Corn-Based Ethanol May Be Nearing Its Death

The Midwest drought could kill this good-intentioned dream

By Aaron Levitt, InvestorPlace Contributor

It’s no surprise that gasoline prices have steadily risen over the last few weeks as Hurricane Isaac made landfall and left destruction in its wake.

After all, the Gulf Coast remains an integral piece of nation’s energy pie, with the U.S. Energy Information Administration estimating that the Gulf accounts for roughly 23% of all U.S. oil production and nearly 7% of its natural gas output. Likewise, about 30% of U.S. natural gas processing plant capacity and 44% of the country’s refining capacity also dot the region.

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So it’s easy to understand how restrictions to this capacity and costly infrastructure repairs could reduce supply and jack up prices for consumers. However, hurricanes and tropical storms aren’t they only weather pattern affecting what we pay at the pump.

The Midwest’s continuing historic drought has hit the nation’s corn harvest pretty hard and that’s causing prices to soar as well. As the main feedstock for ethanol, those higher corn prices have contributed to surging gasoline prices as refiners are forced to comply with the Renewable Fuels Standard (RFS) championed by the Bush Administration and Congress five years ago.

Ultimately, refiners like Valero (NYSE:VLO) have to either absorb those higher ethanol costs or pass on them to consumers — and we clearly know what they are going to choose.

And these rising gasoline prices certainly beg the question: Are we witnessing the end of the corn-based ethanol dream?

Spiking Prices

With memories of the Dust Bowl racing through many farmers’ heads, the drought ravaging the Midwest has been ruled the worst in nearly a half-century and is expected to yield the smallest corn crop in six years. That’s spelling some big issues with corn prices. Over just the last six weeks prices per bushel have risen by over 50%, driving corn to reach record highs.

Aside from higher direct food costs, those record corn prices are also starting to have their way with what we pay at the pump.

The RFS — which was enacted by the Bush Administration and embraced by President Obama — requires that 10% of gasoline stock come from ethanol. That works out to be roughly 13.2 billion gallons of ethanol blended into gasoline this year, and that is set to increase to 15% in a few years. The basic idea was to reduce American dependence on foreign oil by developing a robust domestic biofuels industry.

In a year with a standard corn crop, the RFS would consume roughly 40% of the nation’s corn production. However, with Dust Bowl 2 currently wreaking havoc in America’s heartland, this year’s crop has been forecast to come in nearly 25% smaller than normal. That means ethanol will need to siphon off a greater proportion of the production in order to meet the mandate.

But with less corn to go around, higher corn prices are prevailing. That’s making it pretty tough for many ethanol producers to turn a profit, and the nation’s ethanol output has fallen about 14% over the past two months. However, due to the RFS, blenders are required to demand specific amounts of the fuel, creating a vicious supply/demand imbalance that’s leading to sticker shock when we fill up our tanks.

According to the American Automobile Association, prices for regular unleaded gasoline rose 7% throughout August to a national average of $3.72 a gallon. The EIA estimates that higher corn prices and ethanol’s contribution to that is roughly 6 cents a gallon.

While the EIA maintains that ethanol is “a component of gasoline after blending and there is little evidence of the rising corn prices affecting the current price of gasoline,” I’m not so sure. Refiners still have to purchase it from someone to blend and — while they do get some juicy tax breaks for doing that — tax breaks only go so far before rising costs eclipse them.

The End Of The Dream

Given pressures facing food and fuel costs, several states have now begun to petition the EPA — who is responsible for maintaining the RFS — as well as the Obama Administration to suspend the mandate outright.

Texas Governor Rick Perry — one of the more vocal opponents to the RFS — said in a letter to the EPA, “Good intentions and laudable goals are small compensation to the families, farmers and ranchers who are being hurt by the federal government’s efforts to trade food for fuel.”

Congress already allowed tax credits for ethanol production to expire last year and many analysts estimate that, given rising corn costs, the RFS mandate is the only thing keeping ethanol production around. Likewise, the rise of hydraulic fracturing and the shale revolution has largely undermined the call for boosting ethanol content. It’s much easier and cheaper to convert trucks and fleet vehicles to run on natural gas than to develop economically viable biofuels.

Add this to rising food inflation caused by the price surge and we could be finally seeing the end of the corn-ethanol dream.

The lesson for investors is to run far away from remaining pure ethanol firms like Pacific Ethanol (NASDAQ:PEIX) and BioFuel Energy (NASDAQ:BIOF) — if they haven’t already.

The only reason why BioFuel Energy has seen any sort of a gain this year is that hedge fund manager David Einhorn raised his stake in the ethanol maker. Odds are he’s trying to pursue a break-up and a sale. Overall, things are going to be ugly in the sector for quite a while as the nation grapples with the food versus fuel debate.

And quite frankly, there are plenty of other energy “sure-things” I’d rather bet on. Ending the RFS mandate, though, would allow us to have our cake and eat it too.

As of this writing, Aaron Levitt did not own a position in any of the aforementioned securities.

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