Ethanol Bust

The world doesn't stop when you're on vacation, and I will be playing catch-up for some time, between the implications of the US election, a report from the International Energy Agency on chronic under-investment in new oil and gas capacity, and several other noteworthy developments. Although it doesn't quite rank with a new US president, the Chapter 11 filing by ethanol giant VeraSun seems like a good place to start, because it represents an important warning sign for a sector that was already badly strained by rapid expansion and weak margins, even before the financial crisis and accompanying precipitous drop in commodity prices put it on the ropes. The corn ethanol industry owes its existence to government policy, but policy alone can't shore up its inherent shortcomings, or give it the resilience to withstand the kind of shock that is currently propagating throughout the economy.

In many ways VeraSun exemplifies the US corn ethanol sector under the present system of federal renewable fuel mandates and price subsidies. In 2006 VeraSun operated two ethanol plants with combined capacity of 230 million gallons per year (MGY) of ethanol. After an aggressive program of new construction and its 2007 acquisition of US BioEnergy Corp., its capacity stands at 1,420 MGY from 16 plants, with another still under construction. That's 250% compound growth over two years. During the same interval, the price of corn spiked from $3 per bushel to $7 this summer, and then fell back below $4, while gasoline prices went from the low $2s to over $4 per gallon, recently returning to the mid-$2s. The combination of rapid growth and falling, volatile margins explains the company's current status.

Any number of companies have operated successfully during Chapter 11 and emerged to restored profitability. VeraSun has at least gotten off to a good start, lining up the financing that will be necessary to enable its facilities to continue buying feedstock and paying their bills. However, the larger question is whether the underlying factors that put VeraSun into bankruptcy will change sufficiently to allow them eventually to emerge, or if this measure can only keep them on life support until a better-capitalized firm can take over its assets. The prospects are decidedly mixed.

As long as the economy remains weak, fuel demand is unlikely to pick up, and so the price of the commodity for which ethanol is intended to substitute, gasoline, could remain around current levels. Pipeline gasoline from Gulf Coast refiners now sells for under $1.50/gal. Ethanol is currently over-supplied, relative to the mandated blending requirement, and unless a number of plants now under construction are delayed or halted, that situation could persist for several years. In addition, the blenders' credit is due to drop from $0.51/gal. to $0.45/gal. in January. None of this bodes well for the return of healthy "crush spreads", the margins ethanol plants earn from turning corn into fuel.

At the same time, ethanol remains a cornerstone of federal energy policy, and that role could expand in the new administration. During the campaign, Senator Obama spoke many times of the need to increase biofuel production, in order to reduce our reliance on imported oil. While much of that increase is intended to come from advanced technologies that turn non-food biomass into fuel, most of those processes are still either experimental or extremely expensive, relative to $60 oil. It remains to be seen how they can contribute the expected 21 billion gallons per year by 2022, or whether conventional ethanol will have to expand beyond its contemplated 15 billion gallon maximum to achieve the overall 36 billion gallon biofuels target.

So we have the paradox of a product that we've decided is essential for energy security and environmental reasons--as well as for the continued viability of the US agricultural sector--but that might not be profitable to produce in the desired quantities, at current prices. The government has already raised the possibility of federal assistance for ethanol producers that made bad bets on corn futures. If VeraSun were unable to continue operations during bankruptcy--and its is only the biggest of several recent ethanol bankruptcies--an ethanol shortage could develop, forcing the government to intervene. While it has the authority to issue waivers to oil refiners and gasoline blenders to sell fuel with less than the mandated quantity of ethanol, that was intended as a temporary measure. Perhaps I'm the only one to see a possible parallel to banks that are considered "too big to fail", or to the way the Federal Reserve has engaged in matchmaking to put failing banks into stronger hands, but I see the possibility of much larger ethanol subsidies ahead. At the very least, the combination of $60 oil and tight credit has called the architecture of the government's future renewable fuel policy into question.