It's shaping up to be a great year for you at the gas station. In fact, the U.S. Energy Information Administration estimates that American households will spend less on gasoline in 2015 than at any point since 2004. Ironically, that was also the last year the country went without mandates dictating the production of renewable fuels such as biodiesel and bioethanol and their subsequent blending into the nation's fuel supply. That year, America produced 3.4 billion gallons of bioethanol, and a gallon of gasoline sold for an average price of $1.85.
Fast forward 11 years and a lot has changed. The United States produced close to 14 billion gallons of bioethanol in 2014, which was made possible by investments from companies such as Green Plains (NASDAQ:GPRE) and Archer Daniels Midland (NYSE:ADM). Meanwhile, gasoline prices have remained volatile. After spiking above $4 per gallon in 2008, national average gasoline prices sit at just $2.21 per gallon today.
You may be wondering what low gasoline prices mean for the bioethanol industry, which owes its growth to laws created in 2005 and revised in 2007 that had the sole purpose of reducing America's consumption of petroleum-based fuels. Are falling oil prices good or bad news for bioethanol? As we'll see, it's complicated.
How is bioethanol priced?
Oil refiners extort some control over the price of bioethanol, but not always for the obvious reasons. The first generation renewable fuel is not a direct replacement for gasoline; rather, refiners use it as an oxygenate to reduce the amount of carbon monoxide and soot produced when gasoline is burned. The U.S. Environmental Protection Agency tracks the amount of bioethanol produced and blended into gasoline through Renewable Identification Numbers, or RINs, which are redeemable credits created with each physical gallon.
Once the renewable fuel is blended into gasoline, RINs are separated from the physical volume of bioethanol, which leaves refiners with two options: (1) redeem the credit with the EPA to use against its annual Renewable Volume Obligation, or RVO, or (2) sell the RINs on the open market to capture more value or hedge production. Therefore, a second refiner could purchase separated RINs and redeem them from the EPA without buying or blending a single drop of bioethanol.
The separation of RINs and physical gallons allows refiners to take advantage of price disparities between the two during a given production year, while ensuring ethanol producers are held in check by the markets. Additionally, refiners have until the end of February to meet their RVO from the previous calendar year (rather than December 31), and 20% of a refiner's annual RVO can be satisfied with RINs created in the previous production year. That helps smooth out volatility by ensuring there are always more than enough credits to go around; but it's also helping to create an interesting supply-and-demand problem in the markets at the moment.
Who will blink first?
There's a game of chicken going on between refiners and ethanol producers. Gasoline prices have fallen very quickly. So quickly, in fact, that ethanol now trades at a premium to gasoline. Why? One major factor is that, at the same time oil prices have plunged, corn prices have lifted off multi-year lows caused by a record harvest. Because ethanol only comprises 10% of a gallon of gasoline at most, the price of petroleum will always have a larger effect.
Rising corn prices will make the vast amount of bioethanol production more expensive, and squeeze record margins from last year. That alone is bad news for producers. Archer Daniels Midland enjoyed a 157% improvement in third quarter 2014 operating profit for ethanol production compared to the year-ago period. Green Plains, which is more dependent on bioethanol than Archer Daniels Midland, saw its net income increase 554% for the first nine months of 2014 compared to the year-ago period.
However, neither falling gasoline prices nor rising ethanol prices have deterred refiners, which were churning out finished gasoline at record rates for the last 30-year period before. (Note that production always falls sharply in the final week of the year.)
But refiners are increasingly buying RINs on the open market rather than purchasing and blending more expensive bioethanol, as demonstrated by the recent separation in the blue and red lines in the chart below. In fact, weekly blend rates have been below their three-year average for eight consecutive weeks -- the longest stretch ever recorded.
Interestingly, Green Plains and Archer Daniels Midland are running their ethanol production plants at record highs, too. Why? For one, production facilities don't need to be cooled down in the winter, which lowers production costs during the season. Consider this the "last hurrah" before warmer weather settles in and producers face higher corn prices than they did in 2014.
Meanwhile, ethanol exports in the first 11 months of 2014 were up some 40% compared to the same checkpoint in 2013. That's an important wildcard for ethanol producers, as it creates markets not beholden to the same pricing pressures as that in the United States. Even then, exports represent less than 3% of all ethanol production. Will it be enough?
What does it mean for bioethanol in 2015?
The recent trend doesn't appear to be the friend of bioethanol producers. Since 2011, when the annual national blend rate maxed out at about 10%, production and blending volumes have tracked each other relatively closely. You may notice that there is vastly more bioethanol being produced than blended heading into 2015.
Are falling oil prices good or bad news for bioethanol?
As noted, oil prices have more of an indirect effect on bioethanol prices and production, although the current environment points to bad news on the horizon. When the production-to-blend spread is coupled with rising corn prices, it leads me to believe that the spectacular run of bioethanol producers will come to an end in 2015.
It may not be a crushing blow, however. Investors should be encouraged that the industry is more mature than in years past, which will help insulate against volatility. Exports may help keep margins in the black as production costs rise, but don't expect them to be the industry's savior.
The combination of factors swirling around bioethanol production serve as a reminder that it's impossible to predict movements in commodity markets, let alone three different commodities (oil, corn, ethanol) at once. However, given the complexity of the situation, I wouldn't be inclined to buy or sell bioethanol stocks right now.