Lost In Translation

Given the build-up that went into the 2007 growing season, practically no one was surprised that biofuels growth translated into millions of acres of farmland shifting from crops such as soybeans and cotton to corn. Early on, many market analysts predicted this trend to corn from other crops would continue into 2008 as biofuels continued to expand their market footprint, translating into even higher corn acreage and crop input sales.

However, according to one speaker at the 2007 Mid America CropLife Association (MACA) annual meeting, this translation could be less exact then it first appeared.

“In many ways, there has been irrational exuberance in the nation’s corn fields over ethanol this past year,” said Sano Shimoda, president and founder of BioScience Securities, Inc., an investment banking and industry consulting firm. “Don’t get me wrong. I’m 100% for biofuels, but the strategy behind them is wrong.”

As originally mapped out by its supporters, biofuels were supposed to be the first in a series of energy alternatives to help curb the nation’s dependence on fossil fuel. The goal of this effort was to create new, renewable, low-cost, market-driven, sustainable, non-oil-based energy sources. At first, biofuels — in particular, ethanol — looked like a perfect candidate for this plan, being derived from good old-fashioned American corn.

However, there were bumps in the road, said Shimoda. First, the “market-driven” part of the original plan apparently got lost in the mix. “Public policy towards biofuels, including ethanol, continues to be anchored in farm/rural development policy, not energy policy,” he explained. “There is a subsidy of 51 cents per gallon blender credit for ethanol, which expires in 2010, and the food vs. fuel debate, changing energy politics and reducing ethanol support.”

As evidence of the problems this “support system” created in the marketplace, Shimoda pointed to biodiesel. “Biodiesel capacity was in a rapid expansion phase, driven by renewable fuel demand and its value to meet new diesel standards,” he said. “But higher soybean price pressures, driven by reduced acreage in 2007, and the resulting rise in soybean oil prices, has marginalized production economics. In fact, because of the high cost of feedstock, approximately 40% of the nation’s biodiesel plants today aren’t producing.”

Insufficient Supply

For ethanol, he said, an even bigger problem is the fact that it can’t completely replace oil in the transportation sector — ever. “In 2006, ethanol production was 4.9 billion gallons,” said Shimoda. “Although this was a big number, it represented only 3.5% of the nation’s total transportation consumption of 140 billion gallons. Even if 100% of U.S. corn production was used to produce ethanol, it could still replace only 29% of total fuel consumption.”

Finally, the costs currently associated with biofuels aren’t controlled by market forces alone. “There is presently a price-cost disconnect,” said Shimoda. “Ethanol prices are driven by oil prices and supply/demand parameters. Corn supply/costs are subject to supply variability, especially the risk of a weather-induced or pest/disease-generated ‘short’ corn crop.”

This can’t continue to be the case if biofuels are to succeed, said Shimoda. “Ethanol will be sustainable only if costs are driven to levels that will support market-driven demand, without long-term subsidies,” he said. “Ethanol demand has to be driven by market economics — economic attractiveness as a gasoline blending component, beyond oxygenate/MTBE (methyl tertiary butyl ether) replacement.”

Over the next 12 to 18 months, Shimoda predicts that the ethanol production industry will undergo a “major” ownership shake-up, with facilities consolidating or being scrapped before construction due to higher corn prices, lower oil prices, and lower profit margins. “The bottom line: Ethanol costs must be targeted to be cost competitive with prices as low as $25 to $30 per barrel oil equivalent, without the need for blenders’ credit to incentivize oil refiners,” he said.

The Long-Term View

Despite all these problems, Shimoda said that biofuels do have a future as one of the products to reduce America’s dependence on fossil fuel. “The ability to create a sustainable, market-driven ethanol industry that can compete with potential future oil and ag price volatility will depend on technical innovation — the dramatic reduction in conversion costs and material handling/logistics costs — and business models where world-class economies of scale create a low-cost position. The challenge for corn-based ethanol is the constant focus on reducing costs in order to create this low-cost position.”

To drive this low-cost positioning, Shimoda said that biofuel producers will need to adopt new production technology and energy/process efficiencies through lower production costs. They will also need to develop feedstock sourcing flexibility to minimize availability problems and price risks.

“Biofuels are the right answer — the issue is sustainability,” concluded Shimoda. “Many single facility ethanol plants are strategically and financially vulnerable. Industry consolidators will includes some existing players, as well as conventional and non-conventional world scale global ag and financial players. The survivors will be analogous to Amazon, eBay, and Google in the dot-com world in developing the big ideas that take this industry to the next level.”

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