High Corn Prices Hurt Ethanol Producers

| April 25, 2008 | 0 Comments

Oil is getting out of hand.  $119 per barrel.  Who has that kind of money. It won’t be long before we see Gasoline prices over $3.50.  Oh, wait, we’re already there!  I used to fill my gas tank for $20 and get money back.  Now, I fork over $40 and I’m lucky to get enough change for a pack of gum.

This is where having a free market economy is great.

When prices get out of hand alternative products start showing up.  For high oil, which results in high gasoline, we start seeing other replacement fuels.  Anything and everything from bio-diesel to ethanol.  It’s basic economics.  When prices get too high consumers seek out alternatives.

Ethanol is a perfect example.

Ethanol is a flammable colorless chemical compound that has many different uses.  Originally created from the production of alcoholic beverages, it can also be used as a solvent or as a fuel.

The production of ethanol is very simple.  Sugar is found in many naturally occurring plants like wheat, corn, or sugar cane.  Mix it with certain yeasts that consume sugar and you get ethanol as a byproduct.

It doesn’t matter if you’re making ethanol for human consumption or for use as a fuel, the production is similar.  After fermentation, the more volatile ethanol can be distilled out.

In the 1840s ethanol was used as fuel oil for lamps.  In 1908 the Ford Model T could run on ethanol.  Today, in Brazil, it seems like everything is run on ethanol.

The vast majority of ethanol produced in the world is made in Brazil from sugar cane.  According to some statistics, almost half of the cars in Brazil can run on 100% ethanol.  They use sugar cane because it grows easily in their geography and the high sugar content is easy to extract. Clearly ethanol has a place on the world stage as a gasoline replacement.

So here’s the question.  Is it time for ethanol in the US?

With oil reaching new highs every day, ethanol should be more competitive.  Less than a year ago when gasoline prices were trading on the NYMEX for around $2.00 ethanol cost $1.70.  Today gas is now over $3.00 and climbing.  Ethanol is up as well, but is currently priced at $2.50. A discount of about 16%.

So you’re probably thinking, gasoline prices are up and ethanol demand should increase.  That’s right.  And with an increase in demand comes higher prices.  Right again.  So now is the time to buy ethanol producers like Verasun (VSE) or Pacific Ethanol (PEIX).  Good thinking, but we’re missing a key component.

Just because the price of ethanol is up doesn’t mean that earnings will grow.

Let me explain why.  Unlike in Brazil where sugar cane is the primary input, in the US most of the ethanol is produced from corn.  And corn prices have been rising like crazy.  For years they traded for less than $2.50 a bushel.  Now the price of a single bushel of corn is more than $6 up 140% in just a few years.

This makes the production of ethanol less profitable.  But don’t take my word for it.  I found this buried in Pacific Ethanol’s 10-K:

The principal raw material we use to produce ethanol and its co-products is corn.  As a result, changes in the price of corn can significantly affect our business.  In general, rising corn prices produce lower profit margins and, therefore, represent unfavorable market conditions.  This is especially true since market conditions generally do not allow us to pass along increased corn costs to our customers because the price of ethanol is primarily determined by other factors, such as the price of oil and gasoline.  At certain levels, corn prices may make ethanol uneconomical to use in markets where the use of fuel oxygenates is not mandated.

What lawyer wrote that?  All they had to say is “We don’t make money when corn prices go up.”

Clearly oil prices are high and many are going to look for ethanol as a replacement . . .at least in the short term.  Despite these positive market actions, companies producing ethanol won’t benefit much.  If you’re looking for an investment in alternative energy I’d pass on ethanol. You can do much better than the “broken” business models of Verasun or Pacific Ethanol.

Tags: , , , ,

Category: Commodities

About the Author ()

The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

Leave a Reply

Your email address will not be published. Required fields are marked *