This week's announcement that VeraSun is suspending work on an Indiana ethanol plant underscores the economic impact of "irrational exuberance" in any market. Pork producers could have told ethanol investors all about that. If you doubt that statement look back at the price graphs in last week's edition of North American Preview and study that deep "V" shape in 1998! Furthermore, pig production was not encouraged by a tax credit.
Iowa State University's Center for Agricultural and Rural Development (CARD) has been taking what appears to me to be a brutally objective look at the ethanol business for the past couple of years. Bruce Babcock and Dermot Hayes and their colleagues have probably not been on the ethanol industry's dinner party invitation list after the publication of their work.
Their findings have suggested larger impacts on corn prices than had previously been predicted, and pointed to eventually negative margins in ethanol production at a time when promoters were claiming that little could derail the ethanol train.
Figure 1 shows the most recent estimates from CARD regarding the financial performance of ethanol producers. The graph breaks the total price of ethanol into the amounts spent for natural gas, corn and margin above gas and corn costs. This graph is based on $1.55/gal. of ethanol, $3.69/bu. for corn and $7.05/mm/BTU in natural gas costs.
Note that this ethanol price (represented by the top of the buff-colored area) is the lowest it has been since mid-2005, when the market really started to respond to higher oil prices. In addition, corn now accounts for much more of the cost of producing ethanol, while natural gas costs, which surged in late 2005, are near what appears to be a normal level.
The shocking part of this graph is the decline of the blue area, which represents gross margin over corn and energy costs. It is not a net margin. Ethanol producers must still pay labor, transportation, overhead and fixed costs out of these funds before arriving at a net profit. That gross margin hit a new low for the time period covered here three weeks ago -- and it has improved little since then.
What may be more important is that it doesn't appear that things are going to get better for ethanol producers any time soon. Figure 2 shows the same CARD calculations based on ethanol, corn and natural gas futures. The blue area representing gross margin becomes just a sliver at the end of 2008, even with a stable ethanol price.
Does all of this mean the demise of the ethanol business? No. There is a lot of momentum here, just as we see during an expansion phase in the pork industry. Investors are not going to leave plants half-built. The Indiana plant apparently had site work done but, to my knowledge, no work had commenced on structures. They will complete the plants that are under construction and that will roughly double our current ethanol capacity by late 2008 or early 2009.
In addition, plants will continue to operate as long as they can cover variable costs. Corn and energy (whether natural gas or coal) are the primary components of those variable costs, so it appears to me that as long as there is any blue area in these graphs, corn will still go into ethanol.
Finally, few if any of these plants will close. Just as the new hog farm failed financially for its original owner never had the pigs taken out of it resold for 50 cents on the dollar, some of these plants will change hands at relatively bargain prices. The second owners will be able to withstand these kinds of margins because the items that will have to be deducted from the blue slivers of Figures 1 and 2 to arrive at net profit will be much smaller. Rest assured, there are large funds of money just waiting to fill that role.
Corn demand is still going to be higher than in the past. The question is whether anyone -- ethanol makers included -- will make any money.
Click to view graph.
Steve R. Meyer, Ph.D.
Paragon Economics, Inc.