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.

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.

USDA Regional Roadmap

USDA Regional Roadmap

The USDA published a report this week entitled “Regional Roadmap to Meeting the Biofuels Goals of the

Renewable Fuels Standard by 2022”.  The report makes several assertions that raised our eyebrows.  As we have reported in earlier reoprts, after the startup of the last set of ethanol plants scheduled for this year, we calculate 14.3 billion gallons of available nameplate capacity.  Recently, the industry has been operating in the 90%-95% range of capacity.  After this last surge of plant startups, there are no further significant plant expansions on the horizon.  It appears the USDA thinks that there are 1.2 billion gallons of new plant capacity coming on line that will push total industry capacity to 14.7 billion gallons.  In order for the ethanol industry to produce 15 billion gallons per year of ethanol, a minimum of 15.8 billion gallons of capacity is needed, based on historical operating rates.  From our estimates, a minimum of another 1.5 billion gallons of new capacity needs to be built by 2015 to meet the mandate.  In today’s low margin ethanol market, characterized by frozen capital markets and an uncertain regulatory environment, it will be interesting see when and where this additional capacity will materialize from.  Imports may be the solution.

The other assertion by the USDA that is silly is that cellulosic ethanol capacity will be built at an installed capital cost of $8 per gallon of capacity.  This is opposed to capital costs for a corn starch ethanol plant of $1.50 per gallon of capacity.  Where is the risk capital going to come from to build these plants that have at least a $1.50-per-gallon cost of production disadvantage, let alone a 5 to 1 capital cost disadvantage, and must rely on government tax credits (like biodiesel) and mandates to survive?