Ethanol margins return to seasonal swings

Off to a slow start, 2015 margins improved, thanks to exports and strong driving demand. What will 2016 bring? This article appears in the February issue of EPM.
By Susanne Retka Schill | January 20, 2016

Ethanol margins returned to earth in 2015, after soaring sky-high for much of 2013 and 2014. The seasonality pattern that emerged after 2010 was put on pause during that prosperous period, but returned in 2015, resulting in slim to negative margins in the first few months before recovering as the summer driving season increased demand. The tighter margins didn’t dampen ethanol production, however, with the industry setting new production records throughout the year, even topping out over 1 million barrels per day in the weekly production averages twice before the year ended. The production performance of 2015 is a testament to the industry’s increasing efficiency, as miniscule new capacity was added during the year, but it also raises the worrisome question—with the industry running hard, is supply going to outpace demand? Ethanol Producer Magazine spoke to a banker and a broker for a perspective on the trends shown in the accompanying charts.

“Supply and demand has remained well balanced through the fall,” says Dan Kowalski, director of industry research at CoBank, part of the national cooperative bank system servicing agribusiness. CoBank released a report in September that called 2015 a year of rebalancing in the ethanol industry. Kowalski updated the data through the end of the year for the charts shown here.

Exports and low gasoline prices contributing to increased driving demand are the biggest factors behind that balance, he says.  “We continue to push higher on production but at the same time exports have remained very strong and ethanol is still priced above gasoline and has been since September.”  Speaking in late December, he adds, “Clearly the market is signaling there is not the excess or burdensome amount of ethanol that one might expect at that production level.”

Ethanol production numbers and stocks reports are closely watched, says Will Babler, a broker and principal with Atten Babler Risk Management LLC. “As far as the stocks go and how heavy they can get, I wouldn’t give an absolute number,” he says.  “If storage continues to build and the run rates stay up near the record pace, then the stocks situation will largely depend on exports.”

The start of the year usually sees tight margins, Babler says. “We would expect it’s going to be a tough margin environment until we move into the point where spring driving demand kicks in. You can have surprises where the export market will bail you out and keep the price up, which is a lot of what is happening now. There could be some wrinkles around RIN compliance and the amount of blending needed to meet these more aggressive EPA targets, and that’s not entirely clear yet. But, it’s hard to see a huge runaway market to the upside in the near term. Looking at the downside, if you’re staring at $35 crude oil, or the possibility of something even lower, one shouldn’t be surprised if, all of a sudden, the exports just stop.” In many cases, imports are policy driven, and policies can change, he adds. “That propensity of the export market to change its mind is probably increased when you’re at 10-year low in oil price.”

On the other side of the margin equation, neither observer expects much movement in corn. Kowalski points out that USDA bumped up its projection for corn consumption by 25 million bushels in the report following the U.S. EPA’s announcement of the 2016 renewable volume obligations (RVO) under the renewable fuel standard (RFS).  “It’s not a big move. The broad consensus within the industry is that there’s going to be a minimal impact, maybe in the area of a nickel or a dime on prices.”

Babler agrees that corn is not likely to be a constriction, although the basis has been strong as farmers have been tight fisted. “But the corn is there and there’s a good probability that there’s going to be even more corn globally and in the U.S. as we move into the next crop cycles.”

Policy Influence
The bigger question, Babler suggests, is how the market will balance out in a lower energy price environment. “There’s a lot of open questions the further out you go.    It’s hard to find stability in this market and the root of that is that there’s so much policy influence.” Policy changes in individual countries could impact exports, he says, and the domestic policy front isn't settled yet.

Even though the EPA released its final rule on the RVO for 2016, there is still the possibility of a lawsuit or another attempt for Congressional action to alter the RFS, Babler points out. “For corn ethanol it was a mandate that landed in the middle.” Neither the ethanol nor the oil industries were exactly pleased, he says, nor is the policy impact entirely clear, with alternative viewpoints on RIN balances, the renewable identification numbers used for compliance, and speculation on the potential for biodiesel to be used to comply with the renewable mandate dominated by corn ethanol. 

Kowalski points out that D6 ethanol RIN value rose dramatically after the EPA’s announcement, settling down around 70 cents at year end. For those in the industry who have worked to pass the RIN value on to the consumer, that could help drive E85 and E15 sales by reducing the cost of ethanol for blending. For others, the economics may work against ethanol blending. “At this point, the incentive for the blender is to use RINs they may have accumulated, because ethanol is more expensive than gasoline,” he says. “It doesn’t make sense to blend in extra ethanol into the gasoline pool. It makes more economic sense for them to use the RINs for any obligation that they’re not covering with their 10 percent blend.” The issue of the blend wall has not been solved, he adds. RINs prices could become stronger as obligated parties bid them up for compliance, additional higher blends could be used or noncompliance might become the strategy. “And we’re back at the same place next year fighting this battle, figuring out how this works,” he says.

While policy uncertainty was the 2015 story for biofuels, for commodities as a whole, it was the price collapse in oil. Indeed, across the board globally, all commodities have dropped, turning the focus of commodity analysts on super-cycles. Ethanol’s growth curve coincides with the run-up in the current super-cycle which began in the early 2000s. There were fast growth rates in emerging markets and a debt-fueled boom time in developed countries, Babler points out.  “You had a huge run-up from 2000 all the way in to the financial crisis and then you started to see a lot of things shake out,”  Babler says. “Some ag commodities hung on a little longer, due to drought and extreme weather, but now we’re seeing all that slip.” Investments made to increase capacity during the boom came online just as the economy slowed, thus the record inventories in many, many commodities, Babler says. The front side of the cycle, the boom, is much shorter than the downside, he adds, “And you get a longer-than-expected negative cycle on the back side of it. When you consider everything going on, it seems like we’re moving into that environment now.”  

Kowalski says that at first glance, the commodity price woes are caused by the strong dollar, but not all commodity sectors have performed the same. The energy price index dropped the most dramatically, while ag crops, livestock and industrial metals saw a less dramatic decline. “Macro forces are affecting commodities,” he says, “but they are having differing effects.” Looking ahead to 2016, Kowalski says the dollar is likely to remain strong and alongside higher interest rates won’t help commodities.

2016 Prospects
As a broker, Babler views 2016 prospects in risk management terms. “The most risk is in first half of the year,” he says. “The status quo would be margins stay very tight with some people struggling and some doing okay. That’s the status quo until we get into driving season. But there’s a mine field before we get there. Do exports hang in there? Does the low crude oil price finally catch up with the ethanol industry? Could margins run away to the positive side in the near term? I think there are a lot of headwinds to make that happen. It feels like it’s going to be tough, scratching it out for the start of the year and more downside risk than upside opportunity. If you get further out, more things can change. We’ve seen good gasoline demand all year. If we’ve got low energy prices and we get into peak driving season, and we have an export market hanging in there, things could get better.”

Kowalski views 2016 with the eyes of a banker. “The reality is that liquidity is fantastic in the industry. Ethanol producers have come through very strongly. They have managed their margins up to this point very well and the industry has really learned how to manage itself. So there might be some turbulent times ahead, but the liquidity really will enable most of the producers to handle those struggles, if they do come.” 

Author: Susanne Retka Schill
Senior Editor, Ethanol Producer Magazine