Distilling Ethanol Economics

Transcription

1 Distilling Ethanol Economics By Isaac Perkins Ethanol has come a long way from its roots as a Washington, D.C.-subsidized green project. In fact, 2015 is expected to be the first year in recent history in which consumption of the product will exceed government-mandated levels, putting an end to speculation that demand for ethanol would vanish without help from Washington. But is the U.S. ethanol industry really self-sufficient or just a preferred option in a highly regulated market? In this article, the CMU examines the American ethanol industry in an attempt to establish definitively whether economics or regulation is the primary driver of the success of the agribusiness sector s newest golden child. 4 Brown Brothers Harriman COMMODITY MARKETS UPDATE

2 History The events precipitating ethanol s meteoric rise as the primary oxygenate (see the Oxygenates as Octane Boosters section below) in the American gasoline market are somewhat coincidental. Long distilled as a cheap spirit (read: moonshine), corn ethanol s potential uses as an alternate fuel source were discovered in the mid-19th century. Henry Ford s first Model T was in fact a flex-fuel car, as it could run on gasoline, ethanol, or a mixture of the two. But conventional ethanol consumption failed to take off in the early years of industrial America, due largely to the growth of the petroleum industry, which flooded the domestic market with cheap hydrocarbons, making investment in biofuels or any alternate fuel source economically impractical. The product s transition from marginal to mainstream began in 2005, when use of methyl tertiary butyl ether (MTBE) which had replaced lead as an octane-enhancing additive in the late 1970s was, like its predecessor, found to be toxic and consequently banned. At that point ethanol was already supplying a small portion of American blending requirements, as the government had been subsidizing the industry on a small scale for years, both to foster domestic energy independence and support the farming sector. As a result, the infrastructure needed to fill the gap left by MTBE was already partially built. But the fact that ethanol, rather than one of its substitutes, was adopted as the chief oxygenate in the U.S. was largely due to the Energy Policy Act of 2005 and its successors, the Energy Independence and Safety Act of 2007 and Renewable Fuel Standard (RFS) program. 1 This legislation mandated that gasoline sold in the U.S. contain an increasing Oxygenates as Octane Boosters: What and Why Oxygenates are chemical compounds, generally falling into the alcohol or ether categories, which contain oxygen. These compounds are employed as gasoline additives to affect a cleaner burn during the hydrocarbon combustion process that powers most vehicles, thereby reducing carbon monoxide and particle (i.e., soot) emissions. Much like lead, oxygenates increase a fuel s octane rating, which keeps an engine from pre-ignition or knocking. Use of oxygenates as octane boosters in motor gasoline has been required since the Clean Air Act was passed in percentage of renewable fuel. The consequence of this federal intervention is predictable: ethanol went, in a few short years, from being an uneconomic, sidelined product to virtually the only player on the field. American Ethanol Consumption in million barrels % Ethanol Blending (mbbl, LHS) Source: U.S. Energy Information Administration (EIA) RFS 1 SIGNED INTO LAW, ENERGY INDEPENDENCE & SECURITY ACT FOLLOWS ENERGY POLICY ACT OF 2005 INCREASES BIOFUELS REQUIREMENTS MTBE BANNED AS AN OXYGENATE IN THE U.S. Present Day Today, there are approximately 200 ethanol plants operating in the U.S., with an aggregate nameplate capacity of around 14.7 billion gallons of product per annum. 3 The majority of these plants are located across the corn belt of the American heartland, having been built in the mid-2000s to meet the rising blend demand engendered by the mandates noted previously. Corn/Ethanol Crush Margin Evolution Crush Margin ($/bu) Ethanol ($/gal) Corn ($/bu) Ethanol Blend Rate (%, RHS) 0.0 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Source: Bloomberg 1 Refer to the Q edition of the Commodity Markets Update for additional details on the RFS program. 2 Source: Renewable Fuels Association (RFA). 3 U.S. nameplate capacity as of January 1, 2015, as per the U.S. Energy Information Administration. 12% 10% 8% 6% 4% 2% October

3 Crush Margins Generally speaking, the production economics, or crush margins, driving these plants are based on the price of the process s input product (i.e., corn) and output products (i.e., ethanol and dried distillers grains [DDGs] 4 ). One bushel of corn costs roughly 40 cents to distill and produces 2.8 gallons of ethanol and 17 pounds of DDGs. Therefore, corn distillation into ethanol will be remunerative as long as a plant s corn and production costs remain below that of its finished products. With corn prices currently hovering around multiyear lows and government forecasts calling for domestic corn stocks in the 2015/2016 harvest cycle to be almost as heavy as they are currently, all signs point to lower corn prices in the near future. Plentiful corn means lower prices; lower prices mean favorable input costs for ethanol producers; and favorable input costs are half of the equation to a healthy industry. The output side of the balance is slightly more complicated. While ethanol and DDG demand are relatively stable due to a government mandate and growing global protein consumption, respectively their prices are volatile. 550 ¼ cents per bushel, without any accompanying move in ethanol or DDGs, for producer margins to shift into negative territory. This scenario is dually unlikely, as it supposes both that corn prices move to levels last seen in the crop failure year of 2012/ and that the price of ethanol and DDGs not track their input product in the event of a major price shock. Given the abundant corn supply expected in 2015 and the fact that ethanol prices are stable at current stock levels, the nearterm outlook for ethanol producers looks positive. Ethanol Blend Margin Evolution USD/gallon Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Blend Margin Ethanol RBOB (Reformulated Blendstock for Oxygenate Blending) Source: Bloomberg In the past, ethanol prices have intermittently tracked those of both corn and gasoline. The rout of the energy complex seen in the past few months paired with the corn market fundamentals described previously have certainly not been supportive of ethanol prices. However, one need not look any further than the preceding graph to appreciate that the ethanol market is its own master. While its price may at times follow those of related commodities, it is ultimately driven by a unique set of fundamentals and underpinned by demand guaranteed through a government mandate. These fundamentals have been present for the entirety of Ethanol stocks in the U.S. are at near-record highs for this time of year and, barring any major supply disruption, should remain that way for the near future. This oversupply has been a drag on prices, which have been at five-year lows for the majority of Nevertheless, even with low ethanol prices, corn remains so cheap that ethanol distillation, at least in the near term, is profitable. As a matter of fact, using the crush margin calculation outlined earlier, corn prices would have to appreciate approximately 30%, to Blend Margins While production margins remain robust, the economics behind ethanol consumption are slightly tighter. Mandate aside, ethanol is an additive to gasoline. Blending it into the gasoline supply is the economic equivalent of adding peanuts to bar mix a costeffective way to increase marketable supply without materially changing the nature of the end product. But the price of ethanol must remain below that of gasoline and competing additives for blenders to be economically incentivized to use it. As is evident from the previous chart, the spread between the price of gasoline and ethanol or blend margin has remained primarily positive in the past five years, giving blenders an economic incentive, mandate or not, to mix ethanol into their gasoline. 4 DDGs are a nutrient-rich byproduct of the ethanol distillation process that are sold as premium feed to livestock farmers. For the purposes of this article, the economics of the dry-milling process will be considered. A substantial portion of domestic ethanol is produced at wet mills, which also yield corn oil as a byproduct of the crush process. 5 The result of the worst drought in the American corn belt in 50 years. Refer to the Q edition of the Commodity Markets Update for further discussion on this topic. 6 Brown Brothers Harriman COMMODITY MARKETS UPDATE

4 That margins are positive for blenders is important, as it provides less of an incentive to explore alternative options to ethanol. But to say the use of ethanol is solely price or mandate driven would be inaccurate, as ethanol consumption in the U.S. is a complex amalgamation of economics, compliance, and necessity. For current economics to change, the price of ethanol would have to appreciate materially, or that of gasoline would have to plummet. Considering the latter, and using RBOB 6 as a proxy for U.S. gasoline at the refinery, gasoline would have to fall another 40 cents per gallon, or 20%, without the price of ethanol moving at all for blenders to begin losing money by mixing ethanol into their motor gasoline cocktail. Given the average correlation between RBOB and Brent crude oil seen in 2015, this would equate to global crude oil prices of approximately $44 per barrel (Brent closed at $50 per barrel on September 2, 2015). With crude prices near or below the cost of production for many of the world s marginal producers, substantial, prolonged downside in the energy complex seems unlikely. Ethanol would therefore have to price itself out of the equation for blending to lose its economic viability. But given the relatively bearish fundamentals discussed, a sustained jump in the price of ethanol seems equally implausible. The combination of an energy complex that seems to be bottoming and heavy fundamentals on the ethanol side should comfort blenders in the U.S.; near-term margins will likely remain strong. Having said this, there is some fine print in the discussion of ethanol blend economics that should not be ignored. Internal combustion engines require oxygenated gasoline. As a result of government bans and subsidies, ethanol has become, for better or worse, the sole product in the U.S. available in the quantities needed to supply this requirement. The debate as to whether mandated use of this product is stifling the development of rival oxygenates is beyond the parameters of this article, but the point stands that ethanol use, while mandated, is also guaranteed by the fact that it is the only oxygenate currently available to the domestic blending industry. That margins are positive for blenders is important, as it provides less of an incentive to explore alternative options to ethanol. But to say the use of ethanol is solely price or mandate driven would be inaccurate, as ethanol consumption in the U.S. is a complex amalgamation of economics, compliance, and necessity. Conclusion Having explored the economics driving both the production and consumption of ethanol in the U.S., let us now return to the question posed in the onset of this article: is ethanol sustainable as a stand-alone industry? The numbers provided seem clear enough. Producers in the U.S. will be incentivized to distill ethanol so long as domestic corn supplies remain abundant and demand sustained. Demand will remain sustained as long as ethanol is both cheap and the only available domestic oxygenate. Absent from this arithmetic is any mention of a blending mandate, and this is intentional. The equation no longer needs a balancing item. 6 Reformulated Blendstock for Oxygenate Blending, or RBOB, is the benchmark form of gasoline traded on the New York Mercantile Exchange. October

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