Why are ethanol prices and production profits so high?
click image to zoom The ethanol production industry is in the midst of a long "winning streak" in terms of profits. The current run of historically high profits began in March 2013 and was punctuated by a spectacular spike during February-April 2014. As highlighted in two recent farmdoc daily articles (here and here), the high profits have been driven by a combination of steady or rising ethanol prices and falling corn prices. The latest article concluded that, "Economic logic suggests this situation is unsustainable, and either ethanol prices must adjust lower or corn prices higher to restore a long-run equilibrium in profitability. The most likely scenario is one where ethanol prices bear the brunt of the adjustment, eventually dropping as much as $0.40 per gallon from present elevated levels." While ethanol prices are currently much lower than the peak in April, they persist at high levels relative to corn prices, which have continued to decline (Figure 1). As a result, ethanol production profitability remains about a dollar per bushel above the long term average that has been experienced since January 2007. The purpose of today's farmdoc daily article is to propose an explanation for this pricing and profitability puzzle.
Ethanol Supply and Demand
As the above discussion highlights, the extended period of ethanol production profitability appears to defy basic economic logic. In simplest terms, if the ethanol price is too high relative to the price of corn, then either the ethanol price must fall or the corn price must rise in order to restore the level of profits to a long-run equilibrium. The constraint represented by the E10 blend wall actually allows an even more specific prediction to be made, as outlined in a farmdoc daily article on October 9, 2013. The model presented in that article suggests that with a binding E10 blend wall, as now exists, ethanol prices should be ultimately determined by corn prices regardless of the RFS mandates. (This result has been noted previously by several other writers, including Professor Wallace Tyner of Purdue University.) This expected relationship is depicted in Figure 2. The ethanol demand curve has a vertical (perfectly inelastic) segment at 5 billion gallons in order to represent the demand for ethanol as an MTBE oxygenate replacement. It is vertical since non-ethanol alternatives are assumed to be prohibitively expensive. The demand curve then becomes flat (perfectly elastic) for ethanol prices equal to 110 percent of CBOB gasoline prices between 5 and 13 billion gallons. This breakeven point reflects Department of Energy research on the value of ethanol as an octane enhancer in gasoline blends. The demand curve becomes vertical again to reflect the E10 blend wall, which is assumed here to be 13 billion gallons. The price of CBOB in this particular example is assumed to be $3.00 per gallon.
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