Friday, February 19, 2010

Ethanol At The Crossroads

We have been studying the corn ethanol market closely the last few years.  There are some interesting trends in the market and the makeup of the industry.

The corn ethanol market is maturing and you can see that in a couple key indicators.  The latest RFS2 indicates a significant drop in production and slow down in the construction of corn ethanol capacity.  It appears that the capacity is in line with the RFS demand.

The new capacity coming on line or under construction plus the existing capacity is actually went down in 2009 and is projected to stay down in 2010.

The RFS mandate for corn ethanol is 12 billion gallons per year (BGY) in 2010 and rises to 15 BGY in 2015.  This should mean a reasonably stable period for corn ethanol capacity in the US.  The RFS allows for a slow and steady growth rate.  This will help to reduce the wild speculative market affects on corn and help to keep ethanol at reasonable price for producers and users.

What about the ethanol producer's profitability?  Ethanol profitability is a simple equation.  The price must be higher than the input costs plus the operating cost.    The two highest input costs are corn and natural gas (or other energy source used for heat generation).

The price of oil could go very low again and drag ethanol prices down.  If the currently fragile world economy is  supporting near $80 per barrel oil what will it be when the economy picks up again?  I don't think we are going to see $30 oil for quite some time.  Take a read of other blogs like R Squared energy blog for another opinion.  The price of oil is probably on it's way up before down.  Ethanol should track with a similar ratio to crude.

The price of corn could go up.  We think that we are definitely going to see higher corn prices.  The price of corn has a new floor.  You can't expect the increased demand from corn ethanol to not affect the market.  I don't think corn is not going to fall below $3.00 for a long time and maybe not in our lifetime.  I think that is a good thing. The higher price of corn has effectively eliminated a great deal of the agricultural price subsidies.  I think the increases in corn will be modest because the commercial and speculative demand is not going to shoot up like it did in the ethanol expansion of 2006-2008.  I also think that the corn increase will be mostly offset by the increases in ethanol prices as oil rises.

The price of natural gas could go up considerably.  Every $1 change in the price of gas changes the cost by about $3,000,000 per year.  A swing in gas can really hurt especially if the margins are thin already.  The good thing about natural gas is there is an abundant supply.  We produce the majority of the natural gas we need and Canada has huge supplies backing this up for many years.  The natural gas prices tend to fluctuate with the temperature and weather conditions mainly because of supply constraints.  We feel that while there will still be periods of high gas prices we won't see them go up and stay high for extended periods of time.

We think these 3 factors combine to produce a reasonable ethanol market for the next 5 years.  It may not be see the highs of 2006 and 2006 but we probably won't see the lows of 2008 and 2009.  We think ethanol should provide reasonable return on investment and grow with the RFS demands.

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