Ethanol Industry Situation and Outlook By Paul Gallagher, Associate Professor of Economics Iowa State University, November 2006 The ethanol industry may continue to evolve during the next five years as it did during the previous five years, and perhaps at an accelerating pace. This review concerns the policy, energy and technology factors that are changing the ethanol market. Analysis of the current situation emphasizes the policy and petroleum market changes that have transformed the industry. But discussion begins with some background on demand and supply in the ethanol market, a new topic for many in agricultural industries. The intermediate term outlook for 2012 also is considered. The extent of expansion, the cost situation and the prospects for supplies from corn and biomass processing are evaluated. Ethanol Demand There are two distinct markets for ethanol. The additives market (see Figure 1) is defined by the quality demands for clean and high-octane fuel. Ethanol can generally be sold at a relatively high price (Pc), which is the entry price for competing additives that also have high octane content. Roughly, the entry cost is the production cost for the petroladditive plus the ethanol subsidy, which is about $.50/ gallon. Hence, the consumption subsidy for ethanol provides some protection from competition in the additives market. The vertical segment of the demand curve at Qa indicates the market volume at which the demand for high quality additives is filled. The second market for ethanol is the commodity fuel market. Here, E85 sells in direct competition with gasoline. E85 would sell at a discount to gasoline in a gasoline market with well-informed consumers, because a given dual fuel automobile does not go as far with E85 as it does with gasoline. In the diagram P85 is the derived demand in the ethanol wholesale market. P85 also is elevated with the ethanol consumer subsidy, about $.15/gallon in the wholesale ethanol market. Recent Demand Changes The main sources of expanding ethanol demand during the last five years have been MTBE bans and higher petroleum prices. The size of ethanol’s additives market (Qa) grew from about 1.5 bill gallons in 2000 to about 6.5 bill gallons now due to a combination of state and federal regulations that add up to a de facto national ban on the use of MTBE in the United States. These events include an MTBE ban in California that was announced in 2000 and became effective at the end of 2002. Subsequently, New York

announced a ban and several other states followed. Finally, the federal government refused to grant a liability waiver to gasoline companies using MTBE, so MTBE producers have voluntarily ceased operation. This estimate of ethanol’s additive market expansion comes from a recent study of the gasoline additives market, and the assumption that ethanol will acquire market served by MTBE output before the bane began.

F ig ure 2. Th e E ffe ct of a n Oil Price Pe Pc

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Recent price increases for petroleum products also contributed to the improved competitive position of ethanol (Figure 2). First, prices for petroleumbased additives increased. For instance, the entry price of alkylates (cost + subsidy) increased to $2.5/ gallon recently. Benzene prices have increased more than $2/gal, at times selling for $4.5/gallon. Second, the derived ethanol price from the E85 market, P85, is related to the gasoline price. Hence, P85 also increased from $1.1/gal in 2000 to $1.47/gal in 2005. Ethanol Supply Situation in 2005 By the 2005/06 corn marketing year, ethanol output and capacity had filled the demand expansion associated with the initial California and New York bans, and was filling the new demand associated with the national ban (Figure 3). Production for 2005 was 4.5 bil. gallons, in comparison to an additives market of 6.5 billion gallons. Production capacity at the end of the crop year was estimated at 4.6 billion gallons.

Given the moderate rate of expansion of ethanol output during the 2000/05 period, corn input prices and ethanol production costs remained relatively stable at about $1.15/gallon. Biomass ethanol is technically feasible, but more expensive than corn-ethanol — it starts to become competitive at the $1.40/gallon to $1.60/gallon range. However, a rapid corn-ethanol expansion could alter the cost situation. A 10 bil. corn-ethanol output would raise corn ethanol cost to the $1.75/gallon range with 2005 trend corn yields. Given that production is less than the size of the potential additive market, the ethanol market cleared near the cost of petroleum based additives, in the neighborhood of $2.40/gallon for the September crop year. This is considerably higher than the E85 demand price of $1.47/gallon (Figure 4).

2006/07 Situation Corn prices have risen in the fall of 2006 because three priceincreasing forces combined at the same time — a reduction in corn output (160 mil bu), an increase in corn exports (150 mil bu) and an increase in potential demand associated with an ethanol capacity addition of 1.0 billion gallons. The potential corn demand expansion associated with the new ethanol capacity (370 mil bu) is about as large as the net supply change associated with production and exports.

Figure 4. Ethanol Market, 2006, PG = 1.26/gal
    

  

    

  

The tighter supply situation will increase the corn price and ethanol production cost. A corn price increase of $.70/bu is anticipated, which would bring the season average price for the U.S. average to $2.70. Also ethanol production costs would increase by $.30/gal due to increased net corn costs. 




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Figure 5. Ethanol Processing : 1980-2005 (Capacity Utilization vs. Margin) 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 actual estimated

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It is likely that ethanol processors will reduce their rate of capacity utilization in response to profit margins that are still strong, but not at the historical maximum that occurred in the 2005 marketing year (Figure 5). A 235 mil bu expansion for ethanol processing is consistent with corn market balance, ethanol prices at $1.75/gallon and a 94% capacity utilization rate.

Beyond the 2006 marketing year, corn prices likely will increase corn area for the next crop year to 86 million acres. If trends are realized, a 725 million bushel supply expansion would occur, which would be adequate for another 1 billion gallon increase in ethanol capacity, and corn price likely would decline to the $2.30/bu range. Ethanol production costs would decline only slightly under this circumstance. Expanding ethanol production would mean continued reduction in byproduct feed prices and net corn costs would remain stabile.

Figure 6. Ethanol Market, 2012, PG = 1.64/gal
    

  

    

   




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2012 Outlook A recent U.S. Department of Energy five-year outlook features a baseline with gasoline prices slightly above the 2005/06 level. Under these circumstances, sustained profitability in the ethanol industry likely would lead to a steady expansion in corn-ethanol capacity. This analysis assumes the industry expands at the rate of 0.7 billion gallons per year, which is the recently demonstrated output increase in the specialized capital goods industry that supplies the manufacturers of ethanol plants. So capacity would increase to 10 billion gallon by the 2012 marketing year (Figure 6).

Corn-ethanol production costs would increase to $1.51/gallon. Production costs would increase somewhat over the intermediate term, because the annual demand expansion in the corn market exceeds the rate of corn production growth. Under these circumstances, ethanol prices likely would continue at a premium over gasoline, because the growing additives market still may be larger than ethanol production of 10 billion gallons. This analysis estimates ethanol’s additive demand at Qa=14.0 billion gallons. This estimate comes from a recent study of the gasoline additives market, and the assumption that ethanol will acquire market expansions that would have gone to petrol-additives with low petroleum price. The cost situation would be about the same for corn-ethanol and biomass ethanol. Hence, biomass technology would be adopted. In fact, the first commercial scale biomass plant is now under construction. It is difficult to anticipate the rate of expansion, given another new line of specialized capital equipment and the introduction of new crops and harvesting practices. The 1 billion gallons of capacity installed in the corn-ethanol industry between 1979 and 1985 is a good reference point. If the biomass expansion does occur more rapidly, the ethanol premium likely would erode, and the market would clear near the implied E85 price. In figure 6, the equilibrium ethanol output is 26 billion gallons and the market clears at the E85 price. The corn ethanol output would be about 12 billion gallons and the biomass output would be about 14 billion gallons. Reaching this equilibrium, however, may be a decade-long project of the ethanol industry. Reduced processing profit is the main reason for moderate increases in corn-ethanol production, such as 0.7 billion gallons annually, over the intermediate term. There are additional reasons for more moderate profits. First, corn processors are on the cusp of losing the subsidized corn prices of the last five years. The (adjusted) threshold price is about $2.45/bu even when the market clears

at about $2/bu. The market price must rise above the target price to attract new area for corn production. Second, the price of a new ethanol plant is increasing faster than the rate of inflation. Third, a rapid expansion in ethanol production will erode the ethanol premium over gasoline in the wholesale market. Impact of Gasoline and Petroleum Prices The previous outlook for the ethanol market hinged on continued high gasoline and petroleum prices. Reduced petroleum prices would alter the intermediate term outlook. For instance, biomass ethanol drops to, or below, the competitive margin at energy prices that are only slightly lower. Also, this paper presented a breakeven price between corn-based E85 and petroleum in a recent analysis. This breakeven price was calculated maintaining the recent petroleum-gasoline marketing margin, substituting the E85 cost for the gasoline price, and finding the minimum competition point for E85 in the petroleum market. By this method, corn-ethanol becomes competitive without subsidies when oil exceeds $45-50/bbl. Summary and Conclusions Looking into the future, and beginning with the idea that relatively high energy prices likely will continue, it is easier to see the direction of change than to anticipate the rate of adjustment in the ethanol industry. In the five years ending with the 2005 marketing year, the corn-ethanol industry expanded at a rate that corresponded to the trend increase in corn yields. So the expansion was accommodated with relatively stable corn prices and ethanol costs. Presently, however, the ethanol industry is attempting to expand at a faster rate. Input prices, ethanol processing costs and plant capital equipment prices are increasing. Increasing costs will slow the rate of output expansion in the ethanol industry. Higher costs in the corn-ethanol industry will by default put biomass-ethanol on equal footing, and encourage adoption of this new production technique. Indeed, this analysis contains a long run equilibrium in which corn-ethanol production and biomass ethanol production are about equal. However, the biomass ethanol industry likely will have expansion problems of its own. These include the production of new enzymes, a new generation of specialized capital equipment for processing, the establishment of new perennial crops, new harvesting techniques and equipment for crop residues, and land conversion for the production of biomass tree crops. The biomass-ethanol industry is ready to fly now in the sense of the Wright brothers’ airplane at Kitty Hawk, not in the sense of the U.S. military’s F16. A public commitment to research aimed at increasing processing yields, crop yields and E85 fuel efficiency is critical to the establishment of this industry. The

importance of improving E85 fuel efficiency requires immediate attention now because industry output is moving beyond the high-price threshold defined by the additives market. Those who have observed, experienced or studied the major technology adoption and resource adjustments in U.S. agriculture should expect an adjustment that is measured in decades rather than years. References Gallagher, P., “Biomass Supply from Agricultural Lands in the United States,” 11th International Energy Conference (ENERGEX/International Energy Foundation and Norway Energy Economics Association), Stavanger, Norway, June 13, 2006. Gallagher, P., M. Dikeman, J. Fritz, E. Wailes, W. Gauthier, and H. Shapouri, “Biomass from Crop Residues: Some cost and Supply Estimates for U.S. Crops, Environmental and Resource Economics, 24(2003):335-358. Gallagher, P., G. Schamel, and H. Shapouri, “Some Cost and Price Analysis for the Corn Processing Sector”, in Proceedings of the 14th Annual Integrated Crop Management conference, R. Larson, ed., Iowa State University Extension, 2002. i. Gallagher, P., G. Schamel, H. Shapouri and H. Brubaker, “The International Competitiveness of the U.S. Corn-Ethanol Industry”, Agribusiness: An International Journal (22)(2002): 1-26. Gallagher, P., H. Shapouri, J. Price, G. Schamel, and H. Brubaker, “Some Long-Run Effects of Growing fuel Markets, MTBE Bans and Renewable Averaging Policies on Additives Markets and the Ethanol Industry”, Journal of policy Modeling, 25 (September 2003): 585-608. McAloon, A., W. Yee, R. Wallace, and K. Ibsen, Feasibility Study for C-Locating and Integrating Ethanol Production Plants from Corn Starch and Ligno Cellulosis Feed Stocks, USDA-ARS 193541000-055-000, January 2005. Shapouri, H. and P. Gallagher, USDA’s 2002 Cost-of-Production Survey, U.S. Dept of Agriculture, Office of Energy Policy and New Uses, Agricultural Economic Report No. 841, July 2005.

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