The Ethanol Economic Crisis
AgMRC Renewable Energy Newsletter
Professor of Economics and Energy Economist
Ag Marketing Resources Center
Iowa State University
After two years of exceptional profitability and a year of low to mediocre profits, the ethanol industry entered a period of very depressed returns that began in mid-2008. At this writing (mid-January 2009), the second-largest ethanol producer in the U.S. and the largest one in Iowa (VeraSun) is in bankruptcy, along with at least 5 or 6 other ethanol firms. A bankruptcy court has ordered VeraSun to sell seven of its ethanol plants to help finance its remaining operations. (1) Another plant is in bankruptcy in Ohio that has been offered for sale but has not received acceptable for its facilities. At this writing, about 20 to 25 previously operating ethanol plants are shut down. An additional 15 to 18 plants have been under construction but have temporarily halted construction because of adverse economic conditions in the industry. Construction of some of these is complete or nearly complete. A number of others have cancelled their building plans completely and have decided against initiating construction projects.
Despite the plant closings, about 170 plants across the U.S. are still operating. (2) The Renewable Fuels Association puts operating capacity at 10.58 billion gallons. However, maximum capacity of these plants is about 11.2 billion gallons of ethanol or about 4 billion bushels of corn annually, according to analysts close to the industry who have added several recent plant start-ups to their list. Some currently operating plants are operating at less than full capacity. Annual capacity of formerly operating plants that are now idled appears to be around 1.5 billion gallons of ethanol or about 530 to 540 million bushels of corn demand. This amount of potential corn demand would be lost if all of the idled plants remain shut-down for the entire year.
Is the Crisis Due to Depressed Ethanol Prices?
Even though rack or wholesale prices for ethanol early this year were about 55 to 60 cents per gallon above wholesale unleaded gasoline prices in the western Corn Belt, returns for processing corn into ethanol range from modestly below to only slightly above full costs of production. Actual returns can vary from plant to plant, depending on the size and efficiency of the plant, its access to transportation, local corn prices, the amount of corn and ethanol forward contracted and other local influences on profitability. A few plants remove corn oil and sell it for feed or bio-diesel use to generate an additional revenue stream.
Factors behind the bankruptcy cases range from problems in managing the risks of volatile corn and ethanol prices to poor plant design and/or excessive debt. In some cases, ethanol producers locked in high-priced corn earlier but were unable to lock in prices for the ethanol to be produced from the corn. These developments left them unable to take advantage of the sharp decline in corn prices until previous purchases were processed. The combination of high corn prices from earlier purchases and declining ethanol prices as crude oil and gasoline prices weakened created severe losses. Plants with substantial debt that were caught in this position are experiencing even greater financial stress.
Based on the AgMRC ethanol economic model, ethanol revenue peaked in mid-summer and declined during the rest of the year as shown in Figure 1. Both the ethanol price and the DGS price declined during this period.
Figure 2 shows estimated Iowa ethanol break-even prices if the required volume of corn for the plant was purchased at the spot market price until mid-2008 and then locked in at June 2008 prices through January. The value of distillers grain, priced at the spot market, is deducted from the cost or corn. With a declining price for distillers grain, the net cost of the corn continued to rise from June through December because of the declining revenue stream from distillers grain. The December break-even at $2.58 per gallon of ethanol was about $0.85 to $0.90 above the reported state average rack price and about $1.00 to $1.10 above ethanol prices at the plant.
Actual cost impacts vary from firm to firm, depending in part on the percentage of the corn supply was forward priced, and the length of time supply was covered or partially covered. Also, with the extreme market volatility in the late spring and early summer, prices that were locked in would vary from one day to the next. Thus, the situation shown in Figure 2 using the June average spot price is a hypothetical one that illustrates the type of impact but not the exact magnitude for a specific company caught in this situation.
In contrast, Figure 3 shows the same type of break-even price, but with corn costs determined at the spot market price for the entire period and the spot value of distillers grain deducted from the corn cost. The sharp decline in corn prices in this case allowed the ethanol plant’s break-even price to drop by $0.99 per gallon below those shown in Figure 2. Even so, the sharp decline in ethanol prices from June to December made it difficult for many ethanol plants to cover the full costs of production. With corn locked in at $6.45 per bushel and the break-even price at $2.68 per gallon for the rest of the year, the break-even price was over $1.00 above the ethanol price. With corn at the spot market price, the break-even price was very close to the ethanol price at the plant.
Who is Affected Besides Ethanol Producers?
The outcome of the current financial crisis will be important to much of agriculture including the seed corn and soybean industries, fertilizer suppliers, grain and livestock producers, rural non-farm businesses, agricultural lenders, investors, land owners, farm implement dealers, grain elevators, and ethanol producers. The outcome also will affect tax revenues of local governments, as well as foreign buyers of U.S. grain and feed.
Later in this article, we will look at possible alternative outcomes of the crisis and will assess potential impacts on the corn market as well as whether scheduled future increases in government ethanol blending mandates will alter the picture.
First Principle: after plants have been built, most will not remain idle indefinitely
A guiding principle in economics is that for the longer-run, plants will operate as long as the ethanol price is high enough to more than cover variable costs of production. Variable costs are expenses that would not be incurred if the plant was not operating. They include such things as the cost of corn, electricity, water, the energy source for the plant, and labor. When distillers grain value is deducted from the corn cost, our estimates of variable costs in January 2009 accounted for approximately 90% of our estimated total cost of producing ethanol in an efficiently designed and economically-sized plant. (3) In the short-run, if the plant has substantial debt that it is unable to service, its creditors may cause the plant to be shut down because of inadequate access to working capital. That’s what is happening to ethanol firms that are in bankruptcy now.
Fixed costs of the plant are those costs that would still be present if the plant ceases operations. They include depreciation on the facilities, interest cost on the investment, property taxes, insurance, and related items. While debt payments are not fixed costs, they are a major cash-flow item for plants with significant outstanding debt. If creditors are not receiving these payments, they may force the plant to be offered for sale, as is happening now in some bankruptcy situations with several ethanol companies.
Figure 4 shows our estimates of variable costs for a plant as described above, from January 2005 through December 2008, with the value of the distillers grain deducted from the corn cost. Our cost estimates indicate ethanol prices remained at least slightly above variable costs over this entire period. For a few months in 2005, ethanol prices were only very slightly above variable costs. That situation occurred again in late 2008. Actual costs will vary from one plant to another, depending on the plant design, size of plant, how well it is managed and a number of other factors so that actual costs for an individual plant may vary from those shown here.
Possible Alternatives: Pros and Cons
The likely outcome of the present ethanol crisis is not clear at this time. If no additional government support is provided, the current global economic and petroleum market environments suggest that conditions may worsen for troubled ethanol firms. The market has ways of dealing with depressed returns, but in the process, substantial economic pain will occur for some firms.
With ethanol priced above gasoline at the wholesale level, the ethanol industry has significant excess capacity relative to mandated levels of corn-starch ethanol blending with gasoline that is required by the Energy Independence and Security Act of 2007. As we noted in an article last month, the mandates for corn-starch ethanol will gradually increase until 2015. (4) However, capacity of existing plants and those under construction or that are finished but have not yet come on line appears large enough to more than meet the federal mandates until at least 2012. Also, as the nation’s average ethanol blending percentage approaches the E-10 level, ethanol prices are likely to weaken relative to gasoline prices. These developments suggest that a major recovery from current ethanol economic conditions should not be expected in the near future.
|The capacity of existing plants and those under construction or that are finished but have not yet come on line appears large enough to more than meet the federal mandates until at least 2012. Also, as the nation’s average ethanol blending percentage approaches the E-10 level, ethanol prices are likely to weaken relative to gasoline prices. These developments suggest that a major recovery from current ethanol economic conditions should not be expected in the near future.|
Putting the Assets Up for Sale
One possible solution is to put some or all of a troubled company’s assets up for sale. The stage is now being set for that to happen. Press reports indicate the bankruptcy court is ordering one such firm to sell 7 of its 12 plants. In another case, a single-plant firm has been put up for sale. Unfortunately for the owners and investors, forcing the sale of these facilities in a time of depressed ethanol processing returns almost certainly will cause the plant to be sold at a small fraction of its original construction cost. Unless additional support for the industry is forthcoming from government sources, this will likely be the outcome for a number of troubled ethanol companies. That in turn will set the stage for an almost inevitable consolidation of the ethanol industry into fewer but larger ethanol firms. Unless returns improve, this consolidation process could happen rather quickly.
Additional Government Credit?
Another possible outcome might be to provide additional credit for the ethanol industry in an energy package developed by Congress and the new U.S. Administration. The Obama Administration and many in Congress have indicated they will place high priority on reductions in carbon dioxide emissions to deal with global warming. For that reason, additional credit to the ethanol industry is a definite possibility. While additional credit alone would not solve the problem of zero to negative net returns for ethanol plants, it would buy more time for ethanol firms to wait for improved returns. At the same time, the added production from currently idled plants resuming operations would tend to delay the needed recovery in ethanol prices and improved net returns. Government credit also would slow consolidation of the industry. Consolidation might well bring additional efficiencies in the industry such as reduced production, transportation and marketing costs, as well as more effective management of risks from volatile corn, natural gas, and ethanol prices. However, these efficiency gains would likely come at the expense of the firm’s current owners and creditors.
Livestock Industry Concerns
Providing additional credit to the ethanol industry would be viewed by livestock producers as increasing the biofuels industry’s already large subsidies and making ethanol a stronger competitor for corn. Near-term assistance for ethanol producers would come at a time when the livestock industry also is under severe economic pressure. A major poultry producer is in a bankruptcy situation. Cattle feeders are reporting very large losses, along with hog producers. Strengthening corn demand by bringing idled ethanol plants back into operation would tend to strengthen corn prices relative to levels occurring when they are shut down. That would add to feed costs, and would worsen financial stresses in the livestock industry, triggering loss of equity in producer assets in a manner similar to that now being experienced in the biofuels industry. For the longer run, there is risk that the U.S. livestock industry would be down-sized along with a reduction in employment in the input, production, marketing, transportation, processing and other industries supporting the livestock industry.
What Kind of Signal to Cellulose Investors?
Failure to assist corn-based ethanol plants that have responded to government calls for increased renewable fuels production would send negative signals to investors in cellulose ethanol plants. In the 2007 Energy Independence and Security Act, Congress was counting on cellulose ethanol to become a major source of U.S. motor fuel in the next 10 to 15 years. Mandated blending of advanced biofuels increases from 600 million gallons this year to 3.8 billion gallons in 2014, nine billion by 2017, and 21 billion in 2022 . Much of this “advanced biofuels” is expected to be ethanol made from cellulose feedstocks, with 3 billion gallons blended with gasoline in 2015 and 16 billion gallons by 2022. (5) Cellulose ethanol investors would interpret lack of added support for corn ethanol plants as a sign that the government will not be a partner in sharing risks if those risks become substantially larger than currently anticipated.
Will the Increasing Government Mandates Help?
Government mandated ethanol blending levels that increase in the next few years will provide some added support to the biofuels industry. However, current aggregate plant capacity exceeds the mandates for at least this year and probably will do so until 2012. Thus, the mandates are not an immediate solution to the problem.
If plant shut-downs cause production to drop significantly below mandated levels for an extended period, the tightening ethanol supplies would cause ethanol prices to be bid up. That would be necessary to insure that supplies would match the mandated blending levels. However, the mandates alone do not guarantee profitability for the industry. As ethanol prices increase, corn prices might also rise in response to the added demand for feedstocks. The amount of increase in corn prices would be influenced by weather, costs and available supplies of fertilizer, and other factors. For the longer term, bidding up ethanol prices would encourage the ethanol industry to increase capacity either by building more plants or by expanding existing plants. Also, as we noted last month in an article on blending economics and government mandates, the sharp expansion in cellulose-based ethanol that is mandated in the 2007 Energy Bill is likely to put downward pressure on ethanol prices relative to gasoline. These factors are hints that the mandates may encourage continued excess capacity in the industry. Excess capacity in this sense is the industry’s tendency to build additional capacity until returns turn negative and additional investments cease.
Market Effects from the Crisis
The crisis in the ethanol industry has both local market impacts and industry-wide effects. Industry-wide impacts stem from the loss of demand for corn from plant closings. At this writing the loss of demand for corn from current plant closings if they continue all year vs. demand if all plants were operating at capacity appears to be around 530 to 570 million bushels of corn at an annual rate. At the same time, the domestic livestock and feed industry is facing reduced distillers grain production of about 3.4 to 3.9 million tons of dried distillers grain or dry-equivalent tons vs. potential production at plant capacity. The reduced demand for corn means that ending corn carryover stocks will be larger and corn prices will be lower than if the industry was operating at full capacity. It also means that 3.0 to 3.5 million fewer corn acres may need to be planted this spring than would be the case if the industry were operating at full capacity. Thus, the crisis has spill-over effects on crop farmers, demand for seed corn and fertilizer, grain elevators and grain storage needs for the fall, as well as impacts on other agribusiness firms. These effects are modest in comparison with the collapse in feed and export demand in recent months and the negative effect on market prices from the 75% decline in crude oil prices from last summer’s peak. Lower crude oil prices, of course, led to a sharp decline in gasoline and ethanol prices. Feed, residual, and export demand would be down by about 2.2 billion bushels if the percentage decline to date continues for the full marketing year.
At the local level, ethanol plant shut-downs cause negative impacts on the corn basis (spread between local prices and futures). That reduces the returns for grain farmers but at the same time lowers the cost of feed purchased by local livestock and poultry producers and other local users of corn. Ethanol bankruptcies also have caused pricing problems. Some farmers were not paid for grain delivered to the plant during certain time periods. Others were not paid the full previously contracted price for grain that was sold to bankrupt ethanol plants on forward contracts. Outcomes of these situations are still being determined by the courts. However, these problems have caused many farmers to avoid forward contract sales to ethanol plants. A few elevators also have experienced contract and payment issues with ethanol plants. If these problems are severe enough to create financial problems for individual farmers, they can cause spill-over negative impacts on banks and other agricultural lenders.
The multi-year double-digit expansion in the ethanol industry and double and sometimes triple-digit returns on investments that were experienced for a time were signals that over-capacity and reduced returns for the industry would be unavoidable at some future time. However, the anticipated decline in returns has been aggravated by extreme volatility in both corn and ethanol markets and difficulty of some firms in managing these risks effectively. It also has been amplified by the extremely sharp 75% decline in crude oil prices from last summer’s peak. A sharp drop in crude oil prices has produced a corresponding decline in other energy prices including gasoline and ethanol. These prices have come down more rapidly than the price of corn.
The economic crisis is very severe for a number of ethanol companies including the nation’s second largest producer. At this writing, it appears that about 12% of the nation’s formerly operating production capacity has been shut down, along with a substantial number of ethanol construction projects, some of which were completed or almost completed. Impacts of the crisis go well beyond individual companies and plants to a broad section of the nation’s agricultural economy and the financial sector.
There is no easy and painless solution for the crisis. Government loans for troubled plants would buy time for returns to improve and would help firms adjust to negative impacts from inadequate management of input and output prices. The added financial assistance also would increase confidence of investors in cellulose ethanol and other advanced biofuels that government can be counted on for additional help if risks prove larger than now anticipated. The Energy Independence and Security Act of 2007 places high priority on future production of ethanol from cellulose to reduce the nation’s dependence on imported oil. At the same time, impacts on livestock producers from additional government assistance to the ethanol industry would likely be somewhat negative through their impacts on feed costs. Just how negative would depend on crop growing conditions and yields. Such assistance also would tend to slow an almost inevitable consolidation in the ethanol industry that might bring future cost reductions and increased marketing and transportation efficiencies for ethanol.
1 “VeraSun Ordered to Sell 7 Plants to Get Debt Financing”, DTN electronic agricultural news service, (Omaha, NE), January 15, 2009
2 Renewable Fuels Association Web Site
3 Prospects for the Corn Ethanol Industry - Don Hofstrand - AgMRC Biofuels Newsletter, January 2009
4 For an explanation of why ethanol is priced above gasoline, see R. Wisner, “Ethanol Blending Economics, the Expected "Blending Wall" and Government Mandates” Ag MRC Biofuels Newsletter, January 2009: