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Ethanol Trading


The Essential Guide

Why is Ethanol Valuable?

Ethanol is a clear, colorless alcohol produced mostly from grains or sugar. Since it is made from biomass (*organic material derived from plants and animals), it is considered a renewable energy. Ethanol is often blended with gasoline or diesel fuels to produce a cleaner-burning fuel for automobiles.

The history of ethanol as a fuel source dates back almost 200 years. In 1826, inventor Samuel Morey first used ethanol to power an engine, and in the 1850s, ethanol competed with kerosene as a lighting fuel. However, liquor taxes enacted during the US Civil War made ethanol no longer economically viable as a fuel.

In 1906, the repeal of the liquor tax briefly revived interest in ethanol. In 1908, Henry Ford engineered the Model T, an early automobile, to run on a blend of gasoline and alcohol. However, the passage of Prohibition in 1919 banned the sale of alcohol and effectively ended the ethanol market.

The ending of Prohibition in 1933 produced renewed interest in ethanol. The scarcity of oil during World War II caused a temporary rise in demand.

However, the evolution of ethanol into a significant global commodity really didn’t begin until the 1970s. Rising oil prices, embargoes and increasing dependence on foreign oil revived interest in ethanol in the United States. Since then, tax incentives and environmental regulations have steered oil companies toward creating cleaner burning fuels.

In 2005, the US Congress passed Renewable Fuel Standard (RFS). This law mandated fuel producers to use a minimum amount of renewable fuels including ethanol. In 2007, The Energy Independence and Security Act (EISA) raised the target of renewable fuel usage to 36 billion gallons by 2022. In 2016, fuel producers added about 14 billion gallons of ethanol to gasoline in the United States.

Today global ethanol production tops 25 billion gallons. However, the commodity is the subject of considerable controversy.

While proponents say it produces cleaner fuel and reduces dependence on fossil fuels, critics argue that ethanol produces its own pollution problems and does little more than subsidize the corn industry in the United States and the sugar industry in Brazil.

Why is Ethanol Blended?

Ethanol can be used on its own as a fuel, but it typically is blended with gasoline or diesel fuels. In the United States, gasoline contains about 10% ethanol by volume. There are both economic and scientific reasons for blending.

First, ethanol generally costs more to produce than gasoline. Although grain prices play a role in determining cost, alcohol production is also a significant cost. The distillation of grains is more complicated and costly than the distillation of crude oil.

Secondly, ethanol carries less energy than an equivalent amount of gasoline. As a result, it produces lower fuel efficiency than gasoline.

Finally, current automobile designs make ethanol more corrosive to engines. One reason for this is that ethanol absorbs more water from the air than gasoline, and this may contribute to contamination of fuel systems.

How Is Ethanol Produced?

Ethanol production begins with choosing a feedstock to make the fuel. Typically producers use the sugars in grains such as corn, sorghum and barley in the distillation process. However, other plants can also be used:

  • Sugarcane
  • Sugar beets
  • Potato skins
  • Rice
  • Yard clippings
  • Tree bark
  • Switchgrass

Production of these feedstocks into ethanol takes place mostly through fermentation:

Fermentation

The most common method of ethanol production uses yeast to convert the feedstocks into sugar. This process of chemically breaking down a substance into sugars is known as fermentation.

In the United States, the low price and abundance of corn makes it the most common feedstock used in the fermentation process. Wheat and sorghum are used to a lesser extent.

In other parts of the world, sugar cane and sugar beets serve as common feedstocks for ethanol production. In Brazil, which is the second largest ethanol producer after the United States, most production takes place with sugar cane.

Most modern ethanol plants are “dry grind” plants. In these facilities, machines pulverize corn kernels into fine particles. Water and enzymes are then added to the ground corn to begin breaking down the starch.

Fermentation Tanks
Fermentation Tanks – Image via Wikimedia

The mixture, which is called mash, then gets cooked in ovens and cooled down. At this point, a second enzyme, glucoamylase, gets added to the mash to help convert it into sugars. Finally, yeast is added, and the resulting fermentation creates ethanol and carbon dioxide.

After two days of fermentation, ovens heat the mash again. This heating releases ethanol in the form of a vapor, while the corn and yeast remain in a solid form. The ethanol vapor is collected, cooled and condensed into a liquid. Dehydration removes water from liquid ethanol and produces anhydrous ethanol. This substance can now be blended with gasoline.

Cellulosic Ethanol

A much less common form of ethanol production involves breaking down cellulose in plant fibers. This process, known as cellulosic ethanol, is more complex than fermentation.

In cellulosic ethanol trees, grasses and agricultural residues serve as feedstocks. These crops can grow on land not suitable for grain production and require less fertilizer, energy and water than grains do.

New strains of fast-growing trees can reach maturity in less than 10 years. As a result, cellulosic ethanol holds much promise for the future. However, current commercial production of cellulosic ethanol is very small.

After ethanol plants produce the fuel, trucks and railcars transport it to blending facilities where it is mixed with gasoline to form E-10 or E-85 blends used in consumer engines.

Rail Cars Transporting Ethanol
Railcars Transporting Ethanol – Image via Wikipedia

Unlike petroleum and natural gas, ethanol does not currently use pipelines for transportation. As a result, transportation costs impact the price of the product. Although the physical and chemical properties of biofuels make pipeline transportation more challenging, the industry is looking for ways to overcome these obstacles.

The United States and Brazil combine to produce about 85% of the world’s annual supply of ethanol.

World's Biggest Ethanol Producing Regions

Top 5 Ethanol Producing Countries

RankFlagCountryEthanol Produced (Millions of Gallons)
#1Flag of USAUnited States of America15,329
#2Flag of BrazilBrazil7,295
#3Flag of European UnionEuropean Union1,377
#4Flag of ChinaChina845
#5Flag of CanadaCanada436

Ethanol is almost exclusively blended with gasoline and used as a fuel. There are no other significant commercial uses for the product. In the United States, most ethanol is refined into two types of fuel:

2 Main Ethanol Fuels

UsesDescription
E10 and E15
Automotive Industry
The amount of ethanol blended into gasoline varies by region in the United States, but generally doesn’t exceed 10%. Gasoline with 10% ethanol content is referred to as E10, while gasoline with 15% content is referred to as E15. All vehicles can use E10, while only light-weight vehicles produced after 2001 can use E15.
E85
Fuel Icon
E85 is a blend of gasoline that contains between 51 and 83% ethanol. E85 is referred to as an alternative fuel and is mostly sold in the Midwestern region of the United States.

What Drives the Price of Ethanol?

The price of ethanol is driven mostly by these five factors:

  1. Crude Oil and Gasoline Prices
  2. Production Costs
  3. Ethanol Stocks
  4. Ethanol Mandates
  5. Transportation Logistics

Crude Oil and Gasoline Prices

Crude oil and gasoline prices show a high correlation with the price of ethanol.

The reason for these strong positive relationships is that ethanol is a substitute commodity.

If crude and gasoline prices rise significantly, then consumers are more likely to embrace alternative fuels such as E85. This should drive ethanol prices higher. On the other hand, a significant drop in the price of gasoline could magnify the cost differences between ethanol and gasoline and push ethanol prices lower.

Production Costs

Current production of ethanol in the United States mostly involves corn, and conventional wisdom is that ethanol demand drives the price of corn.

Corn
Corn Supply Disruptions Could Lead to Higher Ethanol Prices – Image via Pixabay

However, corn is also a food source, and it trades independently. In the recent past, there have been ample and cheap supplies of corn, but disruptions in this supply could lead to higher ethanol prices.

Similarly, improvements in the use of trees, grasses and agricultural residues as feedstocks could significantly lower the cost of producing ethanol and drive prices for the commodity lower.

Ethanol Stocks

The US Energy Information Administration (EIA) releases a weekly report that shows changes in ethanol inventories. These inventory levels show a remarkably high correlation with ethanol prices.

When ethanol producers cut back on production, gasoline manufacturers draw down on these stocks. This creates tight supplies and leads to higher prices. On the other hand, increases in production levels can lead to a build-up of inventories and lower prices.

Ethanol Mandates

Ethanol mandates in the United States make ethanol a heavily subsidized commodity. The impetus for these subsidies is the belief that ethanol is more environmentally friendly and makes the United States less dependent on foreign oil.

However, events of the last few years have called this reasoning into question. Fertilizer and pesticide runoffs from the US Corn Belt are contributing to pollution in the Atlantic Ocean and Gulf of Mexico. Ethanol processing plants in the Midwest are also contributors to pollution. At the same time, the United States has developed a vibrant shale oil industry that makes the nation energy independent.

If the US were to revise or scrap ethanol mandates, then it would have a devastating effect on ethanol prices.

Transportation Logistics

Ethanol is prone to evaporation and corrodes easily. These properties make transporting it by pipelines impractical. As a result, ethanol deliveries takes place on trucks, barges and railcars and, therefore, the price is very sensitive to transportation logistics.

Factors such as severe winter weather can delay trucks and cause shortfalls in supply. Similarly, rail traffic congestion can create supply bottlenecks.

3 Reasons You Might Invest in Ethanol

Investors should consider buying ethanol for the following reasons:

    1. Clean Fuel Demand
    2. Emerging Market Demand
  1. Portfolio Diversification

Clean Fuel Demand

Notwithstanding evidence of pollution related to corn farming, ethanol-blended gasoline has a reputation as a more environmentally friendly fuel source. This reputation has led to increases in biofuel mandates in the United States and other countries.

Furthermore, advances in cellulosic ethanol technology could lead to even greener forms of ethanol production.

Ultimately, positive trends in biofuel usage bode well for ethanol in the future.

Emerging Market Demand

One important catalyst that could boost ethanol prices in the years ahead is growing demand from China. Poor air quality in Beijing and other cities has led the Chinese government to focus on greener sources of energy.

Recently, state media reported that China intends to roll out ethanol use in gasoline by 2020. The report cited the desire of the government to clean up smog and support corn farming. It is likely that India and other emerging economies will also intensify green energy initiatives.

China Smog
Ethanol May Be Used to Help Improve Air Quality in Smoggy Cities in China and Other Countries – Image via Pixabay

These trends should bode well for ethanol prices.

Portfolio Diversification

Investing in ethanol along with other commodities is a way to diversify an investment portfolio.

Investors seeking true asset class diversification should consider putting a portion of their investable assets into a basket of commodities including ethanol, other energy commodities, metals and agriculture.

Should I Invest in Ethanol?

Ethanol prices have historically been very volatile, so traders should expect large price swings.

However, investing in ethanol can be part of a sensible plan to mitigate risk and diversify the composition of assets in a portfolio.

Investing in a basket of commodities that includes ethanol, other energy commodities such as natural gas, gasoline and crude oil, agricultural commodities and metals can protect against inflation. It can also protect a trader from the volatility of movements in individual commodities.

There are three specific trends that could boost ethanol prices in the years ahead:

  1. Emerging Market Demand: Concerns about pollution in emerging economies could drive demand for greener forms of energy such as ethanol. Similarly, further advancements in cellulosic ethanol technology have the potential to drive more demand in countries without major agricultural economies.
  2. Environmental Concerns: Fossil fuels such as crude oil are receiving intense scrutiny because of the pollution they create. These concerns make greener energy sources such as ethanol more attractive.
  3. Mandates: Fossil fuels produce harmful and toxic carbon emissions. The United States could increase its ethanol mandate in the future, while emerging market countries begin implementing mandates of their own.

However, traders should also consider the risks of investing in ethanol:

  1. A global recession could weaken energy demand.
  2. Persistently lower crude oil and gasoline prices could diminish demand for biofuels.
  3. Global economic or political turmoil could strengthen the US dollar and weaken demand for commodities.

What Do the Experts Think About Ethanol?

Ethanol Experts

One analyst believes the planned rollout of mandates in China is a major positive catalyst for ethanol. He argues that this news could spur a wave of foreign investment in the ethanol sector in China:

More money will now flow in, including from private and foreign traders.

– Li Qiang, chairman of consultancy JC Intelligence Ltd

A leading supplier in the United States believes relaxed fuel standards by the US government should help support the domestic ethanol market:

The E-15 waiver got people excited for (higher) blends. Blenders will be able to use more ethanol per gallon of gasoline, boosting demand temporarily despite the gas shortage.

– Jordan Fife, BioUrja Trading LLC

How Can I Invest in Ethanol?

Ethanol Trading Methods Compared

Method of InvestingComplexity Rating (1 = easy, 5 = hard)Storage Costs?Security Costs?Expiration Dates?Management Costs?Leverage?Regulated Exchange?
Ethanol Futures5NNYNYY
Ethanol Options5NNYNYY
Ethanol ETFs2NNNYNY
Ethanol Shares2NNNNYY
Ethanol CFDs3NNNNYY

Investors have several ways to invest in ethanol:

Ethanol Futures

The Chicago Board of Trade (CBOT), a division of the Chicago Mercantile Exchange (CME), offers a contract on ethanol futures. The contract settles into 29,000 gallons of ethanol, which is approximately one railcar.

The contract trades globally on the CME Globex electronic trading platform and has a variety of expiration months.

Futures are a derivative instrument through which traders make leveraged bets on commodity prices. If prices decline, traders must deposit additional margin in order to maintain their positions. At expiration, the contracts are physically settled by delivery of ethanol.

Investing in futures requires a high level of sophistication since factors such as storage costs and interest rates affect pricing.

Ethanol Options on Futures

The CBOT also offers an options contract on ethanol futures.

Options are also a derivative instrument that employs leverage to invest in commodities. As with futures, options have an expiration date. However, options also have a strike price, which is the price above which the option finishes in the money.

Options buyers pay a price known as a premium to purchase contracts. An options bet succeeds only if the price of ethanol futures rises above the strike price by an amount greater than the premium paid for the contract. Therefore, options traders must be right about the size and timing of the move in ethanol futures to profit from their trades.

Ethanol ETFs

These financial instruments trade as shares on exchanges in the same way that stocks do.

There are no ETFs that are pure-play investments in ethanol. However, the ELEMENTS MLCX Biofuels ETN (NYSEARCA: FUE) is an exchange-traded note linked to an index that consists of futures contracts on physical commodities that are biofuels themselves or feedstocks used to create biofuels.

However, the index is heavily weighted in soybeans, corn, soybean oil and sugar. Therefore, it is not a direct proxy for an investment in ethanol.

Shares of Ethanol Companies

There are many publicly traded companies that have various levels of exposure to ethanol prices. While investing in companies can be a leveraged way to gain exposure to ethanol prices, many of these companies have some exposure to fossil fuels and other biofuels. In addition, these shares can react to factors such as regional demand for their products, competition, production costs and interest rates. Finally, factors such as company management and the overall stock market can also affect these investments:

CompanyCurrent PriceOverviewListingsFoundedNumber of EmployeesInteresting Fact
Pacific Ethanol

Pacific Ethanol Logo
US producer and seller of low-carbon renewable fuels.New York (NASDAQ)2003500Also produces and markets co-products like CO2 and yeast.
Green Plains
Green Plains Logo
US company that produces, markets and distributes ethanol in the United States and internationally.New York (NASDAQ)20041,300Ships approximately one billion gallons of ethanol each year.
Cosan Limited
Brazilian-based company that operates in the natural gas, sugar, lubricants, ethanol and fuel businesses both locally and internationally.New York (NYSE)193645,000Covering 23 plants, the sites of Cosan spread over 600,000 hectares of land.
Aemetis
US company that operates an international renewable fuels and bio-chemicals company in North America and India.New York (NASDAQ)1987130Aemetis means "The One Prudent Wisdom."
Marathon Petroleum
Marathon Petroleum Logo
US oil refining company that refines a variety of feedstocks and purchases ethanol and refined products for resale.New York (NYSE)200545,440Includes the Speedway LLC retail chain, which is the United State's 2nd largest company-owned and -operated convenience and gasoline store.

CFDs

One way to invest in ethanol is through the use of a contract for difference (CFD) derivative instrument. CFDs allow traders to speculate on the price of ethanol and ethanol shares. The value of a CFD is the difference between the price of ethanol (or shares) at the time of purchase and its current price.

plus500 screenshot of website
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Many regulated brokers worldwide offer CFDs on ethanol and ethanol shares. Customers deposit funds with the broker, which serve as margin. The advantage of CFDs is that traders can have exposure to ethanol prices without having to purchase shares, ETFs, futures or options.

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Important: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail trader accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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