Near record high temperatures and low rainfall across much of the United States impacts several aspects of the economy. One of the greatest impacts has been in yields of the corn crop, estimated at 13% lower production this year than in 2011. Almost 40% of farmland in the U.S. is experiencing severe drought conditions worse than at any time since the 1950s. The impact on food prices to consumers is expected to be noticeable in early 2013. One of the more immediate near term impacts is on the ethanol market.
Ethanol is not strictly corn based, though it is more common than sugar cane based ethanol production in the United States. The most noticeable end product in the U.S. is E85 fuel, which is a blend of 85% ethanol and 15% gasoline, able to be used in many flex fuel vehicles. After nearly three decades of tax breaks for ethanol production, the U.S. recently ended the tax credit in early 2012. It is currently estimated that nearly 40% of corn production goes towards ethanol production and livestock feed, and the Government Accountability Office estimated that increased ethanol production contributes to higher corn prices. A similar move is being made in France, as they experience the fiscal squeeze of maintaining corporate tax breaks. Despite these developed world changes, the Brazilian government is planning to implement tax incentives to encourage greater ethanol production.
One benefactor of planned tax incentives in Brazil may be food producer AdecoAgro (AGRO). They recently received European Union and U.S. approval for sugar cane based ethanol to be imported into those markets. Swiss energy trading company Vitol note that prior to 2010 Brazil was the largest exporter of ethanol, but high sugar prices in 2010 and currency fluctuations shifted the market, allowing the U.S. to become the largest exporter of ethanol. Oddly enough, from late 2010 through early 2011, much of the U.S. ethanol exports went to Brazil, as poor harvests and difficult weather conditions curtailed ethanol production in Brazil. This is something we should watch in early 2013, as the movement of ethanol exports is effectively reversed, with poor crop conditions due to weather in the U.S. and improving conditions in Brazil. Sugar and sugar cane based ethanol production is expected to increase through early 2013 in Brazil, though ethanol usage in Brazil is largely a factor of the price difference to gasoline in Brazil. If the planned tax incentives go through in Brazil, I would be tempted to increase my holdings in AdecoAgro.
The original promise of ethanol in the United States was the hope of decreasing dependence on oil imports. Ethanol is currently blended into gasoline in various amounts, with E15 representing a 15% ethanol to gasoline content, and E85 at 85% ethanol content. There is also a limit across the U.S. for the maximum amount of ethanol used in blending, currently 10% of gasoline consumption. The industry has been producing above the level needed for blending, which is why we see tankers shipping ethanol out of the U.S. passing by tankers carrying crude oil into the U.S.
Raízen is a joint ethanol operation between Shell (RDS.A)(RDS.B) and Brazilian company Cosan. One ton of sugar cane produces around 85 liters of ethanol. Ethanol blended fuels are less efficient than gasoline, so lower prices are necessary to maintain demand. Raízen expects ethanol exports to the United States to increase more than 20% over the next year. Petrobras (PBR) are currently keeping gasoline prices somewhat low in Brazil, impacting the investment in further ethanol production. While Petrobras are very active in blended fuel, flex fuel, and full ethanol distribution in Brazil, that market is mature compared to most parts of the world. Brazil produces nearly 20% of the world supply of ethanol, but continued investment in the sector will depend upon greater export demand from the U.S. and other markets.
Watching weather conditions is one way to judge the sugar and corn markets. Earlier this year Brazil experienced extreme rain and flooding conditions, causing more havoc than benefit. Extreme rain delays harvesting sugar cane, causing commodities traders to bet on price rises in sugar (article link in image above). If there will be an increase in ethanol exports, the port of Paranguá may show the first increase. Checks throughout this month reveal far more cargo ships than product tankers, though some of those cargo ships may be exporting sugar. Green marks in the map below are cargo ships, while red marks indicate tankers. Keep in mind that not all those green marks are bulk container ships, since Paranguá handles other types of cargo too. Dry weather may help Brazil move some of the current backlog in sugar shipments.
The product tanker market is somewhat specialized compared to the crude tanker market. Gibson's Shipping indicates that the fleet of Medium Range (designated MR1 or MR2) tankers increased from 344 to 1174 over the last twelve years. MR1 are sometimes referred to as Handy or Handysize, while larger MR2 vessels are often called Panamax. While product tankers do carry more than ethanol, a recent spot check over the last month, at a few of the major companies, indicate low utilization for ethanol shipments compared to other refined products. Some of these vessels are quite old, so we may see some scrapping activity decrease the overall fleet size. At this time I do not recommend investments in companies with product tankers, since it appears that it may take a few years for the demand/supply ratio to change, and for rates to improve. We can watch some of the progress of spot rates through the Baltic Clean Tanker Index, or more specifically the Handysize or Panamax Indexes. BPI represents Panamax, BHSI is Handysize, and BCTI is the main Clean Tanker Index.
A large portion of ethanol in the U.S. is transported by rail or through pipelines. One of the largest railroad ethanol transport operations in the United States is operated by BNSF, a division of Berkshire Hathaway (BRK.A)(BRK.B). Up to 2009, this was one of the largest acquisitions by Berkshire Hathaway. Some analysts thought that this move by Warren Buffett was due to the dominance of BNSF in coal transportation, though it appears that ethanol transportation may have been another major factor in his investment decision. One of the largest ethanol producers in the U.S. is the Archer Daniels Midland Company (ADM). In 2011 ADM increased bio-products revenues 33%, mainly due to greater ethanol production. ADM are also involved in sugar cane ethanol in Brazil. The company does hedge these operations through derivatives contracts, so the impact of current U.S. drought conditions might be minimized. Nitrogen is used in tanks when transporting ethanol, in order to minimize water absorption. Production of nitrogen requires natural gas, so ADM also have derivative positions hedging against changes in natural gas prices. Ethanol prices dropped for much of 2012, due to oversupply, though they have recently rebounded. Investors should check for disclosures, on derivative gains or losses, in reports from ADM. Credit Suisse estimates that ADM revenues from bio-products, including ethanol, will decline more than 10% in 2012, then rebound about 10% in 2013. Part of that estimate depends upon better weather conditions next year in the United States.
Credit Suisse analysts expect the reduced supply of ethanol, leading to a shutdown of many processing plants, is responsible for the increase in ethanol prices. Higher natural gas prices would also impact storage and transport of ethanol, further cutting into profit margins. The Energy Information Agency has indicated that U.S. production has declined for more than a month. The EIA also show that imports of ethanol from Brazil to the United States have declined, due to weather delays. Companies involved in ethanol production in the U.S. should see some improvement in revenues, if ethanol prices can stay relatively high. In the case of ADM, ethanol production is a small part of overall revenues. The drought conditions in the U.S. are impacting revenues far more than price fluctuations in ethanol. Investors may consider that current conditions are causing a low revenue point for ADM, and improving weather conditions may allow revenue increases in the future.
Another company in Brazil involved in sugar cane based ethanol, and sugar production, is Bunge (BG) through certification from Bonsucro. Investor may want to compare Bunge to ADM, since they have similar P/E ratios, though overall revenues are much higher at ADM. Similar to ADM, revenues from ethanol are a small component of overall revenues at Bunge. Both ADM and Bunge are global companies, not solely dependent upon market and weather conditions in any single region. As the population of the world grows, and frontier economies move towards emerging economy status, the need for food production will increase. Bunge have a great overview on global food markets strategy.
Ethanol is primarily a transportation fuel, usually as a blended component of gasoline. Until recently, the U.S. EPA mandated no more than 10% blending with gasoline for usage in automotive fuels. Despite heavy opposition from auto makers in the United States, the EPA moved ahead and authorized E15 (15% ethanol blend gasoline) in April 2012. These changes from the EPA, combined with a suspension on tarifs of imported ethanol from Brazil, current drought conditions hiking corn prices, and closure of U.S. ethanol plants, point towards a better ethanol market for Brazil, than for the United States. There is some demand to reduce ethanol blending requirements for U.S. refineries, which could decrease ethanol demand, though so far there has not been any change in policy from the EPA. Companies involved in ethanol production in Brazil stand to generate better revenues, if drought conditions last an extended time, and if enough new vehicles are sold that can use flex fuels or high ethanol content blended gasoline.
The American Petroleum Institute performed tests that indicate E15 could harm engines in some cars and trucks. They note that since the introduction of E10 blended fuels, many auto owners in the U.S. have experienced fuel system problems. Auto manufacturers discourage E15 usage through statements that auto owners may void their warranty, if they use E15 fuels in unapproved vehicles. In Brazil the usage of ethanol blended fuels is viewed more favorably, with flex fuel automobiles currently representing 90% of new car sales. Brazil experienced a slight decrease in demand for domestic ethanol, after the country cut the ethanol fuel blending requirement from 25% to 20% in 2011. That may actually help ethanol exports. Demand is increasing in Europe, driven by a requirement for 10% of fuel blends to be from renewable sources by 2020. That demand can be met with E10 fuels. Singapore listed Noble Group is one of the largest Asian companies involved in ethanol production in Brazil. Noble Group recently purchased two large sugar factories in Sao Paolo, and expanded an ethanol tank terminal facility in Rotterdam, betting on the growth of ethanol exports to Europe.
Amongst refineries in the United States, Valero (VLO) is the largest of the traditional refiners to make a major move into ethanol. Most of the ethanol is blended with gasoline to increase the octane. Blending allows refiners to produce a lower octane gasoline, which helps their profit margins. Valero acquired 10 ethanol plants not long ago, most from bankrupt VeraSun Energy. Recently Valero shut down two of those ethanol plants, due to drought conditions and lower energy demands. The company expects to restart operations in fall 2012, with expectations of a better corn harvest.
Privately held Cargill and France's Louis Dreyfus Group landed a 25 year contract in 2009 to operate a bulk cargo terminal in Santos, Brazil (image above). The port of Santos can accommodate deeper draft bulk cargo vessels than the port of Paranguá. Despite that these are privately held companies, investors wanting to watch sugar exports from Brazil should pay attention to port traffic in both cities. Sugar exports are heavily dependent upon dry weather. Using a weather mapping service like WunderMap, which allows past time comparisons, can allow investors an early alert on shipping delays.
The largest sugar cane based ethanol non-fuel venture so far, is a joint venture between Dow Chemical (DOW) and Japanese financial company Mitsui. Rather than a pure ethanol play, the plant in Japan will produce polyethylene for use in resins and bio-plastics. Mitsui would become a 50% owner of what is expected to be the world's largest production facility for bio-polymers from sugar cane ethanol. This facility is scheduled to begin production in the second quarter of 2013. Dow originally planned this facility in 2008, though a change in negotiations prompted a cancellation of the earlier project with CrystalSev of Brazil.
The move by Dow towards sustainable bio-polymer production may prompt rivals BASF (BASFY.PK) and DuPont (DD) to start similar plants, or invest in partnerships with sugar cane ethanol producers. BASF is involved in producing chemicals for the treatment of biogas, but so far have no plans like those of Dow. DuPont are working more towards using biofuels and alternative energy for production, and not directly for making bio-polymers. If the Dow facility in Japan proves profitable using lower priced sugar cane based ethanol, then Dow may find some revenue increases from this move. BASF and DuPont appear to be taking a wait-and-see approach. Investors interested in these three companies may consider waiting to see whether this move is profitable for Dow Chemical. Keep in mind that this move is small on the scale of overall production at Dow.
The number of privately held companies involved in corn, sugar, and ethanol can make it difficult to research moves in the market. Publicly listed companies, mentioned in this article, stand to benefit from higher crop yields, and ethanol production is price sensitive to yields. In the long run, sugar cane based ethanol production is likely to be more profitable than corn based ethanol. Investors are advised to observe changes in flex fuel vehicle sales, as well as production of automobiles able to reliably run on E15. Despite usage in refinery blending, there appears to be some reluctance in the U.S. to install new pumping equipment at service stations, to handle E15 or dispense E85. Public acceptance can drive future ethanol demands, but prolonged drought conditions and higher food prices may temper future demand, or create a backlash against corn based ethanol fuels. Brazil, parts of Europe, and Japan may see demand grow at a faster pace. Prolonged severe weather conditions can disrupt supply, production, and shipment of corn, sugar, and ethanol, greatly affecting prices, revenues, and profits. Despite the risks mentioned in this article, I feel most of these companies should expect increased revenues and profits from corn, sugar, and ethanol in the years ahead. In the near term I would expect these companies to experience revenue decreases, though long term investors may consider this time period as a buying opportunity.
Disclosure: I am long AGRO.
Additional disclosure: I am long RDS.A through ADRD, and long PBR through PXH electronically traded funds. I may initiate a long position in ADM in the near future.