Farmland Bubble: Fuel Prices May Trigger Collapse

by: Robert Wagner

Executive summary:

  • Repeal of the EPA's RFS2 combined with lower RBOB prices is the catalyst most likely to burst the farmland bubble.
  • Currently ethanol is competitive with RBOB, making the calls for the repeal of the EPA's RFS2 sound reasonable.
  • The EPA's RFS2 has a built in mechanism to protect profits of farmers and ethanol producers in case ethanol can no longer compete with RBOB.
  • There is nothing in the EPA's RFS2 to prevent future biofuels from making corn based ethanol obsolete, so preventing the repeal of the EPA's RFS2 only buys corn based ethanol producers and corn farmers time.
  • Corn based ethanol producers must convert their plants and corn producers must find new markets for their corn if they want to survive in the future without the EPA's RFS2 support.

I recently wrote an article about the farmland bubble, but focused mostly on who would be hurt. This article addresses what will likely be the event to trigger the bursting of the farmland bubble. In the previous article I highlighted how a rapid increase in fuel prices drove up the CPI, which in turn drove up ARM rates triggering the mortgage crisis:

In reality, oil prices and inflation spiked after that election and the resulting mortgage crisis nearly destroyed the global economy.

Ironically, fuel prices are likely to be what triggers the bursting of the farmland bubble, only high energy problems aren't the threat, low energy prices are. The reason low energy prices are the greatest threat is because low energy prices threaten ethanol margins, on which the entire farmland bubble is based.

Ethanol competes with RBOB gasoline, and refiners will blend up to 10% ethanol into a gallon of gas as long as it is economical. Refiners will always blend about 4% ethanol for its oxygenating properties, so their is 6% "play" within the system.

Because of the EPA's RFS2 program, refineries have been maxing out the % ethanol at 10%. That amount of ethanol is about 13.2 billion gallons per year, above which causes an issue called the "blend wall." As long as the EPA's RFS2 is in force, the price of RBOB is unlikely to trigger the bursting of the bubble. The reason is because the EPA RFS2 guarantees that the 13.2 billion gallons of ethanol will be demanded regardless of price of RBOB. That demand will support corn prices.

The problem is the EPA's RFS2 ethanol mandate is facing growing opposition. A repeal of the EPA's RFS2 would allow refineries to decide if they want to use the optional 6%, and force ethanol to compete directly with RBOB. The lower RBOB goes the lower the ethanol margin will go, below which ethanol will no longer be profitable and competitive.

Ethanol has two-thirds the BTU energy content of RBOB, so theoretically the price of ethanol should be capped at two-thirds that of RBOB. In reality fuel is sold by the gallon, not the BTUs, so theoretically ethanol can sell for the price of RBOB less the additional costs required to handle and process it.

To calculate out how low RBOB has to go to create problems for ethanol, one must first understand how an ethanol margin is calculated. The top lines of the calculation is what is called the "crush spread." The "crush spread" helps determine if it is better to convert a bushel of corn into ethanol, or simply sell the bushel as corn. The top line of the "crush spread" is 2.8x the price of a gallon of ethanol. That is because each bushel of corn yields 2.8 gallons of ethanol. The second line is the cost of a bushel of corn, and the third line is 0.0085x the price of a ton of distiller's dry grains and solubles or DDGS. Each bushel yields 17lbs of DDGS, and DDGS is sold by the ton. The revenues from the ethanol and DDGS are added together and the cost of the corn is subtracted to get the "crush spread."

Crush Spread Multiplier Price Bushel Gallon
Ethanol 2.8000 $ 1.98 $ 5.54 $ 1.98
DDGS 0.0085 $200.00 $ 1.70 $ 0.61
Corn 1.0000 $ 4.35 $ 4.35 $ 1.55
Crush Spread $ 2.89 $ 1.03

What that means is that by buying a bushel of corn and converting it to ethanol you make $1.03 over the net cost of the corn. Progressive Fuels LLC provides the data to complete the above calculation. They also calculate a "crush spread" but it is different from the above calculation. It does not use net corn cost and adjust for the revenues for DDGS. The trend, however, is a useful tool in estimating the profitability of producing ethanol.

The "crush spread" however isn't complete, there are other costs involved in the production of ethanol. It takes 72,800 BTUs to process a bushel of corn into 2.8 gallons of ethanol, as well as about $0.30 in other operating costs such as methanol and other chemicals. There are also capital costs of about $0.25. Once all those costs are factored in, ethanol currently has an OPEX margin of about $0.57 and a net margin of about $0.32. Those are pretty hefty margins on a historical basis, and why companies like Green Plains Renewable Energy (NASDAQ:GPRE) have been doing so well.

Crush Spread Multiplier Price Bushel Gallon
Ethanol 2.8000 $ 1.98 $ 5.54 $ 1.98
DDGS 0.0085 $200.00 $ 1.70 $ 0.61
Corn 1.0000 $ 4.35 $ 4.35 $ 1.55
Crush Spread $ 2.89 $ 1.03
Natural Gas 0.0728 $ 6.92 $ 0.50 $ 0.18
Other OPEX $ 0.30
OPEX Margin

$ 0.57

Other Fixed Costs/Capital Cost $ 0.25
Net Margin $ 0.32

That margin, however, is misleading because the EPA's RFS2 has distorted the ethanol market. Each gallon of ethanol comes with 1 D6 RIN embedded in it, and currently a D6 RIN trades around $0.56. That means that currently the price of a gallon of ethanol really isn't $1.98/gal, the true price of ethanol is $1.98 - $0.56 = $1.42/gal. If the Congress was to repeal the ethanol mandate, ethanol could theoretically fall to $1.42/gal. That would throw the ethanol net margin into negative territory.

Net Margin $ 0.32
D6 RIN (2013) $ 0.56
Net Margin w/o D6 RIN $(0.24)

That clearly would be detrimental to ethanol production and the price of corn. That, however, isn't likely to happen, and even if the ethanol mandate was eliminated, it is unlikely that ethanol prices would fall by that amount. The reason is that ethanol competes with RBOB for up to 10% of the fuel supply, and ethanol is cheaper than RBOB. Even if the price of ethanol increased by the full D6 RIN amount, it would still be cheaper than the $2.85/gal being paid for RBOB, $1.98 + $0.56 = $2.54/gal. Refiners can still lower the cost of a gallon of gas by blending ethanol into the fuel supply. The cost of 100% RBOB is $2.85 and the cost of 90% RBOB and 10% Ethanol = 0.9 x $2.85 + 0.1 x $2.54 = $2.82, $0.03 less than 100% RBOB. Blenders can still lower their costs by blending ethanol even if 100% of the D6 RIN is added to the current price of ethanol.

There are, of course, other costs involved in blending ethanol, so the above example is optimistic, but it highlights what differentiates ethanol from other biofuels - ethanol costs less than RBOB whereas all the other biofuels cost more. The EPA's RFS2 isn't necessary to make ethanol competitive. In fact, D6 RINs used to sell for $0.05 or less proving only the marginal ethanol producers needed the program.

The RFS2 does have a mandate, but the mandate is only needed if ethanol isn't competitive with RBOB. Refineries will buy ethanol at current prices simply because it is cost competitive, with or without the D6 RIN and mandate. At the current price of $1.98/gal for ethanol, refiners can lower their cost by $0.09/gal by blending a 90/10 mix. If the price of ethanol fell by the full D6 RIN price with the repeal of the RFS2, refiners could lower the cost of fuel by $0.14/gal. The EPA's RFS2 is necessary only when the biofuel it is targeting is not cost competitive. At current prices, even adjusted for a repeal of the EPA's RFS2, ethanol is competitive with RBOB.

Another way to look at this issue is on a BTU basis instead of a per gallon basis. Ethanol has two-thirds the energy content of RBOB, so theoretically it should sell at about two-thirds the price of RBOB. In reality stations sell fuel by the gallon, not the miles per gallon, or BTUs per gallon, so the consumer has no real way of knowing if they are buying 100% RBOB or a 90/10 mix. What matters to the consumer is the price - that is most of the information they rely on. But let's assume that the consumer will demand a lower price for gas if it is a 90/10 mix because they know they are getting fewer miles per tankful. In that case, theoretically ethanol should sell at a two-thirds discount to RBOB (ignoring all other processing costs). In that case, ethanol should sell at $2.85 x (2/3) = $1.90/gal to make a BTU equivalent price for ethanol. Currently ethanol trades at $1.98/gal so there is a $0.08/gal premium built into ethanol on a BTU basis. This concept becomes much more important to the price of ethanol when applied to E85 where the loss of mileage is easily understood by consumers and reflected in its price.

RBOB 0.6667 $ 2.85 $ 1.90
Ethanol 1.0000 $ 1.98 $ 1.98
BTU Premium/Discount $ 0.08

From an economic perspective what that means is that the true value of a D6 RIN isn't $0.56, it is $0.08 + whatever extra processing costs are involved with blending ethanol. The fact that D6 RINs are going for $0.56 and ethanol trades at $1.98/gal pretty much proves refiners are more concerned with lowering the cost of fuel than they are of the extra processing costs and loss of BTUs and miles per gallon. This lack of consumer information/awareness gives the refiners pricing power because the consumer doesn't know the difference between 100% RBOB and a 90/10 mix. There is a $0.09/gal "float" between 100% RBOB and 90/10, which can be exploited. Stations that sell higher RBOB/higher mileage content fuel can be undercut by stations that sell a lower RBOB/lower mileage fuel. The consumer won't know the difference in fuel mileage quality, all they see is the lower price on the board.

The point of the above analysis is to demonstrate that the loss of the EPA's RFS2 isn't likely to play a big part in current ethanol economics. The EPA's RFS2 is acting like a price floor when it is set below the equilibrium price. It simply doesn't matter. If the EPA set a price floor for gold at $50/oz, people will still be paying $1,300/oz. The only problem the EPA's mandated gold price floor creates is if the equilibrium price was to fall below $50/oz. As long as the equilibrium price remains well above the price floor, the price floor is irrelevant.

The real threat to ethanol and the farmland bubble isn't the repeal of the EPA's RFS2. While there would certainly be short-term market adjustments that may be painful similar to what we are now seeing in the biodiesel industry, the real threat to ethanol and the farmland bubble is a fall in RBOB prices and the repeal of the EPA's RFS2. If RBOB prices go higher, ethanol becomes more competitive, but if RBOB falls, it will drive the price of ethanol down with it. If the price of ethanol is driven lower, the price of corn is sure to follow as well. If RBOB falls far enough to drive the price of corn below its cost of production, that could/would be the catalyst to pop the farmland bubble. Just like higher energy prices helped trigger the bursting of the mortgage bubble, lower energy prices could/would trigger the bursting of the farmland bubble. Ironically many of the new frack wells being drilled on farmland may contribute to the collapse.

Currently, the 2014 cost of production of a bushel of corn is estimated to be between $4.84 and $4.24 for a 200 acre farm depending on if they planted corn or soybeans last year. At those prices, ethanol maintains a pretty healthy OPEX margin of between $0.38 and $0.59. Current OPEX margins are $0.57. By the way, that corn production cost deferential dependent upon the previous year's crop may be a way to forecast nitrogen fertilizer sales. A bumper crop of soybeans may result is less nitrogen fertilizer being demanded the following year. (That may be the basis of a future article.)

OPEX Margin $4.48 $ 0.38
OPEX Margin $4.24 $ 0.59

If the spread remained the same between RBOB and ethanol, RBOB would only need to fall to $2.47/gal to wipe out the OPEX margin of the higher cost corn producers, and $2.26/gal to wipe out the OPEX margin of the lower cost corn producers. RBOB has traded that low as recently as 2010.

Ethanol plants don't remain open just breaking even on OPEX margins. If RBOB fell to $2.72/gal and $2.51/gal, net margins would go to $0.00 depending upon last year's crops. Those prices are well within possibilities. It is that fact that highlights how fragile and dangerous a situation the market distorting impact on the EPA's RFS2 has created.

I wrote a previous article highlighting how the EPA's RFS2 has distorted the markets and driven farmland prices into bubble territory. I then explained above how at current market prices, ethanol is competitive and that the EPA's RFS2 isn't needed for ethanol to survive. The key point is "at current market prices." At current market prices, the EIA and environmentalists can write article claiming ethanol is a market success and great green success story.

But on the sixth anniversary of President George W. Bush signing into law the Energy Independence and Security Act of 2007 (EISA), a new study shows that the RFS has provided a positive impact to the nation's economy and environment.

The whole purpose of the EPA's RFS2 was to encourage the creation of an ethanol industry, and the EPA's RFS2 did just that. The ethanol industry can now produce more than 10% of the nation's fuel supply, and at competitive prices, even accounting for the loss of energy content. It is that very success that poses the greatest risk to the farming industry. That success can be used to justify the repeal of the ethanol mandate. Critics can justifiably claim that the EPA's RFS2 is a huge success, it has accomplished its goal. In symbolic recognition of President Bush's involvement the EPA could hang a huge "mission accomplished" sign on their building. Ethanol is now competitive with gasoline so the EPA's RFS2 is no longer needed. Chants of "End the Mandate" will fill the halls of congress. The EPA's RFS2 is no longer needed because "we have won the war on renewable fuels" will be the arguments used.

That plausible scenario demonstrates just how dangerous this program and repeal movement is. The ethanol is currently competitive at current market prices, but this nation is undergoing a huge energy renaissance. Domestic energy production is exploding. The cost of energy is likely to be lower, much lower in the future. Lower prices of conventional fuels will make ethanol once again uncompetitive. Lower gas prices combined with the repeal of the EPA's RFS2 is the greatest threat that faces farmland prices, and is the likely catalyst to trigger the bursting of the farmland bubble.

As long as the EPA's RFS2 remains in force for ethanol, ethanol has a safety net build into it with the D6 RIN. The recent "blend wall" event demonstrated that even when refineries don't want to buy ethanol they will, just to get the D6 RIN. Even though ethanol prices fell, ethanol and corn production remained profitable. That same mechanism would protect ethanol and corn profits if gasoline prices fell. It would simply put ethanol and corn producers back into the economic environment that existed at the start of the EPA's RFS2 program, that being ethanol is not competitive. The RIN system was created to generate the profits in an uncompetitive industry, and it works. It has worked in the past to support ethanol and corn production when ethanol wasn't competitive, and will be needed if gasoline prices fall in the future. Without the EPA's RFS2 providing a profit safety net for when RBOB prices fall, ethanol simply becomes a bankrupt industry that will drag many farmers down with it. The EPA's RFS2 created the ethanol industry and the repeal of it can destroy it.

That, however, doesn't stop the farmland bubble from getting popped, it only delays it. The EPA's RFS2 can only prop up corn based ethanol producers and the farmers dependent upon that demand for so long. Soon cellulosic ethanol and other advanced biofuels will be competing for those D6 RINs, and there is nothing to protect the corn based ethanol producers from the new competition. In fact the RFS2 is designed to replace first generation biofuels like corn based ethanol with the second generation biofuels. Ethanol is part of a model based upon planned obsolescence, and corn-based ethanol is the first to be retired. Corn-based ethanol plants will be forced to convert or shut down in the future, and corn producers will need to find new markets for their product or face a bursting of the farmland bubble.

In conclusion, repeal of the EPA's RFS2 could have a disastrous impact on the farming industry and trigger the bursting of the farmland bubble. The reason, however, isn't obvious and that is why this situation is so dangerous. Critics of the EPA's RFS2 can justifiably call it a success and demand its repeal based on the best of intentions. Well, the road to hell is paved with good intentions, and the cries for the EPA's repeal blacktops it and makes it a superhighway not much different than 2008. What people in Washington fail to grasp is that the repeal of the EPA's RFS2 is plausible now only because corn-based ethanol is competitive with gasoline. If that changes, the repeal of the EPA's RFS2 will remove a needed safety net that could have catastrophic consequences on the farming industry and burst the farmland bubble. There are simply many unintended consequences that will likely result if the EPA's RFS2 is repealed now, even though the current situation appears to support it. Ethanol may have been a bad policy to begin with, and I agree, but blindly repealing the EPA's RFS2 during a time when fuel prices are likely to fall is simply inviting another disaster like 2008.

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.