President George W. Bush's January, 2006, declaration that the U.S. is "addicted to oil" marked the beginning of a gold rush for corn growers: The government policies the comment helped spur have been a boon for the producers of corn-based ethanol, the all-American fuel that now displaces about 4% of U.S. gasoline supply. Over the past 18 months, farmers have rushed to plant more corn—and are set to produce a record crop this year—while small-time entrepreneurs and agricultural giants alike have built plants to expand capacity. A handful of initial public offerings have fed investors' desire to get in on the action.
But while farmers and producers remain bullish on corn ethanol's prospects, a once-enthusiastic Wall Street is growing skeptical. On May 1, the largest U.S. ethanol producer, Archer Daniels Midland (ADM), reported quarterly earnings that fell short of analyst expectations, citing higher corn costs as a problem. ADM shares tumbled 5.4% that day to close at $36.60 as investor disappointment spread throughout the sector. Shares of U.S. Bioenergy (USBE), Pacific Ethanol (PEIX), Andersons (ANDE), Aventine Renewable Energy (AVR), and VeraSun Energy (VSE) dipped 1% to 2%.
Lurking behind ADM's gloomy news are doubts about the future of corn ethanol. A growing number of analysts, once bullish on the product, are warning that an oversupply may be coming as soon as this year. On Apr. 27, a Lehman Brothers (LEH) report projected that production will outstrip demand in the second half of 2007, measuring the domestic thirst for corn ethanol at 420,000 barrels per day but supply at 445,000 barrels a day, mainly because the U.S. lacks the infrastructure to move the product to market.
"There's tremendous capacity coming online, but the infrastructure isn't there to keep up with it," says Michael Waldron, an oil markets research analyst at Lehman Brothers who co-authored the report. "We need a nationwide system to pipe it, and until that happens, we'll likely have an excess of product."
Waldron says the problem isn't a lack of demand for ethanol, which remains high, especially given that the federal Renewable Fuel Standard mandates at least 4 billion gallons, or about 3% of all U.S. transportation fuels, to come from alternative sources today, and nearly double that amount, or 7.5 billion gallons, by 2012. Lawmakers are expected to give the mandate a significant boost later this year. Rather, the problem is getting ethanol to consumers in various parts of the country. Ethanol requires a separate piping system from gasoline, and since Uncle Sam hasn't appropriated funds to build such infrastructure, ethanol is now primarily transported by rail. But the rail system extends only to major metropolitan areas—not to mention the dual problems of its high cost and carbon dioxide emissions.
"It's a chicken-and-egg problem," says Waldron. "If the infrastructure were there, the demand would be there. In the end the government would have to play a role to help build out a [national] dedicated pipeline."
Caution to Investors
A growing number of analysts agree with Lehman Brothers' conclusions. "We remain cautious on the ethanol stocks over a 12-month period," wrote Bank of America (BAC) analyst Eric Brown in an Apr. 24 research note. "Looking ahead we continue to believe that an oversupply of ethanol in the second half of 2007 will depress ethanol's premium to gasoline."
A glut of ethanol stuck in the Corn Belt would be unwelcome news for corn growers and the agricultural entrepreneurs who had set their hopes on a bright future for what has since become a controversial fuel (see BusinessWeek.com, 3/19/07, "Ethanol's Growing List of Enemies"). Farmers are beginning to voice their concern.
"We've got an enormous amount of product coming online in a short period of time," says Geoff Cooper, director of ethanol programs for the National Corn Growers Assn. "The market is surprised by all this volume and can't absorb it now."
He says the problem of transporting ethanol to parts of the country like the Southeast remains a problem, as does a shortage of storage capacity in these areas. Yet Cooper calls those obstacles "bad news but not disastrous" for corn growers, as a more effective ethanol infrastructure will evolve in the next several years. "The oversupply now is more a bump in the road than a catastrophe," he says.
Plus, not everyone agrees with the emerging consensus among analysts. The Renewable Fuels Assn., an industry trade group for ethanol producers, maintains that the problem is a lack of capacity rather than an excess of it. Using Energy Dept. figures, the RFA calculates that demand now stands at 416,000 barrels a day but production is only 386,000 barrels a day. Even the 80 new ethanol plants expected to be operating by 2009 won't be able to meet the growing demand, according to the association.
"Right now we have ethanol making up 4% of transportation fuels, but we can get to 10% with no changes to cars' engines or retail pumps," says Matthew Hartwig, an RFA spokesman. He acknowledges that transportation is an issue but says rail cars are able to transport the product now, and there are studies under way about a national pipeline.
Short-Term Pain, Long-Term Gain?
In any case, Hartwig says, any oversupply domestically could be exported to other counties, as demand for fuel is growing in all parts of the world, and gasoline prices are increasing.
Waldron of Lehman Brothers sees another outcome to a glut. An ethanol oversupply would make ethanol blends cheaper for consumers, potentially eliminating the need for the 51¢-per-gallon subsidy blenders get from the government. In other words, too much ethanol means cheaper ethanol, which could ultimately extend its longevity in the marketplace.
"Too much supply could hurt ethanol producers' margins, but in the end it may be a good thing for prices to come down," Waldron says. "A short-term problem for the industry could be healthier for it in the long run."
Click here to see a slide show on how ethanol is made.