Ethanol Margins and Oversupply
The fundamental problem is a combination of ethanol production being up at the same time motor gasoline demand is down and ethanol production hitting the blend wall of 10%. Average annual gasoline demand is down over 10% from the peak in July of 2007. The Energy Information Administration projects gasoline demand to be down another 0.34% in 2012 and down slightly in 2013.
· With gasoline demand down, ethanol production and stocks spiked at the end of 2011. This is due to Midwest plants producing closer to peak production at the end of 2011, incremental expansion from non-Midwest plants, and likely slowing in ethanol exports due to the stronger U.S. dollar. Production has started to subside as some plants are idling production and more are slowing down production, but that has yet to result in lower ethanol stocks.
· The increased ethanol production and stocks coupled with declining gasoline demand has pushed ethanol to the peak blending potential of 10%. With ample supply of ethanol to meet the RFS requirement and ethanol penetration capped at 10%, price becomes the equalizer.
· Since mid-December RBOB gasoline futures are up over 21%. Ethanol prices did not benefit from this price rise due to the long supplies of ethanol. In this same period ethanol futures prices are only up 6% with corn futures prices up 9.3%.
· This adds up to ethanol production margins that are net income negative for many and cash flow negative for some. A given margin situation is materially dependent on ethanol plant hedging and incremental plant value-added activity such as corn oil recovery, carbon dioxide contracts, and energy savings strategies.
· All of the plants in the Ascendant Partners Performance Improvement and Benchmarking Initiative are reaping the benefits of investments made in value-added or new product streams and/or energy efficiency strategies that make the difference in running and not running during difficult times like these.
· Another key factor affecting plant production decisions is financial capacity. Ascendant does Capital Planning with a number of plants to help them understand the capital they need to retain for both good times and bad. Plants that have a good handle on cash flow and do proactive capital planning can make informed business decisions about the “right time and circumstance” to idle. When it comes to tough times, it is important that both boards and managers are not surprised by the cash implications of a challenging market environment and have a plan to do what is best for the business and shareholders.
· The margin stress has caused many plants to slow production but not idle their plants, hoping margins will improve. Plants are always hesitant to idle production as there are major implications to both upstream suppliers of corn and downstream buyers of ethanol and distillers grains. Therefore, many plants have lowered run rates and are assessing the timing and circumstances under which they would idle their plants.
· The ethanol business is a cyclical business like any other commodity business. There is some risk that the decline in gas demand and lowering of the blend wall could make this cycle-down longer and/or deeper because there is more than an adequate supply of ethanol to meet the RFS requirement. Pushing up the blend wall is the biggest risk to corn‑based ethanol. At the same time oil is at $105 per barrel, even though the developed nations such as the United States and Europe are either growing slowly or in recession. The support for energy prices is driven by the geopolitical risk in the Middle East and the continued strong energy demand from developing countries such as China and India. The outlook for energy prices is more likely higher than lower as growth in the developing nations increases. The U.S. has been exporting more ethanol, which has helped the blend limitations; but this may not be as supportive if the dollar strengthens and Brazil is able to produce more ethanol.
· Ethanol market experts seem to be somewhat mixed on how bad this cycle downturn might be, but Ascendant can attest that most plants are financially stronger than in previous hard times and their boards and management are much better prepared to weather the storm from an experience standpoint. This cycle downturn will likely accelerate some consolidation and restructuring of the industry, but it will not likely be as driven through distress and bankruptcy as it was in 2009 and 2010.