Spring 2004, Vol. 10 No. 2
In this issue...
Agricultural Situation Spotlight: Ethanol: Policies, Production, and Profitability
Ethanol: Policies, Production, and Profitability
Chad E. Hart
The proposed federal energy bill, currently back in committee for further debate, has targeted a dramatic increase in the use of renewable fuel sources, and that has helped focus a vast amount of attention on ethanol over the past year. By 2012, five billion gallons of renewable fuels would make up part of the nation's fuel supply. That is nearly double the current amount of ethanol in use.
Congress is also considering a long-term transportation bill that includes an extension of the ethanol fuel tax break and a modification of the relationship between federal highway funds and fuel taxes. Currently, the federal government provides a 5.2¢ tax credit for 10 percent ethanol-blended gasoline. This credit is scheduled to fall to 5.1¢ in 2005 and expire at the end of 2006. The modification is called the Volumetric Ethanol Excise Tax Credit (VEETC). In short, the VEETC would change how the ethanol tax credit is used. Currently, the tax credit reduces payments to the Highway Trust Fund, which supports the interstate highway system. The VEETC would fund the credit through the federal government's general revenues, with the value of the credit being passed through to the Highway Trust Fund. An estimated $2 billion would be added to the Highway Trust Fund with the VEETC, while the impact to refiners and marketers would be minimal.
Ethanol Production and the Corn Market
Ethanol production has increased tremendously over the last several years. As Figure 1 shows, ethanol production was under 500 million gallons in the early 1980s. There was fairly steady expansion through the 1980s and early 1990s. A corn price run-up in 1996 put the first dent in ethanol expansion, but that decline was reversed by the next year. Over the past three years, the industry has experienced record growth. As production has increased, ethanol's share of the domestic corn market also has grown. The other line on Figure 1 shows the proportion of the U.S. corn crop used by the ethanol industry. The spikes in 1983, 1988, 1993, and 1995 reflect short corn crops in those years. In 2003, nearly 11 percent of the U.S. corn crop was converted into ethanol. In 2004, the industry is projected to produce 3.3 billion gallons of ethanol. Ethanol production is estimated to add between 20¢ and 40¢ per bushel to the corn price.
The ethanol industry is centered in the Corn Belt. Table 1 outlines current and planned ethanol production capacity in the United States. Illinois and Iowa have 45 percent of the nation's ethanol production capacity. When all of the new production capacity comes online, eight states will be able to produce at least 100 million gallons of ethanol per year. Minnesota currently has the largest number of ethanol plants, but Iowa is set to take the lead, with four new plants in the planning or construction stages. Combined, the United States has 75 ethanol plants, with another 12 plants underway. In addition to Iowa's four new plants, Illinois is adding two plants; Missouri, South Dakota, and Wisconsin are adding one plant each; and Nebraska has three new plants underway.
A Profitability Index for Ethanol
Ethanol production has been refined over the years. The dry-mill production technique uses one bushel of corn and 165 thousand British thermal units of natural gas to produce 2.7 gallons of ethanol and 17 pounds of dried distillers grains and solubles (DDGS), a livestock feed. Based on this production technique and the prices for these commodities, we can construct a profitability index for ethanol. As ethanol and DDGS do not have futures markets, we have linked ethanol prices to unleaded gasoline prices and DDGS prices to corn prices in order to make projections. Figure 2 shows corn prices, unleaded gasoline prices, and a profitability index for ethanol. The profitability index compares the receipts of ethanol and DDGS to the costs of corn and natural gas. The index does not imply that any ethanol plant will make a profit; it does indicate that the leverage from the output commodities exceed the costs of the input commodities. All of the series shown in Figure 2 have been normalized by their July 1990 values.
For corn, the July 1990 average price was $2.83/bushel. For unleaded gasoline, the July 1990 average price was $0.60/gallon. This price is from the New York Mercantile Exchange unleaded gasoline futures market. The calculated gross margin for ethanol in July 1990 was $1.17/bushel of corn. For the ethanol gross margin, positive values indicate that, for existing ethanol plants, ethanol adds value to corn. Since the profitability index does not include fixed costs, such as plant construction costs, a positive index value does not necessarily indicate that new ethanol plant construction will be profitable. The ethanol profitability index has been above one for most of the historical period. Relatively low unleaded gasoline prices held ethanol profitability down in early 1994. Relatively high corn prices restricted ethanol profitability in mid-1996. The natural gas price spike of late 2000 took a bite out of ethanol profitability. However, even during most of these episodes, ethanol remained profitable. Only during the summer of 1996 when corn prices exceeded $4.00 per bushel did the ethanol gross margin fall below zero.
Based on futures prices, the relatively high corn prices we are seeing today would limit ethanol profitability over the next 18 months, even though unleaded gasoline futures are relatively high as well. But the index is projected to remain positive over the foreseeable future. The revenue from ethanol sales from existing ethanol plants is projected to exceed the costs of the inputs, based on a dry-mill ethanol production technique. Whether the projected porfitability margin would sustain new ethanol plant construction depends on the fixed costs of the new plants. But these results, in combination with the federal incentives for ethanol (in tax credits, loans, and rural development grants), are promoting the current expansion we are seeing in ethanol. If corn prices fall and/or unleaded gasoline prices rise, the ethanol profitability index will rise. ♦