After briefly rallying in November 2014, the price of ethanol continued to fall through the beginning of 2015. With the collapse of oil prices continuing to dominate the news, it is tempting to assume that the decline in ethanol prices is being driven by the bearish news coming out of the crude oil market. However, there is substantial evidence that producer margins and stocks are playing a significant role as well. This analysis will examine recent activity in petroleum markets before analyzing the effect of producer margins and stocks on price activity in the ethanol market.
Activity in Petroleum Markets Experts have attributed the recent decline in crude oil prices to a glut in the supply of crude oil and the economic slowdown in China and the European Union (Hamilton, 2014; Pirrong, 2014; Smith & Shenk, 2015). The rapid increase in the production of “tight oil” in the United States and other countries around the world has led to a global surplus of crude oil. Domestic production in the United States has increased at an astounding rate, which has substantially reduced the amount of crude oil imported into the United States. The fact that more crude oil is being produced in the United States should not have any affect on the price of ethanol. There has also been negative economic news coming out of China and the European Union. Ethanol is primarily consumed domestically in the United States where the economy remains robust, but exports have become an important part of the demand side picture for ethanol. However, ethanol exports have been increasingly making it unlikely that the economic downturn overseas is responsible for the fall in ethanol prices. It seems improbable that the increase in crude oil production or weak international economy is the reason for the decline in ethanol prices.
Irwin and Good (2015) examined whether competition from other octane enhancers like benzene, toluene, and xylene could threaten ethanol’s competitiveness in the gasoline blend pool. The prices of these octane enhancers, which are highly correlated with crude oil prices, have declined sharply since September 2014. They find that the price of ethanol has remained below the price of these other octane enhancers, which precludes any substitution away from ethanol driven by underlying price competitiveness. Furthermore, benzene and xylene have other uses as petrochemical feedstocks whereas the majority of toluene is already used alongside ethanol in the gasoline blending pool. These restrictions may reduce the potential for further inclusion of these chemicals in the gasoline blending pool.
Producer Margins
Another possible explanation for the fall in ethanol prices comes from the supply side of the market. It looked like an abnormal 18-month period of ethanol producer profits was drawing to a close in September 2014, but margins increased in November and December before falling again. They have recently settled at a slightly positive level as of Feb. 20, 2015. The fact that ethanol producers have had positive daily margins over the past two years, except for a three-day period in January 2015, is nothing short of astonishing (Figure 1). In the long run, Mallory, Irwin and Hayes (2012) found that the industry must return to the long-term no-profit condition that economic theory suggests must hold, with ethanol prices as the primary driver of the adjustment. Even if crude oil prices return to the $80 range, it is very difficult to believe that ethanol prices would increase into the $2.50 range again. However, this could change if something drastic happened in the corn market over the summer.
Source: Iowa State University, CARD
Ethanol Stocks
The correlation between ethanol stocks and prices is remarkable (Figure 2). In September 2014, when it looked like a prolonged 18-month period of ethanol producer profits was coming to a close, ethanol producers cut back production and ethanol stocks began to plummet (Figure 3). However, in October and November ethanol prices rebounded to levels even surpassing those reached during the summer of 2014. Afterwards, production levels increased, and stocks began to build up yet again. During the past few months, stocks have reached their highest level since 2012, and ethanol prices have fallen. Given this simple correlative analysis, it seems ethanol stocks have been behind most of the major ethanol price movement since the beginning of 2013.
Source: EIA and USDA AMS
Source: EIA
Conclusion
Although it is tempting to assume there is some linkage between the fall in petroleum prices and the fall in ethanol prices, other factors such as stocks and producer margins seem to explain recent activity in the ethanol market more effectively. The reasons behind the fall in crude oil prices are unlikely to have much effect on the ethanol market. Other octane enhancers are probably not as substitutable as one might initially think and are not price competitive at the moment. All of the evidence suggests that there is an oversupply of ethanol on the spot market. Record levels of ethanol production continued as producers took advantage of the profitable environment that existed. As abnormally high stocks persist, it is likely that prices will continue to fall until producers are faced with negative margins and cut back production substantially. After such a long run of profits in the ethanol industry, a period of lower margins driven by depressed ethanol prices would not be surprising.
References
Hamilton, J. “Oil Prices As An Indicator Of Global Economic Conditions”. Econbrowser, December 14, 2014. http://econbrowser.com/archives/2014/12/oil-prices-as-an-indicator-of-global-economic-conditions.
Irwin, S., and D. Good. “Further Evidence on the Competitiveness of Ethanol in Gasoline Blends.” farmdoc daily (5):17, Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign, January 30, 2015.
Mallory, M., S. Irwin, D. Hayes. 2012. “How Market Efficiency and the Theory of Storage Link Corn and Ethanol Markets.” Energy Economics. 34(6):2157-2166.
Pirrong, C. “The Oil Price Decline: No Conspiracy Theories Need Apply”. Streetwise Professor, December 31, 2014. http://streetwiseprofessor.com/?p=9051.
Smith, C., and Shenk, M. “Oil Falls to 5 ½ -Low as Russia, Iraq Boost Output”. Bloomberg Business, January 1, 2015. http://www.bloomberg.com/news/articles/2015-01-02/oil-trims-6th-weekly-decline-as-collapse-of-2014-seen-excessive.