Ethanol Fuel Production & Demand
Date April 2019
- The U.S. ethanol industry produced a record 16.1 billion gallons of ethanol in 2018, up 1.4% over 2017
- Exports continue to play an increasingly important role in the industry; over the last year, exports increased 24.8% from 1.4 billion gallons and 8.7% of total demand in 2017 to 1.7 billion gallons and 10.7% of total demand in 2018
- Three countries – Brazil, Canada, and India account for 59% of total exports
- Despite record production and exports in 2018, the U.S. ethanol industry suffered from weak margins through much of the year due to a supply imbalance stemming from the Trump Administration’s trade battle with China and management of the Renewable Fuel Program
- Given the supply imbalance and weak price environment, the U.S. ethanol industry is making a concerted effort to curtail production in an effort to bring down inventory levels
Industry outlook troublesome: The general consensus is that the long-term outlook for ethanol is troublesome due to a combination of factors affecting both domestic demand and exports. First, the Trump administration’s handling of the Renewable Fuel Program (RFP) has had a dampening effect on domestic demand. The RFP mandates refiners blend ethanol into gasoline at a mixture of 10 percent ethanol and 90 percent gasoline. However, the Environmental Protection Agency (EPA), under former Administrator Scott Pruitt, granted a record number of hardship waivers to small refiners exempting them from mandated blending requirements. Many in the ethanol industry believe those exemptions are the primary reason ethanol consumption, which was expected to reach close to 14.7 billion gallons in 2018, dipped to 14.38 billion gallons from 14.39 billion gallons in 2017.
Under the RFP, 15 billion gallons of ethanol are required to be blended into the nation’s fuel supply each year. Researchers at the University of Illinois estimate that the hardship waivers granted to small refiners will reduce demand for biofuels by 1.6 billion gallons, of which ethanol is estimated to account for 1.2 billion gallons. This means that the waivers will have the effect of reducing the mandate from 15 billion gallons of ethanol to 13.8 billion gallons. In addition to the waivers, the Trump administration’s trade war with China has led to the imposition of severe tariffs. In 2016, China was the third largest importer of U.S. ethanol behind Canada and Brazil, accounting for 17 percent of exports.
However, starting in 2017 China adopted a series of retaliatory tariffs that by April 2018 amounted to a tariff of 70 percent on U.S. ethanol and all but closed off the China market to U.S. ethanol producers. So despite record exports in 2018, exports would have been at least 10 percent higher had the trade war not broken out. Consequently, many participants believe that the ethanol industry would not be struggling with excess stocks, weak prices, and low margins absent the trade war. Since June 2018, some in the ethanol industry have avoided the Chinese tariffs by taking advantage of a rule that allows ethanol to enter China tariff-free provided it is blended with 40 percent Asian ethanol. To take advantage of this loophole, ethanol is shipped from the United States to countries such as Indonesia and Malaysia, where it is offloaded and blended with Asian ethanol and then shipped to China tariff-free.
Despite the challenges facing the ethanol industry, there are a few positives on the horizon. First the EPA will likely finalize later this year a proposed rule allowing the year-round sale of E15 gasoline (gasoline with a mixture of 15 percent ethanol and 85 percent gasoline). The additional sales of E15 during the summer months are expected to increase ethanol demand by 1 billion gallons per year over the long run. Additionally, China appears to be moving forward with its nationwide E10 ethanol mandate. The plan, which is designed to boost industrial demand for excess corn stocks, is expected to be rolled out in 2020. Similar to year-round E15 sales, China’s E10 mandate is expected to boost ethanol demand by 1 billion gallons. As the United States is the only country with the capacity to produce that much ethanol, the U.S. ethanol industry should benefit.
Ethanol crush spread an indicator of financial health: The crush spread is a financial metric that ethanol producers routinely use to monitor their financial health. The crush spread is the difference between the combined sales value of the ethanol and the co-products that can be extracted from a bushel of corn and the cost of the bushel of corn and other operating costs. The ethanol crush spread is used to gauge the relative costs of production. When the margin exceeds processing costs, ethanol producers tend to process more corn into ethanol. When the margin falls below processing costs, ethanol producers tend to scale back their operations and idle plants. A narrowing corn crush spread occurs when the price of corn rises relative to the sale prices of ethanol, corn oil, and distiller’s dried grains with solubles (DDGS), the nutrient-rich co-product of dry-milled ethanol production. When this occurs, the spread becomes less positive (or more negative). A widening corn crush spread occurs when the sales price of ethanol, corn oil, and DDGS rise relative to the price of corn. When this happens, the spread becomes more positive (or less negative). Ethanol crush margins declined sharply in the second half of 2018 due to record low ethanol prices, a byproduct of excess supplies brought about by the closure of the China export market and a record number of hardship waivers exempting small refiners from mandated ethanol blending requirements.
Corn prices-the real unknown: Corn is the main feedstock for ethanol production in the U.S. due to its abundance and low price. Today ethanol production consumes approximately 40 percent of the U.S. corn crop, leaving the balance of the crop for feed, food production, and other uses. Due to lower than expected grain demand and ongoing trade issues with China, the U.S. currently has a surplus of corn on hand. As of early 2019, data published by Barron’s pointed to surplus of approximately 1.8 billion bushels. Sal Gilbertie, president and chief investment officer at Teucrium Trading, notes “adequate corn supplies, coupled with bearish headlines associated with the trade war, are masking some really significant changes that are coming to the corn market balance sheet within the next year or so.” Factors that could lead to higher corn prices include: 1) ongoing flooding in the Midwest, 2) China’s national adoption of E10 gasoline, 3) year-round E15 gasoline sales in the U.S., and 4) China’s efforts to resolve its trade war with the U.S.
Flooding in the Midwest could become an issue if it continues into the planting season and limits the number of corn acres planted. The USDA is forecasting corn planting at 92 million acres for 2019 (up 2.9 million acres from 2018), and corn production of 14.9 million bushels. If the wet weather continues and forces planting delays, farmers may be inclined to shift some acreage to soybeans. Others argue that corn can be planted quickly and the wet conditions should not be a significant issue. Additionally, the extra water in the ground could benefit farmers should a drought strike this summer.
The trade war with China is the real unknown. Arlan Suderman, commodities economist with INTL FCStone, Inc., believes China will spend heavily on U.S. agriculture over the next year to force the Trump Administration to accept a less stringent trade deal. Suderman notes that if China were to purchase an additional 10 million tons of corn from the United States, domestic corn stocks could dip to 1.22 million bushels, which is well below the USDA’s projection of 1.65 million bushels. If that happens, corn prices could increase to $4.85 a bushel after the 2019 growing season, as compared to the USDA forecast of $3.65 a bushel, causing a ripple effect of cost increases across many industries, including ethanol manufacturing.
Complex nature of equipment necessitates special valuation approach: A “business overlay” approach is absolutely necessary when valuing ethanol facilities to capture the full income-generating value of the equipment. It considers the overall cash flows and value of a company as a whole. An income approach, or cash flow approach, is a common method to value entire companies. The value of company assets that are known, such as working capital and real estate, are subtracted from the company value to derive a value available to the remaining assets. The residual value essentially determines whether the residual assets are providing an adequate return for the company. If they aren’t, then economic obsolescence exists. In general, this “Fair Market Value in continued use” needs to be supported by the going concern earnings capacity of the business that the machinery and equipment supports. In deriving the residual value (or available return on) the remaining assets, Gordon Brothers’ appraisers will consider all information available concerning the company, its assets, and industry trends affecting the company’s cash-generation ability.