Summer 2005, Vol. 11 No. 3
In this issue...
Agricultural Situation Spotlight: Ethanol Revisited
Chad E. Hart
The ethanol industry continues to evolve. When we last checked in on the industry (Spring 2004 Iowa Ag Review), ethanol prices tracked with unleaded gasoline prices; production capacity was expanding; and Congress was considering an energy bill targeting higher usage of renewable fuels. The future looked good for ethanol as we computed a positive ethanol profitability index for the foreseeable future. Since then, ethanol and unleaded gasoline prices have diverged; the production expansion has continued; Congress is still considering the energy bill; and the industry has gone through some growing pains.
The Ethanol and Gas Continuum
The connection between ethanol and unleaded gasoline prices had been a strong one. Looking at monthly rack (wholesale) price data for Omaha between 1982 and 2004, the ethanol price maintained a consistent positive gap over unleaded gasoline prices, usually between 30¢ to 50¢ per gallon. In 2005, the pricing relationship changed dramatically. Ethanol prices fell even though unleaded gasoline prices rose with crude oil prices. By March, ethanol was priced under unleaded gasoline. As Figure 1 shows, ethanol prices fell from a high of nearly $2.00 per gallon in November 2004 to $1.20 per gallon in April and May 2005. Meanwhile, unleaded gas prices rose from $1.20 per gallon in December 2004 to over $1.60 per gallon in April 2005. More recent monthly statistics are not yet available, but daily prices show that ethanol prices have recovered to be on par with unleaded gasoline prices; both are around $1.80 per gallon on the Omaha wholesale market.
To look at what caused the divergence, we have to look at the relationship between ethanol and unleaded gasoline and the growth of the ethanol industry. Ethanol is both a complement to and a substitute for unleaded gasoline. Most ethanol consumers use ethanol through blended mixtures of unleaded gasoline and ethanol, with ethanol making up only a small percentage of the product. In this capacity, ethanol serves as a complementary product to unleaded gas and ethanol usage increases with unleaded gas usage. But over the last several years, ethanol's ability to compete with unleaded gasoline as automotive fuel, through the promotion of E-85 and flexible fuel vehicles, has grown. This change is one factor breaking the link between unleaded gas and ethanol prices.
The growth in the ethanol industry has also changed the pricing relationship. Table 1 shows how ethanol production capacity has grown over the past year and the amount of expansion that is currently being undertaken. Last spring, ethanol industry numbers showed a planned expansion of roughly 14 percent of capacity. Figures today show the production capacity actually increased by 22 percent, with plans to add an additional 1.0 billion gallons of ethanol capacity shortly. Almost all of the expansion to date has been in midwestern states. Over the past 15 months, Iowa has led the way, with over 240 million gallons in new ethanol production capacity. Illinois, Minnesota, Nebraska, South Dakota, Wisconsin, Kansas, and Missouri have all added at least 40 million gallons each. Looking forward, Iowa also is leading the way in future expansions. Current plans call for an additional 665 million gallons of production capacity in Iowa alone. New ethanol plants are also planned in southwestern states. California, Colorado, New Mexico, and Texas will each be adding at least 15 million gallons of ethanol production capacity. With these planned expansions, ethanol capacity will soon reach 4.9 billion gallons per year. With Congress considering a renewable fuel standard of 7.5 billion gallons per year by 2012, there is still plenty of room for the ethanol industry to continue to grow. If the energy bill is signed into law, the ethanol industry will need to expand by an additional 53 percent to meet the new standard.
Production Heats Up
The growth in production capacity is matched by the growth in production. Figure 2 shows the average daily production of ethanol per month and the amount of ethanol held in stock each month from August 2004 to April 2005. The ethanol industry set an all-time production record for average daily production in August 2004 and continued to set new records until February 2005. While production has cooled off recently, it is still quite high. Ethanol usage managed to keep pace for awhile, but by March 2005, ethanol stocks started to accumulate. In economic terms, ethanol supply was outstripping demand. This put downward pressure on ethanol prices, regardless of events affecting unleaded gas prices.
As the current daily prices for ethanol are running 60¢ per gallon above the May 2005 monthly levels, it looks as though the ethanol market has worked through the short-term oversupply toward a new equilibrium. The ethanol market is still an emerging market. The industry still has domestic fuel markets with limited ethanol availability and faces significant distributional and marketing issues. An ethanol infrastructure is being developed to produce, ship, and utilize ethanol, but it is not nearly as complete as the infrastructure for unleaded gas. Ethanol demand cannot react as quickly to price signals as can unleaded gasoline demand. Given these issues combined with the large leaps in ethanol production, it is not surprising that the ethanol market went through a price decline with a delayed recovery.
Positive Profitability - for Now
But as the numbers show, even the recent downturn in ethanol prices has done little to slow ethanol's growth. Investors in the industry still see the potential for profit in the ethanol market. In March of this year, the Chicago Board of Trade began trading ethanol futures contracts, providing a financial tool to mitigate risk in the ethanol industry. While the trading volume has been small, the ethanol futures price movements have paralleled the cash price movements. Over the last month, ethanol futures have gone up by 30¢ per gallon. The nearby contracts are now trading in the $1.60 per gallon range, with the end-of-year contracts priced around $1.50 per gallon.
Given the ethanol futures contracts, we have modified our profitability index for ethanol. Our index compares the costs of the inputs into ethanol, corn and natural gas, to the revenues from ethanol and its co-products, such as dried distillers grains and solubles (DDGS). The index can be thought of as a gross margin for ethanol production, the difference between per unit revenues and costs of ethanol production. The index does not imply that all ethanol plants will make a profit, but it does signal the potential for profits within the industry. With current ethanol, corn, and natural gas futures prices, we can calculate the expected values of the profitability index for ethanol production. Based on a dry-mill production technique for ethanol, one bushel of corn and 165 thousand British thermal units of natural gas are needed to create 2.7 gallons of ethanol and 17 pounds of DDGS. Figure 3 shows the historical and projected levels of the profitability index. Given the futures prices on July 14, 2005, the profitability index for ethanol in August 2005 is at 58¢ per gallon of ethanol, meaning the per gallon expected revenues from ethanol and DDGS exceed the per gallon expected costs of corn and natural gas by 58¢. But the futures prices show a downward trend in ethanol prices and upward trends in corn and natural gas prices. For December 2005, the index is down to 33¢ per gallon. It is still positive, reflecting the possibility of profits in the industry, but highlights the expected tightening in the ethanol market.
Over the last 15 months the ethanol industry has gone through a volatile period. The industry has experienced significant growth and dramatic price swings. Given the planned expansions in ethanol plant capacities and a renewed effort by Congress to pass an energy bill, the ethanol industry is looking to continue its growth, but until the demand and infrastructure for ethanol mature, we can expect to see more dramatic price swings in ethanol's future that are not necessarily related to events in oil markets. ♦