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Ethanol: at the cliff's edge?

Whatever you think of ethanol, it could well be the most emotional fuel on the planet. Midwestern farmers have invested in ethanol plants and see it as energy that's green and homegrown. Environmentalists who dislike corn despise ethanol even more, blaming it for soil erosion and deforestation. And critics in Congress who view the industry as coddled have finally succeeded in ending its 45¢-a-gallon volumetric ethanol excise tax credit (VEETC). It expires on December 31.

But visit the farms of Jeff Taylor in Gilbert, Iowa, or Paul Kenney of Amhearst, Nebraska, and you'll find a surprisingly upbeat view of the industry's prospects.

Kenney, chairman of the farmer-owned KAAPA Ethanol near Minden, sees challenges ahead but nothing unmanageable.

“I guess I'm somewhat optimistic,” Kenney says as he's combining soybeans. “You know we've still got a great product that doesn't pollute the environment and creates jobs.”

In recent years, KAAPA Ethanol has decided to invest as partial owners in two other ethanol plants, a 54-million-gallon plant in Lima, Ohio, and a 110-million-gallon plant in Janesville, Minnesota, originally built by the bankrupt VeraSun Energy.

And although livestock producer groups are trying to weaken the federal mandate to use ethanol, the renewable fuel standard, Kenney isn't among the cattle producers behind that effort. He feeds distillers' grains to the calves from his 400-cow herd. “I hate it when one area of agriculture is pitted against another,” he says. “What's big oil doing to us?”

Taylor's yield monitor was showing better than 50-bushel beans as his combine wrapped up a field near his Iowa farm. He, too, was optimistic about Lincolnway Energy's prospects. After high corn prices squeezed margins into negative territory in the third quarter, profits returned. “I think we will have finished positive for the whole year,” he says.

The Nevada, Iowa, plant has other sources of revenue. It sells carbon dioxide to a local meat processor that uses it to freeze its products. It extracts corn oil that is sold to biodiesel plants. It's looking at using a boiler that burns coal to burn waste from a cellulosic ethanol plant planned nearby, if such green sources of energy are also profitable.

Nor is Taylor too worried about the end of VEETC.

“I think we have felt that if we lose VEETC, there would be a short period of time when the margins would be tight, and then we would be OK,” Taylor says.

Market aided by exports

Experts on the industry seem to agree, for several reasons. Futures prices of gasoline and ethanol suggest that ethanol will remain cheaper than gas even without VEETC. (See chart on next page.) Operating margins should remain in the black for a few months, at least. And the U.S. has become the Saudi Arabia of ethanol, exporting to Canada, Europe, Brazil, and even the Middle East.

“That's what's supporting the price of ethanol. We're on track to export a billion gallons this year,” says Wally Tyner, a Purdue University economist who is a national authority on biofuels.

The federal mandate for corn ethanol use this year (the renewable fuel standard, or RFS2) is 12.6 billion gallons. The industry is making about 13.8 billion gallons. Some 200 million of that is going to E-85 (85% ethanol blends) and the rest to exports. “The reason the industry is not in dire straits with a blend wall of 12.6 billion gallons is exports,” he says.

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Based on futures for ethanol and gasoline, this chart by economist Chad Hart shows ethanol remaining cheaper than gasoline even after VEETC expires.

The U.S. has replaced Brazil as the world's ethanol supplier for the following four reason.

● High sugar prices. One of the most volatile commodities is in short supply. In Tyner's career, sugar has cost between 4¢ and 35¢ a pound. In the past 18 months, it peaked at 33¢, and by fall it remained at 25¢. “Half of Brazil's capacity can switch on a dime from ethanol to sugar,” he says. So Brazil is making less ethanol.

● Rising fuel demand in Brazil. Brazil's economy is booming, with car sales up about 7% this year and gasoline use up 10%. With sugarcane ethanol in short supply, Brazil has lowered its own ethanol mandate from 25% to 20%.

● A high-priced Brazilian real. Brazil's costly currency has made all U.S. commodity exports, including ethanol, cheaper on world markets. In early fall, there were signs it was weakening slightly. This competitive advantage for the U.S. and the fact that Brazil has little ethanol to export have handed most of Brazil's old ethanol customers to the U.S.

● Green U.S. energy policies that fail in the real world. There are many, but the one that drives ethanol exports is another part of the RFS2. Sugarcane ethanol meets EPA's requirements for advanced biofuels, which must lower greenhouse gas emissions 50% against gasoline. Corn ethanol doesn't, so the U.S. is importing about 300 million gallons of Brazilian ethanol this year, Tyner says, while we ship a similar amount of corn ethanol to Brazil to reduce its shortage.

Besides watching Brazil's crops this winter, you may want to track prices of sugar and the value of the real. “If the price of sugar falls, the Brazilian real falls, and Brazil gets back in the ethanol market, we could have problems,” Tyner says.

No export collapse yet

Sugar analysts expect tight world supplies at least into next spring. And at Eco-Energy in Franklin, Tennessee, CEO Chad Martin believes the U.S. could export another 900 million gallons of ethanol in 2012. His company is a major ethanol shipper that also handles about 5% of the global market. This year, the top U.S. customers were Brazil, Canada, the Netherlands, the United Arab Emirates, and the United Kingdom. He says exports to Canada will decline in 2012 because some U.S. exporters (not Eco-Energy) were using VEETC to discount ethanol before shipping to Canada. That option ends in December.

Brazil should remain a good U.S. customer, partly because it can't ramp up ethanol capacity quickly. European demand for ethanol should remain strong.

In the long run, though, Brazil has more land available for sugarcane, and processing expansion is starting. BP recently announced plans to quadruple its cane-crushing capacity in five years.

“As you look two to five years out, we believe that dynamic shifts back to Brazil, just because of its land capacity compared to the U.S.,” Martin says.

Unlike corn, sugarcane can't be stored. So Martin expects the U.S. to continue exporting some ethanol to Brazil seasonally even when that country is back in the global market.

Better politics?

Back home, the U.S. ethanol industry faces more obstacles, including a slow rollout for E-15, which is needed as the corn ethanol production mandate tops out at 15 billion gallons in 2015. And that mandate, the RFS2, is under attack in Congress. Livestock groups support a bill introduced by Representatives Bob Goodlate (R-VA) and Jim Costa (D-CA). It would reduce the renewable fuel standard in years of tight supply.

The bill calls for adjusting the RFS2 twice a year, which Tyner thinks would be difficult for EPA. “I think Congress will be reluctant to open up the renewable fuel standard, because once you do, anything can happen.” Interest groups with all sorts of goals would weigh in.

Senator Charles Grassley (R-IA), a strong ethanol supporter, also gives ethanol better political odds. “I think we're in a stronger position on ethanol now, if you accept the defeat we had in June,” he says, referring to a Senate vote to end the VEETC. Grassley thinks the Senate will defeat a House maneuver to delay E-15. He's less certain about extending tax credits for biodiesel, wind, and solar.

Cellulose Still Waiting in Wings

For two years, the EPA has given fuel blenders a waiver from using the cellulosic ethanol mandated by the Energy Independence and Security Act of 2007. Except for small amounts from pilot plants, there isn't any.

Now a report for the National Academy of Sciences predicts that the mandate to use 16 billion gallons of cellulosic ethanol by 2022 will likely fail. Short of a big breakthrough, it will cost more to make than corn-based ethanol. And there's a big gap between the prices farmers want for feedstocks (like corn stover or switchgrass) and what plants will pay.

“We have more than 200 corn ethanol plants producing more than 14 billion gallons of ethanol today. It took 30 years to get there. We have 11 years to reach even higher numbers for cellulosic biofuels,” says Wally Tyner, a Purdue University agricultural economist who cochaired the report effort. “We would need a build rate three times that of corn ethanol.”

Tyner says the report doesn't advocate abandoning biofuels; it shows current knowledge about the costs. Congress requested the report, Renewable Fuel Standard: Potential Economic and Environmental Effects of U.S. Biofuel Policy.

Still, ethanol advocates will remain vigilant. Chuck Woodside, CEO of Kenney's Nebraska ethanol plant, is chairman of the Renewable Fuels Association's board. “We're going to have to continue to reinforce what the renewable fuel standard has done in bringing down the price of gasoline,” he says. One estimate put the savings at 89¢ a gallon in 2010.

Staying competitive

“Long term, we think there are great opportunities here,” Woodside says of his industry. “We're going to have our naysayers and opposition. But even today, we're 18¢ a gallon less than gasoline, so there's still a reason to blend ethanol.”

When the VEETC expires next year, Woodside expects a temporary drop in ethanol demand, partly due to last-minute blending in 2011 for the credit.

Chad Hart, an Iowa State University agricultural economist, sees a similar drop in what he calls the blending advantage. In January, it falls from about 5¢ to 1¢ per gallon of E-10 (or 50¢ to 10¢ for pure ethanol).

“I'm seeing a blending advantage to ethanol even with the VEETC disappearing in 2012,” he says. And based on futures prices for gasoline and ethanol, he sees ethanol becoming 4¢ a gallon cheaper than gas by April 2013.

Futures can also be used to give a rough projection of ethanol profitability, which varies among producers, depending on their debts and efficiency.

“Compared to where we were in August, we're still showing a positive margin and actually a somewhat healthy one,” Hart says. “Looking forward, we see these margins hanging on here until we get into the fall of 2012.”

Woodside says locking those in is less certain. “The last quarter of this year, the margins look pretty decent, but after that they're not,” he says. Margins in spot prices likely will widen later, he says.

One private analysis shows ethanol margins between corn and natural gas inputs, and ethanol and distillers' grains outputs at almost 50¢ a gallon in late 2011 and not quite 36¢ in early 2012. That's about what plants need to cover principal, interest, and overhead, he says.

“We still think there will be opportunities,” Woodside adds. “It's going to be a cyclical business like anything else.”

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