The Ethanol Sector's Catch-22

Includes: ADM, GPRE, PEIX, REX
by: Tristan R. Brown

The share prices of independent U.S. ethanol producers are in positive territory in November to date, marking a reversal of the price behavior that has predominated since the summer.

While Q3 earnings have been mixed so far, investors have cheered the recent upward movement of ethanol prices in both absolute and relative to gasoline bases.

The outlook for ethanol producers remains poor, however, as ethanol margins are becoming detached from gasoline prices due to the prevailing demand and policy conditions.

The share prices of independent U.S. ethanol producers Green Plains, Inc. (GPRE), Pacific Ethanol (PEIX), and REX American Resources (REX) are all in positive territory for the month of November to date (see figure). This is a notable accomplishment given their weakness in recent months and the fact that their Q3 earnings reports began to roll out at the end of October. While Pacific Ethanol recorded its seventh-straight quarterly EPS loss and its second-straight EPS miss, news that prompted the company to follow up with the announcement that it is idling 10% of its capacity due to low margins, Green Plains reported a sizable EPS beat (albeit in the process of extending its negative quarterly EPS streak to seven as well). An additional optimistic data point was provided at the end of October when the price of ethanol regained its premium over that of gasoline on an energy-equivalent basis for the first time in almost three months (see second figure).

Chart GPRE data by YCharts

Relationship between the prices of ethanol and gasoline on an energy-equivalent basis. Sources: CARD, EIA (2018).

The way that the respective producers' executives described the sector's outlook during the subsequent earnings calls presented a very different image, however. The CEO of Green Plains noted that "even our best plants" are struggling to achieve positive margins due to low fuel prices and high ethanol inventories, then pointed out that Chinese imports could have eliminated the U.S. ethanol glut but for the Trump administration's trade war with that country. ADM's (ADM) CEO maintained this theme in that company's earnings call by stating that even the recent production curtailments are "probably still not enough" to eliminate the current oversupply and restore the historical ethanol price premium.

Why, then, is the price of ethanol gaining relative to the price of gasoline? The answer is that this new development is occurring because conditions in the ethanol sector are actually getting worse. Indeed, ethanol producers are increasingly finding themselves caught in a Catch-22 situation that is unlikely to be quickly alleviated.

Ethanol has historically traded at a price premium over gasoline because the former has had to be blended at an approximately 10 vol% ratio to gasoline, whereas no such requirement has existed for gasoline consumption. Ethanol also provides value as an octane enhancer. These two factors have caused ethanol to trade at an average premium of 27% over the price of gasoline on an energy-equivalent basis since 2012 (this premium is larger still on a volumetric basis due to ethanol's low energy density relative to gasoline).

That premium weakened earlier in the year after the U.S. Environmental Protection Agency [EPA] announced that it was taking steps to reduce the ethanol blending mandate before completely disappearing in Q3. The timing could not have been worse for ethanol producers. Summer demand for gasoline declined for the first time in several years in response to rising prices, causing ethanol demand to come in under producers' expectations. The usual export markets are no longer as open to U.S. ethanol as they have been in the past due to trade tensions, however, resulting in a domestic ethanol glut. Worse, the weakening of U.S. gasoline demand also caused a domestic gasoline glut to develop and gasoline prices to decline by more than 20% from their 2018 peak (see figure).

Chart RBOB Gasoline Futures Contract 1 data by YCharts

Under normal circumstances the blending mandate would have caused ethanol prices to rise relative to gasoline prices so as to ensure that sufficient production was occurring to allow compliance with the mandate's volumes. That backstop is no longer as strong as it has been in the past, though, and ethanol prices fell by 21% between May and October compared to a 9% decline to the price of gasoline over the same period. The price of ethanol has rebounded both in absolute terms and relative to gasoline over the last two weeks, but only by enough to keep the corn ethanol crush spread from turning negative (see figure).

Sources: CARD, EIA (2018).

The important question for ethanol producers is whether or not the return of the ethanol price premium means that the sector has found the new backstop level under the weakened blending mandate. Early indications are that it does not. The mandate is backed by blending credits known as Renewable Identification Numbers [RIN]. RIN prices increase when the mandate is strong so as to incentivize additional biofuel production under it. They decline, on the other hand, when the mandate is weak because no such incentive is needed. The price of D6 RINs, which is the only category that corn ethanol qualifies for, have collapsed in 2018 to date to $0.08, the lowest level in almost six years (see figure). The price has stabilized in recent weeks but still represents a decline of 50% since October 1. At this point D6 RINs are trading for little more than their transaction cost, meaning that ethanol's current premium over gasoline is due to its limited value as an octane enhancer.

Source: EcoEngineers (2018).

Therein lies the Catch-22 that the ethanol sector currently finds itself facing. Reduced demand for gasoline means that the ethanol glut will only decline if gasoline prices fall to the point that overall fuel consumption begins to rebound, in which case the transportation sector will be able to absorb more ethanol. Ethanol margins would turn negative in such a scenario unless the ethanol premium rebounded, in which case ethanol demand would weaken and the ethanol glut would persist. Negative margins would cause ethanol producers to, at least in the cases of Green Plains and Pacific Ethanol, record negative earnings at a time when their cash reserves are dwindling (see figure). (That of Green Plains is comparatively hefty, but only because of recent asset sales, the proceeds of which are intended to be used to allow the company to reduce its exposure to the ethanol sector.) Higher gasoline prices, on the other hand, would further reduce ethanol demand via lower gasoline consumption but, in the absence of a strengthened mandate, without providing much support for ethanol demand.

Chart GPRE Cash and Equivalents (Quarterly) data by YCharts

Ethanol executives sounded despondent in the Q3 earnings calls for a reason: barring an unexpected strengthening of the biofuels mandate by the Trump administration, the outlook for ethanol margins remains poor regardless of how the underlying gasoline prices behave. Expect the sector's tough conditions to remain in place for the foreseeable future.

Disclosure: I/we 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.