Rising Fears of an Ethanol Bust

With some analysts warning of an oversupply of the corn-based fuel later this year, concern is growing among farmers and investors

by Moira Herbst

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President George W. Bush's January, 2006, declaration that the U.S. is "addicted to oil" marked the beginning of a gold rush for corn growers: The government policies the comment helped spur have been a boon for the producers of corn-based ethanol, the all-American fuel that now displaces about 4% of U.S. gasoline supply. Over the past 18 months, farmers have rushed to plant more corn—and are set to produce a record crop this year—while small-time entrepreneurs and agricultural giants alike have built plants to expand capacity. A handful of initial public offerings have fed investors' desire to get in on the action.

But while farmers and producers remain bullish on corn ethanol's prospects, a once-enthusiastic Wall Street is growing skeptical. On May 1, the largest U.S. ethanol producer, Archer Daniels Midland (ADM), reported quarterly earnings that fell short of analyst expectations, citing higher corn costs as a problem. ADM shares tumbled 5.4% that day to close at $36.60 as investor disappointment spread throughout the sector. Shares of U.S. Bioenergy (USBE), Pacific Ethanol (PEIX), Andersons (ANDE), Aventine Renewable Energy (AVR), and VeraSun Energy (VSE) dipped 1% to 2%.

Lurking behind ADM's gloomy news are doubts about the future of corn ethanol. A growing number of analysts, once bullish on the product, are warning that an oversupply may be coming as soon as this year. On Apr. 27, a Lehman Brothers (LEH) report projected that production will outstrip demand in the second half of 2007, measuring the domestic thirst for corn ethanol at 420,000 barrels per day but supply at 445,000 barrels a day, mainly because the U.S. lacks the infrastructure to move the product to market.

"Chicken-and-Egg Problem"

"There's tremendous capacity coming online, but the infrastructure isn't there to keep up with it," says Michael Waldron, an oil markets research analyst at Lehman Brothers who co-authored the report. "We need a nationwide system to pipe it, and until that happens, we'll likely have an excess of product."

Waldron says the problem isn't a lack of demand for ethanol, which remains high, especially given that the federal Renewable Fuel Standard mandates at least 4 billion gallons, or about 3% of all U.S. transportation fuels, to come from alternative sources today, and nearly double that amount, or 7.5 billion gallons, by 2012. Lawmakers are expected to give the mandate a significant boost later this year. Rather, the problem is getting ethanol to consumers in various parts of the country. Ethanol requires a separate piping system from gasoline, and since Uncle Sam hasn't appropriated funds to build such infrastructure, ethanol is now primarily transported by rail. But the rail system extends only to major metropolitan areas—not to mention the dual problems of its high cost and carbon dioxide emissions.

"It's a chicken-and-egg problem," says Waldron. "If the infrastructure were there, the demand would be there. In the end the government would have to play a role to help build out a [national] dedicated pipeline."

Caution to Investors

A growing number of analysts agree with Lehman Brothers' conclusions. "We remain cautious on the ethanol stocks over a 12-month period," wrote Bank of America (BAC) analyst Eric Brown in an Apr. 24 research note. "Looking ahead we continue to believe that an oversupply of ethanol in the second half of 2007 will depress ethanol's premium to gasoline."