Ethanol and oil markets

April 3, 2006
Sure, ethanol has been receiving a great deal of attention since President George W. Bush's state of the union speech in January. But he was talking about cellulosic ethanol, which is not yet in commercial production.

Sure, ethanol has been receiving a great deal of attention since President George W. Bush’s state of the union speech in January. But he was talking about cellulosic ethanol, which is not yet in commercial production.

Already, thanks to a longstanding tax credit and the renewable fuels mandate in the Energy Policy Act of 2005, billions of dollars are flowing into construction of plants that produce ethanol from grain, as a few large companies and many small ones rapidly add US production capacity.

A report released Mar. 27 by Friedman, Billings, Ramsey & Co. Inc. (FBR) asserts that not only will mandated demand for ethanol rise in the next few years but also prices will remain strong. Additionally, growth in the worldwide biofuels market could help lower crude oil prices in the latter part of this decade.

Demand, supply surge

The analysts who wrote this report, Jacques Rousseau, Kevin Book, and Eitan Bernstein, expect Congress to increase the renewable fuel standard next year, when the 2002 Farm Security and Investment Act comes up for reauthorization. This would raise the minimum demand level Congress set last year. Driving the strong political backing for ethanol are energy security concerns, agricultural interests, and environmentalists.

With this congressional move on the horizon, FBR forecasts that US ethanol demand will approach 10 billion gal/year by 2010 and expects production capacity to grow in step.

The renewable fuel standard enacted in the Energy Policy Act of 2005 requires that the amount of renewable fuels used in the US increase to 7.5 billion gal in 2012 from 4 billion gal this year.

Renewable fuels include not only grain and cellulosic ethanol but also biodiesel. Whatever their long-term supply potential, cellulosic ethanol and biodiesel shouldn’t have much impact on the market in the near term.

While Brazil has been the world’s largest ethanol producer during the past 25 years, FBR expects the US to become the production leader this year, with nearly 5 billion gal of production by yearend.

Further, FBR’s US supply model forecasts a big jump in production capacity additions in the next few years, with an estimated $6.5 billion of investment needed by the end of this decade.

With 3.5 billion gal/year of capacity additions, considering projects under construction and those proposed, the analysts expect that US capacity to produce ethanol will reach 8 billion gal/year by the end of 2008, and 9-10 billion gal/year by 2010. Last year production capacity was 4 billion gal/year, or about 260,000 b/d, which supplied only about 2.7% of the US gasoline market.

With demand projected at about 10 billion gal/year in 2010 if Congress extends the renewable fuel standard, FBR expects strong prices and robust margins for producers. With a $50/bbl long-term crude oil forecast and the current 51¢/gal tax credit for ethanol blended into gasoline, FBR forecasts ethanol prices of $1.90-2.20/gal over the next 4 years and average all-in production costs of $1-1.20/gal.

Oil market impact

One of the more interesting conclusions in the FBR report, at least to this editor, concerns the global energy market and how it will be affected by US biofuels consumption.

The analysts estimate that last year, the world used about 10 billion gal of biofuels, including ethanol and biodiesel. This is 650,000 b/d, or less than 0.8% of worldwide crude oil consumption of 83 million b/d.

Over the next 5 years, FBR forecasts that biofuels will add about 200,000 b/d to supply each year. So by 2010, biofuels would represent 1.6 million b/d, or 1.8%, of global demand.

Ethanol has only about two-thirds the energy content of conventional gasoline, so it doesn’t replace gallons of gasoline on a one-to-one basis. The energy content of average biodiesel in the US is only 8.65% less than No. 2 diesel, though, according to the National Biodiesel Board.

“Assuming normal demand and non-OPEC supply growth, the net result on the global energy market is that the addition of 1 million b/d of biofuels should enable OPEC to increase its spare production capacity and place downward pressure on crude oil prices in the latter part of the decade, in our opinion,” the report said.

For that reason, FBR believes that the long-dated forward curve on the crude oil futures market, around $65/bbl, could be too high and that the analysts’ $50/bbl long-term forecast is likely more realistic.