Doing the Math

An Iowa State University sociologist has developed a tool to help rural communities and policymakers understand how volatile corn and ethanol prices might affect the fate of the ethanol industry.
By Ryan C. Christiansen | May 04, 2009
High corn prices and low ethanol prices are bad for the U.S. ethanol industry. For ethanol producers, this recipe for disaster is a no-brainer. However, not everyone outside the industry understands the gravity of this simple math. Even some industry insiders are surprised when they actually put pencil to paper.

Take David Peters, for example. He's an assistant professor of sociology in the College of Agriculture and Life Sciences at Iowa State University in Ames, Iowa. During the summer of 2007, while working as a community economics specialist in the Department of Agricultural Economics at the University of Nebraska-Lincoln for the university's extension service, Peters assisted communities and local governments with assessing the long-term viability of proposed ethanol plants. "We had a lot of local governmentscities and countiesthat had ethanol companies coming to them asking for them to provide infrastructure revenue bonds or property tax abatements and to extend roads, rail lines, and water, sewer and electric lines," which were expensive propositions for small towns with as little as 500 people, he says. "The question was: If we bond out the infrastructure for 15 to 20 years, what is the long-term viability of the ethanol plant? Will we have a stable, long-term revenue stream?' I did some research and put together this calculator where they can input the parameters and assumptions and look forward in time to determine profits. The goal was to give the communities a tool that can help them to make public policy decisions."

That was when corn prices were low and ethanol prices were high. Peters' calculator hasn't changed, but prices have. Peters can easily show you how high-priced inputs and low-priced outputs mean losses instead of profits, but even he is surprised at how far things have gone up and down. "The main thing that surprised me was how sensitive the bottom line is toward changes in corn and ethanol prices. Obviously, it's intuitive that it would work that way, but what surprised me is how relatively minor changes either way can lead to profits or losses in sizeable amounts. At $3.50 per bushel for corn, the price of ethanol would only have to tick up another dime to change the entire economics of an ethanol plant."

Deciphering the Data
Peters calculates that a typical 100 MMgy ethanol plant with a typical amount of debt breaks even when corn is at $3.75 per bushel and ethanol is at $1.85 per gallon. With $4 corn the break-even ethanol price is $1.90. For every $.25-cent increase in the price of a bushel of corn, the price of ethanol only needs to go up approximately 5 cents per gallon for the plant to break even. If the price of ethanol goes up an additional 10 cents, the ethanol plant realizes profits in the millions of dollars.

"It's important for people to understand that the ethanol industry runs pretty lean," Peters says. "There's not much fat to trim out of the industry. Corn is the big cost component and most of your revenue comes from ethanol. If either of those changes, there isn't much you can cut. Distillers grains help, but you're not in the business of making distillers grains, you're primarily producing ethanol."

Peters' calculator allows anyone to input their own data to estimate what the prices of corn and ethanol would have to be for an ethanol plant to be profitable. The calculator, a spreadsheet, models the data for a typical 100 MMgy ethanol plant built in Iowa or Nebraska in 2005. The plant is assumed to operate at 100 percent capacity with an ethanol yield of 2.9 gallons, a distillers dried grains with solubles yield of 19 pounds, and a carbon dioxide yield of 17.5 pounds per bushel of corn. Inputs include 7 gallons of water per bushel of corn and also 1.1 kilowatt-hours of electricity and 35,000 British thermal units of natural gas per gallon of ethanol. The capital costs for construction and equipment are assumed at $160 million with 60 percent financed at 8 percent and 40 percent equity returned to investors at 15 percent. The calculations include labor costs for 45 workers with an average salary of $47,750 per year with 13 percent tacked on for benefits and 10 percent added for other labor and management costs. The model assumes straight-line depreciation over 20 years with a salvage value equaling 25 percent of investment costs. Other inputs include the cost of enzymes, denaturants, yeasts, chemicals for processing and cooling, various antibiotics, waste management, maintenance, transportation costs, miscellaneous administrative costs, property taxes and sales taxes.

"In general, it's the price of corn and the price of ethanol that really drive profits," Peters says. "The only other inputs that might have a [variable] impact on production costs would be electricity, natural gas and water, but those are secondary inputs. Transportation costs are an issue, but they are a relatively small component, because most of the ethanol is shipped by rail, which is relatively inexpensive per ton-mile."

Besides corn and ethanol prices, another key variable in the ethanol profitability equation is debt. "Timing is everything, as they say," Peters says. "Plants that maybe broke ground in 2004 or 2005 and went into operation in 2006 are in a better position. We've learned about investors getting back double their investments. It was wildly profitable when the Energy Policy Act of 2005 went into effect and the price of ethanol shot up to $2.60 per gallon with corn at almost $2 per bushel. "(However) a lot of plants... are struggling now," he continues. "They made money, but not enough to retire their debt. Or if they gambled and did a risk analysis and thought the revenue outlook was positiveand paid off their initial capital and wanted to expandthen they are in the same situation with a high debt payment."

In the past few years, when ethanol prices were high and corn low, many plants made enough money to retire their debt early. These plants with no capital debt are now roughly breaking even or losing a few cents on every gallon, according to Peters.

"No one has a crystal ball to see the future, but this (spreadsheet) can give people an idea of where prices need to be," he says.

However, corn and ethanol prices haven't been where they should be. "Things really turned the corner last summer (2008)," Peters says. "I think most plants were buying short-term contracts and were kind of banking that the price of corn wouldn't go up as much as it did. I think a lot of plants didn't lock in cheap corn a year or two ahead of time and they were forced to lock in contracts at $5.50 and $5.75. But no matter what contracts they had, the price of ethanol kept falling. The most important advice I have for ethanol producers is to be sure they have a good grain marketer on staff."

Peters says the ethanol industry is partially a victim of its own success. "We were given the [renewable fuels standard] in 2005 and within a couple of years, the industry responded to meet it," he says. "Then prices began to back off. How can you fault them? They saw the demand and met the challenge."

However, a lot of what has happened is not the fault of the industry, Peters says. "Last year, investors started to look for inflation hedges and started dumping into commodities," he says. "When the prices were overbid, people pulled back, and we had an economic downturn. Things began to unravel and oil fell. Everyone got caught up in it."

There is a misperception amongst the general public that the ethanol industry is heavily subsidized, Peters says, "but this industry isn't really that reliant on direct subsidies," because the volumetric ethanol excise tax creditalso known as the "blender's credit"is already factored into the price of ethanol, he says.

More than Money
What his profitability calculator doesn't include, Peters says, are the more intangible profits from producing ethanol: clean air and reducing greenhouse gas emissions. "The benefits for people in larger cities burning ethanol blends and having cleaner airwhile not a benefit to the ethanol producer itselfis a benefit to the communities and to government, and to lowering health care costs. People wouldn't miss as much work and workers would be more productive. We need to look at the benefits of ethanol on a macroeconomic and social scale. It's hard to quantify."

Peters says policymakers need to consider price supports for ethanol. "If ethanol is deemed to be a national priority," he says, "then instead of having a blender's credit, one of the sanest ideas I've heard is to subsidize losses to help smooth out these fluctuations. You need to try to smooth that out because we need to preserve the industry, our rural development, our clean air, and our energy independence. Ethanol producers are making strides to become more efficient and to squeeze out more ethanol, but this country needs to determine whether it is a national priority. This model can help to give policymakers a rough estimate of what that gap is and what we would need to cover. You could boost that up to a point to where at least the plants [are making some profit]. No one is expecting that the government should make the industry profitable, but it should at least ensure there is some guarantee to break even."

The ethanol profitability calculator is just one piece of a much larger set of calculations used to help communities and their chambers of commerce to model the impact of an ethanol plant on their local economies, Peters says, to identify where new job opportunities might materialize and how getting an ethanol producer to agree to buy locally might increase its impact on the community.

"From a rural development perspective, this is something that rural communities see that they can invest in," Peters says. "Ethanol has had a positive impact on rural development, that's all true. For many towns it was the biggest thing to ever happen, as far as industry. People need to better understand how the prices of corn and ethanol really impact the bottom line."

Ryan C. Christiansen is the assistant editor of Ethanol Producer Magazine. Reach him at rchristiansen@bbiinternational.com or (701) 373-8042.