Ethanol: Is E-15 Bullish For Archer-Daniels-Midland And Bunge Shares?

Source: By Andrew Hecht, Seeking Alpha • Posted: Monday, April 22, 2019

Ethanol hit an all-time low in late 2018.

The biofuel is a political commodity.

The EPA and president are trying to increase corn demand for U.S. farmers, which led to lifting the ban on E-15.

ADM is active in the ethanol business with corn.

BG is active in the ethanol business with sugar and is exposed to Brazil.

At their Party Congress in October 2017, President Xi rolled out plans to clean up pollution in China’s most populous cities. In Europe and other nations around the world, alternative energy sources are gaining momentum as policies have shifted from fossil fuels. In the US, the new majority in the House of Representatives is pursuing a “Green New Deal.” The introduction of the catalytic converter in the US in 1975 helps to clean some of the toxins from emission from the environment.

Perhaps the first move to clean the environment while at the same time moving towards energy independence came in the US when the nation introduced an ethanol mandate that required a blend of the biofuel with gasoline for automobiles. At the same time, since US ethanol is a product of corn, the policy provides support for US farmers as a percentage of the annual corn crop makes its way into gas tanks all over the nation.

In late 2018, while the price of crude oil and oil products were slumping, the price of ethanol fell to a new record low, but over recent months the price of the biofuel has worked its way higher. Together the US and Brazil produce 85% of the world’s ethanol. While ethanol is a product of corn in the US, in Brazil it is sugarcane that is the primary ingredient in the biofuel.

The two companies that are involved in the ethanol market are the agricultural giants Archer-Daniels-Midland (ADM) and Bunge Limited (BG). An increase in the price of ethanol could lead their shares higher.

Ethanol hit an all-time low in late 2018

As an energy commodity, ethanol often follows the prices of crude oil and gasoline. During the period when crude oil and gasoline were falling like stones off the side of a cliff in Q4, ethanol did even worse. The biofuel futures fell to a new contract low.

Source: CQG

As the weekly chart shows, the price of ethanol had been declining since hitting a high at $1.76 per gallon wholesale in December 2016. In November 2018 the price fell to an all-time low at $1.1980.

In late December, oil and gasoline futures found a bottom, and the ethanol futures recovered reaching the most recent high at $1.434 in late March. As of April 18, nearby ethanol futures were trading at the $1.33 level in the middle of the trading range from the November bottom to the March high. Meanwhile, crude oil and gasoline continued to power higher with most recent highs during the week of April 8, and both energy commodities were trading not far off the highs on April 18. Ethanol continues to underperform the price of gasoline. On the May futures contract, ethanol was trading at around a 72.3 cents discount to the price of gasoline on April 18.

The biofuel is a political commodity

In the United States, ethanol is a political commodity. The ethanol mandate has had three goals. First, when introduced, the blend of ethanol and gasoline was an effort to lower the demand for crude oil from the Middle East and move the US towards energy independence. Second, cleaner fuels such as ethanol reduce the amount of toxin from automobile emissions. Finally, the US is the world’s leading producer of corn, and the grain is the primary ingredient in US production of the biofuel.

Ethanol has served political purposes in the United States. Perhaps the most significant political reward has been the support the biofuel provides for farmers who have been the beneficiaries of a new demand vertical for their annual crops.

The EPA and president are trying to increase corn demand for US farmers which led to lifting the ban on E-15

The current trade dispute between the US and China has hurt no sector in the US worse than agriculture. The Chinese have traditionally been massive buyers of US soybeans and crops, and their retaliatory measures in response to US tariffs have caused a significant percentage of the addressable market for farmers to disappear last year suddenly. The prices of corn and soybeans dropped substantially from the 2018 high.

Source: CQG

As the weekly chart of CBOT corn futures illustrates, after trading at a peak at $4.1225 in May 2018, the price of corn dropped to a low at $3.2975 per bushel last July on the back of the trade dispute, a decline of 20%. Nearby May corn futures were trading at the $3.5725 level on April 18, a lot closer to the lows than last May’s high even though we are currently in the midst of the time of the year when uncertainty about the annual crops tends to peak.

With the 2020 Presidential election on the horizon, farmers who are a part of President Trump’s loyal political base have been suffering under the weight of lower prices for their agricultural products. For the most part, the President has received support for his attempt to level the playing field when it comes to international trade from the farm belt. However, that support could quickly evaporate between now and the 2020 election if farmers continue to suffer economic woes because of low crop prices.

It is likely that the EPA’s recent move to lift the ban on summer sales of E15, an ethanol blend that contains 15% rather than 10% of the biofuel, could be a political move to boost corn demand and prices in support of the farm belt. While the price of ethanol has recovered since November, the biofuel continues to lag gasoline prices. At the same time, ethanol fell to a low at $1.198 during the week of November 26 when the price of corn was trading at a low at $3.5525. During that week, the price of sugar was at a low at 12.32 cents per pound. Companies involved in processing corn into ethanol are exposed to the refining margin as corn in the US or sugarcane in Brazil are the inputs and ethanol the output. Since late November, the price of corn has moved to $3.5725, only 0.56% higher, and sugar was at 12.74 cents, 3.4% higher. At the same time, at $1.33 per gallon, ethanol has gained over 11% over the period which is good news for those companies in the business of processing the agricultural commodities into the biofuel.

ADM is active in the ethanol business with corn

Archer-Daniels-Midland Company is a diversified agricultural company that is a leading force in the US ethanol market. The company’s website states:

ADM makes ethanol from corn through an efficient process that also produces large amounts of animal feed. In addition, we are working both independently and in partnership with other leading companies and research institutions to develop next-generation biofuels made from cellulosic sources.

ADM stock has moved lower since late November, but higher since the end of 2018.

Source: Barchart

As the chart shows, ADM shares were trading at a low at $45.24 during the week of November 26, 2018, but the stock was on its way to a low at $39.16 in late December. At $42.95 on April 18, the shares were trading less than $1 above the midpoint over the period. ADM fell to lows under the weight of selling in the stocks market.

While ethanol production is only one of many factors that impact ADM stock, the refining margin for processing the biofuel from corn will add to earnings if the price of ethanol outperforms corn over the coming weeks and months.

BG is active in the ethanol business with sugar and exposed to Brazil

Bunge Limited also produces corn from ethanol in the US. BG’s website states:

Our network of grain elevators helps supply the corn-based ethanol industry. We also produce ethanol through our joint venture with Southwest Iowa Renewable Energy.

However, BG is a leading producer of sugarcane and ethanol in Brazil. The BG website says: “We are a leading producer of sugar and ethanol in Brazil and a leading trader and merchandiser of sugar worldwide.”

The ethanol markets in Brazil are primarily domestic, and one of BG’s many revenue verticals comes from the production of the biofuel from corn in the US and sugarcane in Brazil. BG shares have done worse than ADM since late last November.

Source: Barchart

As the chart displays, BG stock traded at a low at $56.80 per share during the week of November 26 and continued to drop and was trading at $51.62 on April 18 after reaching a low at $48.89 in mid-February. BG’s exposure to the Brazilian economy has weighed on the price of the stock as the Brazilian real remains not far off its lows, and the nation is transforming under the new Bolsonaro administration. However, the reforms the new leader pledged on the campaign trail in 2018 have yet to take hold in the commodity-rich and home to South America’s leading economy.

According to Yahoo Finance, ADM shares are trading at a 13.46 price to earnings multiple and pay a dividend of 3.25% at just under $43 per share. BG trades at a much higher multiple at over 31 and pays a marginally higher divided at 3.77% at under $52 per share on April 18.

While the ethanol processing spread is just one of many factors when it comes to earning for ADM and BG each year, both of these companies stand to gain if ethanol prices rise compared to their inputs, corn in the US and sugarcane in Brazil. The depressed state of agricultural commodities is weighing on the share prices of both companies, but these companies provide products that both feed and power the world. The value proposition for ADM and BG could be compelling at their current share prices because the demand side of the fundamental equation for food and energy is rising as a function of the global population. Each quarter, the number of people in the world increases by around 20 million which translates to 80 million each year and 800 million each decade. The addressable market for the products produced by ADM and BG are growing by leaps and bounds which could present a compelling opportunity in both stocks at their current price levels.