Rounding the Corner?

Anthony C. Crooks
Agricultural Economist
USDA Rural Business-Cooperative Service

O ver the past decade, the production of energy from renewable resources has commanded considerable discussion and excitement. Various programs at the state and federal level have provided subsidies to start businesses in this industry. Simultaneously, technological advances have lowered production costs and the promise of economically viable production continues to be "just around the corner."

    Since the early 1970s, many farm groups, including farmer cooperatives, have been studying the economic possibilities of producing ethanol, methane and oil/fat-based fuels. A number of representative organizations have been formed to encourage the use of "renewable fuels" and to promote policies that would provide an economic climate suitable for the industry's growth.

    Currently, a number of new ethanol refining facilities are in operation, under construction on in the planning stage. They offer great potential to add economic value to corn and other feedstocks through the production and marketing of fuel ethanol.

    Despite the general enthusiasm for renewable energy from the heartland, loan analysts from several banks for cooperatives remain cautious. For example, the St. Paul Bank for Cooperatives, which has been assessing the viability of ethanol projects for more than 15 years, has chosen to finance very few. Government tax credit and exhaust emission regulations, among others, are major areas of concern to the emerging ethanol industry.

    The sunsetting of the federal excise tax reimbursement in the year 2000 creates an aura of uncertainty around the industry and especially any new fuel ethanol production venture.

    This situation is not helped by the conflicting signals being sent out by some legislators and policy makers. Even as this article was being prepared, the House Ways and Means Committee was involved in a debate over certain amendments in a larger tax package that would reduce the ethanol tax incentive and prevent further industry growth.

    The House leadership has responded by removing the changes to the ethanol tax incentive included by the Ways and Means Committee from the tax bill. Both the Administration and Senate appear to advocate expanded ethanol production and use with a provision in the new highway bill that extends the tax incentive until 2007. But the lines have been drawn for a significant battle over the future of these tax incentives.

    Even though it is a subsidized industry still in its infancy, ethanol has passed some significant milestones in the U.S. fuel marketplace. Recent recognition of ethanol and ethyl tertiary butyl ether (ETBE) as high quality fuel additives capable of delivering significant environmental, economic and energy benefits to the consumer has spurred industry production to record levels.
 

This plant, owned by the Chippewa Valley Ethanol Co. of Bernson, Minn., is one of many new cooperative ethanol plants either in operation, under construction or on the drawing board. Photo courtesy Chippewa Va/ley Ethanol Co.

    The renewable energy field represents new opportunities and challenges for cooperative interests as well. Cooperatives are major players in providing energy products for farm production, having a 41-percent market share in 1993, according to the most recent study by USDA. That year, more than 2,500 cooperatives sold $5.2 billion of energy products to rural America. Around 29 percent of the gasolines sold by cooperatives contained ethanol.

    To date, there are 11 farmer-owned ethanol production facilities in operation and 14 plants in various stages of planning. When completed, these plants are expected to comprise 38 percent of the ethanol production capacity in the United States.

    Thousands of farmers have collectively invested more than $1 billion of their own money to build the ethanol processing facilities. Many thousands more cooperative members already produce feedstocks that can be used for fuel ethanol production. Therefore, many farmer-members who aren't already involved in fuel ethanol production may rationally expect their cooperatives to at least investigate the potential of producing these fuels as an alternative feedstocks market and value-added opportunity.

    This article highlights certain ideas from a new research report (RR 148) published by USDA Rural Business-Cooperative Service, "Cooperatives and New Uses for Agricultural Products: An Assessment of the Fuel Ethanol Industry." It includes discussions about the future of the fuel ethanol industry, the risks and uncertainties associated with fuel ethanol as a "new-use" opportunity, potential returns, market growth potential and competition and market access.
 

Prominent Industry Influences

    All fuel ethanol plants, whether investor-owned or cooperative, represent investments that were made based on federal and state assistance programs. These programs represent a type of commitment by both levels of government in support of the industry. The industry was created by a mix of federal and state subsidies and loan guarantees and today remains relatively dependent upon that support.

    In particular, the industry depends upon continuation of a federal gasoline excise tax exemption of $0.054 per gallon, equivalent to $0.54 per gallon of ethanol produced. This support is essentially the cornerstone of the nation's ethanol policy.

    While often cited by the American Petroleum Institute as a "huge special interest subsidy," the policy has traditionally held widespread public support. Although scheduled to expire in 1993, the policy was extended to its present sunset date of Jan. 1, 2000. And while support has been expressed for extending the incentive until the year 2007, there is concern among some in the industry that, given some sentiments that currently prevail among policy makers, the law may be allowed to expire.

    Other federal and state subsidy/incentive programs are available to ethanol producers. A federal tax credit of $0.10 per gallon produced, up to $1.5 million, is available to producers of less than 30 million gallons per year (mgy).

    Unfortunately, this credit is currently unavailable to be passed through to member-owners of ethanol cooperatives. However Sen. Paul Wellstone of Minnesota has introduced a bill (S. 1066) that would make this provision available to all small producers, including farmer-owned cooperatives.

    Presently, at least 15 states provide additional production and/or blending incentives to qualified producers. These incentives are generally awarded on a per-gallon-produced basis and are, therefore, potentially quite substantial.

 
Future of Fuel Ethanol Industry

    Future success of the ethanol industry greatly depends on technology that lowers the cost and improves the efficiency of ethanol production. In the next 2-5 years, a range of innovations may save from $0.054 to $0.073 per fuel ethanol gallon produced. Longer term production cost savings ranging from $0.089 to $0.154 are possible.

    The U.S. Department of Energy's National Renewable Energy Laboratory conducts research, or manages the research of others, on a host of projects with the goal of cutting the cost of fuel ethanol production from biomass. In particular, researchers are developing bio-chemical processes that convert cellulosic biomass to ethanol.

    A list of these goals and their respective cost savings is shown in figure 1. These goals anticipate that fuel ethanol production costs will not exceed $0.70 per gallon when these goals are attained. Coincidently, this value is about the same as the expected price of fuel ethanol should the federal excise tax reimbursement be allowed to sunset.

Table 1 - Potential profitability of a 15 million gallon/year dry-mill ethanol plant, ethanol price variation
 

Price assumptions
Ethanol price $/gallon	0.90	1.05	1.20	1.35	1.50
Corn price $/bushel	2.25	2.25	2.25	2.25	2.25
Distillers dried grains price $/ton	106.11	106.11	106.11	106.11	106.11
Ethanol sales (17,067,000 gal/yr @ ethanol price/gal.)	17,920,350	20,480,400	23,040,450	25,600,500	25,600,500
Coproduct sales (58,497 tons @ DDG price/ton)	6,207,435	6,207,435	6,207,435	6,207,435	6,207,435
Total plant sales	24,127,785	26,687,835	29,247,885	31,807,935	31,807,935
Corn cost (18,000/sCorn cost (18,000/day @ corn price/bu.)	12,025,000	14,625,000	17,225,000	19,825,000	21,775,000
Operating cost (personnel, maint., mgt., insur., etc.)	5,193,000	5,193,000	5,193,000	5,193,000	5,193,000
Cost of other ingredients	1,625,000	1,625,000	1,625,000	1,625,000	1,625,000
Depreciation	1,867,000	1,867,000	1,867,000	1,867,000	1,867,000
Total plant costs	20,710,000	23,310,000	23,310,000	23,310,000	23,310,000
General admin., sales, and overhead	1,347,000	1,347,000	1,347,000	1,347,000	1,347,000
Net returns before interest, taxes, and incentives	2,070,785	2,030,835	4,590,885	7,150,935	7,150,935
Returns per bushel before interest, taxes, and incentives	0.32	0.31	0.71	1.10	1.10
Interest expense	1,287,531	1,287,531	1,287,531	1,287,531	1,287,531
State producer's incentive ($0.20/gal up to 15 mgy)	3,000,000	3,000,000	3,000,000	3,000,000	3,000,000
State income tax (8%)	0	94,660	299,464	504,268	709,072
Federal income tax (38%)	0	449,637	1,422,456	2,395,275	3,368,094
Small producer tax credit ($0.10/gal up to $1.5 million)	0	449,637	1,422,456	1,500,000	1,500,000
Returns to producers after interest, taxes, and incentives	(1,376,796)	1,088,594	3,443,840	4,903,811	6,286,238
Returns per bushel after interest, taxes, and incentives	(0.21)	0.17	0.53	0.75	0.97
Returns per bushel - no small business credit	(0.21)	0.10	0.31	0.52	0.74
Returns per bushel - no producer incentive	(0.67)	(0.29)	0.07	0.29	0.51

 

New-Use Opportunity

    As with any unknown, potential investors in fuel ethanol production will want an objective assessment of the risks and uncertainties associated with a project. They wil1 also want to understand the growth potential of the market they plan to enter. They have a right to expect accurate capital estimates required to begin operations and of how much they reasonably can expect to finance. Finally, potential investors will need to appraise their potential competition and the relative access they can expect to the marketplace, paying particular attention to discover any potential barriers that might impede market entry.
 

Potential Returns

    An assessment of the potential returns of a prospective fuel ethanol venture involves comparing total expected receipts against total expected expenses. This exercise amounts to not only examining input costs and output prices (corn/ethanol, net of co-product credits), but should also include an accounting of federal and state incentives.

    A 15-million-gallon per year dry-mill ethanol plant is used to illustrate the patronage returns paid to members. This estimate must take into account relative price changes of fuel ethanol, corn and the coincident price changes in DDG. Patronage returns were generated by calculating a series of pro-forma profit and loss statements after assuming a range of output and input values for fuel ethanol and corn, respectively.

    Production information was obtained from three separate sources (see RR 148 for details). Constant prices were assumed for each commodity: $1.20 per gallon for ethanol and $2.25 per bushel for corn, when not used to generate its own patronage schedule. DDG prices are typically set at between 120- and 130-percent of the price of corn (dry basis). In this analysis, DDG prices were calculated using 124 percent of the price of 10 percent moisture corn. The DDG price is calculated by multiplying a coefficient of 47.16 by the corn price.

    Table 1 demonstrates the potential profitability of a 15 may dry-mill ethanol plant (producing 17,067,000 gal. of denatured ethanol and yielding 15 may undenatured ethanol) when the price of fuel ethanol varies from $0.90 to $1.50 per gallon in $0.15 increments. Corn and DDG prices are set at $2.25 and $106.11 per ton, respectively. The plant is assumed to yield more than 17 million gallons of fuel ethanol and 58,497 tons of DDG. Sales costs, general administration and overhead are set at $0.0789 per gallon. Annual corn use, 6.5 million bushels, is valued at the corn price.

    Total operating costs in this example are $8.68 million, based on the following fixed costs: operating costs $5.19 million; ingredients $1.62 million; and depreciation $1.87 million.

    Per-bushel returns before interest, taxes and incentives range from -$0.45 to $0.63. A separate schedule demonstrates the impact of production and tax incentives provided to ethanol producers. When the $0.20 per gallon (up to $3 million per year) is combined with the federal small business tax credit of $0.10 per gallon, up to $1.5 million per year, per-bushel returns range from -$0.21 to $0.97.

    Ethanol plants organized as cooperatives are exempt from double taxation and would not be subject to the 38 percent federal income tax. They may also be exempt from state income tax obligations, depending upon the state in which they are incorporated. Cooperatives must, however, pay taxes on all business with non-members. In the interest of full disclosure, therefore, each table will present tax obligations.

    Figure 2 graphically illustrates the patronage returned to Minnesota producers on a per-bushel basis from a 15 may dry-mill plant as fuel ethanol prices vary from $0.85 to $1.50 per gallon. The Minnesota producer incentive amounts to $0.09675 per bushel on 6.5 million bushels of corn. The effect of the small business tax credit is progressive and amounts to almost 4 cents a bushel on the 6.5 million bushels of corn needed for the 15 may plant.

    Table 2 demonstrates the potential profitability of a 15 may dry-mill ethanol plant when the prices of corn and DDG are varied from $1.85 to $3.45 per bushel and $87.25 to $162.70 per ton, respectively, and fuel ethanol is fixed at $1.20 per gallon. Annual operating costs, ingredients, and depreciation remain fixed, as before, at $8.68 million. Per-bushell net returns after interest, taxes, and incentives range from -$0.06 to $0.67.

    Figure 3 illustrates the relationship between patronage returned to investors (per bushel) and the price of corn. Per-bushel patronage ranges from -$0.46 to $0.97 and -$1.01 to $0.51, for subsidized and unsubsidized production, respectively, as the corn price ranges from $1.55 to $3.15 per bushel.

    In the absence of the small business tax credit, annual patronage returns are reduced by almost $0.03 per bushel for corn prices less than $2.05 per bushel. When the effects of the federal excise tax subsidy are excluded (fuel ethanol is priced at $0.90 per gallon), annual patronage returns are reduced by almost $0.75 per bushel compared with their full incentives level.

    It is important to note that each of these schedules assumes no price variability, once the levels have been set for an entire year's production.

    In actuality, ethanol and corn prices vary greatly over time and DDG prices remain tied to their relative corn value. For example, while an average annual price of $2.25 per bushel was assumed, corn prices rose to and remained at historically high levels throughout 1995 and 1996. This inordinately high input cost circumstance was significant enough to pressure several fuel ethanol plants to reduce production or cease operations.
 
 

1 15 million gallong/year dry-mill ethanol processor including state and federal incentives  Corn price-$2.25/bu.; Minnesota producer incentive-40.09675/bu. on 6.5 million bu.; small business tax credit -$0.03875/bu. on 6.5 million bu.

 
Market Growth Potential

    Assessing a prospective venture's potential for market growth involves shifting from present circumstances to reasonable expectations for the future. In addition to noting current trends, it will be important to emphasize any changes that might occur in preferences, technology or prices of inputs and/or competing products.

    Expanding the ethanol industry will depend on the relative cost competitiveness of ethanol as a gasoline blending agent. Both petroleum prices and the factors that affect net ethanol receipts are subject to variability. Net ethanol receipts are determined largely by corn prices, federal and state ethanol subsidies, co-product prices, and technology.

    As of August 1996, four new ethanol plants with a combined capacity of 36.5 million gallons per year were under construction. This is considerably less than the expansion pace of 1995 of 250 may or 0.15 percent total industry capacity at the time.

This dropoff may lie beyond present concerns of higher feedstock prices. These more ominous issues lie ahead:

• The industry's anticipation of the sunsetting of the federal motor fuel excise tax exemption in 2000;
• Expectations that petroleum prices will increase only slightly in the next 10 years; and
• Corn prices are likely to be increasingly volatile given the absence of any government storage programs.

     The biggest hindrance to ethanol competitiveness and industry expansion, however, is the anticipated sunsetting of the federal excise tax exemption in 2000. Under current industry norms, a plant that would open in 1997 would operate profitably for three years and endure losses until crude oil prices rose again, around the year 2007.

Table 2 - Potential profitability of a 15 million gallon/year dry-mill ethanol plant, ethanol price variation
 

Price assumptions
Ethanol price $/gallon	1.20	1.20	1.20	1.20	1.20
Corn price $/bushel	1.85	2.25	2.65	3.05	3.35
Distillers dried grains price $/ton	87.25	106.11	124.97	143.84	157.99
Ethanol sales (17,067,000 gal/yr @ ethanol price/gal.)	20,480,400	20,480,400	20,480,400	20,480,400	20,480,400
Coproduct sales (58,497 tons @ DDG price/ton)	5,103,891	6,207,435	7,310,979	8,414,523	9,241,707
Total plant sales	25,584,291	26,687,835	27,791,379	28,894,923	29,722,107
Corn cost (18,000/sCorn cost (18,000/day @ corn price/bu.)	12,025,000	14,625,000	17,225,000	19,825,000	21,775,000
Operating cost (personnel, maint., mgt., insur., etc.)	5,193,000	5,193,000	5,193,000	5,193,000	5,193,000
Cost of other ingredients	1,625,000	1,625,000	1,625,000	1,625,000	1,625,000
Depreciation	1,867,000	1,867,000	1,867,000	1,867,000	1,867,000
Total plant costs	20,710,000	23,310,000	25,910,000	28,510,000	30,460,000
General admin., sales, and overhead	1,347,000	1,347,000	1,347,000	1,347,000	1,347,000
Net returns before interest, taxes, and incentives	4,874,291	3,377,835	1,881,379	384,923	(737,893)
Returns per bushel before interest, taxes, and incentives	0.44	0.37	0.24	0.06	(0.12)
Interest expense	1,287,531	1,287,531	1,287,531	1,287,531	1,287,531
State producer's incentive ($0.20/gal up to 15 mgy)	3,000,000	3,000,000	3,000,000	3,000,000	3,000,000
State income tax (8%)	419,181	299,464	179,748	60,031	0
Federal income tax (38%)	1,991,109	1,422,456	853,802	285,149	0
Small producer tax credit ($0.10/gal up to $1.5 million)	1,500,000	1,422,456	853,802	285,149	0
Returns to producers after interest, taxes, and incentives	4,329,471	3,443,840	2,067,100	690,361	(372,424
Returns per bushel after interest, taxes, and incentives	0.67	0.53	0.32	0.11	(0.06)
Returns per bushel - no small business credit	0.44	0.31	0.19	0.06	(0.06)
Returns per bushel - no producer incentive	0.20	0.07	(0.14)	(0.36)	(0.52)
Returns per bushel - no Fed. Excise tax reimbursement	0.00	(0.21)	(0.44)	(0.67)	(0.85)

 

Competition and Market Access

    Entry into a market or industry is generally regarded to be "barrier free" (sufficiently competitive) if there are no artificial restrictions on entry (such as patents or government restrictions) or if the capital costs of entering the market are not exceedingly high. And while the $37.5 million necessary to turn the key on a 15-million-gallon-per-year ethanol plant is not insignificant, when compared with the petroleum industry, entry into the fuel ethanol market is relatively unimpeded.

    Despite the relative ease of market entry, the fuel ethanol industry is heavily concentrated. Seventy-one percent of the industry's production capacity of 1.4 billion gallons per year is controlled by four firms. Moreover, the top two firms control 60 percent of the industry's capacity.

     Plants owned by the prominent producers, however, are wet-mill processors which are dedicated to the production of high-fructose corn syrup (HFCS). HFCS is principally used by the carbonated beverage industry and its demand is quite seasonal, falling off in the winter months. Wet-mill plants produce fuel ethanol during slack demand periods for HFCS.

     Although ethanol production is heavily consolidated, the marketing of ethanol and co-products is dominated by the cost of transportation. Distilled dried grain has long been valued as a relatively cheap substitute for high-protein meal and has a number of significantly valuable nutritional attributes. Given that co-product prices are essentially bound by shipping costs, spatial markets for distillers dried grain and other co-products may exist and prove profitable even to managers of relatively small ethanol plants.

    Other potentially profitable marketing opportunities for ethanol plants may lie in forming supply alliances with local gasoline refineries. If refinery requirements exceed the supply capacity of the local fuel ethanol plant, marketing alliances may be formed among additional plants to provide a consistent supply in support of refinery needs.

    This also presents opportunities for plants to consolidate market territories, share services and purchasing and, possibly, provide for the formation of a common marketing agency with a membership comprised of cooperatives.

    Each of these ideas is a response to the single basic fact about the ethanol industry: fuel ethanol competes with gasoline and gasoline blending agents. Market entry and market expansion are tied directly to the cost competitiveness of ethanol as a gasoline blending agent (USDA, AER-585). Gasoline prices and blending agent prices are linked closely to the uncertain price of crude oil. Wholesale gasoline sells at about 25 percent above the crude oil price.
 
 

1 15-million gallon/year dry-mill ethanol processor including state and Federal incentives  Ethanol-$1.20/gal with motor fuel excise tax subsidy; $0.90/gal. without subsidy; DDG-$120/ton; Minnesota producer Incentive-$0.09675/bu. on 6.5 mil. bu.; Small business tax credit-$0.0387/bu. on 6.5 mil. bu.

 

Summary and Conclusions

    Cooperative involvement in the biomass fuels industry is currently substantial and growing. Given the right set of circumstances of low corn prices and higher ethanol and distillers dried grain prices, profit opportunities may still exist. The fact remains, however, that the economic landscape of this industry is fraught with uncertainty.

    And despite a growing interest in fuel ethanol plants as a value-added opportunity among Midwest corn producers, industry plans for capacity expansion have remained modest for at least five to eight years. Expansion plans have generally been dampened by anticipation of the scheduled sunsetting of the motor fuel excise tax exemption in 2000. Given, a reasonably favorable business climate, i.e., the appropriate mix of higher petroleum prices, lower corn prices, higher byproduct prices, and an extension of the excise tax exemption, production capacity could expand significantly.

    However, in absence of the excise tax exemption, it has been estimated that oil prices must exceed $40 per barrel and com prices remain under $2.50 per bushel to assure reasonable profitability. Furthermore, if the excise tax subsidy is not extended, ethanol will be unable to compete-at any corn price-for crude oil prices below $25 per barrel. Therefore, this report urges potential investors to take a hard look prior to involving themselves in the fuel ethanol industry.
 

References

Bryan, M. "Editorial Comments," The Energy Independent, vol.3, no. 1, June 1997, pg. 3.

Crooks, A. "Cooperatives and New Uses for Agricultural Products: An Assessment of the Fuel Ethanol Industry," Washington, D.C., U.S. Department of Agriculture, Rural Business-Cooperative Service, Research Report 148, September 1997.

Eversull, E. and J. Dunn, "Petroleum Cooperatives, 1993," Washington, D.C., U.S. Department of Agriculture, Rural Business-Cooperative Service, Research Report 143, July 1995.

Johnson, L., "Policy Initiatives for the Fuel Ethanol Industry: A History and Rationale," St. Paul, Minn., Minnesota Dept. of Agriculture, October 15, 1994.

LeBlanc, M. and J. Reilly, "Ethanol: Economic annd Policy Tradeoffs," Washington, D.C., U.S. Dept. of Agric., Economic Research Service, Agricultural Economic Report Number 585, April 1988.

Wyman, C. "Recent Developments in Ethanol Production form Cellulosic Biomass," U.S. Dept. of Energy, National Renewable Energy Laboratory, Presentation to National Conference on Ethanol Policy and Marketing, Des Moines, Iowa, February 1, 1996.