Is the ethanol boom going bust?

Commentary about business and finance.
Oct. 5 2007 11:52 AM

Popcorn

Is the ethanol boom going bust?

Illustration by Rob Donnelly. Click image to expand.

For years, economists, environmentalists, and poverty activists have been hating on ethanol. It's impractical; it boosts food prices and promotes industrial farming. Their scorn didn't much matter, because there was huge political and social momentum for ethanol production. But now the market is turning on ethanol, too. Ethanol stocks are sinking. Check out this two-year chart of Verasun, Aventine Renewable Energy, and Pacific Ethanol against the S&P 500. All three are down more than 60 percent. Earth Biofuels, which traded at $7 a share in May 2006, now trades for about 5 cents. A gallon of ethanol for November delivery trades at about $1.57 per gallon today, down from about $1.90 in July. As the Wall Street Journal put it (subscription required) earlier this week: "Ethanol Boom is Running out of Gas."

One could blame exuberant investors for the swift rise and fall of ethanol. But the government probably bears more responsibility. Though macroeconomic factors have spurred the ethanol industry—declining domestic oil production, rising energy use in developed markets, and a growing desire for so-called energy independence—government incentives have played a huge role in stimulating the ethanol boom.

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Of the many federal ethanol incentives, the most significant is a 51-cent-per-gallon tax credit given to refiners or blenders who mix ethanol with gasoline. Investors have responded rationally to this incentive, which effectively subsidized production: They've built a great deal of production capacity. U.S. ethanol production tripled between 2000 and 2006. Last year, 4.8 billion gallons were produced. In his State of the Union address, President Bush called for the United States to produce 35 billion gallons of renewable fuels in 2017. As of this spring, according to the Renewable Fuels Association, there were 120 ethanol refineries with a capacity of 6.2 billion gallons per year and enough refineries under construction to more than double existing capacity by early 2009.

But manufacturing ethanol is only part of the story. In order to penetrate the broad consumer market, a manufactured good needs efficient and pervasive distribution and retail systems. And in these areas, the government hasn't provided anywhere near the level of incentives it has to producers. As the Energy Department notes, ethanol presents many distribution challenges. The best way to distribute liquid fuel is via pipeline. Not so for ethanol, which mixes more easily with water than oil does. And because "ethanol is a better solvent than gasoline … initial shipments in a previously existing pipeline could pick up a lot of impurities that had accumulated in the pipeline." Sending ethanol through pipelines would corrode them more rapidly. And the existing pipeline network, heavily focused on the South, doesn't extend to the heartland, where ethanol is produced. As a result, most ethanol is shipped by comparatively inefficient and expensive means such as rail and trucks.

Nor does it appear that incentives have been set at such a level that they would encourage gas station owners to install the pumps and equipment necessary to sell a purer version of ethanol—E85. As of early 2007, according to the Energy Department, there were only 1,200 U.S. fueling stations offering E85. A search of the handy ethanol station locator reveals nine stations that provide E85 in New York state, but six are for government use only and three are marked "PLANNED—NOT YET ACCESSIBLE." And the incentives clearly haven't been sufficient to encourage car manufacturers to make more (or for mechanics to retrofit more) flex-fuel vehicles that can run on ethanol. There are only about 5 million on the road today.

In other words, the lion's share of inducements have gone to production—call it supply-side energy policy. But crudely stimulating this ethanol is actually the cause of the ethanol backlash. As production increases, the price of the commodity used in the process (corn) rises. So does the price of the expertise and materials needed to build capacity. During the railroad boom, the cost of steel and the salaries of engineers rose. During the dot-com boom, the cost of fiber-optic capacity and the salaries of Web programmers rose. The Wall Street Journal reported that the cost of building a new ethanol plant has risen from $1.50-per-gallon last year to $2.20 per gallon today.

The combination of rising commodity prices and production costs and a glut of product makes it more difficult for the manufacturers to turn a profit. In the second quarter, Verasun's gross margins shrunk to 19.2 percent, compared with 41 percent in the same quarter the year before. In its second quarter, Aventine gross margins shrunk from 11 percent to 6.9 percent. Verasun said earlier this week it would suspend construction of a refinery in Indiana.

Critics of ethanol have long argued that ethanol production subsidies are a half-baked industrial policy scheme intended to reward politically powerful farmers in the Midwest. The gulf between the rich incentives for creating ethanol supply and the poor incentives for creating wholesale and retail distribution suggest the critics were absolutely right.

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