China's central government has borrowed a page from Uncle Sam by getting into the ethanol industry in a big way. China is targeting nationwide ethanol blending of 10% gasoline volumes by 2020. Much like in the United States in the mid-2000s, the move is expected to create one of the largest renewable fuel markets in the world virtually overnight. Case in point: China could need up to 5 billion gallons per year (bgpy) of ethanol to meet its goals. 

There's just one problem. It seems very unlikely that China can build enough ethanol capacity between now and 2020 to supply its own mandated volumes. That's great news for American ethanol producers, who boast 16.2 bgpy of production capacity -- nearly 2 billion gallons more than domestic consumption. It could create one heck of an opportunity for ethanol stocks. 

Someone holding a gas pump, with a city street crowded with car traffic in the background.

Image source: Getty Images.

Why Chinese ethanol will likely fall short

By 2020 China wants all gasoline sold in the country to contain 10% ethanol by volume, which is what the United States currently mandates with its Renewable Fuel Standard. Building an ethanol industry is a necessary first step to building the Chinese bioeconomy, but there's a long way to go. China currently produces about 800 million gallons per year (mgpy) of ethanol, with about 500 mgpy derived from corn. Based on expected gasoline demand of 45 billion to 50 billion gallons, to meet the 10% ethanol blending rules in 2020, the country would need between 4 billion and 5 billion gallons of ethanol per year. 

It will be nearly impossible to site, build, and ramp up enough new production capacity to supply demand from domestic production alone by 2020. That's why many industry experts expect the Chinese government to turn to ethanol imports to fill the gap -- and only the American market has enough spare capacity to cash in on the opportunity.

A giant corn pile outside a corn ethanol facility.

Image source: Getty Images.

Three stocks to benefit from American ethanol exports

American ethanol producers have leaned heavily on exports in recent years to help reduce domestic inventories. In 2016 and 2017, the United States exported 1.17 billion gallons and 1.38 billion gallons, respectively -- and it still had close to 500 million gallons of capacity sitting idle. While China was a primary customer in 2016, the implementation of temporary tariffs meant virtually no American ethanol was imported last year. 

Then waivers were granted, and the floodgates opened.

China imported 55 million gallons of American ethanol from November 2017 to the end of February 2018. It could be just the beginning. That would be great news for Archer Daniels Midland (NYSE:ADM), Green Plains (NASDAQ:GPRE), and Valero Energy (NYSE:VLO) -- the three largest publicly traded ethanol producers in the United States.   

Metric

Archer Daniels Midland

Green Plains

Valero Energy

Annual ethanol production capacity

1.7 billion gallons

1.5 billion gallons

1.45 billion gallons

Market cap

$25.4 billion

$761 million

$47.8 billion

Dividend yield

2.9%

2.7%

3.1%

Segment operating income, 2017

$2.5 billion

$87 million

$4.5 billion

Ethanol operating income, 2017

$163 million

($45 million)

$172 million

Source: SEC filings, company presentations.

All three companies stand to benefit tremendously from exports. Why? The U.S. has the ability to produce more ethanol than it needs to blend to 10% of gasoline. So the largest determining factor in ethanol prices has been in input cost of corn and how much extra inventory was available. With a large export market, though, producers could sell that excess capacity outside the U.S. and keep domestic inventories low enough to support higher domestic prices. 

That said, ethanol is about the only thing the three companies have in common. Archer Daniels Midland is an integrated agricultural products company, which generates business from processing corn, soybean, and specialty ingredients on multiple continents. That helps to diversify the business away from historically low-value ethanol, although earnings before income taxes fell 12% from 2016 to 2017 on the heels of continued pressure on global agricultural markets. The business remains comfortably profitable nonetheless.

Sustainable profits have been more difficult to come by for Green Plains, which is the most reliant on ethanol out of the top producers, although management has diversified the business in recent years. The company is now the world's largest vinegar producer (vinegar is made from ethanol) and the fourth-largest cattle feedlot owner in the United States (cows eat corn byproducts made during ethanol production). The result: Ethanol generated just 21% of EBITDA in 2017, down from 45% in 2016.

A birds' eye view of an ethanol facility.

Image source: Getty Images.

Then again, ethanol was most responsible for a lackluster performance last year, but Green Plains has the most to gain from rising ethanol prices. It recently opened its own export terminal to take advantage of the trend in trade flows, and estimates that a 10% price increase in selling prices would generate an additional $158 million in net income per year.

Valero Energy doesn't have a problem generating copious amounts of net income, although that's because the business is overwhelmingly carried by refining throughput and petroleum products. Nonetheless, investors may be surprised to learn it owns 11 large ethanol facilities combining to contribute up to 1.45 bgpy of production capacity. 

The idea to go all-in on ethanol production years ago hasn't exactly panned out recently. Valero Energy spent more satisfying ethanol blending requirements for its refining business in 2017 ($942 million) than it generated in operating profits from producing ethanol ($172 million). Nonetheless, the assets are still profitable, and if the right catalysts come around, then the refiner's ethanol prowess could provide some serious incremental cash flows.

A man staring at a chalk board in front of him with money bags and question marks drawn on it.

Image source: Getty Images.

That being said...

The ongoing threat of a trade war between the United States and China cannot be discounted, as it would almost certainly entangle American ethanol exports. That creates some uncertainty, and there are few things the stock market hates more than uncertainty.

Therefore, while there's an enormous potential opportunity for domestic ethanol producers to tap into new gasoline blending requirements in China, it's not quite a slam dunk. It has the potential to create the opportunity of a lifetime for the American ethanol industry in a few years' time, but trade disputes could effectively close off the Chinese market entirely.

Of course, there are plenty more export destinations than China, and exports will remain strong and growing with or without the country. That hints opportunistic investors should continue to watch the general trend in trade -- with the understanding that China could really tip the scales as 2020 approaches.

Maxx Chatsko has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.