Ethanol Shakeout?

Starting in August, while crude oil prices were breaking out of the high $60s and heading for the $80s, ethanol prices fell off a cliff. The Chicago Board of Trade ethanol contract has dropped from around $1.90/gallon to scarcely above $1.50, and both the New York Times and Wall Street Journal are proclaiming that the ethanol boom has stalled, if not actually ended. As a result oil refiners and gasoline blenders--at least those in the Midwest--can actually reduce their costs by blending ethanol into fuel, though they can't get enough because of various transportation bottlenecks. However, while our grain ethanol energy policy has serious drawbacks, it would be a mistake to conclude from current conditions that we've reached the end of this trend, instead of encountering a routine and entirely predictable outcome of an expansion that got ahead of the underlying demand for its product.

Ethanol producers might not appreciate the comparison to the oil refining business, but having participated in the latter during three decades, I see many familiar features in the margin squeeze that ethanol processors are now experiencing. Investing in capacity to take advantage of high current prices always undermines its own economic driving force, by increasing competition for feedstocks and driving down product prices--unless demand is growing faster than capacity. That's evidently as true for ethanol as it has been for petroleum products. At the same time, though it's not immediately obvious from the way that its capacity costs are quoted, at around $2/gallon of annual output, ethanol has a highly capital-intensive manufacturing process. Translate that figure into oil terms--see Friday's comments on the plague of units of measurement affecting energy--and it exceeds $30,000 per barrel per day of capacity. Ethanol distilleries may come in smaller packages, but their capital cost is on a par with a complex oil refinery.

But while the markets for petroleum products reflect the impact of various fuels regulations, the ethanol market owes its very existence to regulations, including the direct $0.51/gallon blending subsidy and the EPA's renewable fuel standard (RFS) regulation that went into effect this year--a product, incidentally, of the same Energy Policy Act of 2005 that has come in for so much criticism from alternative energy advocates. The problem, however, is that at current annualized production of 6 billion gallons per year, the US ethanol industry has already hit the 2009 RFS target and thus can't look for any help on pricing from that mandate for a couple more years. In other words, ethanol is now in a gap in which market economics dominate.

So aside from all the logistical problems that result from ethanol's incompatibility with the long-haul legs of the petroleum products infrastructure, we are already seeing a classic overcapacity crunch in an industry that has just started gearing up for a much bigger expansion toward the limits of US corn ethanol output, somewhere between 12-15 billion gallons per year. Even if the conference version of Congressional energy legislation doesn't expand the RFS target to 36 billion gallons, as proposed in the Senate's version in June, the market for ethanol has additional headroom, but not until it has digested the recent additions and added enough rail cars and other supply and distribution assets. This timing problem will create severe challenges for startups and under-capitalized firms, and some big opportunities for the scale players. As the Journal suggests, we'll probably see a combination of project cancellations and some industry consolidation, but the survivors will need to think very carefully about the likely future level of ethanol margins, when the fuel will consume up to 30% of the US corn crop. As those who've been around the petroleum downstream for a while can attest, profitable growth can sometimes become an oxymoron.