Issued by Scott Irwin, University of Illinois farm doc daily
There has been a great deal of interest this summer in the ethanol market, RFS mandates, and corn use for ethanol production. This reflects the impact of the historic drought of 2012 in the Midwest and concerns about how reduced corn supplies will be allocated across consumption categories.
The focus of this post moves from the short-term to the long-term. In particular, we are interested in analyzing the basic economic question of how high do crude oil prices have to be in order for ethanol production in the U.S. to be profitable. Sometimes this simple but important issue is lost in the blizzard of daily market data and analysis. The answer also helps provide a frame of reference for thinking about the longer-term outlook for the market demand for ethanol.
In order to assess ethanol plant profitability for different crude oil prices, we use the same model of a representative Iowa plant
as in earlier ethanol-related posts. To review, the final model incorporates these key assumptions:
- 100 million gallon annual ethanol production capacity
- Plant construction costs of $2.11 per gallon of ethanol production capacity
- 40% debt and 60% equity financing
- 8.25% interest on 10-year loan for debt financing
- A total of $0.60 fixed costs per bushel of corn processed
- Non-corn variable costs of $1.05 per bushel of corn processed
- 2.80 gallons of ethanol produced per bushel of corn processed
- 17 pounds of dried distillers grain (DDGS) produced per bushel of corn processed
This model is meant to be representative of an "average" ethanol plant constructed in the last five years. There is certainly substantial variation in capacity and production efficiency across the industry and this should be kept in mind when viewing profit estimates from the model.
Given the model's technical parameters and costs, we only need two prices to compute ethanol production profits. The first is the price of corn, the feedstock for the plant, and the second is the price of ethanol, the main output product.
We don't need the price of DDGs, another output product, because we assume a constant ratio of DDG to corn prices (98%, the average for recent months). So, if we assume a corn price then implicitly we are also assuming a DDG price. We are going to assume three different levels of the price of corn for the analysis: $4, $6, and $8 per bushel. So where do we get ethanol prices?
We explored the linkage from crude oil to gasoline to ethanol in earlier posts found here and here. Give the long-run focus of the present post, a simple model of these linkages is used. The first part assumes that the wholesale price of gasoline is 3.33% of the WTI crude oil futures price. The second part assumes that price of ethanol at the plant level is 78% of the wholesale gasoline price. Both percentages are approximately equal to the average percentages from June-August 2012.
All one has to do is multiply the two together and we have a way to link the price of crude oil to the price of ethanol. Specifically, the price of ethanol is assumed to be 2.6% of the price of crude oil.