Figure 1 shows that the producer’s variable margin was quite high in 2006, but has been low this year even as the price of ethanol rose during the first half of the year. Part of the reason for the low margins has been the fact that both corn and energy prices rose rapidly during the first half of the year. But that is not the whole story. Figure 2 compares spot ethanol price (net of the tax credit for gasoline blending) with the Chicago spot conventional gasoline price since 2003. Generally speaking, ethanol roughly tracks the gasoline price, with occasional excursions below (in 2005) and above (in 2006). But from the middle of 2007 until the very recent dramatic fall in gasoline prices, the price of ethanol lagged far behind that of gasoline. A major reason is that the ethanol industry invested in a significant amount of new production capacity in response to the boom of late 2005 and 2006, but infrastructure to deliver and blend the ethanol into gasoline has not expanded as rapidly, creating supply surplus relative to demand.

Note: At the terminal, the value of fuel ethanol for the gasoline blender is the spot price of ethanol minus the 51 cent-per-gallon tax credit. Fuel ethanol's value after the tax credit is what is used in the economics of blending gasoline.

To see why this happened, it helps to understand the recent boom-bust cycles for ethanol. The first bust for the ethanol industry occurred in the early months of 2005, following a period of rising ethanol demand from 2003 through 2004 as it replaced MTBE in response to State bans over concerns about groundwater contamination. The increased demand for ethanol helped increase producer margins in 2004, but the boost in margins was short lived. In the fall of 2004, a Federal Court stayed the EPA’s requirement for Atlanta, Georgia to begin using RFG. As a result, the extra production and stock build-up intended to serve the new regional market for ethanol turned into a glut that drove spot prices and the spot margin down nearly 75 cpg during the first months of 2005.

The spot margin swiftly rebounded starting in May 2005, however, climbing from 3.5 cpg to $2.85 per gallon in June 2006. Hurricanes Rita and Katrina accentuated the boom when they struck in the fall of 2005. The spike in the weekly fuel ethanol margin topped out temporarily on September 1 at almost $1.50 per gallon before falling back. Although energy costs to produce ethanol rose during the second half of 2005, these increases had little effect on the margin since they were largely offset by a 9-month, 20-cent decline in the net corn price.

In August 2005, the President signed into law the Energy Policy Act (EPAct) of 2005 with a Renewable Fuel Standard (RFS) of 7.5 billion gallons per year – about 490 thousand barrels per day (kbd) – by 2012. A more immediate impact of EPAct, however, arose as it became evident that refiners had decided to quickly eliminate the use of MTBE in response to litigation concerns falling out of the legislation. All refiners that had not already eliminated MTBE discontinued it before or during the winter-summer switchover in spring 2006. The surge in fuel ethanol demand surrounding the elimination of MBTE accounts for the big peak on June 22, 2006 when ethanol prices exceeded $4.00 per gallon and the margin topped off at $2.85 per gallon (Figure 1). Figure 2 shows the tightness in the ethanol market as the blender's fuel ethanol prices after tax credits were at a premium to regular gasoline from April through July 2006.

But supply was already responding rapidly to the strong price signals. Domestic production increased 29 percent over the 12-month period from December 2005 to December 2006. Imports at 52 kbd in June more than doubled those in May, and doubled again by August to 100 kbd. In the 14 weeks after the June peak, the spot price lost about 58 percent. With underlying variable costs remaining relatively constant, the margin tumbled from $2.85 per gallon to 53 cpg.

For the long term, the most important aspect of the 2005-06 boom was that it led to a continuing increase in production capacity, as many new ethanol plants entered operation and others began construction. Furthermore, dry mill plants had become larger and more efficient since 2005. Supply now outpaced demand, and ethanol prices continued to slide for much of 2007, in spite of increasing demand. On top of weakening ethanol prices, production costs were rising. Corn prices began to increase in the fall of 2006. The ethanol producer margin approached zero in late September and October 2007. It is likely that some plants even experienced negative margins at this time. By mid-October, corn prices started a steeper rise and put upward pressure on fuel ethanol prices. Still, the value of fuel ethanol at blending terminals remained at a discount to gasoline until just recently, as gasoline prices have cratered along with crude oil prices. Costs have fallen since July of 2008, and ethanol prices have fallen in tandem, with margins staying low.

The Energy Independence and Security Act (EISA) of 2007, signed into law in December 2007, doubled the corn-based ethanol mandate to 15 billion gallons per year (about 980 kbd) by 2022, but this did not do much for margins in the short term, as shown in Figure 2. EIA estimates total ethanol production capacity in August 2008 at 10.2 billion gallons per year, with potential increases from planned or ongoing construction up to 13.2 billion gallons per year by the end of 2009. Click here to continue article.