Ethanol Industry Approaches the Blending Wall - Cellulosic Ethanol Investments Severely Threatened

AgMRC Renewable Energy Newsletter
May 2010

Dr. Robert Wisner
Biofuels Economist

A fuel ethanol blending wall has been anticipated for the last three years.  When reached, it would halt growth of the ethanol industry or initially would cause demand growth to fall short of the rate of expansion in ethanol production and would be followed by a halt in growth.  With arrival of the blending wall, the industry would experience seriously depressed profits, very possibly another wave of bankruptcies, little or no access to capital for expansion or modernization and for commercial development of cellulose ethanol. 

The price relationship between gasoline and ethanol would be an important indicator of the arrival of a blending wall, since it would signal whether or not blenders and petroleum refiners find it profitable to buy ethanol and blend it with gasoline.  With arrival of the blending wall, most or all of the benefit of the ethanol tax credit would go to blenders and consumers, rather than ethanol plants and corn growers.  That would happen because no amount of additional price incentive or tax credit would by itself generate additional demand.  Prices for ethanol would drop to whatever level is needed to find a market for the last shipment of ethanol or to encourage someone to store it.  Under these conditions, policies to encourage growth of the ethanol industry would need to focus on improving infrastructural bottlenecks and reducing market saturation that comes from government maximum blending limitations.

In watching for the arrival of a blending wall, one should keep in mind that the rapid expansion of the ethanol industry in the past five years was strongly encouraged by various government policies.  It should also be noted that Congress in late 2007 mandated that use the use of ethanol as a replacement for gasoline must be sharply increased each year through 2022.(1)  Removing or moving back the blending wall to allow further expansion of ethanol production rests almost entirely on government policy, which so far has set a limit on further expansion by restricting the maximum ethanol-gasoline blend for conventional vehicles to E-10 (10% ethanol-90% gasoline).  Thus, two different government policies are on a collision course.

In this article, we review indicators that suggest the industry may be rapidly approaching the long-anticipated blending wall.  If that is the case, without government policy changes to remove it, birth of the embryonic cellulosic ethanol industry will be greatly at risk.  Many decision-makers in Congress and the U.S. Administration have portrayed cellulosic ethanol as a key development for future U.S. energy independence as well as a means of reducing dependence on fossil fuels.

The industry setting

After a period of phenomenal growth, the ethanol industry experienced a time of severely depressed profits in the last half of 2007 and 2008.  Growth in U.S. ethanol production from 2006-07 to 2008-09 corn marketing year averaged 37% annually.  A short period of unprecedented large profits was followed by depressed returns and widespread bankruptcies.  The depressed returns came from:
 

1. sharply increased prices for corn (the main feedstock) vs. previous years and
2. an extreme drop in crude petroleum prices from a record high of around $140 per barrel to less than $45 per barrel and resulting in much weaker gasoline and ethanol prices.

Some ethanol biorefineries escaped bankruptcy through careful management of input and marketing risks as well as low debt.  Others failed to effectively manage the twin risks of volatile corn and ethanol markets and/or had excessive debt for current economic conditions.(2)  During the period of depressed returns, demand for ethanol continued to increase, although at a slower rate than in the previous few years.  Thus, the depressed returns could not be attributed to a blending wall. 

Last year was a time of recovery for the ethanol industry.  Many bankrupt ethanol firms and plants were sold at a fraction of their original cost, thus allowing new owners to operate them profitably at lower ethanol prices than in the past.  Merchandisers at ethanol plants focused on managing their processing margins, the difference between feedstock costs and prices for ethanol and distillers grain (DGS).  Forward pricing tools in ethanol markets became more mature, thus allowing the management of returns and risks several months into the future when profitable opportunities were available.  The improved economic performance resulted in a substantial increase in industry operating capacity and expanded ethanol production in 2009 that is continuing into early 2010. 

After reaching a low point in early spring 2009, crude oil and gasoline prices moved into a gradual uptrend that is still continuing at this writing.  Crude oil and gasoline prices suggest the U.S. energy market is relatively strong when viewed from a historical perspective.  The national average gasoline price at this writing has approached $3 per gallon in some areas, and may be a threat to the economic recovery if prices move higher.  Ample corn supplies have held down the cost of corn (the main feedstock) to ethanol plants.  U.S. farmers had a record U.S. corn yield per acre last year and corn has experienced strong competition from feed wheat in world markets as well as weaker demand because of the sluggish world economy.  Under these conditions, along with relatively low natural gas prices, one might think ethanol firms were experiencing strong profitability.  However, ethanol prices tell us the market for ethanol may be almost saturated or at least not growing fast enough to absorb the increased U.S. production capacity.  A weak ethanol market relative to gasoline is a strong warning that the industry may be nearing the blending wall.

Ethanol and gasoline price trends diverge

Figure 1 shows gasoline futures prices since last fall.  After slight weakness until the end of the year, gasoline prices have increased sharply in response to higher crude petroleum prices in world markets.  Figure 2 shows ethanol futures prices over the same period.  In contrast to strengthening gasoline prices, ethanol prices have steadily declined since early this year as new or revived production capacity has come on line.  The very large discount of ethanol prices to gasoline has resulted in depressed returns for ethanol plants.  Some plants reportedly are now beginning to operate at less than full capacity or have shut down temporarily for maintenance. 

Figure 3 shows the AgMRC model estimates of the profitability of a 100 million gallon per year capacity ethanol plant in north central Iowa from 2005 through March of 2010, based on spot or current cash prices for inputs and outputs.(3)  As indicated by the lower line in Figure 3, ethanol profits have turned negative recently.  Profitability as indicated by futures prices for fall 2010 input purchases and output sales shows only a very slight improvement from spot market prices.

As seen from the chart, recent returns have turned negative, although not quite as negative as in early 2009.  Profitability of individual plants may vary significantly from those shown here, depending on size, plant design and co-products extracted, access to transportation, risk-management strategies, local corn and ethanol market conditions, and other factors.  Costs of formerly bankrupt plants may be lower than shown here due to lower fixed costs.  In most cases these plants were acquired at a small fraction of their original construction cost. 
 

Current conditions do not suggest that a reoccurrence of the industry’s 2008-09 financial crisis is at hand.  However, when viewed in the context of expanding production capacity and rising future government ethanol blending mandates, they are a reason for serious concern.  The severely depressed ethanol prices relative to gasoline indicate that low prices have not bought enough additional demand to profitably absorb the added production that is coming on line.  U.S. Department of Energy (DOE) data indicate ethanol production continued its multi-year growth pattern into the early part of this year.  Its latest report shows production in January 2010 was 3.9% above December and 30% above a year earlier.  Inventories rose slightly in January from the previous month, but were 70.3% of monthly production.  That was down slightly from the 5-year average of 73.1%.(4) Inventory levels will be an important variable to watch as an indicator of the arrival of a blending wall, although we should keep in mind that lack of storage capacity is likely to prevent a steep rise in inventories. 

Low prices combined with Brazil’s tight sugar and sugar-based ethanol supply and removal of its 20% ethanol import tax have allowed the U.S. recently to export small quantities of ethanol.  Future U.S. exports will depend heavily on Brazil’s ethanol supply.  In the current marketing year, a weather-reduced sugar harvest in India contributed to a sharp increase in sugar prices and created incentives for Brazilian processors to increase sugar cane use for sugar production, with relatively less being used for ethanol.  This should be viewed as a temporary situation that may be quite different next year, depending on foreign sugar crops.

Incentives for blending ethanol with gasoline & the blend wall

Incentives for blending ethanol with gasoline include added value through:

• octane enhancement,
• the differential of ethanol to gasoline prices when ethanol is less expensive, and
• the 45-cent per gallon of ethanol blenders tax credit. 

Disregarding octane-enhancement incentives, potential gains from blending were as follows. Ethanol futures prices in mid-April were at a $0.77 discount to gasoline.  With the $0.45 per gallon federal blender’s tax credit, that created an incentive of approximately $1.23 per gallon of ethanol to blend additional ethanol with gasoline.  The $1.23 incentive is before any adjustment for lower energy content per gallon of ethanol.  If it is reduced by 70% to reflect lower energy content than gasoline, the incentive was about $0.86 per gallon of ethanol.  It is debatable whether the 70% adjustment is necessary if ethanol is used for E-10. The fuel mileage reduction for E-10 is small enough that most consumers may not detect a difference from E-0.

The actual blending incentive will vary, depending on local gasoline and ethanol prices that may differ from the futures market, as well as transportation costs, state tax incentives, and other factors.  The bottom line is that there currently is a very large incentive to buy more ethanol and blend it with gasoline.  One would expect that process to bid up ethanol prices, thus narrowing the differential of ethanol to gasoline prices.  However, persistence of such a large price differential suggests that the ethanol market is approaching at least a temporary saturation point.  The saturation point comes from:

• EPA’s maximum allowable blend of E-10 for most gasoline-powered vehicles,
• preference of some motorists and owners of off-road equipment to use E-0 in states where pump labeling allows them to do so, and
• infrastructure impediments that limit the ability to move ethanol to consumers in some areas, along with some state policies that do not encourage use. 

For the next few months, there is reason for optimism that ethanol demand will increase because of the normal increase in motor-fuel demand as the summer vacation season arrives.  Also, California’s shift from a required average ethanol blend of 5.7% to 10% this year should increase demand for the next year or two.  After that, California’s air quality regulations could become a serious restraint unless modified to be more in line with those of EPA. 

Tax policy concerns

The blender’s tax credit is scheduled to expire at the end of this year, along with the tariff on ethanol imports.  These two tax policies are closely related since the import tariff prevents the blender’s tax credit from being passed on to foreign ethanol producers.  However, the import taxes are modestly higher than the blender’s credit, thus creating some disincentive for imports.  Until this year, it was generally assumed that these two tax policies would be automatically renewed by Congress when they expire.  But with the extended delay in renewing the U.S. biodiesel blender’s tax credit, automatic renewal of the ethanol tax credit and tariff can no longer be assumed.  Failure to renew the biodiesel blender’s tax credit has led to massive shut-downs of biodiesel plants across the U.S. 

With the current large discount of ethanol prices to gasoline and the ethanol mandates from EISA, it is doubtful that a widespread shut-down of ethanol plants would occur if the ethanol blender’s tax credit is not renewed.  Renewal of the blender’s tax credit but not the ethanol import tariff would create a strong incentive to import ethanol from Brazil in competition with U.S. biorefineries.  Failure to renew the blender’s tax credit with the current large discount of ethanol to gasoline would probably reduce but probably not eliminate the incentive for blending ethanol with gasoline.  Also, failure to renew the tax would likely increase ethanol prices at the consumer level.  In Iowa at this writing, E-10 is priced at about a $0.12 discount to E-0.  That’s a $1.20 discount per gallon of ethanol vs. gasoline. The large discount suggests most of the lower price is being passed on to consumers to encourage increased use.  With all other market factors remaining unchanged from current conditions, the $0.45/gallon of ethanol blender’s credit would be expected to narrow the gasoline-E-10 price differential by around 10% of $0.45, or 4.5 cents/gallon of E-10.

Longer-term concerns

For the longer term, expansion of the ethanol market depends heavily on EPA raising the allowable gasoline-ethanol blend for conventional vehicles to E-15 or higher, and widespread acceptance of this blend by gasoline retailers as well as consumers.  It is widely expected that EPA will approve E-15 blends in late summer or early fall of this year, but will restrict their use to 2001 and newer vehicles.(5)  If so, that will create potential logistical issues.  Retailers will be faced with choices of adding new tanks and pumps, shifting E-10 pumps to E-15 (which might reduce demand), shifting some mid-grade or premium grade tanks and pumps to E-15, or simply not offering E-15.  At one recent conference, a representative of a sizeable gasoline retail station chain expressed the view that his company probably would not offer E-15, unless mandated by state laws.  Reasons included added expenses for more tanks and pumps and concern about possible lawsuits.  He noted that operators’ manuals for all 2001 and newer gasoline-powered cars and trucks except flex-fuel vehicles warn that blends above E-10 are not approved for use in those vehicles.

Implications for corn-starch and cellulosic ethanol

From the ethanol industry’s standpoint, the need for E-15 blends is becoming increasingly urgent.  Failure to approve it would create substantial risk of depressed ethanol industry returns within the next 12 to 15 months and possibly sooner.  Data from industry sources indicate current ethanol production capacity along with plants under construction may exceed annual market potential within the next year by more than a billion gallons, if E-15 is not approved.  It should also be cautioned that E-15 markets would require time to fully develop, in part because of infrastructure issues. 

ESIA mandates for ethanol blending increase steadily to 2022, but will not be reached unless higher blends are allowed.  To reach the mandates, the allowable blend will likely need to be increased to between 20 and 25 percent or extremely widespread use of flex-fuel vehicles will be needed.  However, a major limitation of flex-fuel vehicles is that fuel mileage, according to studies by EPA and Consumers Report, is about 25% less than with E-0.  Channeling a large part of the ethanol supply into E-85 would require lower ethanol prices to make it attractive to consumers.  It is generally expected that cost of producing cellulose ethanol will be greater than for corn-starch ethanol, in part because of the bulkiness and higher cost of transporting and handling the feedstock.  Thus, relying heavily on the E-85 market might retard the growth of the embryonic cellulose ethanol industry.

References

1  Energy Independence and Security Act of 2007, PL 110-140, December 19, 2007. 

2  See Wisner, “Risk Management Issues and Challenges for Starch-based Ethanol Biorefineries, Part I”, Renewable Energy Newsletter, Ag Marketing Resource Center, November 2009  and  “Risk Management Issues and Challenges for Starch-based Ethanol Biorefineries, Part II”, Renewable Energy Newsletter, Ag Marketing Resource Center, December 2009. 

3  AgMRC Ethanol Model.

4 EIA, U.S. Department of Energy, Monthly Petroleum Supply & Distribution Report, March 30, 2010.

5 See Wisner, “

”, Renewable Energy Newsletter, Ag Marketing Resource Center, August 2009.