted for. When blended with gasoline in small quantities, ethanol serves to improve engine performance and decrease certain pollutant emissions. The use of higher quantities quickly damages unmodified engines and fuel infrastructure, however, which is why non-flex fuel vehicles (ones that have been specially modified to handle ethanol blends of up to 85 vol%, or E85) have historically been limited to the consumption of E10. FFVs have had only a minor impact on the U.S. market; many FFV owners weren't initially aware of their vehicle's capabilities, and more recently ethanol has become persona non grata in urban areas, causing the demand for FFVs to suffer. Due to this lack of consumption capacity, the maximum volume of ethanol that the U.S. fuel infrastructure can handle is roughly 10 vol%, which is the so-called "Blend Wall;" blends greater than E10 are unlikely to be consumed.
The Blend Wall therefore limits the U.S. market's capacity for ethanol consumption to 10% of gasoline consumption. The EIA projects U.S. gasoline consumption to peak at 138 billion gallons per year in 2013 and then gradually fall to 121 billion gallons per year by 2032 due to improved gasoline usage efficiency and increased utilization of hybrid electric vehicles:
Source: EIA 2012.
What this means for ethanol is that U.S. ethanol consumption capacity is going to peak next year at 13.8 billion gallons per year and then spend the next 20 years declining. Corn ethanol producers can't rely on the market to absorb any excess production, as the market won't even be able to consume the volumes mandated by the RFS2 so long as E10 remains the physical blending limit.
What About E15?
The above analysis assumes that the Blend Wall remains at a 10 vol% blend. In 2010, however, the EPA approved the use of E15 in newer vehicles. If the entire U.S. fuel infrastructure adopts E15 blends, then ethanol consumption capacity will increase by 50%; another 7 billion gallons per year of corn ethanol production will be able to occur before the E15 Blend Wall is hit. The problem is that nobody outside of the government and rural communities likes the idea of E15. Environmental groups blame corn ethanol for everything from rainforest destruction to global climate change. Automakers, oil companies, and drivers are concerned that the higher ethanol blend will damage their equipment and expose the first two groups to class action lawsuits.
Indeed, environmental groups have even formed an alliance with automakers and oil companies against the EPA (I bet you never thought you'd read something like that) to prevent the implementation of E15. Public opposition has been so strong that the only U.S. gas station offering E15 two years after its approval is located in the middle of nowhere. (Actually, it's in Lawrence, Kan., but as a Mizzou alum I count that as the "middle of nowhere.") Barring legislation that provides legal immunity to fuel blenders and retailers for damages caused by E15, I simply don't see public opposition to corn ethanol easing enough to overcome the legal risks inherent with E15 production.
Ethanol's El Dorado: The Brazilian Markets
The sole remaining hope corn ethanol producers have for future growth is Brazil. Those familiar with the science and economics of ethanol production from sugar cane relative to corn will be surprised by this; cane is a superior ethanol feedstock to corn. While this characteristic can be attributed to several factors, the most important one is that cane sugar is fermentable in its natural state. Corn starch is not and substantial money and energy goes into depolymerizing corn starch into fermentable sugars (for more on this, see my previously referenced corn ethanol article). Other things being equal, corn ethanol is significantly more expensive to produce than cane ethanol as a result.
So why do corn ethanol producers consider Brazil to be a potential market? First, it should be noted that Brazil is a flex-fuel economy with a transportation infrastructure that can operate on blends ranging from 0% to 100% ethanol, leaving much room for growth in Brazilian ethanol consumption. Furthermore, one of the interesting side effects of the Great Recession was a large fall in the U.S. dollar relative to the Brazilian real (likely caused in part by a drastic increase in the U.S. money supply, which is covered by The Inflation Trader here), which made U.S. ethanol less expensive in the Brazilian markets than domestic cane ethanol and resulted in record exports of U.S. ethanol to Brazil in 2011. Since then, Brazilian efforts to counter slowing domestic growth via monetary easing have caused the U.S. dollar to re-appreciate relative to the real (see chart), but U.S. ethanol producers hope that further quantitative easing by the Fed will make U.S. ethanol competitive in Brazil again.
Exchange rates are the result of both market and government forces, making them notoriously difficult to forecast (many would say impossible). I am not an economist and therefore will not attempt to look like a fool by trying to prove Dr. Rogoff wrong with my own exchange rate forecast. I will point out, however, that Brazil's exports of U.S. ethanol were an historical anomaly and, in the face of all of the other headwinds I've described, U.S.-Brazil exchange rates seem like a very slender thread of hope for U.S. ethanol producers to depend on. I expect the effect of U.S. ethanol exports to Brazil to be quite marginal at best and non-existent at worst.
While I don't expect the perfect storm that is currently raging around ethanol producers to last forever, I do expect them to emerge from it only to find themselves quickly becalmed in the doldrums. I also expect this to impact corn ethanol producers such as Archer Daniels Midland (ADM), Biofuel Energy (BIOF), Pacific Ethanol (PEIX), Rex American Resources (REX), and Valero (VLO), as well as cellulosic ethanol producers such as Abengoa Bioenergia (OTC:ABGOY), BlueFire Renewables (OTC:BFRE), BP (BP) subsidiary BP Biofuels, and DuPont (DD) subsidiary Dupont Cellulosic Ethanol. While the larger, more diversified companies in the group will be able to offset the lack of growth in the ethanol industry with investments elsewhere, dedicated ethanol companies (particularly corn ethanol companies) will struggle in the coming decade.
While I don't discount the possibility of another rapid increase in stock prices such as those experienced by dedicated corn ethanol companies last fall, I would strongly advise against adopting a "buy and hold" strategy with those companies. Cellulosic ethanol companies will fare better initially if the cellulosic biofuel category of the RFS2 mandate is enforced by the EPA either this year or the next, but I do not believe that they will ultimately be able to compete with cellulosic hydrocarbon producers such as Amyris (AMRS), Honeywell (HON) subsidiary UOP, KiOR (KIOR), and Solazyme (SZYM) for reasons that I will discuss in a later article.