One of the engines of the Midwest's agricultural economy has started to sputter.

Production of ethanol, the corn-based fuel additive, is slowing as manufacturers struggle with record low profit margins.

Last month, Valero Energy Corp., one of the largest U.S. ethanol producers, temporarily closed two of its 10 plants. Several other ethanol mills have been idled or curtailed production.

The pain comes on the heels of excitement in the fall when ethanol demand jumped as oil companies and distributors anticipated the expiration of a federal tax credit. The market gyrations pose new challenges to a young industry that has enjoyed, with few interruptions, extraordinary growth, thanks to a federal mandate requiring use of ethanol or other renewable fuels in gasoline.

The industry's expansion has boosted farming communities in Illinois and surrounding states where most of the nation's corn is grown and ethanol is made. About 40 percent of the U.S. corn crop last year went to ethanol production.

The Renewable Fuels Association said the cutbacks are merely a reflection of a market that quickly responds to changes in corn and oil prices. But the ethanol industry has excess capacity at a time when questions about future demand are made more complicated by federal regulations that seek to increase ethanol consumption.

"There's a lot of uncertainty in the market," said Sean Hill, an industry economist with the U.S. Energy Information Administration. "The industry is dealing with a lot of moving parts."

At the moment the industry is caught in a classic squeeze. Cash corn prices are trading at abnormally high levels because of dwindling supplies. Farmers are being cautious in making sales of corn because the record-high heat and drought that's scorched the Midwest could hurt their yields in the fall.

At the same time, ethanol prices have faded since the beginning of the year because of falling gas prices. Ethanol follows gas prices pretty closely. Ethanol demand also has dropped because of decreasing exports.

The squeeze became so severe at Valero's plants in Albion, Neb., and Linden, Ind., that it was costing the company more to make ethanol at those mills than it could sell the fuel for, said spokesman Bill Day. The move comes amid drought conditions in both states.

Valero, based in San Antonio, expects to have both plants back in operation by August or September when corn harvests start, Day said.

Decatur, Ill.-basedArcher-Daniels-Midland Co.said weak ethanol margins were in part to blame for a 31 percent drop in its fiscal third-quarter earnings. During the quarter ended March 31, the company announced that it was permanently closing an ethanol plant in Walhalla, N.D.

Other closures include a plant in Atkinson, Neb., owned by Nedak Ethanol LLC.

The shutdowns have brought some anxiety to the farm belt. Many people recall four years ago when a number of ethanol plants were driven into bankruptcy by a confluence of factors similar to those now hitting the market.

But the industry does not fear a repeat of 2008.

"This is a much different situation," said Bob Dinneen, president of the Renewable Fuels Association. "What happened in 2008 was largely a function of the global recession and the banking crisis that occurred."

This time around the decline in production has provided some support to prices and helped draw down ethanol inventories, to about 852 million gallons, from nearly 1 billion gallons at the end of March.

But the cutbacks also mean that for the first time in 15 years, annual U.S. ethanol production likely will not grow. The U.S. Energy Information Administration forecast in June that production this year would be about 13.95 billion gallons, about the same as in 2011.

Between 2005 and 2011, annual production more than tripled.

The ethanol industry expanded in response to the 2005 Energy Policy Act. which ensured that gasoline sold in the U.S. contained a minimum amount of ethanol and other renewable fuels. To decrease the nation's dependence on foreign oil, the standards were increased in 2007 to require 36 billion gallons of renewable fuels be blended into gas and other transportation fuels by 2022.

The industry more than doubled capacity between 2007 and 2008. Capacity now stands at about 14.7 billion gallons, according to the Renewable Fuels Association.

In addition to the mandate, the government has long provided economic incentives to encourage ethanol use. As a result, the percentage of ethanol blended into gasoline has climbed to near 10 percent, the maximum that gas stations can dispense.

The 45-cent-a-gallon tax credit that gasoline blenders receive, intended to spur production, expired last year. Still, the industry has withstood the loss of the subsidy because the mandated level for ethanol use keeps going up every year. This year, fuel companies are required to blend 13.2 billion gallons of ethanol.

Next year, the requirement is expected to increase to 13.8 billion gallons, and there are questions whether consumption will be that high.

Gasoline consumption has fallen about 6 percent since its 2007 peak because of the weak economy. Demand is expected to remain roughly flat next year.

The ethanol industry is counting on a new product to boost demand, although there are a numerous obstacles to clear before it appears at the pump. TheU.S. Environmental Protection Agencyin June has allowed gasoline to be sold containing 15 percent ethanol, a product called E15.

The higher ethanol blend was approved for use only in cars and trucks that are no older than the 2001 model year. The restriction has gasoline marketers nervous if E15 ends up in older cars whose engines can't accommodate the blend. Some automakers also have warned that E15 may not be safe for their newer vehicles.

Dinneen said consumers needn't worry, adding that the EPA has been studying the new blend for more than three years.

Still, Valero, for one, does not plan to sell E15 at any of the 1,000 stations it owns, Day said. "It's not feasible to have one set of sales for one type of vehicle and another set of sales for other vehicles," Day said.

Despite the reluctance, ADM and other ethanol producers expect meaningful E15 sales next year. Analysts are not so sure.

"E15 is not going to have any appreciable impact on ethanol consumption in the next 12 months," said Bill Tierney, chief economist at AgResource Co. in Chicago. "I'll stick my neck out and say the next 18 months."

If that's the case, the ethanol industry had better hope for cheaper corn or economic improvement that leads to higher oil prices. Otherwise, analysts say, they wouldn't be surprised to see more plant closures.

source: The Chicago Tribune

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