Spotlight on Blending Economics: Crushed Margins

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1 Spotlight on Blending Economics: Crushed Margins By Isaac Perkins Times appear tough for ethanol blenders. As the global oversupply of hydrocarbons continues to pressure energy prices, use of ethanol as an additive in the U.S. fuel stream is becoming increasingly uneconomical. But do economics matter? This article examines the dynamics driving the domestic blending market to determine whether ethanol s presence in the supply chain is as precarious as it seems. 1 Brown Brothers Harriman COMMODITY MARKETS UPDATE

2 Ethanol as a Blendstock Ethanol is an alcohol made from the fermentation of starchbased sugars found in everything from sugarcane to sawdust. Long distilled as an intoxicant, the product s value as an energy source was not fully realized until the mid-19th century, when it entered into limited use as a combustible. That said, the intricate process required to distill ethanol in volume, paired with the relative abundance of hydrocarbons worldwide, meant that investment into the biofuel as an alternate fuel source remained economically impractical until well into the late 1990s. Ethanol s shift from marginal to mainstream occurred in the early 2000s, when it came into widespread use as an oxygenate and octane enhancer after the primary alternative at the time methyl tertiary butyl ether (MTBE) was banned for contaminating groundwater. 1 At that point, ethanol was already supplying a small portion of U.S. blending requirements, as the government had been subsidizing the industry on a small scale for years. While the product was already well positioned to fill the void left by the MTBE ban, it gained an additional competitive edge in 2005, when the federal government passed the Energy Policy Act, which mandated that the renewable fuel be blended into the domestic gasoline pool in increasing amounts over the next decade. As may be expected, this mandate and its successors (the Energy Independence and Security Act and the Renewable Fuel Standard) prompted rapid expansion in the ethanol industry, and, in a few short years, ethanol went from being an obscure eco-product to the country s primary octane-enhancing blendstock. Ethanol Industry Today Blends of gasoline containing 10% ethanol now account for more than 95% of the fuel consumed by gasoline engines in the United States, according to the Energy Information Agency. 2 This amounts to roughly 13.7 billion gallons of fuel ethanol blended into gasoline each year, which is supplied primarily by the 195 ethanol plants operating in the country. 3 1 Oxygenates: Oxygenates are added to hydrocarbon (hydrogen and carbon) fuels to effect a cleaner burn. Octane enhancer: A fuel s octane rating refers to the amount of compression it can withstand prior to combusting. Ethanol, an octane enhancer, has an octane rating that is higher than regular gasoline (113 vs. 83, respectively). (Source: Renewable Fuels Association.) 2 Note: All gasoline engines can run off of a 10% ethanol mixture E10; however, some automakers have yet to approve the use of higher ethanol blends such as E15 in their vehicles. 3 Source: U.S. Department of Energy. The majority of these plants are located in the corn belt of the American Midwest and rely on corn as their primary feedstock in the ethanol distillation process. As such, the economics driving ethanol production are heavily reliant on the combined sales price of ethanol and dried distillers grains 4 (the process s two output products) relative to the price of corn (the primary input) that is, the crush margin. Several successive years of bountiful corn crops of which America is the largest producer in the world have kept input costs down, allowing ethanol producer margins in most parts of the country to remain healthy. In short, falling corn prices have helped keep crush margins in the black for ethanol producers, even amid falling hydrocarbon prices, which reduce the economic incentive for blenders to maximize ethanol content per gallon of gasoline. Crush Margin Economics ($/bu equivalent) Feb-14 Aug-14 Feb-15 Aug-15 Feb-16 Aug-16 DDGs Ethanol Corn Crush Margin Source: Bloomberg and BBH Analysis. Blender Margins While ethanol producer margins have been resilient, the economics are less rosy on the blending side of the value chain. In the past two years, the deterioration of the energy complex has caused petroleum-based blendstock prices to plummet. Ethanol, meanwhile, has more closely tracked the price of corn in this timeframe, meaning that the spread between the biofuel and motor gasoline, or blend margin, has compressed materially to the point of being negative as of the publication of this article. Put simply, it currently costs more in pure economic terms for a blender to add ethanol to its motor gasoline than it does to omit the product altogether. 4 Dried distillers grains, or DDGs, are a nutrient-rich byproduct of the ethanol distillation process sold as a 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. Issue

3 Ethanol Blend Margin Evolution Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Blend Margin Ethanol RBOB Source: Bloomberg. Ignoring the federal mandate compliance component of the equation, which introduces compliance credits, or RINs, as a balancing item into the equation, and looking through a purely economic lens, it would appear that the blending of ethanol into gasoline has been negative or breakeven at best for the better part of the past year. However, one could argue that the way in which the domestic blending industry has developed over the past two decades has rendered blending economics outlined herein almost irrelevant. All gasoline sold in the United States must contain both a specific octane level and an oxygenate to effect a cleaner burn. Ethanol is an oxygenate, and adding the octane-rich product to a motor gasoline cocktail is one way to reach the required specifications for commercial-grade gasoline. This is where the equation gets complicated. As a result of the federal bans and subsidies outlined in this article, ethanol is currently the only additive available in the volumes necessary to satisfy the octane and oxygenate requirements of the domestic blend pool. Debate abounds as to whether continued government support for the ethanol industry has suppressed the development of any rival additive. While there are potential substitutes, such as isobutane and tert-amyl methyl ether (TAME), significant investment and research would be required before either was a viable alternative to ethanol on a national scale. In the absence of any notable competition, ethanol s use is guaranteed by the fact that it is the only product available to fulfill a crucial function in the domestic blending chain. Thus, while current blend economics may appear shaky, ethanol s footing is surprisingly stable. To the extent that it remains the cheapest, most readily available oxygenate in the domestic market, the biofuel s position in the supply chain is unlikely to change. 3 Brown Brothers Harriman COMMODITY MARKETS UPDATE

4 Put simply, it currently costs more in pure economic terms for a blender to add ethanol to its motor gasoline than it does to omit the product altogether. Issue

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