Uncertainty lies ahead for the grain-based ethanol industry

Sunday, March 3, 2013

Ethanol will consume 41 per cent of the continent's corn production. But with gasoline consumption falling and subsidies or mandates coming to an end or under review, the industry faces challenges

by STEVE KELL

The development of the North American grain-based ethanol industry over the past decade has had an enormous impact on the agricultural economy. With a new market for more than 40 per cent of the continent's corn production (the U.S. Department of Agriculture estimates that 4.5 billion bushels of 2012's 10.75 billion bushel corn crop will be used to produce ethanol), prices have risen and that newfound prosperity has found its way back into the economy of the country's agricultural regions.

The one potential smudge on the agricultural benefits of ethanol has been the amount of government subsidization of the industry. In Ontario alone, more than $600 million in taxpayer dollars have been invested in the ethanol industry and, in an economy struggling to deal with government debt and fiscal austerity, we need to seriously contemplate the potential impact of government restraint on this important market for agricultural products.

The ways governments across North America have chosen to support the grain-based ethanol industry range from capital grants for facility construction to minimum blending requirements, which ensure the level of demand for ethanol.

For those involved in the corn industry in Ontario, it is critical to understand U.S. ethanol policy because that business creates the demand for more than one third of the continent's corn production in a typical crop year and an even larger portion when weather events, like the drought of 2012, reduce the size of the crop. If ethanol demand backs off, there is no way that the market can support values at their current levels.

At the base of the ethanol industry is the minimum blending requirement for ethanol in all of the gasoline which is sold. The Renewable Fuel Standard (RSF), as it is known in the United States, is an escalating scale of the number of gallons of renewable fuel which must be blended into the gasoline which is retailed in the nation. For 2012, the legislated mandate was 15.2 billion gallons. This increases to 16.2 billion gallons in 2013, putting the current renewable fuel inclusion level right at the 10 per cent "blend wall."

Until quite recently, the U.S. minimum blending requirement also included a $0.54 per gallon tariff on ethanol produced outside of the United States, which effectively limited the import of sugar cane ethanol from South America. The Canadian government never offered biofuel producers here tariff protection. Competition from foreign-produced ethanol limits the manufacturer's capacity to recover the cost of higher-priced feedstock (grain) by passing it along to the consumer.

Although regulators across the entire market have continued to support the principle of a 10 per cent blending requirement, the high price of gasoline in recent years, coupled with more efficient automobile engines, has actually reduced fuel demand. The amount of corn used for ethanol production in the United States in 2012 was five billion bushels; the anticipated demand for 2013 is only 4.5 billion bushels. A significant contributor to that decline is the reduction in gasoline demand. If that trend continues and there is no increase in the minimum blending requirements, the demand for ethanol will decline.

Gasoline demand in North America actually peaked in 2007/2008, around the same time as most of the existing ethanol policy was being developed, and Exxon has forecast that U.S. gasoline demand will decline by 22 per cent between then and 2030. As a result of an escalating legislated mandate for ethanol in gasoline and a declining motor vehicle fuel market, an association of American oil companies is now actively lobbying the U.S. government for repeal of the Renewable Fuel Standard.

Although a complete end to the legislation seems unlikely, it is possible that a compromise solution might tie the blending requirement to an inclusion percentage rather than to a finite mandate, in which case the absolute size of ethanol demand may have already peaked.

Of particular interest to the agricultural sector in Ontario are our federal and provincial governments' strategies to develop and support the grain-based ethanol industry. The federal government of Canada has provided capital grants to assist in the construction of new ethanol manufacturing facilities through both Natural Resources Canada (including $84.79 million over seven years allocated to IGPC in Aylmer), and Agriculture Canada, which delivers capital support through the ecoAgriculture Biofuels Capital program.

In June 2005, the Ontario Government announced a $520-million, 12-year program called the Ontario Ethanol Growth Fund, which consisted of both capital grants to facilitate the construction of ethanol production facilities and operating grants designed to support the industry by helping ethanol manufacturers manage market fluctuations. Every one of the companies currently producing ethanol in Ontario has participated in the Ontario Ethanol Growth Fund.

The operating grant portion of the Growth Fund is not unlike the Risk Management Programs which the provincial government has made available to agricultural producers. To grossly oversimplify, it measures the futures values of oil, ethanol and corn, and trips a credit to the enrolled ethanol producers in market conditions where the fluctuations in the commodity markets cut into ethanol production margins.

Certainly, in the years since the program began (especially 2008 and 2012), the grain feedstock industry has seen no shortage of fluctuation, resulting in payments to the ethanol manufacturers of between $0.04 to $0.11 per litre as calculated monthly. Since last summer's drought the credit has remained at $0.11 per litre (the upper limit of the credit range).

Without the operating grants from the Ontario Ethanol Growth Fund, according to one industry insider, ethanol production would not be profitable and the marketplace would be "a substantially bleak experience." Assuming a typical yield of 11 litres of ethanol from every bushel of corn, in the current market situation, the Ethanol Growth Fund is contributing $1.21 towards every bushel of corn contributed to the Ontario ethanol industry.

The obvious question to Ontario's corn producers is what needs to happen to the price of corn at the conclusion of the operating grant program in 2017 to enable a viable domestic ethanol industry that will keep purchasing corn? In a market where ethanol brings $2.45 per U.S. gallon ($0.66 per litre), ethanol does not cover the cost of $7 per bushel for corn that the market pays today, so it is incumbent on Ontario's corn production industry to consider what the consequences are for corn prices or corn demand beyond 2017.

At this point, the new package of federal and provincial government programs for supporting agricultural market development under the umbrella of Growing Forward does not include operating grants to processors. So it seems likely that, over the next three years, the industry in Ontario will have to wean itself off the price fluctuation protection which it currently enjoys.

In preparation for the changes which lie ahead, we're seeing a push by ethanol producers to increase their efficiency, pay down start-up debt and create value-added opportunities in order to better position their businesses going forward.

The past five years have really been about starting a new industry and getting production ramped up quickly. The emphasis has been largely on developing enough production capacity to fill the legislated mandate for ethanol required under the Renewable Fuel Standard. Having largely met that objective, the sector's new focus is on capturing value from the co-products of ethanol production.

Over the past five years, the fledgling ethanol industry has grown to the point that it consumes 41 per cent of North America's corn. But maintaining this market will require either an easing in the price of corn, the continued enforcement of the Renewable Fuel Standard specifying minimum gasoline content (including limitations or restrictions on foreign ethanol imports) or a price-risk management program to enable ethanol producers to survive volatile conditions. The grain production sector has become reliant on a demand market whose future is far from secure.

In the absence of continued legislative and financial support from government, the only way that the grain-based ethanol industry can survive is higher fuel prices or substantially reduced costs for corn. BF

Steve Kell is a grain merchant for Parrish & Heimbecker Ltd. in Toronto and farms near Barrie as well as in Elm Creek, Manitoba, and Temiskaming.