The Plight of Ethanol Plants
AgMRC Renewable Energy Newsletter
Douglas G. Tiffany
University of Minnesota Extension Service
Ethanol is in the news a lot these days featuring a variety of issues ranging from effects on the environment to effects on engines when using higher blends to economic viability of individual firms. For several months the industry has been digesting the news of the bankruptcy of Verasun, an aggressive, publicly traded firm (that was the darling of Wall Street just a few years ago), and the liquidation of its assets. As discussed by Dr. Wisner in previous articles, the corn ethanol industry faces some further challenges. These challenges include the “blend wall” and the potential of idle or under-utilized industry capacity to be placed back in service. My purpose in this article is to be informative about this industry, which has rapidly become such a force in demand for corn. Figure 1 shows the situation with respect to the capacity in the fuel ethanol industry in the U.S. as of January 1, 2009.
Note the very large proportion of plants under construction in 2007 and 2008. During these years, operating ethanol plants were making tremendous rates of return. The attractive rates of return spurred others to organize ethanol enterprises and try to get a plant built. The crush of investors wanting to build plants at this time raised the price that contractors could charge for ethanol plants. In addition, the suppliers of steel, stainless steel, concrete and other constituents of ethanol plants like pumps, electric motors, thermal oxidizers, faced higher costs for these plant components during a time of strong worldwide demand.
If one considers the value of ethanol as a substitute for gasoline with two-thirds the energy available to move a vehicle down the road, one can determine corresponding break-even prices of corn, the dominant cost in ethanol production. To do this exercise, one must have an economic model for ethanol plants and be aware of the value of the by-product, distillers dried grains and solubles (DDGS) as well as the costs associated with the ownership and operation of the plant.
For simplicity I have divided the world of U.S. ethanol plants into two groups. The first group consists of plants built in 2005 or before and those built in 2007 or after. I assume that numerous ethanol plants in operation as 2006 dawned were able to make excellent profits by making ethanol out of the cheap corn from the 2005 harvest and selling the ethanol in a time of rising gasoline prices. A graph posted by AgMRC, labeled Figure 2 readily shows this very favorable time of profits for ethanol plants when corn price per bushel was less than gasoline price per gallon. This period started in early 2005 and continued until the harvest of the 2006 corn crop.
Using a spreadsheet model that represents dry-grind ethanol plants with nameplate capacity of 50 million gallons per year, I was able to determine the break-even price of corn corresponding to various crude oil prices. One must first determine the typical relationship between wholesale gasoline prices and crude oil prices when acquired by oil refiners. The wholesale price of gasoline per gallon can be reflected by the following formula:
Wholesale Gasoline Price per gallon = $.036 + .029 (Crude Oil Price per bbl) (1)
After one knows the wholesale price of gasoline based on crude oil price, one can determine the price of ethanol based on its energy content relative to gasoline, which is two-thirds. Then the accompanying value of the Volumetric Ethanol Excise Tax Credit (VEETC) of $.45 per gallon and the prevailing market price of Renewable Identification Numbers (RIN), assumed to be $.10 per gallon are added. Both the VEETC and RIN price have value that accrues to the price of ethanol, although there may be times when less than full value is passed through on the VEETC and the value of a RIN can become zero. As a last step, the transportation and marketing charges needed to take ethanol from a plant to a blender are deducted. This figure may vary depending upon location, but let’s assume the figure is $.20 per gallon of ethanol sold. With these assumptions we can construct a graph that defines the zones of production when ethanol is profitable or unprofitable. Factors such as original capital cost, amount of debt, interest rate, cost of natural gas and assumed value of distillers grains and solubles (DDGS) determine the breakeven price of corn for ethanol plants conforming to those conditions. Figure 3 shows the zones of profitable and unprofitable production for a 50 million gallon per year plant operating with natural gas costing $6.00 per decatherm when DDGS are selling for 91% of the price of corn on a per pound basis. (DDGS pricing in Iowa averaged 91% of corn price for 2007 and 2008.) The resulting graph shows the ability of ethanol plants to bid for corn and break even as crude oil price changes.
Figure 4 shows the situation of two plants built in 2005 and 2007, respectively. Let’s assume the plant built in 2005 paid off all its debt and that the plant built in 2007 (which cost more per gallon of capacity) still has 50% debt. This graph shows us that the zero debt 2005 plant has the ability to pay $.51 more per bushel of corn than the 2007 plant. The differential gives the 2005 plant a real competitive advantage to weather through times of unfavorable corn-ethanol price relationships. Low, but positive margins for 2005 plants can easily occur in times of negative margins for 2007 plants.
As this is written crude oil prices appear to be around $60.00 per barrel. It is worthwhile reflecting upon some economic history of prices of crude oil and consumption of crude oil in the U.S. Figure 5 shows the history of U.S. consumption of crude oil and prices from 1973 through 2008. To eliminate distortions of inflation on nominal prices, the crude oil prices have been converted to $2005 dollars. The blue line represents consumption of crude oil in the U.S., while the orange line shows the inflation-adjusted price of this commodity.
Figure 5 tells many stories. The taking of the U.S. hostages in Iran in 1979 and the overthrow of the Shah of Iran triggered a major price rise in crude oil as supplies were curtailed from that important exporter. In response to curtailed supplies, higher prices and encouragement of conservation efforts by the federal government, consumption of crude oil dropped 19% between 1978 and 1982. Use of crude oil hit lows in 1982 and 1983. In response to lower consumption (due in part to a weak economy), the price of crude oil dropped and continued to drop through 1986. The drop in crude oil price was also an effect of the behavior of certain oil producing countries of OPEC, who may have been willing to offer crude oil at cheaper prices than some of their brethren in the cartel. From the mid-1980s to 2003 crude oil was relatively stable and cheap. These cheap prices and a generally favorable economy encouraged U.S. consumers to buy bigger, thirstier cars as the numbers of cars on the road also grew. From 2004 through the autumn of 2008 crude oil prices rose rapidly with consumption staying generally flat and finally breaking lower in 2008 in response to high gasoline prices. When crude oil consumption data are available after 2009, we will see if consumption continues to drop from 2008 even though crude oil prices have been cheap since the financial crisis evident in October of 2008.
Figure 5 and its rich history of consumption and price must be considered at this time of 2009 when we have a wounded economy, perhaps continuing lower consumption of gasoline and low prices for crude oil. One thing you can be sure of, oil producers and ethanol producers both favor a movement to higher crude oil prices from current levels along with growing consumption of their products. Until crude oil prices improve, we should expect continued financial stress for ethanol producers, felt most severely by the firms that started operation in 2007 and 2008.
McCullough, Robert and Daniel Etra. When Farmers Outperform Sheiks: Why Adding Ethanol to the U.S. Fuel Mix Makes Sense. McCullough Research, Portland, Oregon, April, 2005, 12pp