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By Robert Rapier on Jun 7, 2009 with no responses

How to Calculate Ethanol’s Value

There was a comment following the previous post that claimed that ethanol producers are making money – minus subsidies – at $1.75 a gallon. I attempted to set the record straight in the comments, but I thought this was probably worth a post.

The way the blender’s credit works is that gasoline blenders get a credit – recently reduced to $0.45/gal – against the federal gasoline taxes they have to pay for each gallon of ethanol blended into the gasoline pool. However, it is not true that this subsidy actually benefits the oil companies. Ethanol proponents like to make that claim, but any time there is talk of getting rid of the credit, they are the ones who scream loudly. You won’t hear oil companies lobbying to keep it. Thus, it should be clear who really benefits.

If you think about it, though, isn’t it kind of silly to have a subsidy (and I haven’t even mentioned the additional state subsdies) on something that already has a mandate for its use? Are we going to use less ethanol if the subsidy is taken away? No, because we have a mandated amount that has to be blended into the gasoline pool. What would happen if the subsidy is removed – and this is why the subsidy stays – is that consumers would pay more for their gasoline, and ethanol’s impact on gasoline prices would be more transparent.

Anyway, at the current price of around $1.75 a gallon, gasoline blenders are getting a discount of $0.45, paid for by tax dollars. Thus, the real price they are paying for ethanol is $1.30 a gallon today – too low for the ethanol producer to make a living. That is why the ethanol industry – after 30 years of direct subsidies – still can’t survive without them. If you took away the mandates and the subsidies, the entire corn ethanol industry would go bankrupt. Actually, a fair chunk is going bankrupt even with subsidies and mandates.

You can also use a different route to determine that the real, unsubsidized price of ethanol today would be $1.30 a gallon. Last Friday on the NYMEX, gasoline closed at $1.95/gallon. (Note that this price does not include state and federal taxes). Because ethanol contains 67% of the BTU content of gasoline, the price should reflect this. Thus, if I am a gasoline blender, I would be willing to pay 67% of $1.95 for my ethanol, all other things being equal. That puts me at parity to what I am paying for gasoline. How much is that? $1.31. Ethanol would have to trade at or lower than this value, unsubsidized (and at the present price of gasoline) to compete in an open market.

So what if gasoline was trading at $3.00 a gallon? Then the gasoline blender would be willing to pay $2.00 a gallon for their ethanol. But when gasoline prices are rising, generally so are other fossil fuel prices. Because (corn) ethanol is so heavily dependent upon natural gas (for corn fertilizer and for distilling the ethanol) costs will generally have risen sharply for the ethanol producer. This is the vicious circle the ethanol producer is in, and it explains why the industry has been subsidized for 30 years.

Corn ethanol producers have to move away from fossil fuel inputs – or they need to otherwise find inputs that don’t normally track gasoline prices. This is why the sugarcane ethanol producer can compete on a level playing field with gasoline. The fertilizer inputs for sugarcane are much lower than for corn, and the distillation energy is provided by biomass. The only way the ethanol industry in the U.S. will be able to break free from the subsidies is to adopt similar practices.