The Ethanol Disaster And The Ramifications For Producers

by: James Shell

We are currently watching an unprecedented situation unfold in the U.S. Midwest in regard to the drought conditions. It is quite true that droughts have occurred in this area in the past, but over the last five years, we have seen fit to convert a third of our corn crop into 9% of our automobile fuel. Now, with the crop in peril, and more hot temperatures forecast, we can take look at the ramifications of all of this for some of the major energy producers.

First of all, a little background.

The price of corn has gone up 60% in the last six weeks, and as of this morning, is just under $8 per bushel.

Secondly, here is the calculation everyone is looking at right now as to the economic viability of ethanol:

2.77 Gallons of Ethanol per Bushel of Corn
7.93 Dollars per Bushel (Current Corn Price)
2.86 Dollars per Gallon of Ethanol (not including conversion costs)

Here is the current crack spread for refinery products:

WTI 88 Dollars per Barrel
Unleaded 2.6 Dollars per Gallon (December)
Distillates 2.85
Ratio 60/40
Crack Spread 0.605 Dollars per Gallon
Crack Spread 25.4 Dollars per Barrel

The current month price for unleaded gasoline, FOB New York, is closer to $2.80, the above price reflects the December price.

So at the current level, approximately $8 per bushel, Ethanol is a net economic negative.

The WTI spread of $25 per barrel is still high, historically, however.

Let's look at some of the ramifications:

1. Valero (NYSE:VLO)

Valero is the nation's biggest producer of ethanol, with capacity of 3.5 million gallons per day, which converts to 83,000 barrels per day of gasoline equivalent. This is small, relative to the rest of VLO's total refining capacity of 2.7 million bpd. Valero had a conference call in which the management announced pretty good earnings, and the stock price went up in response. The management also announced the temporary shutting down of a couple of ethanol plants in the Midwest, and that may in turn be a major reason that the corn price has temporarily stabilized more or less where it is.

We did a lot of work a couple of years ago to try to understand the investment that Valero tried to make in this business, and the general conclusion was that VLO got into this business at such a favorable entry price that the company's investment would be fine as long as there was not a disaster. Now that the disaster has occurred, it is still such a small part of their business that the company can turn out the lights temporarily and quite possibly benefit from higher utilization in the rest of its system.

2. The Rest of the Refining System

Take a look at this calculation, with data from the Energy Information Administration:

92.4% Current Refinery Utilization
850,000 bpd current Ethanol Production
9,000,000 Current "Finished" Unleaded Production
8,150,000 Gasoline Only
9.40% Current Ethanol Usage
0.60 Unleaded Ratio of Total Refinery Production
5.6% Additional Refinery Utilization Needed to replace Ethanol
98.0% Potential Refinery Utilization to replace Ethanol

One of the big problems in the refining industry for the last couple of years is the fact that even though refining margins have been quite high ($10-15 per barrel is typical) utilization never has made it back up to the 2008 level, mainly because of ethanol. You take the ethanol away, and the refinery utilization in the rest of the system goes back up to the 2008-like levels of over 98%. This would trigger an enormous benefit for the refiners, particularly those with facilities on the East Coast which have been underutilized.

Candidates to benefit from this situation would be Marathon Petroleum Corp (NYSE:MPC) and Phillips 66 Corporation (NYSE:PSX), the two largest independent refiners. Both of the stocks have done well since June, but are not overpriced historically.

3. The Ethanol Pure-Plays

Unearthing this ancient article, from the January 2011 time frame, we can check up on what happened to this industry.

Here is the table from the January article:

2010 Total
Company Stock Price Mkt Cap Mgal/Yr EtOH Rev$M Revenue $M
(NASDAQ:ANDE) Andersons 40.22 740 300 449 3160
(AVR) Aventine 0.93 na 425 473 942
(NASDAQ:GPRE) Green Plains 11.54 412 657 984 1810
(NASDAQ:BIOF) Biofuel Energy 1.28 32.5 115 433 433
(NASDAQ:MGPI) MGP Ingredients 9.84 175.2 79 118 208
(NASDAQ:PEIX) Pacific Ethanol 0.89 79 250 281 281

and here are the current prices:

Company Jan-11 Now
ANDE Andersons 40.22 37.97
AVR Aventine 0.93 1
GPRE Green Plains 11.54 4.44
BIOF Biofuel Energy 1.28 2.78
MGPI MGP Ingredients 9.84 3.25
PEIX Pacific Ethanol 0.89 0.33

It appears that the bad news is already in for most of this group. The true ethanol believers can use this as a buying opportunity, but the better strategy may be to short Andersons (ANDE), which still has some downside if the current situation continues. Keep in mind that the bulk of that business consists of grain elevators and transportation of all of that high priced grain, and although pricing may be favorable, volumes may be down in that industry as well.

So, to summarize:

The current Midwest drought conditions have the potential to cause a lot of problems, but also opportunities. In the case of the refiners, the news is likely to be good. In the case of the Ethanol pure-plays, to the extent that they were ever viable, they may be even less so right now.

There is a seasonality issue. We're in the last month of the summer driving season, and overall demand for the products falls precipitously during the fall season. However, there is going to be a quarter of upside for some of these big refiners, and maybe more than that if the high corn prices persist.

Do with this information what you will. Keep in mind that the world is chaotic, and there are no guarantees on anything.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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