By Logan Caldwell

The capacity to produce ethanol at US plants is expected to outstrip domestic demand for the fuel by the spring given the number of new plants that are under construction. Nevertheless, there may be a silver lining. Demand for ethanol in the United States reached 5.9 billion gallons a year on an annualized basis in May 2006. Production capacity is expected to exceed six billion gallons a year by the spring and continue growing monthly. The volumes of ethanol that US fuel refiners are required by law to mix with gasoline under the Energy Policy Act of 2005 will never exceed domestic production capacity. For example, in 2010, demand must be at least 6.8 billion gallons a year by law. However, another two to four billion gallons of additional capacity are likely to be available by then, raising US production capacity to between eight and 10 billion gallons a year (even more if all announced projects proceed as scheduled). Even though we expect another increase in the socalled renewable fuels standard — or volume of ethanol that blenders are required by law to mix with gasoline — by Congress in 2007, it will take a year or more to modify terminals and develop ethanol and gasoline blend stock supply chains. If ethanol demand is to increase in any significant way in the next two years, it will be because ethanol producers have persuaded blenders to use additional ethanol on their own. It is a tough environment, but there are new opportunities for developers.  

A Roller-Coaster Year
The market has reversed in the space of just a year. A year ago, Congress ordered blenders to use more and more ethanol each year for the next seven years, corn prices had fallen below the 40-year average, and President Bush was complaining that the United States had to wean itself from an addiction to oil. Gasoline refiners were scrambling to figure out how to retool their gasoline production, blending and distribution systems to stop using the fuel additive MTBE. By June 2006, it looked as though the expectations of even the most enthusiastic ethanol producers and developers had been surpassed: oil prices had climbed above $70 a barrel and ethanol commanded a premium of up to several dollars a gallon over gasoline. A gallon produced was easily a gallon sold. It appeared to many in the ethanol industry that the mandates had met their intended purpose and created the additional ethanol demand the industry needed to reach a critical, sustainable mass. Gasoline blenders also felt a sense of satisfaction after successfully establishing ethanol supply to terminals hastily adapted for ethanol blending.However, supply was tenuous, and many terminals in the eastern United States and in Texas were in a state of high alert to assure the supply of finished gasoline for the summer driving season. Participants realized that MTBE had disappeared from the US gasoline supply system in a sudden swoop and not gradually over the course of the year as many expected. Exchanges of finished gasoline, on which gasoline blenders rely to balance supplies, reduce costs and cut truck traffic continued much as before, but with reformulated gasoline using ethanol in place of MTBE. Mirroring this change in the physical markets, trading of gasoline blend stock specially formulated to be mixed with ethanol commenced on the NYMEX (symbol “RB”) while the more traditional gasoline contract (symbol “HU”) started to wind down. It will disappear entirely with expiration of the January 2007 contract. Ethanol demand stepped up between April and May 2006 from 4.4 to 5.9 billion gallons per year on an annualized basis, an increase of 125 million gallons a month of additional demand. Then last May, ethanol demand stagnated. Aside from minor fluctuations in ethanol usage largely explainable by seasonal shifts in gasoline demand, the usual pulses in demand accompanying the major driving holidays from Memorial Day through Christmas, ethanol demand has held steady at 5.9 billion gallons a year. Houston BioFuels Consultants LLC has methods to estimate ethanol demand reliably on a weekly basis, one week in arrears. The weekly low during the period since May was 5.5 billion gallons a year the first week of July and the high was 6.5 billion gallons a year the first week of December. Thus, even the extremes were no more than 10% higher or lower than the mean and variations have generally been much closer.When the weekly demand is averaged over a given month, the variation is even less. One might have expected that discretionary ethanol blending would have dipped as ethanol prices spiked in late June to more than $1.50 per gallon over gasoline or surged in late September as ethanol prices dipped 30¢ cents per gallon below gasoline prices. There are several reasons why ethanol demand has not varied as much as one might expect from spot prices. First, the ethanol spot market is thinly traded, meaning very small amounts of ethanol are actually purchased and sold at the reported spot prices as a percentage of total market volume. On some days, few if any trades take place in the major regional market hubs (Los Angeles, Chicago, Houston and New York harbor), and trades often involve only a few rail car loads of ethanol. (A rail car contains approximately 29,000 gallons or 690 barrels.) Second, much of the ethanol that is used in the United States is purchased in short-term deals, often three to six months in advance of the first delivery period. Many of these gallons are purchased at either a fixed price or at floating prices tied to a gasoline index. (Some ethanol purchased on a floating price basis is indexed to one or more of the regional ethanol market prices, and prices on this basis will fluctuate with the ethanol spot market.) Thus, most of the ethanol gallons used by blenders are at prices that can differ significantly from the spot ethanol price, and blenders and sellers have volume commitments made months in advance. Examples of how these prices are less volatile than spot prices can be observed in the publicly-reported quarterly financial statements and press releases of the publicly-traded ethanol companies. Aventine, Pacific Ethanol and VeraSun reported average sales prices of $2.37, $2.45 and $2.38 a gallon, respectively, for the July-to- September quarter. By comparison, for the previous quarter (April-to-June) VeraSun reported average prices of $2.39 a gallon, or practically the same as in the third quarter. Another major reason for the flat demand for ethanol is the physical inability of gasoline blenders to use additional ethanol without major investments. Ethanol is blended into gasoline at the last terminal in the supply chain, literally into the truck that delivers the finished gasoline to the retail station. (It is unlike other gasoline components that are blended in the refinery.) These terminals are typically well within 200 miles of the markets they serve. Once a terminal is blending 10% ethanol into all the gasoline it sends out (making what is termed an “E10” blend), even if it has the capability to blend more ethanol, it is unable to blend greater than 10% because that is the limit the auto makers warrant for non-flex fuel vehicles and because any amounts greater would violate a “substantially similar” rule imposed by the US Environmental Protection Agency. An exception would be if they blend E85 (an 85% ethanol blend that can be used legally by flex fuel vehicles only), but E85 is limited currently by a host of issues. Longer term, E85 could play a significant role in balancing both the ethanol and the US transportation fuels market, but E85 is not expected to be a significant factor in ethanol demand during the next two years. As a consequence, most terminals in the United States that are currently blending ethanol are not in position to use more ethanol. Thus, for there to be a significant increase in ethanol demand, terminals that are not blending ethanol currently need to start blending ethanol. For terminals to blend ethanol, dedicated facilities are needed at the terminal to unload, store, pump and measure the ethanol blended into gasoline. In addition, to take economic advantage of the high octane properties of ethanol, the blender needs to use a suboctane blend stock called “CBOB.” Otherwise, the blender is merely “splash blending,” or blending 10% ethanol into a conventional finished gasoline. Splash blending to make E10 without using a CBOB creates another potential problem for the blender during the summer when the vapor pressure of the gasoline is of particular concern. Adding ethanol typically increases the vapor pressure of the finished gasoline by one pound per square inch. Since conventional gasoline specifications are regulated at the state level, some states have enacted “one pound waivers” to allow 10% ethanol to be splash blended with finished gasoline rather than CBOB to produce E10.With or without a waiver, the blender must consider the impact of ethanol on the volatility of the finished gasoline blend. Costs for installing the facility modifications can vary significantly from terminal to terminal depending on the terminal throughput, availability of existing facilities that can be put into ethanol service and local labor,materials, engineering and permitting requirements. In 2004, before construction costs escalated to where they are today, it was reported that one oil company invested more than $2 million to modify a terminal to blend ethanol near Atlanta. It appears an existing tank was modified for ethanol storage; otherwise if a new tank were needed, the cost would have been greater. The cost of facility modifications can easily be around $5 million dollars if a new tank or extensive rail facilities are needed. Blenders and gasoline marketers have many exchange programs in place to manage costs, reduce truck traffic and air emissions and provide reliable supply. This creates a cross linking between the terminals whereby, for example, one terminal will supply gasoline for another company at its terminal and at the second company’s terminal will supply gasoline for the first company. If the retail stations of one of the companies does not want to sell E10 for whatever reason, that means the exchange will be disrupted. Thus, in areas where ethanol blending is not already prevalent, the complexity of rearranging exchanges is another hurdle to overcome for additional ethanol blending to occur. In practical terms, it means several blenders in a given area need independently to decide to blend ethanol for ethanol blending to take place. The capital cost of facility modifications, the effort and expense of arranging for suitable CBOB, and the complexity of realigning of product exchanges have singly or in combination acted as a strong braking mechanism to further ethanol blending in the United States.They explain why ethanol demand has not changed since May 2006.

What’s Ahead?
At the end of 2006, US ethanol production capacity was approximately 5.6 billion gallons a year.New ethanol plants already under construction are scheduled to come on line every month for at least the next several years. Announced projects for additional plants will add further to capacity for several years after that.With the new capacity additions and completion of plant expansions, ethanol production capacity will exceed US ethanol demand sometime in the spring 2007 since, by March 2007, new plant additions will bring US production capacity to six billion gallons a year. Every month thereafter for the next two years, more new US ethanol capacity is expected such that by the end of 2008, somewhere between eight and 10 billion gallons of ethanol production capacity will be available. Total announced projects would double that amount by 2010, but we expect many will be delayed or canceled because of lack of demand. Imports have slowed but, for a variety of reasons, imports are expected to continue to come into the US even with a 54¢-per-gallon tariff and 2.5% ad valorem import duty.We expect increases in ethanol production in Brazil to parallel capacity increases in the United States. Brazil has a strong interest in exporting ethanol.With the announcement by Canada of an ethanol mandate by 2010 of 5%, an additional demand of around 0.5 billion gallons a year north of the border would absorb only a small fraction of the US oversupply since ethanol capacity is being added in Canada, too. It is likely to be 2008 or later before the Canadian mandate is actually implemented since, for now, the rulemaking process has only just begun with an announcement in late December 2006 by the Canadian federal government. Could the wet mills swing to high fructose corn syrup and balance the ethanol market? Even though the wet mills (ADM, Cargill, Tate & Lyle and Aventine) either have or could in principle install facilities to increase high fructose corn syrup production instead of ethanol,we doubt this will occur to any significant degree because the wet mills generally have around a 10¢-pergallon or more margin advantage over dry mills; the higher value of the co-products more than offsets the higher operating costs. In retrospect, it is clear that the mandated use of ethanol played only a minor role in the volume of ethanol used since May 2006. The increase in ethanol demand was due to the disappearance of MTBE from reformulated gasoline, and ethanol was the only economically viable replacement.The current renewable-fuel-standard volumes do not reach current ethanol demand levels until 2009 when 6.1 billion gallons a year will be required. Even if Congress increases the mandate early in 2007, due to the time required to modify facilities and establish supply chains (we estimate nine to 18 months), this will not have a significant impact on ethanol demand until 2009. In the meantime, for ethanol demand to increase, ethanol producers and marketers have only the mechanism of price incentives to spur potential blenders of additional ethanol to invest capital and resources to modify facilities and begin using ethanol. Potential blenders of ethanol need to perceive ethanol prices will be low enough relative to gasoline for a long enough time to recover their investments of capital and resources needed to bring about additional ethanol blending. With the prospect of an oversupplied market, ethanol producers and marketers may be best served by focusing on the price of ethanol in relation to the price of gasoline. This will be key to encouraging greater use of ethanol. It is clear that the price gap between ethanol and gasoline this past year was not sufficient to induce additional discretionary blending. (Ethanol was around 20¢ a gallon over gasoline on average during 2006 after taking into account the blenders tax credit.) As a guide to the relative price of ethanol to gasoline needed to spur discretionary blending, in the spring 2005, ethanol sold at a discount to gasoline (before taking into account the excise tax credit), and additional discretionary blending was installed and has been in service ever since. If ethanol prices are tied to gasoline, the opportunity may be available to manage the commodity price risk, and if similar programs are put in place on the corn and natural gas components, the ethanol producer may see whether his variable cash margin is going to be positive or not. If not, the deal normally should not be consummated since it would be better to forego the addition to capacity if it is only going to increase the loss. (Ethanol producers whose stakeholders supply corn to the plant may be an exception.) However if the variable cash margin is positive, even though nowhere near the levels achieved in 2006, it should be better to increase output and use the positive margin to help offset fixed costs.

Opportunities
If problems are opportunities in disguise, then one may feel that the opportunities in the ethanol industry over the next two years are very well disguised indeed. Since one of the major concerns of potential ethanol blenders is the cost to modify a terminal and each major blender may have multiple terminals needing modification, one opportunity may be to work with a blender to take on the capital risk in exchange for a portion of the value that will be realized by blending relatively lowpriced ethanol into gasoline. It may be that the developer uses this mechanism as part of a multi-year offtake agreement that could then be used to improve financial terms on an existing project that does not already have a firm offtake agreement or be coupled with a new ethanol plant that would come on line in 2009 or later. Another opportunity could be in the logistics for supplying ethanol to a new marketing area. An example is a destination terminal that could operate on a hub-and-spoke arrangement to supply multiple small terminals and would itself be supplied by rail car unit-trains or marine vessel. While perhaps not as glamorous as ethanol production, logistics are just as vital to growth of the industry and will be a limiting factor (in the form of cost) for many years to come. Similarly, from the supply end, a gathering terminal with a hub-and-spoke arrangement similar to the terminal being constructed in Manly, Iowa could be another opportunity. If lower ethanol prices over the next two years put downward pressure on margins, then the expected higher corn prices will exert further pressure.With such a rapid increase in the number of ethanol plants and capacity, any number of investors may consider shifting their investments elsewhere. Developers may find opportunities in combining, or re-combining, individual ethanol plants so as to create additional value that was not available with single plant operation or the current combination.