American ethanol producers must have fallen asleep in economics class, because they don't seem to grasp the concept of supply and demand.

While all producers have paid the price of a grossly oversupplied market in recent years, none has suffered as much as Green Plains (NASDAQ:GPRE). The business is much more dependent on ethanol output and selling prices than peers Archer Daniels Midland or Valero Energy, which generate the majority of their income from agricultural raw materials and petroleum refining, respectively.

That said, there was a silver lining in the full-year 2018 operating results reported by Green Plains: Producers are sharply reducing output in an attempt to push the market closer to equilibrium. When coupled with recent debt repayment and cost-cutting efforts, curtailment could help to lift the financial performance of the nation's fourth-largest ethanol manufacturer. But it looks like 2019 will be another difficult year for shareholders.

A giant pile of corn kernels next to a grain storage facility.

Image source: Getty Images.

By the numbers

The American ethanol industry is dependent on two main sources of demand: domestic consumption and exports.

Domestic demand is dependent on total gasoline consumption, as the U.S. Environmental Protection Agency mandates 10% of the nation's gasoline supply comprises ethanol. That creates about 14.4 billion gallons of demand per year. Meanwhile, exports have become an increasingly important source of demand in recent years. The United States slung a record 1.6 billion gallons of ethanol across the globe in 2018 -- and the numbers for December have yet to be reported. 

While that means American ethanol producers such as Green Plains got to play in a market totaling approximately 16 billion gallons in 2018, the problem is that production capacity has always been at or above demand. Last summer (when ethanol production is lowest) there was an estimated 15.8 billion gallons of active production on an annualized basis, but 16.3 billion gallons of installed capacity. The result: There's a near-record 1 billion gallons of ethanol in inventories across the country right now. 

That sent average ethanol selling prices tumbling last year to their lowest levels since 2002. Green Plains exited 2018 losing $0.25 per gallon and hasn't produced a profitable gallon since August 2018. It showed in the company's operating results.  

Metric

2018

2017

Change (YOY)

Ethanol revenue

$2.12 billion

$2.51 billion

(15%)

Total revenue

$3.86 billion

$3.60 billion

7%

Ethanol gross profit

$1.8 million

$73.6 million

(97%)

Total gross profit

$215.7 million

$294.6 million

(27%)

Ethanol operating income

($111.8 million)

($45.0 million)

N/A

Total operating income

$115.7 million

$41.7 million

177%

Data source: Press release. YOY = year over year.

A poor performance from the ethanol segment overshadowed solid results from the company's secondary segments in agribusiness, food ingredients, and logistics that aren't broken out in the table above. Green Plains only reported a year-over-year increase in operating income when including the gain on the sale of multiple assets.

Those asset sales were the result of management realizing downright awful ethanol market fundamentals were suffocating the company as previously structured. It sold three ethanol manufacturing facilities and its vinegar business in 2018 to pay off its term loans, save tens of millions of dollars in interest expense per year, and refocus on higher-margin opportunities. While it still wields about 1.1 billion gallons of annual production capacity, it produced just 205 million gallons of ethanol in the fourth quarter of 2018. That marked the lowest volume of output since 2013 and the company's lowest utilization rate ever.

Investors may want to get used to curtailed production throughout 2019. That will be needed to reduce losses in the current margin environment and help to push the overall market toward equilibrium, as Green Plains is the nation's fourth-largest ethanol producer. The good news is that peers are also reducing output. American ethanol output has fallen in six of the last seven weeks as of early February, according the the U.S. Energy Information Administration. While that has yet to make much of a dent in inventory, sticking to the strategy for several months heading into the summer driving season would be wise. The industry could also get a boost from multiple catalysts this year. 

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Image source: Getty Images.

Multiple events on the horizon for 2019

Green Plains and peers are eagerly awaiting the EPA to change a long-standing rule capping ethanol blend rates to just 10% ethanol. Regulators previously signaled a willingness to allow between 10% and 15% ethanol blends year-round, which could create up to 1.3 billion gallons in additional annual domestic demand within five years. The government shutdown and general understaffing of the EPA under the Trump administration have hampered the expected timeline for the policy change, however.

Management has also noted that resolving the trade war between the United States and China could further boost exports, since China has slapped a 70% tariff on American ethanol imports. However, it may not create the catalyst Green Plains expects. That's because ethanol traders have circumnavigated Chinese tariffs by selling fuel to Asian countries, conducting ship-to-ship transfers at sea, then selling it into the Chinese market anyway. Booming exports in 2018 show the trade war isn't weighing on international demand.

That said, China has ambitious plans for blending ethanol into its own fuel supply by 2020, but will likely need to import 1 billion gallons of ethanol or more per year to make it work initially. The United States is the only market capable of supplying that volume of fuel, so a trade compromise would help domestic producers exploit that opportunity more directly.

A snail moving up stacks of coins.

Image source: Getty Images.

Relief appears distant for Green Plains

It's likely that 2019 will be remembered as one of the most transformational years in the history of the American ethanol industry. The issue is investors don't yet know whether that will be a good thing or a bad thing.

Curtailing production is a good first step and one that's long overdue, but it would take a near industrywide commitment for many months to deliver results -- and take over one year to drive inventory to healthy levels. The expected policy change at the EPA could provide a significant catalyst for producers by promising to help balance the market more quickly. It would take years to play out, but at least Wall Street analysts could take the accelerated demand growth into account. Meanwhile, the pace of exports isn't expected to slow down anytime soon, and the trade war doesn't seem to be affecting that in the slightest.

All that said, there's a long way to go before Green Plains can reverse its $0.25 loss per gallon produced. Management has high hopes for a new, high-margin protein production process that can be bolted onto existing ethanol facilities, but it will take years to implement across the fleet. That suggests the business might struggle to find much relief in 2019 -- despite trading at just 0.67 times book value -- unless multiple catalysts fall in the industry's favor.