TURBULENCE IN THE ETHANOL SECTOR

The flurry of speculation that drove some ethanol stock prices to over $40 per share some months ago has abated, with some of the better performing stocks such as Pacific Ethanol Inc. and Aventine Renewable Energy Holdings falling to the low $20 range during the past week. Without a doubt, these declines cloud the futures of other ethanol companies attempting to raise money through initial public offerings.

Currently more than 50 new large capacity ethanol plants are in the planning stage in the U.S. Because the majority of the planned facilities are very large—generally producing over 50 million gallons per annum—they represent considerably more than a 50% increment in capacity over that of the present total of 105 large fuel ethanol facilities. Such large facilities are very expensive to build—often over $100 million dollars apiece—and thus any hesitancy on the part of investors may have serious consequences on the still burgeoning ethanol fuel industry in the U.S. Simply put, investors losing confidence could severely hinder or even cripple the domestic ethanol fuel industry.

Our Analysis – the 50,000 Foot View

Many financial analysts attribute the decline in the valuations of large, publicly traded ethanol producers to the lack of visibility of ethanol in the marketplace. While more than 1,000 service stations now offer E85, a blend of gasoline and ethanol where ethanol comprises 85% of the whole, the huge majority of those stations are located in the Midwestern farm belt where the ethanol itself is manufactured locally. Futhermore, no one other than BP has succeeded in establishing a recognized national brand for E85.

I also see this lack of visibility as a serious problem for the home grown ethanol industry—though it’s far from the only problem. Successful branding begets exuberance, and exuberance begets investment and profits. But, for successful branding to occur, the ethanol producers would have to communicate clear benefits to the end user, and, for the most part, they’re not doing that. Arguing that ethanol will somewhat reduce CO2 emissions or somewhat reduce our dependence on Middle Eastern oil is not a strong selling proposition in respect to the individual, especially when the pricing of ethanol per BTU is rather unfavorable even with subsidies.

Demand for ethanol as a fuel additive remains very strong, and will almost certainly grow stronger, but that kind of business-to-business market typically lacks the incendiary quality of a thriving consumer market. After all, the petroleum industry will quite likely bid down rather than bid up the price of ethanol. There is no cartel of ethanol producers to influence pricing positively, nor is there likely to be one as increasing numbers of producers in the developing world strive to undercut North American firms.

With methanol-based MTBE on the way out as an oxygenate and octane booster, and subject to legal restrictions in an increasing number of states, the market for fuel ethanol would seem fairly assured, but without enormous investments in plant construction, probably exceeding twenty billion dollars altogether, the American ethanol industry simply will not be able to meet the requirements of the petroleum industry for oxygenates, let alone establish E85 as a credible rival to gasoline.

The obvious source for fuel ethanol other than the United States is Brazil, currently the world’s largest producer and eagerly investing in new capacity. India is also gearing up to increase production, and we may expect other tropical zone agrarian nations to follow suit, especially in Southeast Asia. Currently tariffs disadvantage such overseas producers, but the petroleum industry’s desire for low cost oxygenates cannot but influence the legislative climate. If big oil can’t get the additives they want here in the U.S., they’ll make sure they get them elsewhere, and at an attractive price. But perhaps not at as attractive a price as they might assume—and this is of crucial importance to American ethanol producers.

The conventional wisdom is that Brazil and similar low wage producers of cane ethanol enjoy a tremendous cost advantage over North American producers. But, according to our analysis, this notion is fundamentally inaccurate. USDA studies indicate that the admittedly low Brazilian cost structure of the present is unlikely to be maintained if that country expands production, which it intends to do. And, if that seems paradoxical, it proves not to be the case when one performs a detailed breakdown of production and distribution costs for cane ethanol. I would add that misleading notions as to the cost advantages of sugar crop feedstocks are also prompting efforts in the U.S. to encourage the cultivation of sweet sorghum, which is also sugar crop, and, unfortunately, one whose economics are actually inferior to those of cane in many instances.

Extensive cultivation of warm weather sugar crops may indeed lower ethanol prices, at least temporarily, but it will do so only because of the transient over-capacity that is likely to ensue. Ethanol in the tropics is likely to exhibit the classic characteristics of the one crop economy—boom followed by bust as production consistently fails to track demand. It won’t be a bonanza for the sugar cultivators though it may be a catastrophe for American ethanol producers.

One could consider further possibilities such as the oil companies themselves producing ethanol for their own use, but at least for now that is at worst a potential threat. The one petroleum firm with an avowed interest in alcohol production, namely, British Petroleum, is leaning toward butanol, not ethanol.

I will expand upon these topics in upcoming articles. I will also consider ethanol in the context of other alternative fuel frenzies such as the now receding hydrogen wave. Much more information will be available in a report on the fuel ethanol industry which is being prepared by our team.

A further note:

Cellulosic ethanol production techniques as well as synthesis of ethanol from biomass are unlikely to play a major role in ethanol production for years if at all. Truly low cost ethanol will not become a reality in the marketplace any time soon.

Meanwhile, investment in new facilities in the U.S. serves a real need, and no over-capacity is present in the U.S. as yet. My concern is that production abroad will result in over-capacity, however, at least as concerns the oxygenate market.

Investment in ethanol facilities with a view to competing directly with gasoline producers must be considered highly speculative. E85 faces many rivals, some of which may be cheaper to produce, and cheaper, in our view, always wins. This topic also will be explored in depth in an article to follow.