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.

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.

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.