In a recent research report, Wall Street firm Goldman Sachs noted: “Many investors are understandably concerned that ethanol is nothing more than a politically motivated, media-hyped, high oil price-inspired fad.” Many on Main Street share these thoughts. Does ethanol represent more than federal subsidies to the corn belt? At certain prices for corn and oil, most likely.

Corn-based ethanol will not replace gasoline, but it may help keep gasoline and oil prices in check. If, as happened during the summer of 2006, oil prices rise over $65 per barrel and corn prices remain at $2 per bushel, ethanol is economical, even without subsidies from Uncle Sam. Improvements in the efficiency of ethanol refineries, and a switch to more economical and environmentally preferable feedstocks, will likely improve its competitiveness further.

What is Ethanol?

Ethanol is a gasoline additive or an alternative motor fuel derived from corn or other plants. There are 105 ethanol refineries in the U.S., producing ethanol at a rate of 4.6 billion gallons per year, or 3% of total motor fuel produced. Another 44 ethanol refineries are planned or under construction. These refineries remove the starch from the grain (corn), ferment it, and then distill the alcohol (ethanol) from process water. Almost all U.S. ethanol production is being blended into E10 vehicle fuel, also known as gasohol, (10% ethanol, 90% gasoline), while a significantly smaller amount is blended into E85 (85% ethanol, 15% gasoline). Ethanol is blended into approximately 40% of all U.S. gasoline, as E10, according to the American Petroleum Institute.

Environmental and Regulatory Drivers

Combustion of E10 can reduce vehicle tailpipe emissions of greenhouse gases, carbon monoxide, and, at least in certain seasons, smog-forming pollutants, by more than ten percent. The Energy Policy Act of 2005 mandates that 7.5 billion gallons of ethanol and biodiesel be blended into gasoline by 2012, up from 4.2 billion gallons in 2005. In addition, the U.S. government removed liability protection for an ethanol alternative, fuel additive MTBE, that has contaminated groundwater in a number of states. At least 20 states have full or partial MTBE bans. Thus, most gasoline refiners are now blending ethanol into fuel to meet environmental demands.

Economics of Ethanol E85 was competitive with gasoline during the summer of 2006, even without federal assistance, according to Walden’s analysis. While the operating costs of ethanol plants are significantly higher than those of oil refineries, corn feedstock was priced much lower than crude oil, on an energy equivalent basis, in July and August 2006. Ethanol’s competitiveness was improved by a federal tax credit of $0.51 per gallon of ethanol for energy companies that blend it into their fuels.

Should we all purchase flexible fuel vehicles and use E85? Not quite yet.

The commodity markets are volatile. Ethanol prices have dropped by $1 per gallon in the past month, along with crude oil and gasoline, while corn prices have risen by 50%. Based on current oil and corn prices, and adjusting for ethanol’s lower efficiency (gallon for gallon, the heat content of ethanol is approximately two-thirds that of gasoline), our analysis shows ethanol remaining competitive only as long as the federal blending credit stays in place. Given a poor corn crop this year, the futures price of corn is significantly higher than current prices, indicating additional challenges ahead for ethanol.

Corn Ethanol’s Energy Balance

A significant criticism of ethanol has been a reportedly “negative energy value”: that it takes more energy to make ethanol than is derived from ethanol. However, in separate reviews of relevant literature, the U.S. Department of Agriculture and environmental group Natural Resources Defense Council (NRDC) concluded that ethanol has a positive energy value. Previous studies indicating negative energy values appear to be based, at least in part, on data from older, smaller scale ethanol facilities, using corn grown with less productive farming techniques and lower yielding seeds, and using fertilizer that was produced less efficiently. Unfortunately, some of these more productive seeds and farming techniques are not necessarily desirable from an environmental perspective.

Alternatives to Corn?

While corn ethanol costs are currently cheaper than other potential clean fuels such as biodiesel or fuel cells, additional economical and environmentally friendly alternatives exist. Costs for sugar canebased ethanol production in Brazil, where ethanol accounts for one third of the fuel use, are less than half of those for corn in the U.S. This is primarily due to the higher yield-per-acre and starch-per-plant of Brazilian sugar cane (as well as lower land and labor costs). However, in order to protect the U.S. corn industry, there is a $0.54 per gallon tariff for most ethanol imported to the U.S.

Switchgrass or other crops may be a promising source of cellulosic ethanol, which uses the entire plant to make ethanol. Research in this regard has support from the Bush Administration and environmentalists. As noted by NRDC, switchgrass is a “native, perennial prairie grass that has low nitrogen runoff, very low erosion, and increased soil carbon, and also provides good wildlife habitat.” This contrasts with corn, which requires significant irrigation water, use of fertilizer, and land use. Corn for ethanol currently accounts for approximately 15% of the U.S. corn harvest, and an estimated 75% of U.S. cropland would be needed for 50% of U.S. gasoline needs. A key benefit of cellulosic ethanol is the reduced use of cropland and fossil fuels. Canadian biotech company Iogen, backed by Goldman Sachs and energy firm Royal Dutch Shell, operates a demonstration plant that is refining ethanol from cellulosic ethanol.

Where Do I Fill Up?

There are only a few million flexible fuel vehicles (FFVs) in the U.S. that can run on E85 or gasoline, even though such vehicles cost only a few dollars more to mass produce than standard vehicles. By comparison, most vehicle sales in Brazil are now FFVs. And, there are less than 1,000 E85 pumps at the 170,000 U.S. retail gasoline outlets. Nonetheless, the Big 3 automakers have ramped up production of FFVs, and the Bush Administration is boosting credits and grants for retail gasoline stations that convert to E85 pumps.

While not a panacea, and albeit with significant subsidies thus far, ethanol has played a significant role in mitigating the U.S. “addiction” to large cars and trucks. More innovation, more efficient feedstocks and better public policies will help improve its economics and environmental benefits. As such, ethanol may play a small but important role in a diversified mix of cleaner energy sources.

—K. Scott