Friday, January 14, 2011

Future Prospect for the US Fuel Ethanol Industry

The US fuel ethanol industry exhibits the same type of boom/bust cycles as the typical commodity chemical business, characterized by overbuilding of capacity outstripping demand and causing a collapse in prices.  The collapse in prices are followed by a rationalization and consolidation phase, where weak producers that have either high production costs or weak balance sheets shut down or are absorbed by stronger industry players.  The ethanol industry experienced its overbuild bust in 2008, followed by 2009 and 2010 as years of rationalization/consolidation in the industry cycle.  There are no new greenfield plants on the drawing board for the US industry at this time, and the industry showed the ability in the last month to generate a production rate of close to 14 billion gallons per year.  This production rate may not be sustainable year-round, but, by the end of 2011, with several other plant restarts and plant modifications, it is reasonable to assume that 14 billion gallons per year will be sustainable going into 2012.

The RFS2 mandate for 2011 for corn-based ethanol is 12.6 billion gallons and grows by 600 million gallons per year until it hits a mandated ceiling of 15 billion gallons in 2015.  With the gasoline market currently structured with E10 as the maximum amount of ethanol that can be blended with gasoline, based on EIA’s latest gasoline demand estimates, the blend wall starts to arrive in 2014 when the gasoline market can only absorb 13.95 billion gallons of ethanol as E10, but the mandate for that year hits 14.4 billion gallons.  The ethanol industry has taken a two pronged approach to defeating the blend wall: E15 adoption for the bulk of the US auto fleet, and the build out via government subsidy of E85 dispensers.  The key initiative for the industry is the approval of E15 to be used by the existing automobile fleet without engine modification.  We think there is a high probability that E15 will be approved for a significant portion of the fleet, and the numerous legal and technical hurdles to implementation will be overcome by 2013.  The volumetric ethanol excise tax credit (VEETC) is going to expire, with no effect on demand sometime in the next several years.  So, by 2013, mandated demand will be 13.8 billion gallons, and E15 will be available in significant portions of the country to soak up large amounts of ethanol. 

US export demand, in terms of total industry production, is relatively small, at over 325 million gallons in 2010, but it is a key market outlet that will continue at these rates for the foreseeable future.  Both Canada and Europe do not have any new ethanol plant expansions scheduled from mid-2011 forward.  Europe’s demand will continue to grow as the expansion of E10 gasoline continues at a slow steady pace across the continent to replace E5 in the gasoline pool.  The expansion of ethanol production in Europe will be hindered by the shortage of competitively priced agricultural feedstocks to produce biofuels profitably.   Wheat and cereal grains are the feedstocks available for expansion in Europe.  The predicted expansion of demand may hit one roadblock over the Indirect Land Use Change (ILUC) debate, which is a major issue in Europe.  The results of this debate, and the potential change in biofuel sustainability requirements that could result, cast uncertainty on the EU Commission’s policy and its stated commitment to expanding the use of biofuels in transportation.  Currently, the typical US Midwest ethanol plant, based on a dry DDGS production process, can meet Europe’s GHG emission reduction requirements through 2017.

The Brazilian ethanol industry, once a major exporter to the US during the 2006 – 2008 time period, experienced the same overbuild capacity bust n 2008/2009 that pushed the country’s sugarcane-based ethanol industry into a rationalization/consolidation period at approximately the same time as it occurred in the US.  The Brazilian ethanol industry focused its expansion during the recent years in the key sugarcane production state of Sao Paulo that is located in the center-south portion of the country.  This made sense, since significant infrastructure is already in place in Sao Paulo, reducing the cost of expanding sugarcane plantations and transporting finished products, both sugar and ethanol.   Sao Paulo also has a pool of labor to support expansion of the labor intensive sugarcane growing/harvesting business.  Now that Sao Paulo is essentially built out, in terms of sugarcane production, new greenfield plants must look to states further inland that lack the same infrastructure of labor and logistics, as well as further distances to the major markets located near the coast.   Moving away from Sao Paulo makes new greenfield plants more risky because they are more expensive to build and agricultural inputs are more expensive and return lower prices for finished products due to higher logistical costs.  For these reasons, the new greenfield plants face higher investment hurdles that are hard to climb at the moment.  In terms of new sugarcane mills, 9 new plants came online in 2010, and an additional 4-5 are anticipated to come on stream for 2011.  No new plants are planned for 2012 and beyond.   The industry could show a 5%-10% growth in production of both sugar and ethanol if growing conditions are favorable, but without the expansion of sugarcane acreage, sustained production growth is not possible.   All the investment activity has been consolidation-type investment, or a financially strong company buying out financially weaker companies.  Other issues that frustrate new plant investment are the lack of fuel tax equalization for ethanol among the states of Brazil that causes undo market distortions, and the continued imposition of the US 54 cpg import tariff that eliminates any demand upside for expanded ethanol production. 

On the demand side, Brazil has created a huge demand sink in the form of the ever-growing flex-fuel vehicles (FFV), plus the development of green plastics industry in the form of ethanol feedstock from sugarcane used to produce polyethylene.  The FFV fleet grows by over 2 million units each year, and is now 50% of the overall vehicle fleet in Brazil, generating approximately 3.5 billion liters of potential new ethanol demand each year.  The FFV fleet acts as a double edged sword for potential ethanol industry investment, with fears that the state owned oil company Petrobras would control gasoline prices, holding them below market value and putting pressure on the ethanol industry, whose prices are unregulated.  In summary, Brazil for the next 3 to 4 years will not be a significant participant in the international fuel ethanol market.

The profitability picture for the US ethanol industry looks very attractive for the next several years, based on the following key points:
  •          US Ethanol mandate growing 600 million gallons per year
  •          E15 approval and adoption anticipated for 2013 and beyond
  •          No new greenfield ethanol plants for the next several years
  •          Continued solid export potential to Canada and Europe
  •          Brazil ability/desire to export ethanol greatly diminished
  •          Crude moving to $100 per barrel

The only potential downside at the moment is a potential corn price shock that could reignite the “food vs. fuel” debate and threaten the US government mandate, which we deem as highly unlikely.  Also, a corn price shock will put significant pressure on plant margins, forcing ethanol prices to move up as quickly as corn during corn market rallies; ethanol prices have a tendency to lag surging corn prices, hurting plant margins until the market reaches equilibrium.   

In summary, based on an the lack of new plant investment on the supply side, and steady demand growth during the next three years and beyond , the profitability prospects for the US ethanol industry look very good.

2 comments:

  1. This is good information to help make an investing decision in companies producing ethanol.

    ReplyDelete
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