Economic Impacts of Locally Owned Biofuels Facilities

AgMRC Renewable Energy Newsletter
January 2009

David Swenson
Department of Economics, ISU
dswenson@iastate.edu

The idea of farmer or community ownership of industry and other production and processing systems is not new.  Over the decades there have been guilds, cooperatives, and other beneficial associations that allowed producers, processors, or merchants to band together and achieve, mutually, production or distribution efficiencies and ultimately greater profits.  Many of the somewhat recent models of modern biofuels industrial development involved, first, farmer ownership of the operation, and then later, broader community-wide or region-wide investment.  Proponents of the then rapidly expanding ethanol industry during the 2005 and 2006 period touted the community economic benefits of local ownership.  Many of Iowa’s earlier ethanol plants were locally and significantly farmer-owned.  As monopoly profits graced that industry when the market for ethanol took off, there were reports of these early local investors recovering their initial investments in just a few short years and realizing very strong dividends to boot.  When the industry looked to expand smartly during that boom period, it looked to local investors to provide the start-up capital.

Our 2006 research into Iowa’s ethanol industry specifically dealt with the issue of local ownership of ethanol plants and the resulting economic impacts on the surrounding communities.(1)   We found that given the kinds of profits realized in Iowa’s ethanol industry during that period, each 25 percent of local-ownership helped to support a total of 29 jobs in the local economy beyond those that were supported by the ethanol plant operations.  These jobs would be as a direct consequence of the robust dividends at the time being re-invested in the regional economy or otherwise consumed as household income. If we considered the opportunity costs of those investments, that is assuming that farmers and other local investors would have invested profitably nonetheless locally, then we would look at the amount of profits in excess of normal that might have been attributable to the ethanol boom at the time.  With that in mind, anywhere from half to two-thirds of those jobs could have been attributable to the very high, albeit relatively short-lived, returns and not to something intrinsically attributable to local ownership.  The conclusion was that local ownership yielded a notable boost in job levels in rural areas due to the high returns.  The impact of local ownership during times of normal industrial profits is much more muted.

The nation’s ethanol industry is now going through growing pains and average profits are meager.  Local investment was a major factor in many recent new plant and expansion business plans, but externally owned plants too became more common.  A major producer, VeraSun, was actively traded on the stock market but is in bankruptcy and has shuttered six of its plants.  Another large operation in Lima, OH, is shuttered as well.  Still others have folded, and the profit margins of modern ethanol facilities have shrunk considerably regardless of ownership structure.  It remains to be determined which model survives the shakeout of this industry as it matures.  Will the older and smaller locally owned plants prevail, or will the larger and externally owned plants overwhelm the earlier prototype?  This article explores the plusses and minuses of local investment and local ownership in the ethanol industry over this recent ethanol boom and moderation cycle.

Why was Farmer-Ownership So Important?

The early ethanol industry, the one that emerged during the 1990s and early part of this decade, was a highly regionalized niche industry located in northwest Iowa,southwest Minnesota, and in eastern Nebraska and South Dakota.  The cost of ethanol per gallon was and currently is greater than the cost of gasoline, the energy source that it replaces, and the industry required and still requires government subsidies to support production and to induce consumption.  On a comparatively small scale, then, ethanol production served as a price-hedging opportunity for local corn farmers.  In periods where corn prices were low, then returns to ethanol production would be greater.  In periods where corn prices were higher, they would accept lower returns from ethanol production in exchange for higher profits at the farm gate.

While that model makes good sense from an economics point of view, see for example the work of Gallagher (2), the fact remains that the theoretical benefits of local ownership under normal market conditions in this configuration are highly localized.  The primary grain farmer beneficiaries are those within the logical buying circle for the ethanol plant.  They would reap the biggest gains through a reduction in their basis penalties – the cost of shipping their corn to distant terminals.  Beyond that circle, the benefits of a local sale versus the price hedging opportunity would diminish sharply as local transport costs rose.  Additionally, ethanol plants are expensive.  Convincing local farmers to speculate in a new industry whose overall acceptance nationally was comparatively low was a daunting task.  At the turn of this decade it was assumed that ethanol plants cost a dollar per nameplate capacity (3)  – a 50 million gallon per year plant would cost $50 million.  Still, in one form or another, locally-owned plants sprang up across this Plains region, many of which were significantly farmer-owned.

A combination of several factors led to a perfect profit-making storm for ethanol plant owners by the middle of this decade.  Hurricanes that damaged domestic gasoline production capacity and international uncertainty bid up the price of and demand for alternatives to petroleum, fuel reformulation standards drastically increased the demand for ethanol as a fuel additive, the federal government mandated usage of ethanol, as well, and relatively large surpluses of corn kept costs of production low.  As a consequence, for a period of time, the nation’s ethanol plants posted incredible returns.  By extension, the farmer or local owners of many of those plants realized windfall profits.  Figure 1 dramatically portrays the magnitude of profits realized during this period and the profit making ebbs and flows of this industry.

This is a display of the modeled return to operators on both a per bushel of corn and gallon of ethanol basis maintained on the AgMRC Web site (4). The net returns rose sharply per gallon of ethanol in late 2005 to $1.33 per gallon, due in large part to Hurricanes Katrina and Rita.  Those returns grew to as much as $2.00 per gallon with the shift in reformulated fuel standards that favored ethanol as an additive over MTBE. 



 (Click to enlarge.)

But the remainder of the graph tells us the rest of the story.  In the fall of 2006 grain prices shot up and stayed, as did the costs of other important inputs.  They stayed relatively high throughout until peaking in the summer of 2008 before declining of late (along with the price of ethanol). Net returns in the industry have been trending downward since, and the nation’s ethanol industry is now operating on very lean margins, a situation that is expected to continue for the next few of years according to another set of projections that can be found at the Center for Agriculture and Rural Development at ISU (5).

So we are left with a discussion of the short term and long term merits of local ownership and investment in Iowa’s ethanol plants.  These are or were some of the major considerations for local investment.

1. Early ethanol plants served as a market stabilizing hedge for corn farmers that were suffering the greatest price basis penalties.  That is why the preponderance of ethanol plant development occurred in corn production areas that were the greatest distances from major Mississippi and Illinois River grain terminals.
2. Early investor-owners realized strong returns for a period of time, and as long as those returns exceed all other investment opportunity costs, the local economies benefited as a result.  The multiplier effects were demonstrable and tangible in areas where the local investors lived.
3. Local investors are assumed have a greater stake in local economic activity levels and may be willing to forego short term profits or dividends in light of overall regional economic stability and job creation.
4. Local investment likely resulted in greater amounts of banking activity in the region of interest as farmers pledged their farms as collateral against investment loans in the local ethanol plant thereby indirectly inducing banking investment locally as well.

There are however practical detractions from or limits to local investment.

1. Farmer willingness to invest in ethanol plants as a hedge or as an outright investment opportunity is limited as most Midwestern farmers are not direct investors in ethanol plants.  Farmers are sophisticated investors and are likely to diversify their investments to maintain their long term values and to maximize their returns and minimize risk exposure.  Some opted early and largely for ethanol plants, and others did not.  Those that invested early realized strong gains.  Those that invested later may have had much more muted gains. Similarly, many of the “local” investors in ethanol plants were not really local.  In our research for ISU we discovered that high fractions of the investor-owners of several ostensibly “locally-owned” plants actually lived far beyond the grain marketing area or were otherwise not involved in grain production.  Consequently, the plant represented more of a speculative investment opportunity as compared to a logical extension of grain farming.
2. Many plants are paying very low, if any, dividends of late.  While the overall diversified stock market of the U.S. looks awful, as well, in comparison, the fact remains that a large fraction of ethanol investors are not realizing returns on their investments.  There is, therefore, locally-owned economic impact of consequence.
3. Some locally owned plants actively sought external investors so that their exposure in the long run was limited – risk diversification and access to expansion capital became important considerations as the industry matured. These factors appear to have trumped the urgency for local investment for the time being.
4. Most economic models predict that larger, more recently built plants that are much more efficient will replace the older and smaller plants.  This supposes the locally owned plants are, therefore, at a production efficiency disadvantage.  This may not be true, and it remains to be demonstrated that later plants will replace the preponderance of earlier plants.  It is also the case that many later plants were sited without regard to regional grain supply. Consequently, assumptions about their overall efficiency may be unwarranted at this stage of industry development.
5. Overall, across our entire economy, much more wealth has been developed from diversified investor systems that are actively traded in open markets than from systems that excluded or limited participation to parochial interests or local preferences.
6. Many farmers borrowed against their farming operation to invest in ethanol plants.  As those plants struggle and reduce their dividends, loan payments must come from other farming incomes.  There is an irony here that the boost in grain prices for some is offset by low or no returns on their ethanol plant investment. 

Where does this leave Iowa and the issue of local ownership of biofuels plants?  The overall merits of local ownership are somewhat strained and hard to maintain over the long haul.  In fact, one rarely hears about the topic now a mere two years since the peak of enthusiasm.  The markets in many areas simply have judged local ownership to be primarily a niche consideration in the broader scheme of things.  The marketing of shares locally still exists, especially in light of the unwillingness of the broader investor class to support ethanol investments.  Most publicly traded ethanol shares have declined from between 65 percent to 95 percent from their peaks in early 2006.

In the evolution of a product cycle, early owners of a successful product realize the greatest gains.  It is usually the case that in new technologies or new commodities the number of early owners is limited and tightly organized spatially – they are, therefore, localized.  When the firms succeed, if they do, their monopoly profits are attacked immediately by all investors and copy-cat producers in an open market, the profits of early positions erode sharply and profits then accumulate to the firms that achieve production efficiencies and establish their industries firmly in the market.  It is simply impossible for a group, a community, a state, or a region to horde profits and exclude access. Consequently, the politically and rhetorically pleasing idea of local ownership has very practical limits in this industry and in emerging industries as well. Like many things, it probably wasn’t meant to last.

This doesn’t presume that local ownership of biofuels was for naught or necessarily will be.  It very well may have marked a significant paradigm shift that might serve farmers and landowners into the future.  There is a second generation of biofuels production that is promised, if not a third.  Some of that future production may make better sense on a smaller scale – a scale that may be optimized by relatively compact groups of producers, processors, and users.  Similarly, the rapid deployment of wind-energy generation may again create opportunities for operator as well as community investment in energy production.  There are regional economic benefits to be gleaned from energy production.  Future energy development in the U.S. will likely contain a mix of technologies,opportunities, and investments – some favoring small and tight configurations,and some much more expansive in scope.

References

1 Swenson, David and Liesl Eathington.  Determining the Regional Economic Values of Ethanol Production in Iowa Considering Different Levels of Local Investment.  Staff Research Report, Department of Economics,ISU, July 2006.

2 Gallagher, P. (2005) Pricing relationships in processors' input market areas: Testing theories for corn prices near ethanol plants.  Canadian Journal of Agricultural Economics.  53, pp. 117-139.

3 More modern plants, usually at or in excess of 100 million gallons per year, cost in excess of $2 per gallon of nameplate capacity to build.

4 Tracking Ethanol Profitability, Agricultural Marketing Resource Center

5 Weekly historical and projected crush margins for ethanol are posted at this location: