(ethanol producesup to one-third less carbon monoxide and one-quarter less CO2 than acomparable gallon of gasoline).r Ethanol can be mixed with gasoline as an oxygenate additive to improve combustion efficiency and reduce pollution.r Ethanol is easy to distribute using the current U.S. and global gasolineretail distribution system (unlike hydrogen for fuel cells).r Ethanol industry provides an economic stimulus to a country’s agriculture sector and overall economy.Disadvantagesr Ethanol-fueled internal combustion engines still release CO2 and otherpollution into the air.r Ethanol produces about 25 percent lower mileage than gasoline.7r Ethanol raises a feedstock debate about “food or fuel,” although thatissue will disappear when cellulosic ethanol becomes more prevalent.r Corn-based ethanol is not a particularly efficient way to produce fuelbecause of the large amount of energy and land that goes into producing each gallon of ethanol.r Ethanol is more expensive to transport than gasoline because ethanolcannot easily be sent through pipelines and is currently transportedonly by rail car, tanker truck or ship. Ethanol in the United States isproduced mostly in the Midwest and transportation costs are high tothe east and west coasts.r Ethanol helps promote internal combustion engines, which from apolicy standpoint should be eliminated in favor of more environmentally friendly vehicle propulsion methods such as electric or fuel cellvehicles.
U.S. GOVERNMENT SUPPORT FOR ETHANOLU.S. ethanol producers are currently receiving strong support from theU.S. federal government, which has helped the U.S. ethanol industry toget on its feet. First, the U.S. federal government has a Renewable Fuels
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Standard (RFS), which requires fuel distributors and blenders to use 7.5million gallons of biofuels per year by 2012. The industry will easily beatthat standard and reach the 7.5 million gallon goal by early 2008, four yearsahead of schedule. Washington is in the process of raising the RFS.President Bush has proposed his “Twenty in Ten” plan, which seeksto reduce gasoline usage by 20 percent over the next 10 years. The planinvolves raising the Renewable Fuel Standard (RFS) to 35 billion gallonsof renewable fuels by 2017, which would reduce the need for gasoline by15 percent. The remaining 5 percent of gasoline savings would come fromreducing gasoline demand by raising the Corporate Average Fuel Economy(CAFE) standards for cars.8In addition, there are two tax provisions that provide strong support for the U.S. ethanol industry. First, the federal government gives fuelblenders a 51-cent per gallon excise tax credit for blending ethanol intogasoline (the credit lasts until 2010). Second, the federal government protects U.S. ethanol producers with a 54-cent per gallon import tariff on imported ethanol, which is enough to make large-scale ethanol imports fromBrazil uneconomical. The 54-cent per gallon tariff is currently set to expireon January 1, 2009, although it is likely to be rolled over.States are also taking action on their own to boost ethanol use. California Governor Schwarzenegger in early 2007, for example, moved to reducethe carbon content of transportation fuels in California by 10 percent by2020, which would largely be met with increased ethanol usage.
OBSTACLES FOR THE U.S. ETHANOLINDUSTRYEthanol is currently used in the United States almost solely as a gasolineadditive in E10 (10 percent ethanol and 90 percent gasoline). Ethanol isblended into about 46 percent of the nation’s gasoline, according to Biofuels Journal.9 That usage stems mainly from the fact that ethanol is an“oxygenate” that helps the gasoline to burn more completely, thus reducing pollution emissions. Ethanol is used to raise the octane of the fuel mix,thus meeting octane requirements. Demand for ethanol as an oxygenateadditive rose sharply in the spring and summer of 2006 when gasoline retailers dropped MTBE (methyl tert-butyle ether) as an additive due to liability and ground water contamination issues, instead substituting ethanolas the oxygenate of choice. Ethanol is also being used as an additive tomeet the federal Renewable Fuel Standard, which requires blenders to use7.5 billion gallons per year of renewable fuels by 2012.Ethanol as a primary fuel in the form of E85, however, has yet to takeoff in any significant way. U.S. automakers have been manufacturing a
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fairly large number of “flex-fuel” vehicles (FFV’s) in the past several yearsbecause they received credit toward their fuel economy standards for producing those vehicles. There are already about 6 million flex-fuel cars onthe road in America. U.S. automakers have announced plans to double production of flex-fuel autos by 2010. Flex-fuel vehicles can use straight gasoline, E10, or E85.However, many car owners do not even realize that they have a flexfuel vehicle. Even those that know they have a flex-fuel vehicle would havea hard time finding a service station that carried E85. In California, for example, only one of the state’s 10,000 public service stations carried E85ethanol as of mid-2007, according to U.S. Department of Energy Web site(there were also four private E85 stations in California but those were notopen to the public).10 In the United States as a whole, there were only 1,250service stations that carry E85 as of mid-2007, which represents only 0.7percent of the 169,000 service stations in the United States.11There are three main reasons why E85 pumps are not being installedat many service stations in the United States:1. E85 pump costs. First, E85 equipment is a large expense for the service
station. A service station usually must install a new underground tankand pump on the service island, a process that can cost as much as$200,000.12 The federal government provides a tax break for installingthe E85 equipment, but there is still a relatively large up-front cost forservice stations to install E85 pumps.2. E85 obstruction by major oil companies. The second obstacle forinstalling E85 pumps is that some major oil companies are blockingthe efforts. Ethanol is not a product produced by major U.S. oil companies and instead provides direct competition to gasoline. Oil companies therefore have an interest in blocking E85 from being sold inservice stations alongside gasoline. Service stations that are owned bymajor oil companies will certainly not be installing ethanol pumps anytime in the near future, unless they are required to do so by law.The oil companies also have a way of blocking independentlyowned service stations from selling E85 because many of the contractsbetween major oil company suppliers and independent service stationsstipulate that the service station must exclusively sell the products soldby the major oil company, which typically do not include ethanol. Oilcompanies are using that contract provision to block E85 from beingsold at independently owned service stations, although the oil company can provide an exemption if they wish. It is no coincidence thatof the stations that have E85 available, 91 percent are independentlyowned and only 9 percent are owned by the major oil companies, according to the Center for American Progress.13
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3. Ethanol economics. The third obstacle for E85 adoption is simple
economics. Many service station owners see little demand from thepublic for E85. Service station owners may also have about doubtsabout whether E85 is inexpensive enough to compete with gasoline.A motorist gets about 25 percent less mileage with E85, which meansE85 needs to be substantially cheaper than gasoline to compete.According to the U.S. Department of Energy, consumers need tomultiply the price of E85 by 1.41 to place it on an equal mileage footingwith gasoline.There are various efforts being made to expand the availability ofE85. VeraSun (NYSE: VSE), for example, which sells its own brand ofE85 (called VE85), partnered with Ford in order to launch an ethanolcorridor in service stations located along Interstate 55 in Illinois andInterstate 70 in Missouri. VeraSun has also partnered with General Motors to bring E85 to the Pittsburgh area. Wal-Mart is considering sellingE85 at its service stations around the country as part of its partnership with Murphy Oil. Moreover, many states are considering legislation that would require, or at least make is easier, for service stationsto install E85 pumps. That would go a long way towards forcing theavailability of E85 to motorists with flex-fuel vehicles.4. Underwriters Laboratories E85 certification. Another hitch for E85arose when the Underwriter’s Laboratories (UL) in late 2006 said thatthey had not yet certified existing service station tanks and pumps tohandle E85, which is more corrosive than gasoline. Existing tanks andpumps have only been certified by UL for a mix to a maximum of 15percent ethanol. Existing fuel tanks and pumps have already been usedfor a decade to sell E85 and there have been no reported safety problems. However, the technical issue remains that without UL certification, some existing tanks and pumps may be in violation of state andlocal fire codes that require certification of an independent tester suchas UL. BP responded to the UL news by saying that it will delay theexpansion of E85 pumps at its service stations in the United States until the issue is resolved. Underwriters Laboratories in March 2007 saidthat it expected to publish its certification requirements by the end ofthe fourth quarter of 2007, which would then allow pump manufacturers to make sure they are UL compliant and eliminate the problem.14
BRAZILIAN COMPETITIONBrazil is the world’s second largest producer of ethanol behind the UnitedStates. In 2006, Brazil produced 4.227 billion gallons of ethanol, which wasjust slightly behind the U.S. production of 4.264 billion gallons in 2006
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0U.S.
China
Brazil2004
2005
India
2006
FIGURE 14.1 Top World Ethanol Producers—Annual Production 2004–06Source: Renewable Fuels Association, “Annual World Ethanol Production by Country,”July 2007, http://www.ethanolrfa.org/industry/statistics/#E.
(see Figure 14.1).15 Ethanol accounts for over one-third of Brazil’s totalfuel usage.Brazil’s government started an energy independence program morethan a decade ago and actively pushed for domestic ethanol productionto eliminate the need to import foreign petroleum products. Brazil hasnow achieved that energy independence. About 75 percent of the new carssold in Brazil are flex-fuel vehicles that can use any mix of gasoline andethanol. Brazil currently requires its fuel to contain a minimum of 20 percent ethanol, and the government is considering raising that requirementto 25 percent.The big difference between ethanol production in the United Statesand Brazil is that the United States uses corn to produce ethanol whileBrazil uses sugar. Brazil uses about one-half of its sizeable sugarcanecrop to produce ethanol. Brazil’s sugar-based ethanol is about 50 centsper gallon cheaper to produce than U.S. corn-based ethanol, mainly because sugarcane produces much higher ethanol yields than corn. In addition, labor and other production costs are generally lower in Brazil.Brazil’s lower ethanol production costs make it possible for Brazil to export ethanol and have money left over to cover the transocean shippingfees.Brazil is the only country in the world that is capable of producingmajor ethanol exports over the short to medium term. Brazil’s presidentsaid in April 2007 that Brazil could expand its sugar production and double
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its ethanol production over the next 10 years.16 As far as actual exportdeals, Brazil’s state-owned oil company, Petroleo Brasileiro SA (Petrobras)in April 2007 was in an advanced stage of negotiations with Japan to supplyup to 800 million gallons of ethanol annually within 4 years.17 That wouldamount to about 55 percent of Brazil’s projected export capacity by 2012according to the Wall Street Journal.18 In the same reportage, Petrobaswas in talks about long-term ethanol contracts with buyers in China andSouth Korea.19It is not currently economical for Brazil to export large quantities ofethanol to the United States primarily because of the 54-cent per gallon U.S.import tariff on imported ethanol that the United States imposed startingin 1980 (that tariff is currently due to expire on January 1, 2009). Brazildid, in fact, temporarily export large quantities of ethanol to the UnitedStates in the spring and summer of 2006 when the phase-out of MTBE as anoxygenate additive caused a surge in demand for ethanol and an upwardspike in prices. That upward spike in ethanol prices temporarily made iteconomical for U.S. blenders to import Brazilian ethanol. However, ethanolimports dropped back when U.S. ethanol prices normalized later in 2006and again made Brazilian ethanol uneconomical.The reality is that Brazil is waiting in the wings to pounce on the U.S.ethanol market, which would happen if the 54-cent U.S. tariff on ethanolwere dropped. There are some groups and politicians who believe thatthe U.S. ethanol import tariff should be dropped. For example, the Interamerican Ethanol Commission co-chaired by Jeb Bush (President Bush’sbrother) favors dropping the U.S. ethanol import tariff in order to expandU.S. usage of ethanol and to promote U.S. petroleum independence and environmental goals (see www.helpfuelthefuture.org). Former World BankPresident Paul Wolfowitz, at a carbon-finance conference in London inMarch 2007, also argued in favor of ending ethanol tariffs in the interest of creating a healthy and efficient global biofuels market.20 Droppingthe U.S. ethanol import tariff would make ethanol cheaper for U.S. motorists and would result in even greater use of ethanol and reduced used ofgasoline.However, the U.S. farm lobby is very powerful and is fighting hard toretain the 54-cent import tariff. If the 54-cent tariff were to be dropped,then Brazilian ethanol would start flowing to the United States in quantity,thus providing competition for U.S. corn-based ethanol companies and undercutting U.S. ethanol company profits. The U.S. ethanol industry is protected by the 54-cent tariff through January 1, 2009, and another rollover ofthat tariff is likely. Nevertheless, the politics of the tariff must be watchedcarefully since any serious attempt to drop the tariff would likely cause asharp sell-off in U.S. ethanol company stock prices.
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HOW FAR CAN ETHANOL GO TO REPLACEGASOLINE IN THE U.S. TRANSPORTATIONFUEL SUPPLY?In the United States, ethanol production has been growing very rapidly inthe past several years. As of July 2007, there were 123 operating ethanol distilleries in the United States, 76 plants under construction, and 7 plants being expanded, according to the Renewable Fuels Association.21 The annualcapacity of the plants under construction and expansion totaled 6.374billion gallons, which is nearly as much as the existing plant capacity of6.444 billion gallons. That means that when the new capacity comes onlineover the next 12 to 18 months, U.S. ethanol production will roughly double.U.S. ethanol production in 2006 totaled 4.855 billion gallons, whichwas up 24.4 percent from 3.904 billion gallons in 2005 (see Figure 14.2).In March 2007, U.S. ethanol production was 500 million gallons, whichequates to an annualized production figure of 6 billion gallons. That meansthat annualized production in March 2007, in just the third month of theyear, was already running 24 percent higher than 2006. Considering theamount of capacity that is in progress, ethanol production in 2007 is likelyto show growth on the order of 30 percent or more from 2006.From a consumption standpoint, the United States used 539.1 milliongallons of ethanol in March 2007, which translates to an annualized rate5
4
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1992
1994
1996
1998
2000
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FIGURE 14.2 U.S. Annual Ethanol ProductionSource: Renewable Fuels Association, “Industry statistics,” www.ethanolrfa.org/industry/statistics/.
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of about 6.5 billion gallons.22 U.S. ethanol usage in March 2007 thereforeaccounted for about 4.3 percent of total U.S. fuel consumption.President Bush in his State of the Union Address in January 2007 announced a very ambitious plan for the United States to use 35 billion gallons of alternative fuels annually by 2017. That is about six times currentusage and five times the current Renewable Fuel Standard of 7.5 billiongallons per year by 2012.However, the U.S. corn-based ethanol industry simply cannot produce35 billion gallons per year of ethanol because (1) there isn’t enough farmland in the United States to support that much corn acreage; (2) therewould not be enough corn left over for human food consumption and livestock feed (about 55 percent of U.S. corn currently goes for livestock feed);and (3) corn prices would likely soar beyond economical levels for ethanolproducers.The practical limit for corn-based ethanol is probably about 15 billion gallons per year, which is two-and-a-half times current productionand about 10 percent of the U.S. fuel supply. Even on that scale, cornbased ethanol producers would need about 3.6 billion bushels of corn,which would represent one-third of the U.S. 2006–2007 corn crop andwould require the use of about 12 percent of all U.S. corn/soybean/wheatfarmland.23Practically speaking, there are only two ways for a 35 billion gallongoal to be met: (1) open up the United States to ethanol imports fromBrazil and other countries by dropping the 54-cent tariff; and/or (2) create 20 billion gallons of cellulosic-based ethanol by 2017 in addition to current corn-based ethanol production. At present, there are no commercialethanol plants that use cellulosic feedstocks (such as switchgrass, cornstalks, wood chips, etc.) because more research needs to be done to develop economical ways to process that cellulosic material into ethanol. Theindustry consensus is that it will take another five years before cellulosicbased ethanol can be produced economically on a large scale.There is a negative aspect to government mandates for increasedethanol usage since the United States can only produce a limited quantityof corn-based ethanol. If the government pushes too hard for corn-basedethanol output, there is a risk that corn prices will be driven to excessively high levels, thus causing negative earnings for ethanol producers andbankruptcies among the smaller and weaker ethanol producers. The U.S.corn-based ethanol industry can only grow as fast as farmers are willing toboost corn production, thus keeping corn prices stable.The U.S. ethanol industry will be able to produce much larger quantities of ethanol when cellulosic ethanol becomes more feasible and costeffective, but the day of mass production for cellulosic-based ethanol isstill about five years away according to most industry estimates. In the
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meantime, federal and state governments must be careful not to pushthe ethanol too quickly and cause an upward spike in corn prices andwidespread losses among ethanol producers.
THE FUTURE OF ETHANOL: CELLULOSICBASED ETHANOLEthanol is currently produced using either corn or sugar as the feedstock.However, ethanol can also be produced from cellulosic feedstocks suchas agricultural plant wastes (corn stalks, corn cobs, leaves, cereal straws,rice straw), wood waste (sawdust, wood chips, and paper pulp), and energycrops grown specifically for fuel production such as switchgrass. Conventional ethanol and cellulosic-based ethanol are exactly the same product,they just come from different processes.24The problem with cellulosic feedstocks is that the sugars are locked incomplex carbohydrates and it is difficult to separate out those sugars. As aresult, processing cellulosic biomass into ethanol is more difficult than getting ethanol from corn or sugarcane. Two processes can be used to extractthe sugar from cellulose. One way is to use acids to break down the carbohydrates. The other way is to first reduce the biomass into small pieces andthen use enzymes to convert the biomass into sugars. In both cases, the laststep is to use microbe fermentation to convert the sugar into ethanol.The big advantage of cellulosic ethanol is that it is derived from plantmatter that is either waste or is from nonedible crops, meaning it is nottaking food away from the nation’s food supply or causing a run-up infood prices. In addition, the quantity of ethanol that could theoretically beproduced from cellulosic feedstocks is much higher than from corn-basedethanol since there are so many different types of cellulosic feedstocks.A researcher with the U.S. Department of Energy estimates that therecould be as many as 1 billion tons per year of cellulosic biomass available inthe United States from agricultural and forest residues, trees, energy crops,and other sources. That would be enough feedstock to produce 65 billiongallons of ethanol at current yields of 65 gallons of ethanol per biomass ton,and enough to produce 90 billion gallons per year of ethanol at the targetedconversion yield of 90 gallons per ton by 2012.25 Adding 90 billion gallonsof ethanol from cellulosic feedstocks to 15 billion gallons of ethanol fromcorn feedstock (which is near the limit mentioned earlier for corn-basedethanol) would produce a grand total of 105 billion gallons of ethanol. Thatwould be enough ethanol to satisfy about two-thirds of current U.S. fuelconsumption and reduce gasoline consumption to one-third of its currentlevel.
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However, this theoretical potential would take decades to achieve. AU.S. Department of Energy researcher sets a best-case scenario of 44.8 billion gallons of cellulosic ethanol production by 2030.26 Adding in 15 billiongallons from corn-based ethanol would produce a grand total of ethanolproduction of 60 billion gallons, which would be enough to satisfy about 40percent of current U.S. fuel consumption.These back-of-the-envelope figures are very tentative because it is notyet known how far production costs can be cut for cellulosic ethanol orhow far yields can be increased. The U.S. government is targeting a cut incellulosic production costs to just over $1.00 by 2012 from about $2.00 in2005. However, this depends on how well the R&D goes on cutting enzymecosts and plant processing costs. In addition, biomass feedstock costs needto be cut in half.There are many companies around the world that are working furiously to make cellulosic ethanol commercially attractive. There arecurrently about 30 pilot and demonstration cellulosic ethanol plants inoperation or being built around the world.27 However, there are no cellulosic ethanol plants at present that are producing ethanol in mass quantity at commercially attractive prices. Yet the companies that achieve thebreakthroughs needed for mass production of cellulosic ethanol will be ina highly attractive position of having virtually unlimited and cheap feedstocks available and of being able to push production costs well belowthose of corn-based ethanol producers. In short, these progressive companies will be in the driver’s seat as the low-cost, mass producers, much tothe consternation of the legacy ethanol producers who would still be usingthe old-fashioned method of corn-based ethanol production.
ETHANOL COMPANY INVESTMENT ANALYSISA corn-based ethanol company is simply a processing company that buyscorn as its raw material and converts it into ethanol, which is then sold asa transportation fuel. An ethanol company’s profit margin is highly dependent on the margin that can be earned by buying corn, processing it intoethanol, and then selling the ethanol. In this sense, ethanol producers havea business model that is similar to petroleum refiners that buy crude oil,process it into gasoline, and then sell the gasoline. Corn-based ethanol producers are also similar to food processing companies that buy raw crops(corn, soybeans, etc.) and process them into retail products such as livestock feed, high fructose corn syrup, processed food products, etc.Corn accounts for about 50 percent of a corn-based ethanol producer’scosts (depending on corn, ethanol and other costs at any given time). This
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$3
$2
$1
4/05
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1/06
4/06
7/06
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$0
FIGURE 14.3 Ethanol-Corn Crush Proﬁt Margin (in $/gallons of ethanol)Note: Corn-ethanol crush = CBOT nearby ethanol future prices – CBOT corn nearbyfuture price/2.8 gal./bushelSource: Corn and Ethanol Prices from Chicago Board of Trade.
means that the largest determinant of an ethanol producer’ profit is thespread between ethanol prices and corn prices, that is, the extent to whichthe ethanol company can buy corn low and sell ethanol high.The profit margin between ethanol prices and corn prices is theethanol-corn crush spread and is simply defined as the ethanol price minusthe corn price. Figure 14.3 shows a recent price history for the ethanol-corncrush spread. Before subtracting corn prices from ethanol prices, however, corn prices need to be converted into dollars per gallon (by dividingthe quoted corn price by the 2.8 gallon/bushel yield of the modern ethanolplant).For example, on July 27, 2007, the last day of data on the price chartin Figure 14.3, front-month futures at the Chicago Board of Trade weretrading at $3.21 per bushel for corn and $1.964 per gallon for ethanol. Theethanol-corn crush spread is calculated as follows: $1.964 − ($3.21/2.8 conversion) = 82 cents per gallon. This means that as a very rough estimate, acorn-based ethanol producer could make a profit of about 82 cents per gallon on converting corn to ethanol, minus the producer’s other costs suchas other raw material inputs, labor, plant operating costs, depreciation ofplant construction costs, administrative and selling costs, and any financing or other costs (distiller-dried grain revenue needs to be added back intothe profit margin).
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5045
$4.00Corn - Nearest Future(left scale - $/bu)
4035
$3.00
3025
$2.00
2015
$1.00World Sugar - Nearest Future(right scale - cents/lb)
$0.0000
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FIGURE 14.4 Ethanol Feedstock Prices: Corn and SugarSource: Chicago Board of Trade (corn prices) and New York Board of Trade (sugarprices).
The ethanol-corn crush spread is critical to understanding ethanol industry profits. One can readily see that an ethanol producer’s profit marginwill improve as ethanol prices rise, but fall as corn prices rise. The realityis that an investor in an ethanol company is betting more on the spreadbetween ethanol and corn prices than on anything else.As seen in Figure 14.3, the ethanol-corn crush spread can be veryvolatile, which in turn creates a large amount of volatility in ethanol company profits and stock prices. The volatility in the spread can stem fromsharp changes in ethanol prices, corn prices, or both (see Figure 14.4 forcorn prices and Figure 15.1 in the next chapter for ethanol prices).In the first half of 2007, the ethanol-corn crush spread ranged froma low of 43 cents in January 2007 (when corn prices rallied above $4 perbushel) to a high of about 90 cents in July 2007