Ethanol Market Fundamentals

Based on research and footnotes I encountered in doing the last post, I said it was worthwhile to revisit ethanol fundamentals. From the website of Cumberland Advisors, from whom much of the information in the previous post was gleaned, comes additional interesting information on the fundamental economics of the ethanol industry. Little of it will be comforting to ethanol's supporters or investors.

The economics of ethanol from corn can be divided into two categories: 1) the basic math and physics involved in growing corn and brewing it into ethanol as a replacement for part of our oil budget, and 2) the market economics of producing ethanol from corn (as opposed to say, sugar beets) and competitiveness of ethanol as an additive per se.

For background on the first factor, see this summer's posts on Bottom Line Economics On Ethanol and Gas and What Part of $3.50 a Gallon Don't You Understand?.

As for the markets for corn-based ethanol, Cumberland Advisors comments in Ethanol, Gas Prices and Your Pocketbook

Some US politicians deserve to walk not ride. Their ethanol protectionist policies are causing energy prices to be higher than they might otherwise be. Those same policies will harm the lower income folks in the US because they are causing the price of food to rise. Lastly, this policy may contribute to the hunger of millions of folks around the world.

In the US, the combination of $1.05 ethanol protectionism is still not enough to render corn-based ethanol competitive. See the Simons piece for the math. What happens when protectionism fails? Simply put, the ones who want the special treatment seek even more of it. That is probably coming in the new Congress.

We expect a move to raise this corn-based ethanol subsidy after the new Congress convenes. The corn crowd may also seek greater mandate of corn-based ethanol usage. The Bush Administration tried to repeal the tariff on sugar-based ethanol. On May 9, 2006, five corn state Senate Democrats effectively blocked lifting the tariff. The Senators were Harkin (Iowa) Dorgan (North Dakota) Durbin (Illinois) Johnson (South Dakota) and Obama (Illinois). Cries for energy independence and environmental protection were used to cover the real culprit which is a politically misguided raid on the pocketbooks of our country.

The best outcome would be a total repeal of the 51 cent subsidy and of the 54 cent tariff. That would lower ethanol cost and take the pressure off food source prices in the grain markets. It would also lessen the starvation that will occur in some parts of the world where the marginal cost of grain negatively impacts the hungriest and the very poor.

Cumberland advisors cite the work of Chicago-based Bianco Research in a paper entitled An Impending Ethanol Cost Squeeze that demonstrates how falling margins on ethanol production combined with the rising costs of corn-based ethanol essentially in lockstep with gasoline prices mean that ethanol is far from an effective oil substitute.

More important, the 54¢ per gallon tariff on imported ethanol, distilled primarily in Brazil from sugar, de facto makes U.S. ethanol distillation a corn conversion process.

...the diversion of corn from domestic and export human and livestock feedstock to yeast feedstock inevitably will affect the economics of all industries involved. The distortions to come in agricultural economics will be the largest disruptions since the early 1970s. Global grain, oilseed, livestock and fuel markets will be affected, as will competitors for agricultural land.

The increases in food prices will affect commonly quoted consumer price indices. Core inflation, we are happy to report, will remain unaffected. This inescapably will be a divisive public policy issue from which there will be no escape.

That ethanol prices expand to capture the rent of higher gasoline prices should give pause to anyone operating under the illusion blending ethanol into gasoline can painlessly lower retail prices at the pump. A deterioration of either gasoline or ethanol prices, or as is most likely the case both in tandem, coupled with higher corn prices will turn ethanol production uneconomic in the absence of further subsidization in addition to the 51¢ per gallon exemption from the federal motor fuels excise tax and the aforementioned tariff.

The entire corpus of international economics from the 18th Century forward has been based on the theory of competitive advantage. You do what you are good at doing and import cheaper goods and services as warranted. Brazil and other sugar producers are better at feeding yeast than are American corn farmers. Producers of conventional hydrocarbons are better at fueling internal combustion engines than are American ethanol distillers. The impulse to declare energy independence in a dangerous world is understandable, but should be resisted if it is uneconomic in the absence of subsidization.

That these market analysts are on to something is reflected in the latest ethanol plant news from across the state. A proposed plant in Belmond, Iowa (near my childhood stomping grounds) has been canceled. Whether or not due to construction costs, the finger points to longer payback due to lower margins. The builders were two large ethanol companies and I'm sure they are looking at the fundamentals as hard as the suits in the investment think-tanks.

The long-term solution is to eliminate both the 51-cent a gallon subsidy and the 54-cent a gallon tariff on imported ethanol. Scarcity in the oil market will eventually make corn (or cellulose-based) domestic ethanol production economically viable as a fuel additive, especially in regions located close to the production zones. Or not.

The take-aways for the reader should be: 1) That ethanol is not and will never be a solution to oil scarcity and our dependence on foreign oil and, 2) the U.S. ethanol market resembles more a socialist, centrally planned market circa the Soviet Union of the 1980's than it does what most Americans expect to see in a modern 2006 free market of goods and services.

The long term solution to oil scarcity and dependence on foreign oil remains as simple and as controversial as it ever was: drive less, consume local goods.