For Ethanol, Conditions Are Changing And Positive

Summary

• Post record lows seen in April, gasoline demand has rebounded in recent weeks and might likely improve from here, with all 50 states having gradually re-opened.
• Ethanol production in April, which had fallen c.46% below the long-term average, continues to be adversely affected, with only c.30% of the country’s 204 plants running at normal capacity.
• Other potential tailwinds include regulatory support for higher ethanol content in fuels and opportunities in the export market, especially in some of the previously lost markets of China and Europe.
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"It seems that the worst may be behind us" - Geoff Cooper, Renewable Fuels Association

Here’s a little stat that surprised me the other day - apparently, 80% of US gasoline consumers are unaware of the fact that ethanol is included in this fuel! Well, that’s according to a study conducted by The Renewable Fuels Association. That little trivia aside, I’ve been watching developments in this biofuel segment over the last few months and I can see that economic conditions here are now turning for the better. And if you follow me on Twitter or subscribe to The Lead-Lag Report, you’ll know that I’ve always been guided by conditions, above all.

So, what are these conditions in the ethanol segment that have caught my attention? Let me elucidate.

COVID-19 impact and developments since

Whilst ethanol also has some industrial applications, in the US, it is primarily used as a blending agent in gasoline. As with most other industries, the ethanol industry was grossly affected by the pandemic conditions in the spring season, precipitated by stay-at-home mandates which saw gasoline demand plummet.

Source: Pacific Ethanol Inc.

To put things into perspective, the average weekly gasoline consumption over the last 5 years (from 2014-2019) was 9.12 million barrels. By the second week of April, demand had crashed to 5.08 million barrels, down by a whopping 44%. This resulted in more than 150 ethanol manufacturing units in the US coming to a standstill. Weekly gasoline production, which had averaged 997,000 barrels a week for the last 5 years (2014-2019), dropped by 46%, to 537,000 barrels a week, by late April.

However, in recent weeks, I have been somewhat encouraged by the production and demand numbers in the ethanol space and think a bottom may now be in place. Firstly, with all 50 states re-opening to some extent, travel behavior and gasoline demand have picked up significantly. Since the demand lows in April, there has been a c.46% pickup in gasoline demand.

Source: US EIA

On the production side of things, ethanol plants are still reeling under pressure. As of last week, more than 40% of the country’s 204 ethanol plants remained offline with only 30% running at the normal output. The remaining units were either completely or partially shut down. Looking at the 4-week average of the weekly gasoline production numbers, one can see that production continued to fall all the way till the first week of May and has only recently begun to inch up.

Source: RFA

In addition to that, since peaking in mid-April at 27.7m barrels, inventory levels have been declining for 4 straight weeks now (by c.14%), dropping to 23.6m barrels, which is more in tune with levels seen at the start of the year.

Source: RFA

As the economy begins to re-open and general locomotion kicks into gear with the start of the summer season, I expect the demand side aspect of things to continue to perk up. I just don’t think the supply side will be able to adjust at the same pace and we might continue to see a drawdown in inventory levels. In fact, recently, I was listening to the Pacific Ethanol (PEIX) earnings call, and management mentioned that a lot of ethanol plants around the country went down hard, laying off workers permanently, making it a challenging proposition to just ramp things up quickly if sustained demand were to come on board as we move through 2020. Thus, any increase in production will likely be gradual, rather than rapid, and this should continue to help rebalance the ethanol market. Just for some longer-term context, do note than ethanol production in the US peaked in 2018 with an annual production of 16.1 billion gallons. Last year, this had declined to 15.8 billion gallons, and this year, on account of the pandemic, the RFA thinks we could have a further c.20% drop-off in production by c.3 billion gallons. All this bodes well for ethanol prices.

Other opportunities for Ethanol

E-15 gasoline variant gaining traction

For the uninitiated, ethanol is primarily used as a fuel oxygenate, which when blended with gasoline allows engines to reduce emissions and meet certain federal and air emission standards. It is also used as an octane enhancer to improve the octane rating of the gasoline with which it is blended. Octane is a measure of fuel performance, or, in other words, the ability of a fuel to resist “knocking” during combustion. Ethanol is regularly used to upgrade lower octane blending gasoline to regular grade and regular graded gasoline to premium grade. In some cases, it is also used as a gasoline substitute.

The commonly used variant of gasoline is the E10 variant (10% ethanol and 90% gasoline). Ethanol stakeholders have been looking to push through the E15 variant (15% ethanol and 85% gasoline) that is cheaper, cleaner and has a higher-octane rating (88) than the E10 variant (84-87), but due to insufficient infrastructure at retail outlets and pump labeling challenges, the former has not become as popular as the latter. The other key hiccup towards greater adoption of E15 was regulation. But this has changed since May 2019. Basically, until last year, E-15 gasoline did not have the same RVP waiver (Reid vapor pressure) as the E-10 variant. This meant that under regulations, it could only be sold from September 16 through May 31. However, last year, the Environmental Protection Agency (EPA) granted the same RVP waiver for E-15, for the summer months, thus kicking out a previously significant barrier towards greater adoption. Since this regulation came into effect, the number of retail pumps selling the E-15 variant has shot up over the last 2 years. As the economy normalizes, the attractive cost, octane-element, carbon benefits and health benefits of ethanol should all continue to drive greater adoption of the E-15 variant.

Source: Green Plains Inc.

Source: Pacific Ethanol, Inc

Fiscal and regulatory push for higher blends of ethanol

Over the last month, I’ve seen some very encouraging fiscal and regulatory developments for the ethanol segment. At the start of this month, the USDA (United States Department of Agriculture) had announced that it would make available up to $100 million in competitive grants under the Higher Blends Infrastructure Incentive Program to support activities designed to expand the availability and sale of ethanol and biodiesel. This should help strengthen the ethanol infrastructure in the country. Then, in mid-May, the House of Representatives passed a COVID-19 bill that included a proposed 45-cent-per-gallon stimulus to support ethanol producers.

In addition to that, last week reports emerged that EPA was looking to scale up its biofuel blending target quotas. As per the proposed ruling (which is currently undergoing White House review and faces a Nov. 30 deadline), the EPA would like fuel refiners to use a higher quota of 5.17 billion gallons of advanced biofuels as against the previous 5.09 billion gallon target for 2020. This should help spur demand for ethanol next year.

Export opportunity

The US is by far the largest producer of ethanol in the world, accounting for c.55% of total global production, followed by Brazil which makes up for c.30%. Countries the world over are largely dependent on ethanol produced from these two countries and ethanol adoption trends in the US tend to get replicated in other countries. I also think we could see an influx of low-carbon fuel policies all over the world.

Source: Statista

There’s been a lot of clamour from global auto companies for high octane fuels to power the next generation of efficient engines, but conversely, world markets continue to be increasingly octane short. On account of the pandemic, exports in Q2 and Q3 2020 will likely be hit, but I think towards the end of the year and by 2021, we should see this pick up (interestingly, ethanol exports in Q1 were quite resilient at 500 million gallons). I am particularly enthused about the ethanol prospect in two regions - China and Europe. As part of the Phase 1 trade deal between China and the US, ethanol shipments will likely see a rebound. Worth noting that on account of the retaliatory trade tariffs between the two countries, prior to the phase 1 deal, tariffs on ethanol were as high as 70%, effectively obliterating demand for the product. This has since been scaled back, and in some ways, China will feel like a new market.

Source: Green Plains, Inc

In Europe, too, there are similar patterns of a previously lost market potentially coming back, although this region might take longer to recover from the pandemic. Due to anti-dumping duties, US ethanol had been banned from the European market from 2013-2019. In May last year, the European Commission repealed these duties which saw ethanol imports surge by more than 3x YoY from 1.15 million hectolitres in 2018 to 3.85 million hectolitres (Source: Eurostat). When the Eurozone moves away from COVID-19, we could see some ethanol import momentum come back here.

How to play ethanol?

Having made my case for ethanol so far, I’d now like to provide some suggestions on how best you can exploit the opportunity here. If you’re looking for an ETF/ETN, one may consider the Elements MLCX Biofuels Index-Total Return ETN (FUE), but this would be a sub-optimal choice as you have exposure to the varied movement of seven other biofuel related commodities. Besides, the expense ratio of 0.75% is quite steep and it’s also quite illiquid.

If you’re in it for the short haul, then maybe consider dabbling in Ethanol Futures (EH=F) directly, although this is a rather risky option on account of leverage. After having bottomed out in April at around $0.80/gal, the price in May has been following a bullish flag pattern and is currently trading at $1.10 with the potential to test the previous resistance zone of $1.30.

Source: Yahoo Finance

In the direct equity space, you may consider US ethanol producers such as Pacific Ethanol or Green Plains Inc. (GPRE) that could benefit from ongoing gasoline demand and federal support. On the weekly chart, PEIX has seen a breakout after forming a base. GPRE is the second-largest producer of ethanol in North America and the stock’s chart pattern has been closely following that of ethanol futures over the last few weeks. Alternatively, if you want some diversification away from American ethanol, and considering how the Brazilian Real continues to depreciate, you may also want to consider Adecoagro SA (AGRO) - a Brazil based ethanol producer whose export situation could look rather favorable.

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Analyst’s 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.

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Comments

[squirrl22]

Overall pretty good, but a couple missteps here: 1. The House Covid bill that grants .45 cents /gallon to ethanol companies is so full of surplus graft, it is DOA in the Senate.
2. Ethanol companies can ramp far faster than Neil led on in the PEIX call- plants regularly go down for annual routine maintenance for 2-3+ weeks per year, and it only takes a week or so to get them back up and running.
3. China has clearly signaled they have no intention of honoring their trade agreement, so forget ethanol exports to China.
4. The level of surplus Ethanol in storage is still HUGE, and even with the ramp up in demand, will take well into 2021 to bring down to a reasonable level..
5. You need to explain to your readers what is happening to the Brasil ethanol market, because it has a major impact on the USA export market.

[krk]

Any opinion on ADM which gets 30% of its operating profits from Ethanol?
Has been planning to spinoff its ethanol biz but not sure how fast will be able to under current conditions.