The share prices of U.S. ethanol producers tumbled on Monday (see figure) after Canada announced a new wave of retaliatory import tariffs against American products over the weekend. Green Plains, Inc. (GPRE) led the decline, followed by Pacific Ethanol (PEIX), REX American Resources (REX), and Archer Daniels Midland (ADM). Ethanol producers were not the only names affected as biomass-based diesel producer Renewable Energy Group (REGI) lagged the broader S&P 500 index, but ethanol producers were hit the hardest.
U.S. ethanol producers have already been beset by concerns over deteriorating trade relations with many of America's largest trade partners. Last spring China imposed new tariffs on its imports of U.S. ethanol, for example, reducing the effectiveness of what has been an important pressure relief valve for U.S. producers in the past.
The effects of that development are continuing to be felt throughout the industry: Green Plains, Inc. fell sharply last week after it was downgraded by an analyst on the grounds that the market was overestimating the benefits that U.S. ethanol exports to China would bring to producers (Green Plains had positioned itself until recently to take advantage of the export market).
China's impact, however, had more to do with the future than today's operating conditions. While the country did briefly become the world's largest importer of American ethanol in early 2016 (see figure), this was only a temporary development. U.S. ethanol producers viewed it as an important growth opportunity due to the size of China's economy and its ambitious emissions reduction targets for particulate matter and other forms of pollution from refined fuels, but the new tariffs are unlikely to have an immediate effect on the U.S. ethanol operating environment.
The bigger concern following last weekend's announcement is that U.S. ethanol could become a target of its largest importers at present. While Canada's imports of U.S. ethanol have not reached some of the monthly highs set by China, its steady consumption of the fuel caused it to be the U.S. ethanol industry's largest foreign destination in both 2015 and 2016, and its second-largest destination last year (see figure). Ethanol has yet to be targeted by Canadian tariffs but that could quickly change, especially in the event that last weekend's new restrictions herald a breakdown of the ongoing NAFTA negotiations.
The Midwest U.S. holds outsized influence in American politics, and President Donald Trump's narrow victory margin in 2016's electoral college vote came entirely from swing states in the Corn Belt. Much as Kentucky bourbon has been a common target of retaliatory tariffs by America's trading partners due to the Senate Majority Leader representing that state, ethanol could also be placed at risk in the run-up to the 2020 midterm elections.
The slim bit of good news for U.S. ethanol producers as America's various trade disputes escalate is that this could also potentially cause their feedstock costs to decline moving forward, much as has already occurred in the biomass-based diesel industry with soybean prices. Exports of U.S. corn to Mexico, which was the largest destination last year, are up 4% YoY in 2018 to date. Reuters reported last month that Mexico is already considering new tariffs on U.S. corn (and soybeans) as a retaliatory measure, making such a move a distinct possibility.
While it would be disastrous for an American farming sector that is already dealing with low crop prices (see figure), cheaper corn would provide a much-needed offset at a time when U.S. ethanol producers are roughly breaking even after accounting for capital costs.
The fact that ethanol production margins are currently as low as they are is why this year's export volumes matter as much as they do. U.S. ethanol exports in 2018 to date have been several times greater than in the same periods of any of the last four years (see figure), providing much-needed demand support.
That demand became even more important last week after the U.S. Environmental Protection Agency [EPA] proposed corn ethanol blending volumes for 2019 that, while nominally unchanged from this year's volume of 15 billion gallons, will actually be lower if finalized in November due to the EPA's mass allocation of "hardship waivers" to obligated blenders (i.e., refiners). (The EPA also announced that it will not be holding the conventional public comment period on its new hardship waiver policy either, increasing the likelihood that it will indeed be finalized in its present form.)
While the volume by which next year's mandate will effectively be reduced is currently unknown due to the opacity of the EPA's waiver allocation process, a coinciding reduction to export volumes would likely send production margins into negative territory (barring a large increase to the price of gasoline over current levels).
Brazil will be the wild card in this already-uncertain production environment. The country is a major consumer of ethanol due to its large amount of cane ethanol production capacity and the popularity of flex-fuel vehicles on its roads. It had to turn to U.S. ethanol earlier in the decade as a multi-year drought took a major toll on its feedstock production, causing it to surpass Canada as the largest destination for U.S. ethanol last year.
Brazil responded with a 20% import tariff, but even that was unable to prevent the volume going to Brazil in Q1 2018 from surpassing America's total export volume in the same quarter of previous years. The Trump administration is currently negotiating a repeal of that tariff, although recent trade tensions could place that effort at risk too.
Plateauing U.S. gasoline consumption and a temporary weakening of the biofuels mandate have made domestic ethanol producers more reliant on export markets for sustained demand than at any time in recent history. Unfortunately, for producers, this new development has coincided with the Trump administration's decision to implement protectionist trade policies that have already prompted numerous rounds of retaliatory tariffs on U.S. goods. The outlook for U.S. ethanol producers is weakening in response.
Disclosure: I am/we are long FF. 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.