February 27, 2019
Demand growth for ethanol in the U.S. stalled in 2018, basically approaching 0%. This lack of ethanol growth is hitting the corn market hard at the same time that the soybean export market continues to struggle with tariffs. Corn and soybeans remain the big drivers of acreage and crop inputs in the U.S.
So what is capping the growth in ethanol? Unfortunately for the U.S. ethanol producers and corn growers, this doesn’t seem to be a short-term slowdown. U.S. highway miles driven only grew 0.4% from 2017 to 2018, which underperformed the economic and population growth. U.S. gasoline usage showed 0% growth during the same period. Fuel efficiency improved enough to compensate for the slight growth in driving miles. Looking down the road, every electric vehicle that comes into the fleet helps put a ceiling on gasoline and ethanol distributions.
Ethanol tried to buy market share away from gasoline, but it didn’t work. In 2018, ethanol was a relative bargain compared to gasoline, even with the BTU differential taken into consideration. However, even that didn’t convince drivers to seek out E85 pumps and take advantage of the small incentive. It appears that too many of the drivers of E85 vehicles don’t really think about switching. They either buy E85 all the time, or not at all.
This has led to a very unprofitable situation for the ethanol producers. Even in a world with $3.50 per bushel corn, they can’t make money with $1.20 per gallon ethanol. Ethanol producers get two things when they process a bushel of corn. First, they get 2.85 gallons of ethanol. Second, they get back some distillers grain (DDGs) and corn oil. Every ethanol producer has some slight variation on these two revenue streams, and they also have variations on costs. Regardless of the variations, for all ethanol producers, the biggest piece of their revenue stream is the ethanol, and the bigger cost is the corn. The following graph shows that it costs them more in terms of the corn they put into the still than the ethanol they get out. It’s unlikely that the DDGs and the corn oil can make up this negative margin on top of all of their other costs of processing and SG&A.
Even so, the ethanol producers have continued to produce at full steam.
So what is keeping the ethanol producers from slowing production just enough, perhaps 3−4% to get the prices back up to profitability? It is the same problem faced by so many industries that have high fixed costs. With a diversity of producers with different efficiencies, everyone gets different price signals from the same price. And, if you are going to run your ethanol plant, you run it at maximum capacity to absorb the fixed cost overhead. Just like U.S. dairy producers, ethanol producers either flip the switch or they don’t. They are trying to force some other marginal producer to give up entirely. This characteristic leads to periods of high profits and brutal losses. Some ethanol producers will need to run out of money before they stop producing, and that process can take longer than seems reasonable.
So what upside can the ethanol producers hope for in the short-term?
- First, a strong economy with good job growth will lead to more driving. Hopefully, the U.S. economy performs well in 2019, and highway miles will go up enough to expand gasoline and ethanol demand. But, it will have to grow faster than fuel efficiency to translate into ethanol demand growth.
- Second, exports have been a bright spot for the ethanol industry. In 2018, 11% of U.S. ethanol production was exported. This may continue to grow, but it’s unlikely to grow fast enough to solve all of the industry’s pricing problems.
- Lastly, higher crude oil and gasoline pricing will give ethanol pricing some breathing room.
Unfortunately, the industry faces some long-term challenges that will only continue to accelerate. Each new electric car purchased represents a 100% loss of future demand for ethanol. Battery technology will certainly improve its cost effectiveness faster than ethanol. This should be something that both ethanol producers and farmers keep in their strategic plans as they make their future bets.