December 26, 2008 The Future of Ethanol

Volume 4 | Issue 4

Coming on hard times, the ethanol industry must face a long road ahead and battle against competing technologies, among other factors, to ke

It is widely known that the ethanol industry is facing difficult economic times. More than 20 ethanol plants have filed for bankruptcy in recent months and several more have ceased operations for various financial and economic reasons. The economic trauma in some instances has been partly the result of factors affecting all ethanol plants; in other situations the economic hurdles have been more severe for recently constructed plants. Dramatic fluctuations in the price of corn (the major input) and in the price of crude oil (which has a considerable influence on the price for ethanol) have wrenched the industry well beyond anything what could possibly have been anticipated by investors in ethanol plants.

The steep rise in construction costs has contributed to the economic uncertainty, also. That factor has been especially important for ethanol plants built over the past couple of years. Earlier plants have a fixed cost advantage which has enabled those plants to continue operations profitably.

Five bankruptcy filings occurred because of steps taken to manage risk with the hedges resulting in huge losses as the price of corn first rose to record levels and then declined sharply to more normal levels.

FACTORS DETERMINING THE FUTURE

The future of the ethanol industry depends heavily upon three factors:

• the energy policy of the United States government;
• the economics of conversion of feedstock (principally corn, to date) into ethanol fuel;
• the emerging technologies and their competitive positions.

U.S. energy policy. Over the 30-plus years of Congressional concern about dependence on foreign sources of energy, notably crude oil, U.S. energy policy has been uncommonly friendly to ethanol. The result has been a robust subsidy on ethanol production (51 cents per gallon through 2008 and 45 cents per gallon thereafter); a 54-cent-per-gallon tariff on imported ethanol (aimed principally at ethanol, much of which is derived from the lower cost sugar cane in Brazil); and an escalating government mandate running through 2022 for 37 billion gallons of ethanol (and other biofuels) in the United States.

How did ethanol merit such a boost from government? Aggressive and effective lobbying over a period of many years was certainly a factor. The National Corn Growers Association was responsible for keeping the issue before Congress from the 1970s onward. Gradually, members of Congress from farm states (especially major corn producing states) took up the cudgel. Environmentalists got on board more recently as MTBE as a fuel additive was found to be polluting the environment in a manner believed to pose a risk to human health. Ethanol as an additive was a more friendly substance for that purpose with states moving to embrace ethanol to meet federal requirements. The citizenry in general found the mantra that it was in the public interest to reduce the dependence on foreign oil to be a highly attractive public policy move. Investors, seeing that government, environmentalists and the general population were behind the ethanol industry sensed that the industry was on the fast track and investment in ethanol plants posed minimal risk. Those factors encouraged plant construction at a breakneck pace without much regard for demand and supply factors.

Essentially, the growth of the ethanol industry proceeded heavily because of promotion and not because of economic factors. Decisions were removed from the stern discipline of market considerations. As a result, a glut in production occurred in the second half of 2007, with the industry rescued by a boost in mandates legislated by Congress.

The economics of conversion. The second issue, the economics of conversion of feedstock (mostly corn, thus far) into ethanol, has uncovered largely unanticipated economic problems.

The first is the built-in “brake” inherent in ethanol production. As the production of ethanol has increased, the demand for corn has boomed, driving up the price of corn worldwide, not just in the areas surrounding ethanol plants. With corn comprising 60 to 70 percent of the production costs for ethanol, the increase in corn price boosted the costs of production with the result that the profitability of ethanol production declined. In some instances, that factor drove profitability to dangerously low levels. For plants in production (or under construction which was far enough advanced to assure completion of construction even in the face of diminished profitability of plants), the plants could be expected to remain in production or continue with construction so long as the plants could cover their variable costs. Plants facing economic pressures are well advised to continue with production, even though they cannot cover fixed costs, inasmuch as continuing production with variable costs covered means that losses are less than the losses that would result if the plant were shuttered. In that event, fixed costs would continue to be incurred and result in ongoing losses. This factor, encouraging ethanol production if variable costs can be covered, suggests that corn price is likely to remain elevated for some time to come.

The second issue involves the relationship of the price of ethanol to the price of crude oil. With crude price more than doubling in 2008, partly attributable to speculation in crude oil markets, the price of ethanol was boosted in tandem with the price of crude. That helped to offset the rising price of corn which rose to nearly $8 per bushel. When crude oil began its precipitous decline in late 2008, the price of ethanol also declined, with ethanol prices dropping by roughly 40 percent. That put the squeeze on ethanol producers and for some it was a death squeeze.

Competing technologies. The third factor helping to shape the future of ethanol is the collection of emerging technologies that pose a competitive threat to reliance on ethanol as an energy source. There is little question that whichever energy source can provide energy in the amounts demanded by consumers, and with the reliability and safety needed to replace petroleum-based energy sources at the least cost, is going to be in the driver’s seat. It is not enough to be able to produce energy from alternative sources. It must be done at an equal or lower cost compared with traditional energy sources.

The level of economic incentives now being applied to the energy problem assures that unprecedented progress is likely to be made over the next few decades. It is not clear at the moment which technology will win out but nuclear power, hydrogen, hydrogen fuel cells, solar, wind energy, geothermal, coal gasification, algae and cellulosic ethanol (which is presently costly but that the cost per unit is likely to decline over time) are expected to compete effectively against ethanol and petroleum as energy sources.

Food versus fuel. Although the level of the debate has subsided as corn (and soybean and wheat) prices have declined, the concern over the effect of ethanol demand for corn on food prices continues as a potential issue. Certainly, rising commodity prices do have some impact on food prices although part of that impact has been delayed as rising commodity prices in some sectors of food production (notably meat and meat food products) result in higher food prices at supermarkets only after the higher feed prices cause a drop in supply.

Ethanol is likely to merit a place in the sun for three to five years. Beyond that, ethanol may rank as a component of the package of alternative energy sources for some time into the future. Economic considerations will be the major determinants as to which energy alternatives survive as energy sources.

Neil E. Harl is a Charles F. Curtiss Distinguished Professor in Agriculture and Emeritus Professor of Economics, Iowa State University, Ames, Iowa.

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