Ethanol

Stirrings in the corn fields

When Fidel Castro roused himself from his sickbed last year to write an article criticizing George Bush's unhealthy enthusiasm for ethanol, for once he had a point. Along with other critics of America's ethanol drive, Mr. Castro warned against the “sinister idea of converting food into fuel”.

America's use of corn to make ethanol biofuel, which can then be blended with gasoline to reduce the country's dependence on foreign oil, had driven up the price of corn. As more land was used to grow corn rather than other food crops, such as soy, their prices also rose. And since corn is used as animal feed, the price of meat went up, too. The food supply, in other words, was being diverted to feed America's hungry cars.

But corn-based ethanol, the sort produced in America, is neither cheap nor green. It requires almost as much energy to produce (more, say some studies) as it releases when it is burned. And the subsidies on it cost taxpayers, according to the International Institute for Sustainable Development, somewhere between $5.5 billion and $7.3 billion a year.

Ethanol made from sugar cane, by contrast, is good. It produces far more energy than is needed to grow it, and Brazil – the main producer of sugar ethanol – has plenty of land available on which to grow sugar without necessarily reducing food production or encroaching on rainforests. Other developing countries with tropical climates, such as India, the Philippines and even Cuba, could prosper by producing sugar ethanol and selling it to Americans to fuel their cars.

Even so, ethanol investors binged on the corn-based fuel in 2005 and 2006. But with the bankruptcy of VeraSun Energy, the biggest listed U.S. ethanol producer, they might want to reconsider. It is the latest grim news for a sector where listed companies have lost 80% to 90% of their market value over the past two years and, ironically, for an industry savaged by rising corn costs, VeraSun shows that falling corn prices are one of the biggest short-term threats.

Like some rivals, VeraSun took out hedges to protect against rising prices after corn hit a record price of $8 a bushel in June. Yet those hedges backfired as bushel prices went on to halve, leaving the company strapped for cash. For others also, the recent pullback in corn prices has offered little respite. As recession fears have grown, ethanol prices have plunged in tandem with corn prices, so depriving producers of any hoped-for boost to margins.

Eventually, demand will improve. The amount of ethanol to be blended into gasoline in the U.S. is set to quadruple by 2022 because of government mandates. With annual sales running at about $20 billion, the supply glut that has pushed down ethanol prices should ease by 2010 or 2011 as demand catches up. But in the long run, low barriers to entry – all it takes to become a producer is a field of corn and a simple still – means gains will be fleeting. New producers will compete away margins, leaving the biggest buyers of ethanol – the refiners who blend it into gasoline – able to dictate prices. The likely result is prices that are sufficient to keep ethanol plants ticking over, but barely profitable. All the more reason for investors to stay away.