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.

Brazil's Potential Role in Ethanol Trade

This year, Brazil’s exports have tracked at a level 50% below last year’s exports.  It is our opinion that Brazil’s participation in the international fuel ethanol market is going to be very limited over the next two years.  The following is a list of factors that will contribute to keeping Brazil off the fuel ethanol export market:

•          Dry weather conditions have reduced sugarcane yields per acre by 5% or more below forecast this harvest season.
•          The poor weather conditions during the last two years have conspired to disrupt the typical replanting share of 20% of the cultivated acreage.  This has left the industry with a substantially older crop in the field that yields less cane than younger sugarcane.  It will take at least another growing season to remedy this imbalance in the sugarcane crop.
•          Sugar prices are again at record levels, and it appears that the sugar industry will not be able to replenish stocks this year, leaving the sugar market fundamentally tight for at least another year. 
•          Higher sugar prices will continue the favoring of sugar production in Brazil, where mills can swing approximately 1 billion liters of ethanol production towards sugar.
•          High sugar prices generating copious amounts of cash, coupled with the government loan program for ethanol inventory, has allowed mills to show market discipline and not dump ethanol onto the market to generate cash.  This is evidenced by the industry holding more than 2 billion liters more of inventory than last year at this point in the harvest, allowing the mills to maintain high ethanol prices.
•          The startup of significant chemical demand to produce green plastics.  Braskem’s new polyethylene facility will consume 500 million liters per year of ethanol starting next year.
•          The continued growth of the flex-fuel vehicle (FFV) fleet by 2.7 million vehicles per year.  If these FFVs shift from E25 to 100% hydrous ethanol, they have the potential to consume an additional 3.5 billion liters per year of ethanol.  FFV fuel demand is very elastic and will respond to price quickly.   Higher prices this year have reduced ethanol demand by over 1 billion liters as the FFV fleet has responded to high ethanol prices relative to gasoline.  The overall size of the FFV fleet is estimated at 11.7 million vehicles by the end of 2010.  In our opinion, this is the single largest reason why Brazil, at least for the next several years, will not be a major exporter of ethanol due to the potential for a huge surge in demand domestically when the prices are set accordingly.

Brazil's Inventory Bubble

As we noted in last week’s newsletter, the increase of ethanol inventory in Brazil this harvest season is surpassing last season’s inventory build substantially.  The following chart clearly illustrates the dramatic change in the inventory profile between the two harvest seasons:

  

How much inventory does the Brazilian ethanol market need to cover the inter-harvest period when sugarcane processing and ethanol production are at minimums?  To determine the answer, we have forecasted monthly consumption for the inter-harvest period as follows:

                   Monthly Consumption

Fuel Use                 1,875

Non-Fuel Use             210

Exports                  __150

Total                      2,235 million liters

Fuel use is based on average consumption this year, according to data published by the National Petroleum Agency (ANP).  Fuel demand is lower than last year’s consumption by 160 million liters per month.  Non-fuel use is predicted to be approximately 50 million liters per month higher than last year due to the startup of new chemical (non-fuel) demand for ethanol.  This new demand is anticipated to come on line in the 4^th quarter.  Exports are forecast to follow last season’s pattern. 

With the drier harvest season this year, December ethanol production will fall off to inter-harvest levels due to the poor quality of the late harvest sugarcane, which was impacted by dry weather.  This results in an estimated ethanol production of 400 million liters per month for the period of December of 2010 through March of 2011. 

These numbers indicate a market that is short by 1,835 million liters per month for the December 2009 - March 2010 time period, yielding a total shortfall of 7,340 million liters leading up to the start of the 2011 harvest.  As of August 15, Brazil’s physical inventory was 5,673 million liters and building monthly by 1,500 million liters.  Assuming this inventory build rate continues through October, and the carryout inventory at the end of the harvest season is 1,000 million liters, the Brazilian ethanol industry will meet this inventory level by mid-October.  If nothing changes in the supply/demand balance, inventory levels by the end of November could reach 10,000 million liters, assuming the industry has the storage capacity to hold this quantity.

Brazil’s ethanol prices have been remarkably stable this harvest season, due in large part to the industry’s ability to finance the increased inventory.  The ethanol market in Brazil is moving into some uncharted waters as this inventory level continues to reach new heights.  Going into October, it would not be surprising to see weaker prices in Brazil that would stimulate demand to slow down the inventory growth.  A countervailing force for lower prices is the anticipated increase in European ethanol prices.  The European ethanol market is suffering significantly from higher feedstock costs due to the poor wheat harvest, which could result in sizeable export demand for Brazilian ethanol.

Proposed 2011 Renewable Fuel Standards

This week, the EPA issued a notice of proposed rule making to address Renewable Fuel Standards (RFS) for 2011 that, pursuant to RFS2 regulations, need to be determined by November of each year for the upcoming year. The table titled “Proposed Percentage Standards for 2011” indicates the percentages that obligated parties need to meet for 2011. The numbers are lower than last year due to the inclusion of small refiner volumes in 2011, even though the total mandate increases.

Cellulosic ethanol continues to be a large failure. The 2011 mandate calls for 250 million gallons, and the EPA is anticipating a range of available cellulosic ethanol of 6.5 million to 25 million gallons.

What is to be done about the shortfall, and how will both the Advanced Biofuels and Total Renewable Fuel requirements for 2011 be adjusted to address this shortfall? The EPA is proposing not reducing the totals, but just adjusting the Cellulosic mandate and anticipating that biodiesel and sugarcane ethanol will pick up the slack. The adjacent table titled “2011 EPA Proposed Rule Changes” describes the 2011 mandate. The Advanced Biofuels mandate consists of three types of biofuels based on feedstock minimum 50% GHG reduction performance: cellulosic biofuels, biodiesel, and undifferentiated advanced biofuels. A renewable fuel meeting cellulosic requirements can satisfy the cellulosic and advanced biofuels requirements, but not biodiesel. Biodiesel can satisfy the biodiesel and advanced biofuels requirements, but not cellulosic. The only approved pathway for undifferentiated advanced biofuels is sugarcane ethanol, and a gallon of this material can satisfy the advanced biofuels requirement, but cannot satisfy either the cellulosic biofuels or biodiesel requirements. One gallon of physical biodiesel generates 1.5 RINs because of biodiesel’s higher energy content.

The EPA also admits that the biodiesel industry has been struggling and is currently not producing enough biodiesel to meet the mandate. They also believe there is enough idle biodiesel capacity that can be restarted to produce a minimum of 800 million gallons in 2011. The adjacent bar chart titled “United States Biodiesel Production” indicates that the most the industry has produced in any calendar year is 670 million gallons in 2008. The EPA shrugs off the lack of a biodiesel tax credit and an industry that today is producing at a 360-million-gallons rate for 2010. The EPA blithely mentions that there are 2.2 billion gallons of capacity just ready to restart. They, however, do not address the numerous bankruptcies and facility abandonments since Congress’s failure to renew the biodiesel production tax credit; this makes estimating what capacity is left to surge production in a short time frame next to impossible. The EPA also makes no mention of the $1.00-per-gallon price premium for biodiesel over regular diesel that exists in today’s market. We are extremely skeptical that 800 million gallons of biodiesel will be produced at today’s feedstock prices without a significant change in tax policy to support the industry, which, in today’s political climate in Washington, appears to be next to impossible.

In proposing no change to the total Advanced Biofuels mandate, the EPA is also assuming that sugarcane-based ethanol, essentially from Brazil, will be available to fill the gap left unfilled by cellulosic biofuels and biodiesel. The EPA assumes 144 million gallons, or 544 million liters, of ethanol will be available for export to the US in 2011. They further point out, more specifically, that the California Low Carbon Fuel Standard (LCFS), which begins in 2011, should attract sugarcane-based ethanol, and that can be applied to the Advanced Biofuels mandate. With government regulators in the US, California, Europe, and Japan all wanting to use sugarcane-based ethanol to meet their GHG reduction goals, colliding with the hard facts of weather-related negative pressure on Brazil’s sugarcane production and expanding Brazilian domestic demand, will force importers to bid ethanol away from Brazil’s domestic market. So far this year, Brazilian exports are 665 million liters, which are 50% below previous year’s exports, and the outlook for 2011 is not any better for material available for export. None of Brazil’s exports this year have come to the US for use in the transportation fuels market. If the import tariff on Brazilian material is left in place, CBI hydrous ethanol dehydration plants may start processing again by being able to offer a 10-20 cpg discount to direct shipped anhydrous ethanol from Brazil.

In summary, the Advanced Biofuels portion of the RFS2 is struggling. The hard taskmaster of economics is proving to be a difficult hurdle. With a highly efficient cornstarch ethanol industry producing cost-competitive ethanol, it will require strong government support and a long-term financial incentive to bring high-cost cellulosic ethanol to market. The biodiesel industry is in the same situation, with a product that is not cost competitive. We question the ability of the government to follow through with the needed financial and market support to make cellulosic ethanol a reality. The EPA is counting on imported sugarcane ethanol to meet a portion of the US renewable fuels mandates, even when there are significant quantities of US-produced cornstarch ethanol available. It appears that US environmental policy is promoting the importation of transportation fuels, which is diametrically opposed to stated policies of promoting energy independence. Conflicting government policy on Brazilian sugarcane ethanol has the EPA promoting the importation to meet renewable fuels goals, while the same US government continues to impose a 54 cpg import tariff on Brazilian ethanol to protect the US cornstarch ethanol industry in the name of energy independence.

Global Ethanol Trade Flows

Global Ethanol Trade Flows

Ethanol trade has started to slow down for many producing and consuming countries.  The table on the right titled “Global Ethanol Trade Flows” examines trade flows between various regions around the world comparing year to date April of 2010 versus year to date April of 2009.  The six key trade flows that have shown significant year over year changes are evaluated as follows:

· USA => CANADA

Looking at the table on the right, according to the US Census Bureau, exports of ethanol from the US to Canada have almost doubled this year compared to the same time frame last year.  This is due to provincial ethanol blending mandates in Canada taking effect within the last year, as well as preparation for the national E5 mandate that is set to be implemented at the end of the year.  There is one new plant expansion scheduled in Canada by Suncor of 200 mln liters in Q1 2011.  With no other new capacity on the drawing board beyond the Suncor plant, this level of Canadian imports will continue into next year.

· Brazil => CBI  => USA

Brazil’s exports to the CBI nations are down 76% of what they were a year ago.  CBI nations enjoy duty-free access to the US market.  The CBI countries have essentially no indengious ethanol production and rely solely on the dehydration of Brazilian ethanol.  The dehydration arbitrage of Brazilian hydrous ethanol is closed and we expect the arbitrage to remain closed for the foreseeable future reducing this trade flow to zero.

· Brazil => USA

Due to feedstock prices in their respective countries, imports of ethanol into the US from Brazil have diminished during the last two years.  Brazil’s poor harvest last year and substantial growth in Brazil’s domestic ethanol demand by the burgeoning FFV fleet has maintained strong domestic prices reducing the incentive to export. The US import tariff of $0.54-per-gallon tariff is also a strong barrier to open trade.  Although corn prices are rising in the US at the moment and pushing ethanol with them, it is remains uneconomical to bring material in from Brazil, especially with the added tariff.

· Brazil => Asia/Pacific

Brazilian ethanol exports to Asia are somewhat lower this year compared to the same time last year.  This market represents a potential growth opportunity for Brazil.  Other than China, there are no substantial producers of ethanol in Asia, especially for export, and countries such as Japan and India have invested in sugar mills and ethanol technologies in Brazil, leading to a natural trade flow between Brazil and these countries.  South Korea is a major recipient of ethanol from Brazil, but much of this volume is for beverage-grade consumption since  South Korea does not have a fuel ethanol blending mandate.

· Brazil => EU

Exports of ethanol from Brazil to the EU have fallen by almost half of what they were last year during the same time period.  This has been due to abundant T2 ethanol supply in Europe, as well as a function of price; when adding the EU import ethanol tariff, it simply has been largely uneconomical to send undenatured EN spec ethanol from Brazil to the EU.    We expect ethanol demand to grow in Europe with increased blending penetration percentages kicking in the second half of the year.  With this increased demand, regional price spreads will widened at some point to draw in the necessary volume to cover demand.

· USA => EU

Exports of ethanol to the EU from the US have increased substantially.  This change in trade flow has been a function of price.  Ethanol prices in the US have been low relative to EU and Brazilian prices prompting the surge in exports.  Export volumes have receded recently with the narrowing of regional prices.  This week’s strengthening in corn prices due to changes supply fundamentals will keep US ethanol prices too high for further sustained exports to the EU.