How Should Ethanol Producers Respond to External Conditions?
Published in the January/February issue 2011 of Ethanol Producer Magazine. Written by Pete Dominici, Managing Director, Energy Restructuring Practice.
With external factors looking unfavorable, producers should look to internal variables.
Ethanol producers in the U.S. are currently feeling the strain of low margins and uncertain tax incentives. The futures pricing for corn, natural gas and ethanol does not provide an outlook for any immediate relief of this strain. In fact, current forecasts of input costs and ethanol sales prices continue to show costs of corn and natural gas exceeding 90 percent of the projected sale price of ethanol. Given such market conditions, to continue to operate and generate profits, ethanol producers must look internally—to their controllable production costs and to their capital structure.
The demand for ethanol in the marketplace is currently subsidized by the U.S. government through the federal tax credit made available to the ethanol producers’ primary customers—the blenders.
The blender’s objective is to earn a profit by mixing or blending lower net-price per gallon ethanol with higher net-price per gallon unleaded gasoline, and then selling the blended fuel to customers at the higher-per gallon unleaded gasoline price. The federal tax credit, which declined from 51 cents per gallon of ethanol purchased by the blender in January 2005 to 45 cents in January 2009, has historically increased a blender’s profit when the blender’s net blended cost of a gallon of E10 gasoline is below the blender’s net purchase price for a gallon of unleaded gasoline.
Further adding to the complexity of the ethanol producer’s business model is an artificial demand side of the market. The U.S. EPA had imposed a ceiling that only allowed ethanol to be blended at a rate of 10 percent ethanol to 90 percent unleaded gasoline in every E10 gallon sold (known as the blend limit), with an annual aggregate ethanol usage ceiling imposed at 10 percent of total U.S. annual unleaded gasoline consumption each year (known as the blending ceiling). This artificially imposed demand ceiling had remained constant at 10 percent, both on the E10 blend limit and on the annual aggregate blending ceiling, since 1978. The combination of the blend limit and the blend ceiling is known in the ethanol industry as the blending wall.
The proposals discussed on including ethanol tax credits in the bill extending the Bush-era tax incentives, which was passed and signed just before Christmas, ranged from eliminating tax incentives for ethanol, to extending them at current levels for one year, to extending them for multiple years at a reduced rate of 36 cents per gallon of ethanol blended.
Over the years, ethanol producers have lobbied to have the mandated 10 percent blending limit raised to 15 percent, and recently the blending limit was raised to 15 percent in some cases. It was not mandated, however. Currently, the decision to blend beyond the current mandate of 10 percent rests with the blenders. Blenders will only blend at the higher level if an appropriate blending profit is available to them.
The recent increase to E15 is also impacted by market conditions. Gasoline that contains 15 percent ethanol can only be used in cars and light trucks sold since 2007. Therefore, even if the blending profit motive exists for blenders to blend, demand will be limited to the percentage of gasoline that is utilized by post-2006 light cars and trucks. The additional complexity in the delivery system for fuel products will also be a limiting factor. As a result, increased demand at the ethanol producer level is uncertain.
Assuming the tax credit remains at 45 cents per gallon of ethanol, raising the blending limit to 15 percent would result in an additional tax credit of 2.3 cents per gallon (45 cents per gallon of ethanol multiplied by the additional 5 percent), assuming the 15 percent blending ratio is used. In contrast, reducing the tax credit to 36 cents per gallon of ethanol reduces the blenders profit by 0.9 cents per gallon (9 cents per gallon of ethanol multiplied by the 10 percent ratio).
External Factor Outlook
Moving forward, ethanol producers will need to analyze the impact of the four variables affecting their business, in conjunction with tax credit changes, blending limit changes, and the price of corn and natural gas. Of the four variables impacting a producer’s profit, three are external—the primary direct costs of corn and natural gas, ethanol prices, and coproduct sales. One is internal—production efficiencies, including conversion rates, natural gas usage, and enzyme and chemical consumption.
The outlook through June does not look good for ethanol producers. The primary external costs to produce a gallon of ethanol (cost of corn per gallon and cost of natural gas per gallon) are projected to be greater than 100 percent of the projected ethanol sales price per gallon over the same time period. Figure 1 displays the relationship between these factors for 2010 and the forecast through June. Historically, ethanol producers do not fare well financially when their primary cost components (corn and natural gas) are greater than 90 percent of ethanol’s sale price.
Figure 2 extends the forecast period from December 2010 to December 2013. The long-term outlook is also weak as the cost of corn and natural gas per gallon of ethanol produced is greater than 90 percent of the projected sales price over that same period.
External factors do not support strong projections for earnings before interest, taxes, depreciation and amortization for ethanol producers. While commodity markets do change, the corn, natural gas and ethanol prices have not resulted in combinations that facilitate strong cash flow performance for ethanol producers since the first quarter of 2008. As a result, assuming external market conditions will improve for ethanol producers is not a viable forecast. Producers cannot look to the external market to correct their financial performance issues. Internal factors related to production efficiencies, overhead costs, and capital structure will need to be the primary focus.
An analysis of performance data for seven Midwestern ethanol plants shows production and overhead costs can range by as much as 16 cents per gallon, depending on labor and other production costs. With the ethanol producer’s margins so tight because of market conditions, the management of these internal costs is critical. Labor costs for these plants range between 3.3 cents and 6.6 cents per gallon. Other operating costs range between 1.4 cents and 8.1 cents per gallon.
In addition to these production-related costs, interest expense and debt amortization requirements are key to the ability to survive this period. Producers will also need to be focusing on reducing capital structure-related cash outlays.
Looking near-term, ethanol producers will have limited ability to reduce input costs or increase ethanol prices. In addition, tax credit changes may erode profitability and, from a long-term perspective, relying on the tax code to provide profitable operations is an added risk.
Ethanol producers must engage in strict review of expenses and tough negotiations with equity partners and lenders. In many cases, the ethanol producer would benefit from a third-party review of operations and capital costs. This review would provide an independent analysis of staffing and production costs, and an independent assessment of the capital structure and costs. At this juncture, the dollars spent in this type of assessment may be the most valuable monies an ethanol producer can spend, if the probability of long-term survival is to be increased.
This is not the time to blame outside conditions for performance problems. Everyone knows those issues exist. This is the time for ethanol producers to differentiate themselves as industry leaders by thoroughly assessing their production costs and capital structure.
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