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Watch for Falling Ethanol Profits

Ethanol prices have fallen in the last couple of weeks, but that hasn't stopped the industry from seeing off-the-chart profitability in recent weeks and months. Is it sustainable? One expert says that's not likely.

For a typical Corn Belt ethanol plant and the grain keeping its processing underway since early February, per-bushel corn profits for that grain flowing to an ethanol-maker has been on a major roller coaster; early February saw profits at $4.50 a bushel, then that number backed off by almost $3 per bushel and has since settled around $2 a bushel, says Scott Irwin, University of Illinois Extension ag economist. That's still yielding some major industry profit levels: That average plant, Irwin says, netted a $23.4 million profit in the first third of this year, the highest such level in the industry's history.

"The reason for the spike in profits is simple. Ethanol prices at plants spiked to new record levels exceeding $3 per gallon, while only modest increases in corn prices occurred. More specifically, ethanol prices increased 63% between the end of January and end of March, while corn prices increased just 8% over the same period," Irwin says, adding that high gasoline prices, strong ethanol export demand, low ethanol stocks, and the harsh winter weather in the U.S. are some of the factors that contributed to the spike. "It does not appear that a single factor accounts for the majority of the price rise, but instead, the combination of factors was something of a perfect storm."

So back to the initial question: Is it sustainable? Irwin argues no. Basic "economic logic" dictates one of two things will happen next: Either corn prices will have to rise or ethanol prices will have to fall, creating the equilibrium that's typical of any market like ethanol.

"Profits have already declined almost all the way back to where they stood at the beginning of the year. Nonetheless, profits of $1.45 per bushel remain at a very high level by historical standards. Economic logic still dictates that this situation is not likely to last. There is a documented 'co-integrating' relationship between ethanol and corn prices, which simply means that the relationship between ethanol and corn prices tends to revert to levels implied by an equilibrium long-run level of ethanol production profitability. If the ethanol price is too high relative to corn prices, then either the ethanol price must fall or the corn price must rise," Irwin says. "Over 2007-2013, ethanol production profits averaged $0.20 per bushel. Assuming this is the 'normal' level of profits in the industry, then we should expect profits to eventually fall from the current level of $1.45 to $0.20. If ethanol prices do all of the adjusting and other prices are held constant, the ethanol price would have to drop from the current level of $2.23 per gallon to $1.78 ($2.23 - $1.25/2.8) to restore equilibrium."

That's just if ethanol prices do all of the adjusting. What if corn prices move higher?

"The corn price would have to increase from the current level of $4.95 per bushel to $6.20 ($4.95 + $1.25) to restore equilibrium (not taking into account the impact on DDGS prices)," he adds. "For any particular episode it is difficult to know whether ethanol or corn prices will bear the brunt of the adjustment, but if corn prices now tend to drive ethanol prices due to the E10 blend wall, then one would expect ethanol prices to do the bulk of the adjusting."

Though these numbers paint a pretty clear picture, there are a few variables that could cause them to shift one way or another on the profitability scale, namely other associated costs and what they could mean to the industry's bottom line, one way or another.

"There is substantial variation in capacity and production efficiency across the ethanol industry, and this should be kept in mind when viewing profit estimates from the model. The analysis assumes that input purchases and output sales occur at the spot prices for the week, which means that the impact of forward marketing strategies is not incorporated," Irwin says. "Third, some ethanol plants may not have been able to take full advantage of the high ethanol prices this winter and spring due to railcar shortages."

Ultimately, look for ethanol prices to take on most of the price shift to restore the necessary equilibrium for the industry to stay on track, the economist says.

"Ethanol production profits literally went off-the-chart in late winter and early spring. This was driven by a sharp increase of ethanol prices to new record levels due to a combination of factors. Economic logic suggests this situation is unsustainable, and either ethanol prices must adjust lower or corn prices higher to restore a long-run equilibrium in profitability," Irwin says. "The most likely scenario is one where ethanol prices bear the brunt of the adjustment, eventually dropping as much as $0.40 per gallon from present elevated levels."

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