Corn Dogs

The continuing crisis over high food prices has inspired a round of global finger-pointing. Politicians blame speculators, and speculators blame the Federal Reserve. Free-traders blame countries with agricultural subsidies, and countries with agricultural subsidies blame free-traders. And everyone blames the ethanol industry: The current mania to turn food crops, especially corn, into gasoline is pushing up the global price for maize, crowding out the production of other crops and generally creating an unfair competition between gas tanks in Missouri and poor consumers in Mumbai.

But judging by recent financial results, the big villains in this story—the American companies that are responding to government mandates by buying about 20 percent of the U.S. corn harvest and processing it into fuel—aren't exactly thriving. In fact, their bottom lines and stock prices are suffering pretty badly.

VeraSun is one of the largest U.S. producers of ethanol. Last month it completed its merger with U.S. BioEnergy, giving it an annual capacity of nearly 1 billion gallons. (For 2007, total U.S. production was about 6.5 billion gallons.) In the 2007 fourth quarter, VeraSun ran all out, making 142.1 million gallons, double its output in the 2006 fourth quarter. But prices fell (down 14 percent), and gross profit (broadly speaking, the difference between sales and what it costs to make it) slumped by one-quarter. For all of 2007, VeraSun's gross profit fell to 11.3 percent of revenues from 34.5 percent of revenues in 2006. The stock has lost nearly 60 percent of its value in the past six months.

The chart tells a similar tale at Pacific Ethanol, whose stock has fallen from about $15 to about $3. Pacific Ethanol's gross margin dropped from 11 percent in 2006 to 7.1 percent in 2007 partly because of higher corn costs. Aventine Renewable's one-year chart shows a precipitous fall in stock price from $20 to $4. And a Wall Street analyst recently noted that it faced a potential cash shortfall. When it reported quarterly earnings last week, Aventine said that its average sales price per gallon rose from the first quarter of 2007 enough but not enough to outweigh the rise in corn. And thanks to the high price of energy (it takes energy to produce energy), the cost of converting corn into ethanol rose more than 10 percent per gallon during the same time period. So, between the first quarter of 2007 and the first quarter of 2008, Aventine's operating margins shrunk from about 6.5 percent of sales to 4.7 percent of sales. And MGP Ingredients said profit margins in its distillery products unit fell to 2 percent in the fourth quarter of 2007, down from 22 percent in the final quarter of 2006.

What gives? In theory, business should be gangbusters in the ethanol patch. Government policy has mandated consumption of the fuel, thus stimulating investment. The Energy Policy Act of 2005 called for 5.4 billion gallons of renewable fuels to be sold in 2008 and 7.5 billion gallons by 2012. Last year, the Energy Independence and Security Act of 2007 dramatically jacked up the short-term targets (9 billion gallons by 2008) and the long-term targets (36 billion gallons by 2022), with corn-based ethanol expected to meet most of this demand.

But just because the government forces people to buy your product doesn't mean it's a surefire win. The combination of high oil prices, tariffs that protect domestically produced ethanol from imports, and tax credits for companies that blend ethanol into gasoline has stimulated something of an ethanol bubble. And as always happens during a bubble, excess capacity—and the vicious competition it creates—winds up eroding margins. The Renewable Fuels Association has excellent data on ethanol production that show a massive spike in capacity. The U.S. industry has grown from 3.4 billion gallons of capacity in 2004 to 6.5 billion in 2007. Today, some 134 plants with a capacity of 7.23 billion gallons are in operation, and another 77 with 6.2 billion gallons of capacity are under construction. Capacity has more than doubled since 2004, and, once all the plants in the works are completed, it will nearly double again. But with demand for gasoline declining nationwide, and with ethanol an imperfect substitute for gasoline (not all vehicles can use it; the distribution network isn't fully built out), producers aren't always able to dictate prices to the marketplace.