Many in the ethanol industry believe ethanol prices are intrinsically related to gasoline prices since ethanol is blended and sold as a gasoline component. However, ethanol prices are fundamentally based on ethanol supply and demand balances. Sometimes the balance creates a link between ethanol and gasoline prices. Other times it breaks the link. Understanding when and how these relationships change helps ethanol producers make better decisions about their ethanol production and marketing plans.
 
 This article uses the Chicago-area market as the reference for ethanol and conventional gasoline spot prices. Chicago is used because it's the only Midwest point of the four major regional gasoline markets, and the Chicago Board of Trade (CBOT) ethanol futures contract specifies a Chicago-area terminal as its delivery point. Comments about the Chicago market apply to the other major regional markets as well as the rest of the United States. The other major regional gasoline markets are the Gulf Coast, New York Harbor and Los Angeles. 
 
 <center><img src="/images/upload/20070613041532.jpg">
 Figure 1. Ethanol spreads in the major regional markets</center>
 
 Figure 1 depicts the market linkage between ethanol and gasoline by showing the difference in the spot price of ethanol and conventional gasoline (referred to as the spread) in each of the major regional markets as reported by the Oil Price Information Service (OPIS). While the absolute level of prices is different in each market due to differences in specifications and logistics costs, gasoline and ethanol prices in all markets are strongly correlated.

 
 <center><img src="/images/upload/20070613041541.jpg">
 Figure 2. Chicago ethanol spot price spread compared to gasoline</center>
 
 When the magnitude of ethanol demand is relatively close to ethanol production capacity and import volumes, ethanol prices have tended to closely track gasoline prices and the spread is constant. When demand increases relative to supply, ethanol prices will increase relative to gasoline prices and the spread will increase. A clear example of this took place during the spring of 2006 as ethanol demand surpassed production capacity and prices needed to increase high enough to attract imports (Figure 2). When sufficient ethanol supplies from Brazil weren't readily available, prices had to rise to $2 per gallon or more above gasoline prices to attract the needed volume of ethanol from China.
 
 The opposite took place in the spring of 2005 when ethanol supplies were increased in anticipation of Atlanta switching to E10. When the switch didn't occur, the resulting oversupply depressed prices and the spread went into negative territory for several months. During the back-to-back hurricanes Katrina and Rita, we saw how quickly ethanol prices could respond and track gasoline prices when there was a balanced ethanol supply and demand situation. 
 
 As discussed in the June issue of Ethanol Producer Magazine, Houston BioFuels Consultants LLC forecasts that from the spring of 2007 through at least the end of 2008, ethanol supply capacity will significantly exceed demand. Figures 1 and 2 show how the increasing supply relative to stagnant demand is causing erosion in the ethanol spread. This decline in the spread is expected to continue until the absolute price of ethanol drops low enough to persuade ethanol producers to reduce operating rates and balance the market. The resulting underutilized production capacity will act as a weight on ethanol prices. Producers will try to bring it back on line, causing an oversupply that will lower prices. It's expected the ethanol market will ultimately come back into balance as a result of higher demand created by gasoline blenders increasing their use of ethanol as it becomes an "irresistible" blendstock from an economic point of view.
 
 The floor price of ethanol is likely to be set by the variable cost of producing the incremental gallon of ethanol. There are many definitions of variable cost. In this article, variable cost refers to the costs an ethanol producer incurs to produce an extra gallon of ethanol. Alternatively, variable costs can be viewed as the cash costs an ethanol producer can avoid if he/she decreases ethanol production. When an ethanol producer has an opportunity to sell more ethanol, the rational decision is to produce and sell when the price is greater than the cost it takes to produce. Conversely, if the price offered is less than the variable cost, the producer is better off declining the sale and not producing.
 
 Historically, ethanol prices haven't tracked corn prices. However, since corn is the major component of ethanol variable cost, it's expected this will change during the period of oversupply. As the excess production capacity increases, ethanol prices will continue to trend downward until they begin to parallel, or correlate with, corn prices. Prices will continue to trend with corn until ethanol supply and demand comes back into a semblance of balance. 
 

 Much additional corn has been planted this year in anticipation of increased ethanol production. However, there could well be downward pressure on corn prices if ethanol demand doesn't keep up. Lower corn prices would then present the ethanol producer with lower variable production cost, and the result will be more ethanol supply trying to find its way into the market. This will play out as a further reduction of ethanol prices until the additional supply is turned off. In turn, corn demand will decrease and bring down corn prices. This vicious circle will continue until balance is restored in the ethanol and corn markets. As this process plays itself out, ever lower ethanol prices and the desire of ethanol producers to run their plants at higher capacity utilization will set the stage for offtake arrangements with ethanol blenders that will provide the certainty of economic advantage for blending larger amounts of ethanol, even with all the additional costs blenders will need to incur to increase ethanol blending.
 
 One of the steps blenders will take to assure they receive the best price for the ethanol they purchase will be using ethanol market prices as the index in their term ethanol agreements. Examples of ethanol market prices that will be increasingly used are the spot prices reported by the major price reporting services such as OPIS and Platts. As ethanol prices are used more, we could well see an increase in the volume on the CBOT ethanol futures contract as both ethanol buyers and sellers use the contract to hedge their positions.
 
 Logan Caldwell is the president of Houston BioFuels Consultants LLC. Reach him at <a href="mailto:lc@hbioc.net">lc@hbioc.net</a> or (281) 360-8515.
 
 The claims and statements made in this article belong exclusively to the author(s) and do not necessarily reflect the views of Ethanol Producer Magazine or its advertisers. All questions pertaining to this article should be directed to the author(s).

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The Changing Ethanol Market: Implications for Stakeholders