Market Mosaic. U.S. Biofuels Revisited

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1 Market Mosaic Vol. 5 No.2 Summer 20 U.S. Biofuels Revisited Market Mosaic is a quarterly newsletter published for our customers, suppliers and stakeholders by the Market Analysis group of The Mosaic Company. The spring and fall issues recap our assessment of the near term outlook for agricultural and crop nutrient markets. The summer and winter issues provide an in-depth look at topics of special interest to our readers. Michael R. Rahm Vice President mike.rahm@mosaicco.com Joseph Fung Market Analyst joseph.fung@mosaicco.com Mathew Philippi Market Analysis Assistant matt.philippi@mosaicco.com We examined U.S. biofuels in a special 12-page edition of Market Mosaic in December 20. This issue described the ethanol and biodiesel production processes, recapped U.S. biofuels policies, analyzed the potential impacts of biofuels on energy and grain markets, and made six assessments about U.S. grain-based biofuels assessments that still look valid today. Biofuels were the darling of crop production agriculture back then. The introduction to this issue noted that biofuels not only were powering more vehicles but also were fueling the most optimistic outlook for agriculture since the 1970s. Capital was gushing into this sector and contractors could not build plants fast enough to keep up with demand or to suit investors who included not only traditional farm cooperative members but also diverse outside financial interests. Biofuels were lauded as the environmentally friendly motor fuel and the greatest rural development program never planned. Political support looked rock solid with large usage mandates, blending tax credits and import tariffs firmly in place. A lot has happened during the last two and one-half years. The exponential increase in biofuels production coupled with a run-up in grain prices dissipated profits -- despite mandates and tax credits. Margins sank from a peak that produced project paybacks measured in months to a level so razor-thin that mistakes in forward pricing corn could prove fatal. Public support also waned as grain and food prices began to increase in 20. Some politicians blamed biofuels for the 20 price spike and a few went so far as to call turning grain into fuel a crime against humanity. Food companies and livestock producers fingered biofuels as the root cause of their economic woes. Academics and environmental groups began to question how green grain-based biofuels really are. This extraordinary turn of events warrants another look at grain-based biofuels. Biofuels have both passionate proponents and passionate opponents. This issue of Market Mosaic reviews developments since 20, takes a dispassionate look at the prospects for grain-based biofuels during the next decade and highlights key policy issues that are stirring a passionate biofuels debate. We draw several conclusions from this updated analysis. First, the United States has developed a large grain-based biofuels industry during the past few years. The exponential increase in corn-based ethanol output has displaced a substantial amount of gasoline and impacted grain and oilseed markets. Second, despite current economic and political challenges, our assessment is that prospects for the U.S. grain-based biofuels industry look positive during the next decade. That conclusion is based on the assumption of no radical changes in current U.S. biofuels policies, a bullish energy price outlook and the expectation of large yield increases during the next 10 years. Finally, despite recent attacks on several fronts, we expect that political support for U.S. grainbased biofuels will remain intact. The debate over the role of government in agricultural and energy markets no doubt will rage on. The best hope for less government involvement in grain-based biofuels comes not from expectations of sweeping libertarian reforms but rather from the potential for positive market developments during the next decade. -- continued inside

2 Developments Since 20 A good measure to track the performance of the U.S. biofuels industry is the ethanol grind margin. This is the difference between revenue from the sale of ethanol as well as feed co-products and the cost of corn. Our calculation assumes that one bushel of corn produces 2.8 gallons of ethanol and that dried distillers grain with solubles (DDGS) is sold at a 15% discount to the price of corn. The grind margin is calculated using the daily closing prices of the nearby futures contracts for ethanol and corn and is akin to the soybean crush margin or the petroleum crack margin. The chart shows that the grind margin peaked at an extraordinarily high level in June 20 and has trended downward since then. In fact, the grind margin peaked at $3.70 per gallon of ethanol produced or $10.37 per bushel of corn processed. The average margin for the entire 20 calendar year was $1.86 per gallon or $5.21 per bushel. For a typical plant that produced 50 million gallons of ethanol from 18 million bushels of corn, the grind margin totaled about $93 million in 20. Other operating costs likely were in the $0.40 to $0.45 per gallon range or $20 to $23 million per year. The capital cost of such a plant was approximately $75 million back then so first movers in this industry earned attractive returns. $ Bu Ethanol Grind Margin Lucrative margins early in the game resulted from a combination of record high ethanol prices and low corn costs. For example, the peak margin in June 20 was the product of ethanol prices that traded as high as $4.30 per gallon and corn prices that hovered in the $2.30 per bushel range. Ethanol prices climbed to record highs as the fledgling U.S. industry struggled to produce enough ethanol to meet the fixed demand for about 5 billion gallons as a fuel additive in reformulated gasoline. Federal regulations require the use of reformulated gasoline in some regions Source: NYMEX & CME $ Gal during certain times of the year in order to meet ambient air quality standards. Ethanol was the only viable fuel additive following the ban of methyl tertiary butyl ether (MTBE) by more than two dozen states due to environmental risks resulting from potential leaks into groundwater. Corn prices in 20 also had declined following a record crop in 2004 and another large crop in $ Gal The ethanol grind margin has trended downward from this peak due to a combination of factors. First, U.S. ethanol production has surged from 4.9 billion gallons in 20 to 9.2 billion gallons in 20 and output likely will reach 10.5 billion gallons this year. Production has climbed as a result of the large number of new plants commissioned during the last few years. For example, the Renewable Fuels Association counted 101 operating plants with 4.8 billion gallons of capacity in y 20. By y 20, the count had increased to 196 plants with 12.6 billion gallons of capacity. That is the equivalent of adding 50 million gallons of new ethanol capacity each week for the past three years! Second, the rapid growth in production has outpaced the capacity of the supply chain to move ethanol from facilities in the Midwest to consumers in the large markets along the U.S. coasts. These distribution bottlenecks referred to as a blending wall resulted in local supply gluts, steep discounting and lucrative blending margins. Finally, corn prices spiked to record levels in mid-20 in response to planting delays in the Midwest, the large increase in the ethanol grind and record exports. In theory, ethanol used for blending with gasoline should trade at a premium to wholesale gasoline with the premium equal to the tax credit paid to blenders cents per gallon through 20 and 45 cents per gallon since the beginning of this year. In reality, the chart shows that ethanol has traded at both a large premium and a steep discount to Ethanol vs. Corn Daily Cash Prices Ethanol Corn Source: NYMEX & CBOT Bil Gal U.S. Ethanol Production Ethanol Production Ethanol % of U.S. Gasoline Use Source: EIA $ Bu Percent 12% 10% 8% 6% 4% 2% F 0%...biofuels hinges on three key drivers the price of oil, grain prices, and U.S. biofuels policies.

3 $ Gal wholesale gasoline depending on supply and demand conditions. For example, ethanol traded at a premium of more than one dollar per gallon in y 20 as blenders scrambled to find enough ethanol to meet the demand for reformulated gasoline. However, ethanol traded at a discount of more than one dollar per gallon in June 20 due to the high blending wall and a spike in corn prices. Grain-Based Biofuels Outlook The outlook for U.S. grain-based biofuels hinges on three key drivers the price of oil, grain prices, and U.S. biofuels policies. This analysis makes no judgment about current U.S. biofuels policies, but simply assesses the outlook assuming current programs remain largely intact during the next decade. Assuming a stable policy environment, the profitability of grainbased biofuels production, like any other agricultural commodity processing business, will vary over time and depend on relative output and input prices or, in this case, relative energy and grain prices. The volatility of the past year illustrates the hazards of forecasting commodity prices, but many government and private analysts forecast that real energy prices will trend upward during the next decade while real agricultural commodity prices will remain in check due to large expected increases in productivity during the next decade. For example, the Energy Information Administration (EIA) recently projected that the real price (in 20 dollars) of U.S. sweet crude would increase to about $115 per barrel in That would translate into a nominal price of about $150 per barrel assuming an inflation rate of 2% per year. EIA s low and high price scenarios project nominal prices of about $65 and $240 per barrel in $ Bu Ethanol vs. Wholesale Gasoline Daily Cash Prices Ethanol Premium Ethanol Premium Ethanol Gasoline $ Gal Source: NYMEX & CBOT 2.5 Real Corn and Oil Prices ($ 20) CBOT Corn Nearby Contract WTI Crude Oil Global Spot Price Source: CBOT, Dow Jones Energy Service and U.S. DOL $ BBL Private forecasts are within this wide range as well. PIRA, a leading energy consulting firm, predicts that the real price (also in 20 dollars) of West Texas Intermediate (WTI) crude will trend upward during the next decade due to the combination of strong demand growth, production declines in non-opec countries such as Russia and Canada and significant production increases required from OPEC members to meet projected demand. In particular, PIRA s most recent expected scenario projects that the real price of WTI oil will increase to $104 per barrel or to $140 per barrel in nominal terms by the end of the next decade. PIRA s low and high price scenarios project nominal prices of $57 and $219 per barrel in On the grain side of this equation, the winner of the race between demand growth and productivity gains will determine the direction of real agricultural commodity prices during the next decade. Global grain and oilseed demand is projected to continue to climb at a steady pace of more than 2% per year as a result of predictable population growth and moderate increases in per capita incomes, especially in the large and rapidly developing Asian economies. The global harvest will need to increase approximately 20% or 500 million tonnes in order to meet projected demand by Given this positive demand outlook, the rate of increase in yields will be the key driver of real commodity prices during the next decade. Some analysts have voiced concerns about a potential slowdown in productivity gains due to land and water constraints as Source: USDA and Mosaic U.S. Corn Supply Unit: Mil Bu Beginning Stocks 1,304 1,624 1,720 1,621 1,250 1,000 Production 13,038 12,101 12,761 12,893 13,227 13,911 Planted Acres (1,000) Harvested Acres (1,000) Average Yield (Bu Acre) Imports Total Supply 14,362 13,740 14,496 14,528 14,492 14,926 Domestic Demand 10,302 10,170 10,775 11,278 11,392 11,726 Feed and Residual 5,938 5,250 5,300 5,253 5,256 5,330 Food and Industrial 1,338 1,270 1,275 1,294 1,314 1,333 Ethanol 3,026 3,650 4,200 4,731 4,823 5,2 Implied Ethanol Production 8,624 10,403 11,970 13,485 13,746 14,428 Exports 2,436 1,850 2,100 2,000 2,100 2,200 Total Demand 12,738 12,020 12,875 13,278 13,492 13,926 Ending Stocks 1,624 1,720 1,621 1,250 1,000 1,000 well as reductions in public funding for basic agricultural research. They acknowledge that maybe Malthus was right after all and warn of a reversal of long term trends of declining real prices for agricultural commodities. Other analysts point to global agriculture s long history of productivity growth and recent scientific breakthroughs such as completion of the corn genome mapping project that are expected to lead to significant yield gains during the next decade. For example, the two leading seed corn companies are touting products in their R&D pipeline that promise to deliver large yield increases during the next decade. DuPont Pioneer indicated at The Fertilizer Institute s annual Outlook Conference last fall that new varieties

4 have the potential to lift U.S. corn yields 40% before the end of the next decade. Monsanto DeKalb s man-on-the-moon mission is to double U.S. corn yields to 300 bushels per acre by The real price of corn has trended downward for several decades because productivity gains have outpaced demand growth. In fact, most U.S. agricultural policies ranging from price support programs to international food aid and school lunch programs were developed in response to this chronic situation. Current strategies of the leading seed companies argue against a reversal of this long term trend. Investment in grain-based biofuels is a bet that real energy prices will continue to trend upward and that agricultural productivity gains will continue to outpace expected demand growth for traditional uses. We illustrate the importance of yield growth by examining prospects for U.S. corn-based ethanol under two different scenarios. The first assumes that corn yields increase at trend rates. The second assumes that seed companies deliver on their promises to boost average corn yields 40% by the end of the next decade. The table shows potential U.S. corn supply/ demand situations under each scenario. and Demand Crop Year Beginning September 1 Scenario 2 Scenario ,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 14,445 14,980 15,514 16,049 16,584 17,118 17,653 14, ,460 15,995 16,529 17,4 17,599 18,133 18,668 15,922 12,160 12,645 13,129 13,614 14,9 14,633 15,168 12,472 5,372 5,385 5,348 5,301 5,253 5,204 5,145 5,791 1,353 1,374 1,394 1,415 1,436 1,458 1,480 1,480 5,435 5,886 6,387 6,898 7,410 7,971 8,543 5,202 15,490 16,776 18,203 19,658 21,118 22,718 24,347 14,825 2,300 2,350 2,400 2,450 2,500 2,500 2,500 2,450 14,460 14,995 15,529 16,4 16,599 17,133 17,668 14,922 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 In the first scenario, we assume that the average yield increases at trend rates to 180 bushels per acre in That is an 18% increase from the current three-year average. We assume that U.S. corn acreage creeps upward and stabilizes at 90 million acres. The U.S. corn harvest increases from more than 12 billion bushels today to about 15 billion bushels in 2019 under this scenario and, based on aggressive estimates for other uses, approximately 5.2 billion bushels of corn are left over that could produce 14.8 billion gallons of ethanol or roughly the mandate in In the second scenario, we assume that the average yield increases at trend rates until 2011 and then yield gains are projected to accelerate due to the introduction of new genetically modified varieties. In particular, we assume that the average yield climbs to almost 213 bushels per acre in 2019 or the 40% increase targeted by leading seed corn companies. We again assume that U.S. corn acreage trends upward and stabilizes at 90 million acres. The U.S. corn harvest climbs from more than 12 billion bushels today to almost 18 billion bushels in 2019 under this scenario. Based on this analysis, about 8.6 billion bushels of corn are left over that could produce more than 24 billion gallons of ethanol. Alternatively, it would require only about 75 million acres in this scenario to grow the amount of corn needed to produce 15 billion gallons of corn-based ethanol as well as to meet the other use forecasts in Biofuels Policy Developments Despite heightened scrutiny and criticism of grain-based biofuels, policy developments since 20 have fortified mandates and extended tax credits and import duties. The most important policy changes are contained in Title II of The Energy Independence and Security Act of 20 (20 Energy Bill) and Title XV of the Food, Conservation and Energy Act of 20 (20 Farm Bill). President Bush signed the 20 Energy Bill into law on December 19, 20 and the 20 Farm Bill became law on June 18, 20 when both the House and Senate voted to override the President s veto of the bill. Title II of the 20 Energy Bill expanded and extended the renewable fuel standard (RFS) or the mandate for blending renewable fuels into U.S. motor fuel supplies. The Energy Policy Act of 2005 (EPAct 2005) established the first renewable fuel standard (RFS1). Under this legislation, the mandate increased from 4.0 billion gallons in 20 to 7.5 billion in After 2012, the law stipulated that the proportion of renewable fuel to gasoline must equal or exceed the proportion in 2012 and that at least 250 million gallons of this quantity must be derived from cellulosic feedstock. The renewable fuel standard included in the 20 Energy Bill (RFS2) looks like RFS1 on steroids. RFS2 expanded the renewable fuel mandate to 9.0 billion gallons in 20 and to 36 billion gallons in The 20 Energy Bill defined four categories of biofuels and for each category established both a RFS and a lifecycle greenhouse gas (GHG) emission threshold for facilities beginning construction after implementation of the legislation. The Act also authorizes the Environmental Protection Agency (EPA) Administrator, states, refiners and blenders to petition for a waiver of the mandate. The EPA Administrator can waive the renewable fuels standard if, after seeking public comment, the Administrator determines that implementation would severely harm the economy or environment or if there were inadequate domestic supplies of renewable fuels to meet the mandate. The emissions threshold is the minimum reduction in lifecycle GHG emissions that is required for a renewable fuel to qualify for

5 U.S. Renewable Fuel Standard EISA 20 RFS2 Unit: EPAct Total Advanced Biofuel Conventional: (bil gal) 2005 Renewable Total Biomass- Total Less Year RFS1 Fuel Advanced Cellulosic Based Diesel Advanced na na na na na na na na na na na na na na tbd tbd tbd tbd tbd tbd tbd tbd tbd tbd tbd tbd tbd tbd tbd tbd tbd tbd tbd tbd Source: Energy Policy Act of 2005 (EPACT 2005) and Energy Independence and Security Act of 20 (EISA 20) Category GHG Threshold Definition Renewable Fuel 20% All advanced biofuels and any other fuel made from renewable biomass that is used to replace or reduce the quantity of fossil fuel in transportation fuel Advanced Biofuel 40%-44% All cellulosic biofuel and biomass-based diesel, as well as other renewable fuels including ethanol from sugar, starch or waste materials, biogras and butanol and other alcohols Cellulosic Biofuel 60% Renewable fuel made from cellulose, hemicellulose or lignin Biomass-Based Diesel 50% Any renewable fuel that is a diesel fuel substitute the mandate. The reduction is calculated from a 2005 baseline for petroleum fuels. RFS2 requires that the EPA estimate the GHG impact of renewable fuels using a comprehensive lifecycle methodology that takes into account emissions from all stages of fuel and feedstock production and distribution as well as the delivery and use of the finished biofuels. The methodology estimates both direct and indirect emissions including the net impact of potential changes in land use worldwide. Supporters of this indirect land use component of the methodology claim that an acre of land used to produce biofuels in the United States results in the conversion of rangeland or rainforest into crop production in other parts of the world and the corresponding loss of this land as an important carbon sink. Title XV of the 20 Farm Bill made a few noteworthy changes in the blending tax credit and import tariff. First, this legislation reduces the ethanol tax credit paid to blenders from 51 cents per gallon to 45 cents per gallon effective at the beginning of the first calendar year after the EPA certifies that 7.5 billion gallons of renewable fuel was blended into gasoline. The lower credit went into effect uary 1, 20. Second, the legislation establishes a temporary credit of $1 per gallon for blenders of cellulosic-based alcohol. This credit is scheduled to expire on December 31, Finally, this legislation extended the 54 cents per gallon secondary tariff on imported ethanol through December 31, The United States levies a 2.5% ad valorem tariff on imported ethanol and imposes a secondary tariff of 54 cents per gallon on imports to offset the value of the tax credit given to U.S. refiners blending ethanol in the United States regardless of origin. Biofuels Issues A few policy issues could significantly impact U.S. grain-based biofuels during the next decade. The first is the ability of biofuels to meet the threshold for the reduction in GHG emissions established in the 20 Energy Bill. The second is meeting state standards for low carbon fuel and the third is a need to increase the maximum blending percentage in order to absorb the large expected growth in ethanol supplies during the next 10 years. Based on the comprehensive lifecycle methodology spelled out in the 20 Energy Bill including the controversial indirect land use calculation, EPA estimated that corn-based ethanol reduced GHG emissions approximately 16% compared to the threshold of 20% required to qualify for the blending mandate. In the case of soybean-based biodiesel, EPA estimated GHG reductions of 22% compared to the threshold of 50%. Excluding the controversial indirect land use estimate, both corn-based ethanol and soybean-based biodiesel exceeded the thresholds by comfortable margins. Grain-based biofuels proponents responded to the EPA estimates released in May by arguing that the indirect land use calculation was flawed. Recent statistics raise legitimate questions about the methodology. For example, Brazilian soybean area peaked in 2004 at 22.9 million hectares due to a combination of high soybean prices and an extremely weak currency that super-charged this export dependent sector. Brazilian soybean area declined 10% to 20.7 million hectares in 20 and harvested area is projected to climb to about 2 million hectares in 20, according to U.S. Department of Agriculture (USDA) estimates. This decline occurred at the same time that U.S. ethanol production was increasing at an exponential rate. U.S. ethanol output totaled just 3.4 billion gallons in 2004 and we project that output will climb to about 10.5 billion gallons this year. If the United States stopped grinding corn into ethanol in 2010/11, U.S. farmers would need to plant less than 65 million acres of corn next spring rather than the 87 to 88 million most analysts expect today in order to meet non-ethanol corn demand. The world does not need another 25 mil-

6 lion acres of U.S. soybeans even though U.S. soybean exports will set a new record during the 20/ crop year. Without ethanol, U.S. policy makers likely would be debating the need to take large amounts of U.S. land out of production due to surplus supplies and low prices. The methodology issue came to a head during the debate on the climate change bill this summer. The House bill includes a provision that prohibits the EPA from using the indirect land use calculation for at least six years. The provision requires a five-year study of the land use issue and also mandates the EPA, the U.S. Department of Energy and the USDA to agree on the validity of the results. If all three agencies sign off on the study, Congress still has another year to intervene if they do not agree with the results. The bottom line is the GHG emission standards are on hold for six years under this provision in the House bill. The total renewable fuel standard climbs to more than 20 billion gallons and the ethanol mandate increases to 15 billion gallons by 2015 when officials expect to resolve this issue. Another different but related issue is state regulations for low carbon fuel. For example, the California Air Resources Board (CARB) in il voted to implement a Low Carbon Fuel Standard (LCFS) requiring a 10% reduction in GHG emissions from transportation fuels by The standard goes into effect next year, but it requires only the reporting of GHG emissions in The mandated reduction in GHG emissions from a gasoline baseline increases gradually to 2.5% in 2015 and then accelerates to 10% in Several eastern states also have pledged to develop a joint LCFS that most analysts expect will look a lot like the California standard. The California standard also estimates GHG emissions of various motor fuels using a comprehensive lifecycle methodology including an indirect land use component. The results of this methodology showed that ethanol produced via the dry milling process has only slightly lower lifecycle GHG emissions than gasoline and ethanol produced via the wet milling process has higher lifecycle GHG emissions than gasoline. Based on criticism of the methodology, the CARB has agreed to review the LCFS by uary 2011 and to create an expert working group to review the science underlying the indirect land use calculation. Another issue facing the U.S. ethanol industry is the need to increase the maximum blending percentage in order to efficiently absorb the large expected increase in biofuels supplies during the next few years. For example, U.S. gasoline use totaled almost 138 billion gallons in 20 and analysts forecast that use could decline to about 130 billion gallons at the end of the next decade due to increases in the average fuel efficiency of the nation s fleet, changes in demographics and other factors. If every gallon of gasoline in 2020 was an E10 blend (90% gasoline and 10% ethanol), then blending demand would total about 13 billion gallons compared to a total renewable fuel mandate of 30 billion gallons and a corn-based ethanol mandate of 15 billion gallons in 2020 On March 6, 20 Growth Energy, a group committed to stimulating U.S. economic growth through the development of cleaner and greener energy, and 54 ethanol manufacturers petitioned the EPA to increase the maximum ethanol blending limit from 10% to 15%. Increasing the blending rate in the near term makes more sense than moving ethanol into every nook and cranny of the United States to achieve 100% saturation for E10 blends. EPA solicited public comment on this petition through y 20. EPA Administrator Lisa Jackson recently indicated to the Senate Agricultural Committee that the agency has received and is analyzing thousands of public comments. EPA has up to 270 days from the date of the petition to act on the request and a decision is expected by December 1, 20. Boosting the blending maximum still does not solve the potential long term challenge of incorporating 36 billion gallons of biofuels into motor fuel supplies by Even higher blending rates and significant increases in the number of flex-fuel vehicles and the distribution infrastructure required to fuel them will be required down the road. The Mosaic Company Atria Corporate Center, Suite E Campus Drive Plymouth, MN (800) toll free (763) This publication contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of Such statements include, but are not limited to, statements about future financial and operating results. Such statements are based upon the current beliefs and expectations of The Mosaic Company s management and are subject to significant risks and uncertainties. These risks and uncertainties include but are not limited to the predictability and volatility of, and customer expectations about, agriculture, fertilizer, raw material, energy and transportation markets that are subject to competitive and other pressures and the effects of the current economic and financial turmoil; the build-up of inventories in the distribution channels for crop nutrients; changes in foreign currency and exchange rates; international trade risks; changes in government policy; changes in environmental and other governmental regulation, including greenhouse gas regulation; difficulties or delays in receiving, or increased costs of, necessary governmental permits or approvals; the effectiveness of our processes for managing our strategic priorities; adverse weather conditions affecting operations in Central Florida or the Gulf Coast of the United States, including potential hurricanes or excess rainfall; actual costs of asset retirement, environmental remediation, reclamation or other environmental regulation differing from management s current estimates; accidents and other disruptions involving Mosaic s operations, including brine inflows at its Esterhazy, Saskatchewan potash mine and other potential mine fires, floods, explosions, seismic events or releases of hazardous or volatile chemicals, as well as other risks and uncertainties reported from time to time in The Mosaic Company s reports filed with the Securities and Exchange Commission. Actual results may differ from those set forth in the forward-looking statements. Copyright 20. The Mosaic Company. All rights reserved.