Ethanol and Corn Profitability
AgMRC Renewable Energy Newsletter
Co-director, Ag Marketing Resource Center
Iowa State University Extension
|Corn-Ethanol Profitability Chart|
The emergence of the ethanol industry has generated substantial profits for individuals involved in ethanol and corn production. However, different sectors of the industry benefit at different times. Outlined below are the beneficiaries and when they benefit. This is shown graphically in Figure 1.
To understand how returns are allocated, it is important to understand the role of prices. The ethanol price is the major factor determining the total amount of revenue to be divided among the participants in the corn-ethanol industry. The corn price determines how this revenue is allocated between the ethanol producer and the corn farmer. The price of seed, fertilizer, etc. and the cropland cash rental rate (essentially a price) determine how the revenue received by the corn farmer is divided among the farm operator, the input supplier and the land owner.
Another important concept is that, over time, profits (losses) accrue to the limiting resource in the production chain. This can be seen when we trace how the profits of the ethanol industry have been allocated so far (Figure 1) and how the profits are expected to be allocated in the future.
Who Gets the Profits (losses)?
The various segments of the corn-ethanol industry are the recipients of ethanol’s profitability. However, the profitability is not distributed among the segments when it occurs. Rather, the various segments are recipients at different points in time. In essence, the profits are transferred from one segment to another.
During the initial expansion period of ethanol production during 2005 and 2006, large profits accrued to ethanol producers. They benefited from the combination of high ethanol prices and low corn prices. Ethanol prices were high and demand was strong due to the need to supply the oxygenate market vacated by (Methyl Tertiary Butyl Ether) MTBE. At the same time, corn prices were low due to overproduction. The small size of the ethanol production capacity was the limiting resource.
However, ethanol production is a commodity business. It sells a commodity (ethanol) and buys a commodity feedstock (corn). Typically commodity industries expand production capacity until profits are driven to a minimum. The generous profits generated during this period attracted others to the industry in an attempt to also capture these profits. So more ethanol plants were built and the industry expanded. It expanded until corn shortages emerged and the price of corn increased. Ethanol production capacity is no longer the limiting resource. As shown in Figure 1, this started to occur in late 2006.
As ethanol production capacity expands, the limiting factor in the supply chain changes from ethanol production to corn production. The price of corn (the limiting feedstock) is bid up. As corn price moves upward, ethanol profits are shifted from ethanol producers to farmers. As shown in Figure 1, by mid-2008, almost all of the profits accrue to farmers. However, as farmers expand corn production to take advantage of these generous profits, they begin bidding up the price of production inputs (e.g. seed, fertilizer, land).
As farmers expand corn production, they bid up the price of production inputs such as fertilizer, chemicals and seed. Higher input prices generate larger input profit margins for agribusinesses. This leads to competition and expanded input production capacity which over time limits input prices and profit margins. The exceptions are production inputs whose ingredient price increases (e.g. natural gas in the production of nitrogen fertilizer) and inputs that increase yields (e.g. yield enhancing seed varieties).
Cropland is the eventual limiting resource in the supply chain. All other segments of the supply chain can expanded to meet demand. But the amount of corn produced is limited by the number of acres of farmland available for corn production. So, excess profits are bid into rental rates and land values. Over time cash rental rates rise until most of the profits accrue to the land owner. The other segments of the supply chain give up their profits because they expand through competition until they earn only normal profits.
Although high ethanol prices have created substantial profits in the corn-ethanol industry, declining ethanol prices during recent months are leading to reduced profit margins and actual losses. Lower ethanol prices are putting pressure on the profitability of ethanol producers. This is subsequently leading to lower corn prices. Lower corn prices are clashing with rising input prices and land rental rates and putting pressure on corn producer profitability. As discussed above, any change in profitability is eventually transferred to the land owner. However, land rental rates tend to change slowly. So, considerable losses may be incurred by other segments of the industry during the transition period.
Ethanol prices are correlated to the price of crude oil. So the recent decline in oil prices has put considerable financial pressure on the corn-ethanol industry. An indication is the recent bankruptcy of VeraSun.
The questions facing the short-term viability of the corn-ethanol industry are:
- How low will crude oil and ethanol prices go,
- When will prices recover, and
- How much damage will be inflicted on the corn-ethanol industry during the process?
We will continue to track these changes every month in our model in Figure 1. A continuing decline in ethanol prices will lead to greater losses in the industry. Corn price will allocate these losses between the ethanol producer and the corn farmer.
Figure 1 Explanation
(Everything is expressed as dollars per bushel of corn)