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July 2003

Gentlemen, start your ethanol engines

Thanks to government-induced demand, ethanol production is on the fast track in the district

Frank Jossi
Contributing Writer

Construction on the largest ethanol plant in the Upper Midwest began on a 417-acre parcel of land in February in Aurora, S.D., a tiny town just outside Brookings. Opening next year, the plant will have the capacity to produce 100 million gallons of ethanol, two and a half times more than the average plant found in the Ninth District, and so immense its presence could edge South Dakota ahead of Minnesota as the region's largest ethanol producer.

The investors are led by Don Endres, a former Internet entrepreneur who sold an e-commerce company in Brookings to a Silicon Valley firm a few years ago and then turned his interest to a different potential gold rush, ethanol. Endres made investments in several Midwest ethanol plants before forming VeraSun Energy and raising more than $100 million to build the project.

VeraSun sales and marketing vice president Bill Honnef, who worked with Endres in the Internet boom years, said investors in the project saw a rare convergence of market opportunities that make ethanol look like a winning investment for years to come. The federal government's continued requirement that gasoline be blended with an oxygenate to reduce air pollution helps ethanol's cause. But even more important has been the replacement of the former oxygenate standard, MTBE (methyl tertiary-butyl ether), by ethanol in several of the nation's most populous states.

The federal government seems likely after years of debate to pass a renewable fuels standard, or RFS, that will only help increase ethanol's sales. “The renewable fuels standard has picked up steam and if it passes it will triple the demand for ethanol over the next eight years,” said Honnef. “We're counting on a strong demand, especially on the West Coast.”

It's not California dreamin' to believe Honnef's prognosis. California gave MTBE the boot earlier this year due to concerns over its potentially carcinogenic nature, and producers there stepped up the state's deadline by removing it this year from blended gasoline. With MTBE gone as an oxygenate, the Golden State has grown a healthy appetite for ethanol, which VeraSun has big plans to exploit, said Honnef. Once completed, the plant will send ethanol on unit trains—entire trains composed of ethanol-filled container cars—to Carson, south of Los Angeles, where an unloading facility will then move it to refineries.

Putting the plant in corn-rich South Dakota made sense. “We're looking to build economies of scale and become a low-cost producer of ethanol, and the way to do that is put the plant in a low-cost corn state, and South Dakota has the lowest corn prices in the country,” explained Honnef.

The good times roll

Times have rarely been better for ethanol. New York and Connecticut have given producers until the end of the year to remove MTBE from gasoline. More than a dozen other states will likely take the same step over the next two years. Most of them require oxygenated fuel, and ethanol is the only viable alternative.

Ethanol's growing popularity has led many states outside the Midwest to consider subsidy programs to kick-start production in their states, using Minnesota as a model, said Monte Shaw, spokesman for the Renewable Fuels Association (RFA) in Washington, D.C. Among those states are New York, Mississippi and Alabama, all potential competition for Ninth District ethanol plants.

Meanwhile, a U.S. Department of Agriculture (USDA) study and a separate privately sponsored scientific study suggest the amount of energy required to create ethanol is less than that produced by ethanol—a huge bone of contention for several years. The finding is a small victory but a victory nonetheless for ethanol's supporters. If it does not settle the score for good, it at least provides politicians and others a measure of cover and comfort when combating charges that ethanol, which is produced from corn, cannot pay for itself in terms of energy production.

All of this bodes well for the Ninth District, home to 27 plants, the majority in Minnesota (14) and South Dakota (10). Including plants in northern Wisconsin and North Dakota, the Ninth District represents 25 percent of the nation's ethanol production capacity. Major corn producers in South Dakota and Minnesota see ethanol as part of an effort to shore up the flagging rural economy, and their success is encouraging other Ninth District states to follow the same recipe.

State subsidies and ethanol's growing demand have increased plant proposals in Wisconsin and North Dakota, too, both small players that are starting to see green in the product's popularity. And on Capitol Hill the ethanol industry has a great friend in South Dakota Sen. Tom Daschle, who has been a force in maintaining federal ethanol subsidies, while pushing for the RFS and against MTBE.

If the proposed federal legislation becomes law, “you'll see some major growth, with plants even in places like New Jersey, North Carolina, Pennsylvania and Mississippi—its production will move out to the demographic areas where the people are at,” said Peter Nessler, director of renewable fuels at FC Stone LLC in West Des Moines, Iowa. “We've got a lot of growth to go.”

How rich can the market get with a little push by an RFS? “We've got 10 plants under construction and another 20 to 30 under development,” said Trevor Guthmiller, executive director of the American Coalition for Ethanol in Sioux Falls, S.D. “As the demand escalates, the growth will be phenomenal, it could be 5 billion gallons of production by 2006. I don't know if we'll make it to that goal, but we'll at least get to over 4 billion.”

Ethanol's positive impact extends to corn growers, who see prices rise on average 6 cents to 8 cents a bushel near ethanol plants, according to the information provided by the Washington-based National Corn Growers Association. The presence of ethanol in the corn-buying market adds 30 cents on average to the price of a bushel of corn, according to the USDA. If passed, the renewable fuels legislation is expected to push ethanol's corn consumption to 2 billion bushels a year by 2012, up from its current 1.3 billion bushels.

MTBE and federal legislation

Petroleum-based MTBE's history began as early as 1979, when a small number of service stations blended it with gasoline. In 1990, MTBE's use skyrocketed when oil and gas conglomerates began using it as a cost-effective method to raise the oxygen content of emissions, which reduces the amount of air pollution cars emit through their exhaust systems. Many states moved toward adding oxygenate to meet demands imposed by the 1990 Clean Air Act amendments.

While a useful additive, MTBE creates a potential problem for states because it contaminates groundwater and drinking water and could—the question remains under study and debate—pose a threat to humans at high doses. The fall from grace began when California's regulators asked producers to remove it, and they quickly acceded to the new requirement by buying an additional 600 to 700 million gallons of ethanol this year, a figure that could rise to 900 million next year, said Shaw. The New York and Connecticut regulations should add at least another 300 million gallons of demand, based on those states using a blend of 10 percent ethanol, 90 percent gasoline.

The industry had little trouble filling California's demand, nor will New York or Connecticut diminish supplies greatly. Producers set a record of 176,000 barrels per day in March, an increase of 34 percent over the same month last year, according to the U.S. Department of Energy. This year 2.6 billion gallons of ethanol will be produced in 70 plants; another record, said Shaw.

Guaranteed to help the cause is congressional support for a comprehensive energy bill featuring an RFS of 5 billion gallons a year by 2012, nearly double what the industry will produce this year.
In early June the Senate voted for such a measure, including a ban on MTBE; the House called for similar action in April, absent the MTBE ban.

Shaw and Guthmiller argue ethanol provides one way to reduce the United States' reliance on imported oil and mitigate disruptions in the oil supply. The more blended gasoline there is, the less foreign oil the United States requires, more so with ethanol being blended at higher percentages, they argue.

Not so fast, say critics of ethanol. The United States consumes close to 9 million barrels of gasoline a day, which means ethanol is replacing less than 2 percent of gasoline consumption in this country; it replaces an even smaller portion of oil consumption when home heating and other fuel uses are considered. Cornell University agriculture professor David Pimentel, a longtime critic of ethanol, has said the United States would have to cover 97 percent of its land mass with corn to replace gas. A huge rise in corn consumption—ethanol accounts for 10 percent of all production now, according to national statistics—could put pressure on livestock producers who depend on corn for feedstock. Ethanol supporters contend the fuel's production results in feed for livestock, but the question looms about the potential impact on the nation's food production and distribution systems in the future.

Another effort to promote ethanol seems to be gaining ground. The use of E85, a fuel composed of 85 percent ethanol, has jumped 600 percent in Minnesota over the past two years, the Environmental Protection Agency reports. More than 20 foreign and domestic automobile lines have vehicles capable of using the fuel, and stations have opened in several other states. Though a tiny part of the market, said Guthmiller, E85 continues to gain popularity as stations open in Maryland, Colorado, the Dakotas and Utah.

Subsidize this

The federal government continues to offer a 5.4-cent reduction per gallon on the federal excise gas tax of 18.3 cents for every gallon of blended gasoline. At the standard blend (10 percent ethanol per gallon of gas), the result is a 54-cent subsidy for every gallon of ethanol, a loss to the nation's treasury estimated by the Cato Institute to be around $770 million annually. Archer Daniels Midland owns 41 percent of the ethanol market, making it the nation's largest recipient of ethanol subsidies. Critics charge ADM was behind the turn against MTBE and point to its continued lobbying for extensions to the tax break, now set to expire in 2007, as evidence ethanol exists in an artificial market.

Guthmiller dismisses the subsidies argument. “What about oil subsidies?” he asked. “We've subsidized oil producers for 100 years in this country. We should have a tax policy that encourages the production of renewable fuels in this country. The real question is what is our policy for energy, and renewable? Ethanol should be part of it because it re-creates jobs, opportunities and economic development in rural America.”

The debate, of course, will persist. At the state level, the subsidies are getting squeezed by legislatures staring at budgets drowning in red ink. Minnesota Gov. Tim Pawlenty had plans to jettison $27 million in ethanol subsidies in this year's budget, but quickly backpedaled when the agricultural lobby descended upon the state capital to show strong support for the industry.

The current subsidy of 20 cents a gallon—up to $3 million annually per facility—will likely drop to anywhere from 16 cents to 10 cents a gallon in Minnesota under various plans at the Legislature, said Ralph Groshen, a marketing specialist with the state Department of Agriculture.

Just a short distance behind Minnesota among the nation's leading ethanol producers is South Dakota, where a 40-million-gallon plant opened in March a year ahead of VeraSun's debut. South Dakota's complex subsidy formula gives its currently operating plants a 20-cents-a-gallon subsidy up to a preestablished limit of 416,666 gallons this year, with a $1-million or 5-million-gallon cap per plant.

The state puts an annual cap on subsidies it will pay producers based on revenue gained from a variety of funding sources. This year $4 million is available, and next year producers will split $5 million, said Joan Serfling, director of administrative services at the Department of Revenue and Regulation in Pierre.

The program caps what an individual producer can receive at $1 million annually and $10 million during the lifetime of the plant, she said. The state has paid out $25.6 million since the subsidy program began 1989. “Producers understand the issues we have with the budget,” she said. “Would they like to get the entire subsidy? Yes, but we've been at this a long time and we're trying to be equitable by paying a subsidy to all producers. It's a pretty good program for them to work with, really.”

Elsewhere in the Ninth District, Wisconsin's subsidy program offers 20 cents a gallon on a maximum of 15 million gallons a year. The only plant currently in northern Wisconsin, Ace Ethanol in Stanley, can produce 15 million gallons and, although barely open a year, announced plans to double its capacity through expansion. (Wisconsin's two other plants are downstate in Oshkosh and Monroe.) Earlier this year, the Eau Claire Leader-Telegram reported an outcry among neighbors in Hay River concerning a proposed 40-million-gallon ethanol plant not far from Menomonie. Another has been proposed for Augusta.

Montana has no program because the state's major agriculture crop is wheat, although the Ethanol Producers and Consumers, a trade group in Nashua, has advocated for ethanol in the state for 13 years. North Dakota just created a countercyclical plan based on the prices of ethanol and corn, which offers up to a $10-million subsidy for the life of the plant, said John Schneider, executive director of the Agricultural Products Utilization Commission in the Department of Revenue. The state's two current plants receive subsidies, slated to expire in 2005, totaling $900,000.

North Dakota, which has dedicated nearly $18 million to ethanol subsidies since 1989, may offer additional financial assistance to two proposed plants. Among them is Fargo-based Dakota Renewables LLC's effort to build a plant in Valley City or Wahpeton, said Duane Davis, the group's chairman. Investors and banks want the cushion a subsidy offers if ethanol oversupply becomes a problem or corn prices skyrocket, Davis argued, and without the government's helping hand his organization's proposal would evaporate.

Gray clouds

As a consultant to farmers' co-ops and investors looking to build plants, Jeff Kapell sounds plenty of warnings about the viability of ethanol to potential clients. As corn prices rise—as they are now—the profits plummet as ethanol producers pay more for their primary ingredient, said Kapell, associate principal at SJH and Co. in Boston. “At $2.45 a bushel it's really starting to squeeze margins on these facilities,” he said.

Location plays an important role, since most regions consume all ethanol produced in them. As more states build plants and devote more of their corn production to ethanol—even if corn represents a small part of their agricultural economy—the result could hurt Upper Midwest plants far from urban areas. Sending ethanol on rail out of the region can add 10 cents or more a gallon to the cost, a price that will be figured into what the consumer pays at the pump, he said.

Ethanol from Brazil and China could impact Midwest operations, suggests Kapell, and more domestic plants could cause an oversupply that would decrease prices. Can the market absorb all the ethanol that will be produced two years from now and international competition? The RFS would help enormously but “when production begins after all this construction you'll see a definite impact on price,” he said, as plants compete for the same markets.

Of course, ethanol's investors and supporters have a keen understanding of the risk. VeraSun's Honnef recalls addressing potential investors about the risk and telling them the state subsidy could go by the wayside and the plant could still go forward. The real question was one of public policy, he said, of the federal government continuing its much richer subsidy program, passing an RFS and continuing an oxygenate requirement.

“Supply and demand are the drivers,” he concluded. “The public policy things that go on in D.C. are going to help create demand. Supply doesn't get absorbed unless demand has been created.”

For additional reading on ethanol, see the January 2001 fedgazette.

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