The U.S. Ethanol Sector Is Experiencing A Partial Recovery

Source: By Tristan R. Brown, Seeking Alpha • Posted: Tuesday, December 3, 2019

The share prices of some independent U.S. corn ethanol producers have substantially outperformed the S&P 500 in Q4 to date.

The rally has coincided with rebounding corn ethanol production margins.

The improved margin environment has not been due to more favorable commodity prices or increased ethanol demand, however.

Rather, U.S. ethanol production has fallen sharply in recent months, causing the ethanol price to rise relative to that of gasoline.

A divergence is occurring in the U.S. ethanol sector that has important implications for the sector’s investors.

The last six weeks have seen the share prices of U.S. ethanol producers such as The Andersons (ANDE), Green Plains, Inc. (GPRE), and REX American Resources (REX) outperform the broader S&P 500 index; only the heavily-indebted Pacific Ethanol (PEIX) has missed out on the rally (see figure). While the share price of Green Plains, Inc. has only moved into positive territory on a YTD basis and remains below its May 2019 highs, that of REX American Resources is trading at its highest price of the year. This marks a major reversal in a quarter that is usually characterized by declining production margins following the end of the summer driving season and uncertainty over the ongoing corn harvest.

Data by YCharts

As it happens, the recent corn ethanol share price rally has occurred as production margins have improved to levels not seen in the last 18 months (see figure). While still low relative to previous years, the sector’s average return over operating costs in Q4 to date of $0.22/gallon is on par with the cost of capital, meaning that margins are positive for most producers (likely excepting those such as Pacific Ethanol that are, as noted above, heavily-indebted). This margin improvement also occurred very quickly, surprising investors with both its timing and its speed.

Sources: CARD (2019), EIA (2019).

What has been especially notable about the margin improvement is that it has not been driven by the underlying commodity price environment. It is true that the price of corn has declined by 5% in Q4 to date. This was closely tracked by the price of gasoline until a week ago, however, while the price of natural gas, which is another important input, has increased over the same period (see figure). This would not normally result in a substantial improvement to ethanol production margins.

Data by YCharts

The cause of the margin increase has been a sustained increase in the price of ethanol relative to that of gasoline (see figure). Ethanol serves as a partial replacement for gasoline, with up to 10 vol% of U.S. gasoline demand having been displaced by ethanol as a fuel oxygenate and octane enhancer. The price of ethanol therefore tracks the price of gasoline after accounting for the former’s lower energy content. This correlation is not perfect, however, and Q4 has seen the ethanol price rise to its highest level relative to the gasoline price. Specifically, the ethanol price has been an average of 35% higher than the gasoline price on an energy-equivalent basis in Q4 to date compared to an average premium of 14% in the first three quarters of 2019. The growing ethanol premium has resulted in higher margins for ethanol producers even though the price of gasoline has held relatively steady since October.

Sources: CARD (2019), EIA (2019).

Investors should not interpret the rising premium as a sign that the market now expects the Trump administration to reverse the earlier steps that it took to weaken the U.S. revised Renewable Fuel Standard [RFS2] biofuels mandate, however. Rather, the ethanol price premium has increased due to a sharp decline in U.S. ethanol production volumes that occurred in late Q3 and early Q4 (see figure). While production has since rebounded, producers are collectively running at their lowest production volumes since at least 2016. The biofuels blending mandate is still in effect even if weakened, however, and the price of ethanol has appreciated in response to the lower production volumes as supply has fallen relative to mandated demand.

Source: EIA (2019).

The fact that the production margin increase has occurred due to lower supply rather than higher demand or an improved commodity price environment has meant that not all ethanol producers have benefited. Those that run higher-margin and/or low-debt operations, such as The Andersons, Green Plains, Inc., and especially REX American Resources, have been able to take immediate advantage of the presence of higher margins. Those that run lower-margin and/or high-debt operations, on the other hand, such as Pacific Ethanol and Valero Energy (VLO), have underperformed in recent months. Valero suspended production earlier this quarter at two of the three facilities that it bought from Green Plains a year ago. Likewise, Pacific Ethanol announced in November that it had shuttered one facility and had reduced production volumes at its remaining facilities.

Investors should expect this divergence between the industry’s major producers to expand so long as the current operating and policy environments continue to prevail. There continues to be more U.S. production capacity available than the domestic and export markets require. So long as this remains the case, then, investors should only expect ethanol production margins to be positive when producers run at reduced capacities, and even then only those producers that benefit from a stronger financial position will be in a position to take advantage of the positive margins.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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