Chicago, 10 March 2011

The recent slump in corn prices has helped U.S. ethanol producer margins rebound from their recent plunge into negative territory, and has prompted ethanol manufacturers to snap their recent five-week streak of declining production. However, sluggish off-take levels have led to a rise ethanol inventories to their highest level in eight months, and reveal a lingering threat to ethanol market fundamentals that may limit a further recovery in producer margins over the near term.

THAT WASN'T SO BAD?

As corn values stretched to their highest levels in more than two years during the opening weeks of 2011, spot ethanol producer margins were shunted aggressively lower, and spent roughly the whole month of February in negative territory before recovering lately as corn prices pulled back to help lower ethanol input costs.

Judging by the latest production data released by the U.S. Energy Information Administration, ethanol producers seem to view the recent spell of corn price weakness - and the recovery in production margins - as a sign that they have weathered the storm and can now get ready for the upturn in demand that is expected as the U.S. 'driving season' of spring and summer nears.

The EIA's Weekly Ethanol Plant Production data revealed that U.S. producers increased ethanol output by 1,000 barrels a day to 883,000 barrels a day in the week ending March 4. While the increase in output is clearly a modest one - marking only a 7,000 barrel increase in total production over the prior week - it indicates that producers may be anticipating additional corn price weakness as the U.S corn planting season approaches, or at least for corn prices to struggle sustaining their recent upward trajectory in the face of potential record U.S. crop production.

At the very least, the output rise reveals that ethanol producers remain prepared to crank up throughput levels whenever production margins pop back into positive territory. This mindset may not appear especially surprising, particularly in light of the expected rise in demand as a higher level of ethanol gets blended into the U.S. fuel stream in the wake of the recent ruling by the Environmental Protection Agency to approve 'E15' for a majority of U.S. vehicles.

(E15 is a fuel that contains 15 percent ethanol, and would mark a 50 percent increase in ethanol content from the current blend level. It is not known when it will become widely available in the U.S, as logistical and labeling issues still need to be ironed out following the EPA's late-January ruling.)

Proceeds from the sale of Distillers Dried Grains, a by-product of corn-based ethanol production that can be sold to livestock feeders as a substitute for corn, have also proven to be appealing enough lately to encourage continued ethanol production despite the recent sprays of red ink.

But until the new fuel blend is actually being distributed to gas stations across the country, the current fuel system continues to cap ethanol content at 10 percent - presenting an enduring bottleneck that ethanol producers and fuel blenders must continue to contend with.

BURDENSOME STOCKS KEEP GROWING

The problem with ramping up output ahead of any actual jump in demand is that inventories of ethanol - which are already high by historical standards - continue to climb. The latest EIA stocks data reveals that U.S. ethanol inventories increased by close to 750,000 barrels in the week to March 4, to their highest level nationally since July 2010.

This trend in stocks levels is not all that surprising given the prevailing low demand environment amid high overall gasoline prices, and the seasonal tendency for U.S. travel miles to remain subdued through the U.S. winter. However, the fact that the rise in ethanol stocks was more than 100 times larger than the rise in weekly output highlights how weak current off-take levels remain, and suggest that producers may be serving to worsen their own market's fundamental appeal every time they ramp up output while demand remains slow.

Indeed, the steeply rising ethanol inventories may serve to undermine the fundamental profile of the entire gasoline market, given that the combined level of gasoline and ethanol stocks just recently climbed to its highest level in more than twenty years.

Should gas and ethanol prices head lower in response to these stocks levels, or due to enduring slow demand, ethanol producer margins will likely come under pressure once again irrespective of the continuing trend in corn values. So while the recent return to profitability may be a welcome reprieve to ethanol producers following a harrowing loss-making period, it should not be interpreted as a green light to ramp up output levels aggressively.

Rising stockpiles and a soft demand environment - not to mention continuing disputes by policymakers over the merits of ethanol subsidies during a time of high energy prices and record budget deficits - continue to shroud this market's outlook in deep uncertainty.

Ends --

By Gavin Maguire, Reuters market analyst - for Commodities Now.

The views expressed are his own.