Jun 22, 2020
Ethanol producers' share prices have largely recovered to the levels at which they traded shortly before coronavirus-related lockdown orders went into effect in the U.S.
Ethanol production margins have made a full recovery and are approaching 3-year highs.
Ethanol demand has rebounded, but the recovery has been incomplete as gasoline demand has remained below its normal weekly volumes.
Investors should not expect ethanol producers' share prices to return to the levels seen when production margins were last this high until gasoline demand has fully recovered.
The share prices of U.S. ethanol producers Aemetis (AMTX), The Andersons(ANDE), Green Plains, Inc. (GPRE), Pacific Ethanol (PEIX), and REX American Resources (REX) have largely recovered from the coronavirus-induced swoons that they underwent in March and April. One producer, Pacific Ethanol, has even recorded a sizable gain over the period, although its share price had been battered by the company's poor financial position well before the pandemic severely disrupted U.S. ethanol demand.
The sector's recovery has been driven by a strong rebound in ethanol production margins that has occurred since late April. This rebound has in turn been the result of a 34% gain by the price of ethanol from April's lows compared to 7% increases by the prices of corn and natural gas, two important inputs, over the same period. Production margins as measured by Iowa State University's Center for Agricultural and Rural Development set a multi-year low in April but have since moved back into positive territory, most recently pushing above the capital cost threshold (not that the construction of new capacity is likely).
Two factors have had an outsized impact on the ethanol sector's improvement. The first has been the partial recovery of U.S. gasoline demand. While the fuel's consumption remains approximately 20% lower than is normally seen in June, it has increased by 50% from April's lows. Ethanol demand is closely tied to gasoline demand since almost all of the former is blended with the latter prior to retail, and the collapse of gasoline demand that occurred earlier this year was the primary cause of the ethanol sector's poor production margins. Improved gasoline demand has therefore translated to higher ethanol demand.
That said, ethanol demand has recently rebounded by more than would be expected just based on the recent gasoline demand trend. Weekly ethanol blending volumes by the refining and wholesale/retail segments are only 15% lower than the normal volume for this time of year, having increased by almost 60% from April's lows. As I wrote earlier this month, Renewable Identification Number [RIN] prices have surged since early April, increasing the incentive to blend ethanol under the revised Renewable Fuel Standard [RFS2] biofuels blending mandate. It is possible that the superior recovery of ethanol demand is attributable to this development.
More directly, ethanol production margins have benefited from the continued strength of ethanol's price premium relative to the price of gasoline. While this has declined from the extreme ratio that was reached in March and April as rapid demand disruption occurred, it remains well above the long-term average. A strong ethanol price premium often reflects a dynamic in which ethanol demand is stronger than gasoline demand, as appears to be the situation now.
Ethanol prices have also benefited from a less-advantageous development, though: the large decline in ethanol reserves that has occurred since early April. Normally such a decline would be a good sign since it would mean that demand was outpacing the ethanol sector's ability to supply ethanol. In the present case, though, the decline to stocks has been the direct result of the mass shuttering of U.S. ethanol production capacity that occurred in March and April. While much of the capacity that had been idled has returned to production, the country's current production volumes remain 20% or more below the historical summer levels.
The primary factor for investors in the ethanol sector to watch this summer, then, is gasoline demand. A full recovery as the summer driving season commences would allow ethanol production margins to remain strong even as production returns to normal levels. On the other hand, an incomplete recovery would threaten to cause a repeat of Q4 2019, when rising margins became self-defeating by inducing oversupply by producers. (The exception is if E15 demand experiences exponential growth, but there is little evidence that this is happening yet.)
Two secondary factors for investors to keep an eye on are the U.S. Environmental Protection Agency's [EPA] upcoming RFS2 rulemaking and the ongoing COVID-19 pandemic. Following multiple legal defeats in the federal courts, the EPA is supposed to require the full biofuel blending required by statute in 2021. Merchant refiners have embarked on a last-ditch effort to have this volume effectively reduced, however, injecting a fresh source of uncertainty into the outlook.
Likewise, resurging coronavirus rates in many southern U.S. states following the re-openings of their economies have both dashed earlier hopes that the virus would struggle in warm weather and worsened the outlook for the pandemic in H2 2020. While some energy analysts have argued that the reopening would ultimately see higher-than-normal summer gasoline (and, by extension, ethanol) demand this year as travelers opted for cars over airliners, this is unlikely to happen if infection fears cause travelers instead to opt for "staycations" over driving vacations. The prevailing gasoline demand weakness certainly raises the prospect that the latter scenario will occur.
Any investor asking when ethanol producers' share prices are likely to return to their January 2020 highs, as opposed to their pre-coronavirus levels, must consider the supply scenario. Production margins have recovered to their earlier highs, it is true, but production volumes remain lower than they were at that time (let alone than their historical summer levels). Producers' earnings and, by extension, share prices are unlikely to set new highs in 2020 until the demand situation has improved to the point at which margins can remain strong following a full rebound of supply. Much will depend on how drivers respond this summer to the ongoing COVID-19 pandemic.
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