Ethanol Investing: The Tipping Point
By S.R. Nunnally
In this article
April futures for gasoline touched a high of 2.1488 a gallon today, while ethanol April futures peaked at 2.195… less than a 5-cent difference.
Ethanol has started following the price of corn a bit more closely than the price of gasoline.
We've played ADM before, but now's the perfect time to get back into this stock.
Ethanol Investing: The Tipping Point
This latest surge in oil prices has pushed wholesale gasoline prices quite nearly to par with unsubsidized ethanol prices. April futures for gasoline touched a high of 2.1488 a gallon today, while ethanol April futures peaked at 2.195… less than a $0.05 difference.
The current ethanol subsidy is $0.51 per gallon, and that puts ethanol's price down at 1.685.
Truth be told, we haven't seen wholesale gasoline prices that low since mid-February. Since February 16, wholesale gasoline prices have climbed 25.8%!
But don't think ethanol's been trading flat… It's climbed 6.8% since February 16, once topping out at 15.8%.
This, of course, means that ethanol has dipped these past few weeks. In fact, ethanol has started following the price of corn a bit more closely than the price of gasoline. Here's a chart showing all three:
As driving season comes into full swing, you can expect gasoline prices to climb even higher… but what will ethanol prices do?
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Ethanol Investing: The Crush Spread
Historically, corn prices peak at midyear. Ethanol normally does the same thing (sometimes slightly later than corn prices), though we don't have as complete a history.
According to the Chicago Board of Trade, the crush spread, or the estimated gross margin for the price of ethanol and the price of corn, also peaks in summer.
For the past two years, that's been because the price of ethanol has been significantly higher than the price of corn.
This year could be different.
Since early fall, corn prices have outpaced ethanol prices, and only now have ethanol prices started to catch up. Ethanol has a much stronger correlation with gasoline prices than with corn prices, and that should help the alternative fuel battle rising corn prices…
But there will be a tipping point.
Ethanol Investing: Do the Math
Ethanol producers can typically get 2.8 gallons of ethanol (not to mention 17 pounds of distillers grain) from one bushel of corn. So let's do the math using futures prices.
Currently, ethanol is going for $2.195 a gallon (without the subsidy). The U.S. Department of Agriculture assessed productions costs (not including capital for new production or expanded production) to be $1.213 per gallon back in 2002, when feed stock costs were $0.68 a gallon.
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Now feed stock costs are $1.27 a gallon (cost of corn/bushel divided by 2.8), which pushes production costs up to $1.813 a gallon. Based on current prices, profits are $0.382 per gallon… not including the $0.51 subsidy, of course.
What that means is corn prices can rise to $4.645 a bushel before ethanol profits are completely wiped away.
If we apply the $0.51 subsidy to the production cost, we get $1.303 in costs, putting profits at $0.892 per gallon. That means corn prices could climb to $6.074 per bushel before subsidized profits are eliminated.
Ethanol Investing: A 27.76% Gains in Two Months
Corn prices are trading around $3.576 a bushel. These two scenarios mean corn prices could trade up by 29.9% or 69.9% respectively before ethanol is not cost effective.
That's good news for both ethanol producers and corn growers, as both commodities have room to grow.
Ethanol producers, like our favorite Archer Daniels Midland (ADM:NYSE), are looking forward to a nice summer driving season, with a nice upswing in ethanol demand. ADM produces more than 1.2 billion gallons of ethanol a year. This stock has already started to rise, and it could test its previous high of $46.71 by Labor Day.
That's an increase of 27.76% in two months.
I know we've played ADM before, but now is the perfect time to get back into this stock.
Tomorrow, buy Archer Daniels Midland (ADM:NYSE) at or below $37. Use a 25% trailing stop with this recommendation.
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S.R. Nunnally is a commodities expert and technical analyst for Taipan Financial News. She is the editor of Material Profits, a monthly newsletter providing in-depth, cutting-edge research in the commodities sector. She is also the founder of Material Profits Wildcatter, employing an elite group of aggressive investment strategies.
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Related Resources
USDA: Cost of Production Survey. - NCGA
RFA: The Renewable Fuels Association
CBOT Futures: Key Charts for Ethanol. - CBOT