Oil Prices Will Sting, but Won't Kill This Government-Backed Commodity

By Markets Fool.com

Falling oil prices have sent a shock wave through the energy sector. For consumers, however, there's been more joy than pain. Gasoline prices have fallen from around an average of $3.70 a gallon in June to $2.17 a gallon today. And while falling gas and oil prices have been bad news for ethanol, this government-backed fuel additive is still the go-to octane enhancer.

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Corn in your car
Ethanol is, essentially, an alcohol distilled from corn. One of the largest ethanol producers in the world is Archer Daniels Midland Company . In 2014, bioproducts, which is where the company categorized its ethanol business, made up nearly 20% of the company's adjusted segment operating profits. To be fair, ADM uses corn to make all sorts of bioproducts, but ethanol is a very large component of that business. Results in this segment improved over 60% year over year, largely driven by "favorable ethanol results" according to the company's fourth-quarter earnings release.

Source: Graham Horn, via Wikimedia Commons.

You, however, probably know the word "ethanol" from filling up your car. That's because it's one of the most used octane enhancers; benzene, toluene, and xylene are three others. While you are used to seeing the sign about your gas being "up to 10% ethanol," it's far more complex than that because the government doesn't actually mandate ethanol specifically be used to meet its biofuel mandates or for increasing the octane rating of gasoline. Uncle Sam only requires that renewable identification numbers (RINs) be purchased (although the biofuel behind the RIN must be created, the RIN can be purchased separately by companies to meet compliance standards). But, in the end, ethanol gets a boost from the entire RIN business.

That said, ethanol is a contentious gas additive, with some saying the RIN mandate is little more than a government handout to the corn industry, and others saying it makes car emissions cleaner. Regardless of your take on that debate, ethanol goes in gas, and that doesn't look like it will change anytime soon. In fact, more ethanol was made last year than the government mandated.

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But how much ethanol gets used is really a relative thing, because it is the relative price of ethanol to competing products that leads to its choice as an additive. For example,University of Illinois Extension ag economists Scott Irwin and Darrel Good recently explained to Agriculture.com, "Refinery economics are extremely important in evaluating the competitiveness of ethanol in gasoline blends... Ethanol prices have indeed increased relative to the price of 'aromatic' octane enhancers, but are currently well below the price of those alternatives." Their take: Current price relationships, "paint a much less threatening picture for ethanol blending."

That doesn't mean that ethanol isn't dealing with notable headwinds. For example, ethanol producers ramped up production toward the end of last year and that's left the industry with a glut. In fact, ADM CEOJuan Luciano is expecting, "some rationalization of capacity." And industry analyst Farha Aslam, with Stephens Inc, suggests that as much as 30% of the industry is at break even or worse. Indeed, ethanol prices have fallen and that's not a good thing in the near term.

However, as Irwin and Good point out, ethanol is still a relatively better option than competing products. One of the big concerns in recent years is that the United States is producing so much ethanol that it will pass the so-called 10% blend wall, or the point where so much ethanol is produced that it would push the blend beyond 10%. That's a legitimate concern for the industry, particularly since it produced more than mandated in 2014. To combat this risk, the industry is pushing the idea of increasing the blend to 15% or higher, as is used in some other countries. There are notable headwinds to that, however, since it would require major changes to the way gas is used and handled. In fact, there's rumbling that the government could even pull back on the mandate all together.

Some positives
So,in the near term, ethanol producers like ADM are likely to feel some pain from falling margins. And supply and demand have to come back into balance. But, as long as ethanol is the cheapest option to boost octane, it's a good bet it will remain a key factor in the gas mix. That will likely remain true even without government biofuel mandates, since the infrastructure to handle ethanol is already in place.

Moreover, demand has been increasing in the export market. For example,Archer Daniels Midland exported just under 200 million gallons of ethanol in 2013, but it sent over 800 million gallons overseas last year. It expects that number to be roughly the same this year. If foreign demand remains strong, ethanol producers will have a backstop of sorts for their businesses.

Source: Mariordo Mario Roberto Duran Ortiz, via Wikimedia Commons.

All in, ethanol producers could see near-term pricing pressures from falling ethanol prices. And that may push some weaker industry players to the brink. But larger players like ADM and its ethanol bussiness should easily survive the downturn and come out stronger on the other side.

The article Oil Prices Will Sting, but Won't Kill This Government-Backed Commodity originally appeared on Fool.com.

Reuben Brewer has no position in any stocks mentioned but writing about ethanol reminds him that he likes an occasional corn on the cob, with butter and salt -- time for a trip to the grocery store! The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.