Ethanol 4th Quarter 2010 – Is it a Train Wreck?

By the 4th quarter of this year, the industry is scheduled to bring on another 550 mln gallons of annual capacity. This represents another 36,000 bpd of new production. By October of this year, the driving gasoline demand bump with have dissipated reducing overall gasoline demand by 250,000 bpd resulting in the loss of another 26,000 bpd of ethanol demand. This assumes that ethanol blending penetration stays in the low 80’s% through the balance of the year. We think the blending penetration staying in this range as a good assumption based on the very low price for 2010 ethanol RINs tracking in the 1.5-2.0 cpg range.

Export opportunities will be limited because of certification requirements for renewable fuels into Europe go into effect in December and it is uncertain if US producers will go to the trouble of getting their supply chain certified. Brazil may be an export outlet, but with very strict ethanol specification for imports, it is difficult to produce and move significant quantities of this type of ethanol to Brazil to relieve length in the US ethanol market.

On the positive side, if we assume $4/bushel corn and $75/barrel crude oil, there will still be a 20-40 cpg blending incentive for ethanol even without renewal of the VEETC. The EPA will issue a ruling on some type of E12 or E15 waiver by September. This will be good news psychologically for the ethanol market but the higher blends could not be realistically implemented until the middle of 2011 offering no physical relief to the market in the 4th quarter. Renewal of the VEETC prior to its expiration again is psychological but will not affect demand in the 4th quarter.
The market is paying a 6.4 cpg premium for Q1-2011 swaps over prompt pricing. The market sees the E12/E15 waiver, the higher RFS2 mandate of 12.6 bln gallons, the elimination of the small refiner exemption as all changes that will kick in for Q1. It should be noted that during the 1st quarter of any year, gasoline demand falls another 250,000 bpd below demand levels experienced in the 4th quarter due to winter weather. Even though there is good news for the 2011 market, Q1 may be too soon for this good news to physically impact the market resulting in higher ethanol prices and plant margins.

The corn crush margins for Q4-2010 and Q1-2011 are in the 24-26 cpg range which are not sustainable for the industry.

With an industry at a nameplate capacity of 14 bln gallons in the 4th quarter and demand softening or at best staying flat, ethanol plant margins are going to come under strong pressure resulting in some temporary plant slowdowns or shutdowns to balance supply and demand.

E15 Update

The EPA announced last week that the agency was delaying the decision on whether to grant a waiver to allow E15 in gasoline, citing the agency’s desire to wait until the DOE has completed its engine testing in September. The DOE engine testing is focused on late model Tier II emission control vehicles that went into production in 2007. In announcing this delay, the EPA intimated that it may only approve a waiver for these types of vehicles, and older vehicles may not be part of the waiver. The ethanol industry was hoping for a minimum waiver that included vehicles 2001 or younger that would have made more than half the existing fleet eligible for E15. Backing up the waiver to 2007 or younger will shrink the available vehicles to approximately 20% of the fleet. This type of waiver will do little for the ethanol industry. As we have discussed previously, a bifurcated market will have gas station liability issues, product labeling issues, and distribution issues for the gasoline marketer offering clear unleaded 87, E10, E15, E85, and premium gasoline.

ADM has petitioned the EPA to consider an E12 waiver based on the “substantially similar” concept that bypasses any engine testing by deeming the product substantially similar. This approach appears to be a long shot. The year and half delay in making any type of decision by the EPA is indicative of the difficulty in moving the gasoline market past E10 with the existing fleet of vehicles. Always keep in mind that when a difficult decision is required by a government bureaucrat that involves risk, the “make no decision” reflex will win out, as evidenced by the long delay on this E15 decision.

We believe the clear path to large ethanol consumption is to focus on moving the fleet towards E85-capable vehicles. In order to achieve the desired amount of renewable ethanol in the US gasoline pool, the solution that Brazil has embraced is the Flex-Fuel Vehicle (FFV). The FFV in Brazil has been tremendously successful in developing the ethanol fuel market in that country. It is very inexpensive to produce an FFV versus a non-FFV, so that is not an impediment. The key to unlocking the E85 market is getting the fuel dispenser infrastructure in place. There is proposed legislation to mandate the auto manufacturers to produce 90% of the fleet as FFV’s by 2013, and the legislation offers substantial federal grants for blender pump installation at gas stations.

Looking forward into 2011, the RFS mandate increases by 600 million gallons, and the small refiner exemption will be removed. These two actions will be enough to complete 100% penetration of E10 into the gasoline pool and consume all the production scheduled to come online by the end of this year. E15 is not necessary to consume all the domestically produced ethanol over the next 18 months, but the delay is having a negative impact in market psychology.