Late last year, I visited with a person close to the ethanol industry. Cash corn prices had reached the $4 mark, but she noted with confidence that the newest and most efficient plants could make money with corn prices up to $5/bu. The ethanol boom, I fear, is about to go bust. Exhibits A and B for your consideration: $5 corn as far as the eye can see and sinking share prices for publicly traded firms with focused interests in biofuel production.
Before I make my case for an ethanol bust, let me make it clear that I am not pro- or anti-ethanol. For me, ethanol production is simply a business that converts corn to fuel. When margins and profitability suffer, they retrench, consolidate and rationalize assets.
The boom environment for ethanol grew out of surging energy markets and investors' exuberance for renewable energy. Ethanol production was incredibly profitable for several years leading up to the second half of 2006. Subsidies encouraged expansion, along with a longstanding attitude that $3 corn (or lower) was a birthright, etched into the cornerstone of every new plant.
I wonder how many plants used $2.50-3/bu. for a long-term average price in their pro-forma income statements. Can you imagine the excitement when someone dropped the all-too-common $2 corn into the spreadsheet? Pro-forma analysis probably assumed $4 corn as an occasional occurrence, while $5 corn was the outlier.
Nevertheless, with 50 or more ethanol plants at various stages of construction, the pressure keeps building for even higher corn prices and/or lower ethanol margins.
I'm puzzled and frustrated by policies that fed the expansion fire. In the debate over renewable fuels vs. oil, ethanol subsidies seem to make sense. Who can argue against efforts to replace oil imports?
But on another level, a different debate asks, “Is corn a food, feed or fuel?” At this level, ethanol subsidies are market distortions at their worst, creating an upward spiral in grain and oilseed prices and placing incredible pressures on the livestock and dairy industries.
Now we add government mandates for renewable fuel production (did they mandate profitability, too?). Mandates for renewable fuel production are questionable policies at best — they are wishful thoughts repackaged as “decisive action” by policymakers.
Current margins are breakeven, and adding another 50 plants is more than the market can absorb. And while the boom may go bust, echoes of the current boom will affect grain markets for years to come.
COULD CORN HIT $7?
Ethanol plants are made of cement and steel, and they will continue to run as long as they cover variable costs (the cost of corn, natural gas and people) and have something left over for fixed costs (primarily debt service).
If a plant goes broke, another firm with deeper pockets will pick it up at a discounted price. A new owner will run it as long as they cover variable costs, or put it into mothballs until margins improve. With corn yields growing about 2 bu./acre/year, corn production will eventually grow to a level that supports higher ethanol production.
A bumper corn crop (165 bu./acre or better) in 2008 can delay the bust. Bumper crops happen, but it's not good business to rely on them year after year.
I think we have the possibility of $7 corn with a modestly disappointing crop (150 bu./acre). A short crop of 140 bu./acre could send corn prices into double-digits.
But there is a different scenario that does not involve higher corn prices — simply take energy and ethanol prices sharply lower while holding corn prices in the $4-5 range.
I've outlined an unpleasant scenario for the end game in ethanol. What's your take on the current situation? What will the ethanol industry look like next year? Three years from now? E-mail your thoughts to me ([email protected]) and I will summarize some of the best ideas in a future column.
Ed Usset is a grain marketing specialist for the University of Minnesota Center for Farm Financial Management (CFFM). He can be reached at [email protected].