Ethanol’s Future: A Perspective
November 3, 2009 
Ethanol has been on a roller coaster over the last four years. The boom during 2006 and early 2007 was short-lived. Industry profitability deteriorated through 2007 and collapsed in 2008’s second half (though ethanol profitability has made a moderate recovery in 2009). The major questions facing market supporters now are what is the outlook for ethanol and how will the biofuels evolution impact the industry’s long-term business/financial outlook?
On the surface, the roller coaster ride in ethanol profitability can be blamed on the sharp spike in corn prices and the overall boom/bust cycle in major commodities during 2007-08, along with the impact of The Great Recession on the demand for ag commodities. However, the real underlying cause was the structural deficiencies in the industry’s business model.
Out of the era of biofuels euphoria during 2006-07, the Energy Independence and Security Act (EISA) of 2007 was passed in December of that year. EISA legislated an increase in the Renewable Fuels Standard (RFS) from the existing mandate of 7.5 billion gallons of gasoline by 2012 to a broader mix of biofuels at 36 billion gallons by 2022. In addition, the RFS mandated a maximum of 15 billion gallons for conventional biofuels. The general recognition that the carbon emissions profile of corn-based ethanol was less advantageous than other advanced biofuels was also critical in capping corn-based ethanol’s RFS.
The remaining 21 billion gallons is to be supplied by fuels derived from biomass that can achieve a 50% reduction in greenhouse gas emissions, of which cellulosic biofuels was mandated at 16 billions gallons.
With the ethanol industry’s capacity expected to reach about 14.5 billion gallons, industry capacity — largely utilizing corn as a feedstock — is close to the RFS 15 billion-gallon maximum.
Despite the fact that the capacity of corn-based ethanol is bumping up against the 15 billion-gallon RFS, the renewable fuels and ethanol industries, agriculture, and government have continued to broadly support the viability of the corn-based ethanol’s developed infrastructure. This enthusiasm is based on the view that the existing corn-based infrastructure is the launch pad for the development of cellulosic-based biofuels, of which the ag-based cellulosic ethanol is expected to play a major role.
Dialing In Cellulosic
The ethanol industry has moved on from corn-based biofuels to cellulosic-based alternatives in terms of market growth. In part, this shift recognizes that cellulose-based ethanol is superior to corn-based ethanol from a carbon emissions and energy balance perspective (in the amount of British thermal units produced relative to those utilized in the process). In addition, ag residues (as well as the development of energy crops such as switchgrass) were expected to compete less with direct food crops, lessening the “food vs. fuel” issue.
Recognizing the limitations to growth for corn-based ethanol, the concept of cellulose-based biofuels made sense. Simplistically, the competitive economics for renewable-based cellulosic biofuels married the economics of perceived “low cost” renewable feedstock (ranging from food crop-based ag residues such as corn cobs/corn stover and rice straw to non-food related sources such as wood chips and municipal solid waste) and high-cost, capital-intensive biorefineries necessary to overcome the technical/commercial hurdles of converting cellulose-based components.
A large number of companies are focused on developing cellulose-based technologies and businesses from a broad range of renewable feedstocks, each with its own set of technical/commercial hurdles. In all probability, should individual cellulosic biofuels technologies reach commercial thresholds, we would expect multiple technology platforms to exist, depending on regional solutions.
An Industry Looking for A Market
Today, the ethanol industry has a fundamental problem. The transportation fuels market does not need more capacity. In fact, the 15 billion RFS for renewable biofuels reflects more capacity than current market needs.
Why is this the case? The ethanol industry has hit the blend wall. Currently, the U.S. transportation fuels market is about 135 billion to 140 billion gallons. At an EPA-established 10% maximum blend rate, the maximum ethanol that can be used is about 14 billions gallons — close to industry capacity.
EPA has to rule by Dec. 1 on a request to increase the maximum blend ratio to 15%, which would expand the market. However, an increase in the blend ratio is being opposed by a number of industry sectors, including the automotive industry, small engine manufacturers, the oil refining industry, and many ag sectors that would be adversely affected by upward pressure on corn prices.
Most knowledgeable observers expect an increase to 12% to 13%, which would only increase maximum demand to 18 billion gallons. Even should EPA increase the maximum blend level to 15%, demand would only increase to 21 billion gallons. As a result, only 3 billion to 6 billion gallons of cellulosic-based ethanol capacity would be needed. This is substantially less than the mandated 16 billion-gallon cellulosic biofuels RFS. More importantly, long-term demand for ethanol could prove to be much lower, given the likelihood that U.S. gasoline demand has fundamentally peaked and will decline.
From a broader perspective, the key motivation behind the RFS of EISA 2007 was to drive the expansion in flex-fuel vehicles and E85 production. This would dramatically increase the amount of biofuels used in the U.S. gasoline pool beyond the 10% (or even 15%) blend ratio mandate. For example, due to Brazil’s emphasis on flex-fuel vehicles, gasoline in the country utilizes 20% to 25% ethanol.
Expanding the market potential for cellulosic biofuels in a shrinking market will require two major structural shifts. First, there needs to be a dramatic shift in the mix of U.S. autos toward flex-fuel vehicles. Second, there needs to be a dramatic expansion in the gasoline distribution and retail infrastructure to expand the availability of flex fuels, which use higher ethanol levels. The oil industry is reluctant to make these changes beyond mandated levels due to the added investment required and uncertainty over the long-term economic viability of ethanol-based biofuels.
Apart from “food vs. fuel” impacts, there are valid concerns over the market-driven sustainability and risk that ethanol technologies could be obsoleted by new technologies. Longer-term, it would appear the growth potential of cellulosic ethanol will also be determined by structural changes in the industry’s business model. What is needed is the development of value-added and market competitive co-products. Such products would enhance broad market potential beyond commodity fuel markets and improve business economics from the standpoint of not only increasing overall profitability but also reducing profit vulnerability to commodity price/cost swings in the basic fuels/ag businesses.
Hype Meets Marketplace Reality
The biofuels industry started to shift focus to cellulosic-based ethanol during the 2006-07 period as constraints to the growth of corn-based ethanol became increasingly evident. However, apart from the basic problem of market size potential, there is a more fundamental problem in the development of cellulosic-based biofuels.
It is simple economics.
From a competitive economics perspective, cellulose-based ethanol has to reach cost economics that are equal or less than current corn-based ethanol, whose cost is about $1.40 to $1.75 per gallon (based on $3 to $4 per bushel corn). Initial development will require significant government subsidies at multiple levels to prove commercial feasibility. However, the ability to develop a sustainable cellulosics industry that can attract large sums of investment capital will depend on market-driven scalability and sustainability without the need for ongoing operational subsidies.
More importantly, the key cost/development hurdles are not where the lion’s share of focused efforts have been placed. The primary focus has centered on the technology challenges of developing high activity enzymes or microbes that could efficiently break down and convert the cellulose components into ethanol.
In my opinion, what has been understated from the very beginning is that the critical constraints on the development of cost-competitive biofuels from cellulosic ag-based materials was not the development of efficient/commercial cellulose conversion technologies to compete with corn-based ethanol, but rather the somewhat more mundane hurdles tied to the real world of agriculture. In addition, there is a real concern over water availability, given growing competition between agricultural uses, broad consumer/industrial uses, and reduced availability in many regions.
4 Economic Hurdles To Cellulosic-Based Biofuels
There are four real economic ag-related hurdles to the development of a sustainable/commercially viable cellulosics biofuel industry:
– Feedstock Costs. Despite the large quantity of ag residues, feedstock prices will be high. Ag residue has significant economic value to the grower: soil fertility, reduced erosion, maintaining fertility and structure, and retaining moisture. In addition, the amount of ag residue that can be safely removed, without impairing the above factors, could vary quite dramatically from field to field. Early commercial development will require sizable subsidy payments to growers, beyond a typical $20 to $30 per ton price for baled ag residue. It is quite possible that ag residue such as corn stover might be priced at costs greater than $50 to $75 per ton.
In addition, market competition from the recognition that ag residue is to be valued as a co-product could result in much higher prices. Value could also be influenced by competition from new developing uses such as BioPower (biomass-fired power plants).
– Harvesting, Transportation, Supply Logistics. It has long been recognized that the harvesting and supply logistics of dealing with high volume and bulky ag residues will be costly, whether the biorefinery system is centralized or not. While many companies are working on prototypes, new harvesting equipment has to be commercialized and new transportation/supply/storage logistics/facilities will have to be built. It is clear that growers will look at incremental net revenues (less any costs incurred) derived from the sale of ag residues. However, given the weather dependent uncertainty over the fall harvest window, growers will not want to slow down for ag residue removal. Also, ag residue removal could increase soil compaction — a negative for crop growth and yields in the following growing season.
– Supply Risks. Some biomass sources such as municipal solid waste negate the need for large volume storage facilities. On the other hand, ag residues are produced once a year (energy crops, which are perennials, have the advantage of potential multiple harvests during the years). In contrast to corn, there is need to develop a massive broad area storage infrastructure for ag residues, whose storage conditions have to be controlled to minimize deterioration in quality. What is underestimated is the need for additional emergency supply reserves to ensure availability should adverse weather conditions reduce local supply availability.
– New Business Models. Unlike major row crops, there is the question as to whether futures markets for major ag residues can be developed to reduce financial risks. Otherwise, new business models, possibly multi-year contracts, will have to be developed to provide revenue/profit visibility for the grower and cellulosic biofuels producer, as well as security of supply for commercial operations.
A large number of companies are in different stages of developing commercial cellulosic-based biofuel technologies, commercial scale pilot/demonstration, and derived businesses. However, it is unlikely that enough production will meet the 2010 mandated target of 100 million gallons from cellulosic biofuels. Furthermore, large volume commercial supplies will fall substantially short of escalating mandated levels for at least the next few years.
In addition, what appears to make the most sense is piggybacking incremental cellulosic conversion operating units on existing corn-based ethanol facilities. This long-term strategy would also increase production flexibility, based on the availability and pricing of alternative feedstocks. This is best exemplified by Poet’s Project Liberty, which is expanding an existing corn-based ethanol production facility in Emmetsburg, IA, by 25 million gallons of cellulosic ethanol, utilizing corn cobs.
The Only Game In Town
While corn-based ethanol is not the perfect biofuel, it is the only game in town from the standpoint of a biofuel that is commercially viable today.
A number of companies are focused on the commercial development of biobutanol, which would replace or be complementary to ethanol. Biobutanol is superior to ethanol, given its higher energy density, less volume usage, and lower greenhouse gas emissions. More importantly, biobutanol can be directly blended with gasoline in higher concentrations than ethanol without the need to modify vehicles and is compatible with the existing oil refining/distribution infrastructure.
While the goal is to develop biobutanol to be cost competitive with ethanol, further technical developments are needed to reach cost parity. In addition, biobutanol has the same agricultural issues and risks as ethanol since the targeted feedstocks are grains as well as cellulosic ag-related biomass materials.
Over-optimism on the ramp-up and the reality of much higher than expected overall costs facing the cellulosic biofuel industry will have to be reckoned with, from both a government mandate and commercial perspective. It will take breakthrough technologies to offset the inherent cost disadvantages of cellulosic ethanol/biobutanol biofuels, and such revolutionary technologies will take much longer to develop.
Meanwhile, the corn based-ethanol industry has moved back into the black due to current low corn costs and the rise in ethanol prices. Yet long-term viability of most players in the industry is still questionable. Another spike in corn prices to $4.50 to $5-plus per bushel within the context of lower oil prices range would likely create renewed red ink, shutdown economics for many facilities, and promote a government re-evaluation of viability of ag-based biofuels.
The current consolidation phase is expected to continue and will create more sustainable business strategies and business models. It will be critical that larger multi-plant, geographically dispersed, corn-based ethanol businesses mitigate localized supply/costs risks as well as take maximum advantage of economies of scale.
An expected slow ramp-up of cellulosic ethanol plants, combined with improving economics of low cost corn-based ethanol companies and reduced greenhouse gas emission generation as well as the dampening price effect of an acceleration in corn yield gains, could provide the basis for changes in the corn/cellulosic biofuels RFS mix and a modification of current mandates.
The potential result would be a further expansion of corn-based ethanol over the intermediate term, based on technology that works today rather than what might work tomorrow.
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