Ethanol Margins Are Flying High, But Potentially Not For Much Longer

Source: By Tristan R. Brown, Seeking Alpha • Posted: Wednesday, July 8, 2020

The ethanol sector’s production margins have rebounded strongly over the last month as ethanol production and demand volumes have both mostly recovered from their spring collapses.

Ethanol producers’ share prices have followed suit, staging an impressive rally from April’s lows.

While the current production environment is strong, two developments in recent weeks threaten to cause production margins to fall.

The COVID-19 pandemic has regained strength in the U.S. since lockdown orders were lifted, and the federal government has placed an indefinite hold on its upcoming biofuels mandate rulemaking.

The improved operating conditions that U.S. corn ethanol producers first began to benefit from in May remained present in June. The prices of gasoline and, by extension, ethanol have mostly recovered from the lows that were set in late March/early April, whereas the price of corn has continued a steady decline that began in February (see figure). These developments have in turn pushed corn ethanol production margins up to levels that were last seen in Q4 2019 (see next figure).

ChartData by YCharts

Production margins at a hypothetical dry mill corn ethanol facility in Iowa. Source: CARD (2020).

The share prices of ethanol producers Aemetis (AMTX), Green Plains, Inc. (GPRE), Pacific Ethanol (PEIX), and REX American Resources(REX) all increased by 50% or more in Q2 as the bleak conditions that caused much of the sector’s production capacity to be idled in March quickly eased after U.S. coronavirus-related lockdown orders were lifted (see figure). Only The Andersons (ANDE), which operates a number of other segments in addition to ethanol production, has experienced a share price decline over the same period. The largest gains have been by Green Plains and Pacific Ethanol, both of which have substantial debt loads that prompted major investor concern when ethanol demand collapsed; ethanol demand’s subsequent rapid recovery prompted an immense relief rally in those names.

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Notably, ethanol margins have remained high even as the earlier idling of capacity has largely been reversed. U.S. weekly ethanol production in early April was more than 40% below its normal volume for that time of the year (see figure). The weekly production volume then increased by 50% in less than two months, though, and it is now only 12% below its normal level. Whereas Q4 2019’s high margins quickly moved lower after production increased in response, production margins have remained steady in recent weeks despite rebounding production volumes.

Source: EIA (2020).

The primary reason for production margins’ continued strength is strong demand from the refiners and other blenders that combine ethanol with gasoline prior to retail. Refiners’ and other blenders’ net ethanol inputs collapsed in late March but have since mostly recovered: weekly net inputs have been only 12% lower than the historical average for this time of the year in recent weeks (see figure). Indeed, this demand has been so strong over the last month that ethanol stocks, which were at record highs in early April, recently set a new 3-year low (see next figure).

Source: EIA (2020).

ChartData by YCharts

Taken together, these tailwinds would normally be expected to push ethanol producers’ share prices higher still. Even those ethanol companies with the strongest balance sheets were very undervalued as the market panic peaked in late March and, despite the subsequent rally, share prices remain largely lower than they were as recently as December 2019. Any continued strength in production margins would be quite bullish for the sector as a result.

Two recent developments have raised questions about the sector’s ability to maintain its recent high production margins in the second half of 2020, however. The first is the ongoing resurgence of COVID-19 in the U.S. While the lockdown orders that were in effect across the country in April and May were successful in “flattening the curve” of new cases, the subsequent relaxation of the orders and a general unwillingness in society to practice social distancing measures have caused the virus to resume its earlier exponential transmission rate. Florida, which had largely avoided the virus’s worst effects earlier in the year, recently set a record for new 1-day positive coronavirus cases, surpassing the earlier record that was set by New York back in April. Other states such as Arizona, California, and Texas are all experiencing similar growth, and rising positivity rates across the U.S. point to higher transmission rates rather than increased testing as the cause.

The earlier-than-expected return of COVID-19 in the U.S. threatens to once again disrupt refined fuels demand, but ethanol demand is particularly exposed. U.S. ethanol demand is mandated by Congress in the form of the federal biofuels mandate, the revised Renewable Fuel Standard [RFS2]. Through a quirk in the regulatory rulemaking process, the absolute demand volumes that Congress had set for 2020 have not been binding, meaning that ethanol demand for the year functions instead as a percentage of refined fuels demand. The recent rebound in demand coincided with what has historically been a seasonal increase to weekly ethanol demand of approximately 20% between January and July. The impact of a severe demand disruption on ethanol producers’ earnings in April is smaller than in July or August as a result. While Q2’s earnings are likely to be dismal, the fact that demand appeared to be recovering in time for the summer driving season to commence certainly contributed to the ethanol sector’s recent rally.

Many medical experts now believe that the U.S. has roughly one week in which to get a handle on the virus’s resurgence before it storms out of control. Failure to do so could, in the words of a recent Washington Post article, either “force whole swaths of the nation back into lockdown” or result in “a massive number of hospitalizations and deaths.” Both outcomes would severely hamper economic activity (the former via official restrictions on consumption and the latter via voluntary individual limitations on the same) and likely cause refined fuels demand to once again be severely disrupted. There is already evidence that the latter is happening, both in the demand data and anecdotally, via reduced personal travel.

A second tailwind behind the ethanol sector’s recent rally has been the recognition that, no matter how dire 2020 is, those producers that survive until 2021 will benefit from the full force of the RFS2 in that year. The rulemaking quirk that caused ethanol demand to be disrupted in 2020 is unlikely to occur again next year, ensuring that the statutory blending volumes established by Congress will be enforced in 2021. While recent court rulings made such an outcome likely, the recent decision by the U.S. Environmental Protection Agency [EPA], which is tasked with implementing the annual blending mandates, to put the proposed rulemaking for 2021 that is due imminently on indefinite hold, creates substantial uncertainty.

Information on the hold, which was reported by Reuters last week, is scarce. It is surprising, though, given that the proposed rulemaking was on track for a release by early July. The hold is potentially related to a recent request by refiners, which are tasked with achieving the blending mandates that Congress established, for the EPA to retroactively allocate exemptions to the mandate going back almost a decade. The increasingly poor refined fuels outlook for 2021 has placed refiners in a challenging position with regard to that year’s statutory blending targets, raising the stakes of the proposed rulemaking. The EPA’s indefinite hold may represent a last attempt to limit 2021’s biofuels blending volumes.

The occurrence of these headwinds is possible but not guaranteed. There is still time for the U.S. to limit the coronavirus’s spread without resorting to April’s lockdown measures, and no official information regarding the EPA’s next steps has been released. That being said, investors also need to recognize that the ethanol sector’s current high margins will come under immense pressure should either headwind develop, let alone both simultaneously. The developments of recent weeks have increased the probability that such margin compression will occur, potentially as soon as this summer.