Could ethanol's expansion be at risk from high natural gas prices?

Ethanol use in the U.S. has seen dramatic growth in recent years. According to the Renewable Fuels Association, in 2006 approximately 4.8 billion gallons of grain ethanol were produced in the U.S. This is up from approximately 1 billion gallons a decade ago. The rapid growth in U.S. ethanol production is due to high gasoline prices, special tax incentives for refiners, and renewable fuel targets, which are driven partly by energy security concerns. The argument for relying on U.S. grown corn versus Middle Eastern oil has been compelling - especially as the election cycle ramps up.

While the impact of increasing corn based ethanol demand on a wide range of other commodities and consumer goods – from beef prices to cans of soda pop - has received attention, the connection between corn based ethanol and natural gas markets has seen little discussion.

Almost all ethanol produced in the U.S. today is from corn and the production process is fairly similar across the existing refineries. It takes a fair amount of energy to process corn into liquid transportation fuel that can be blended with gasoline. There is much work being done on “cellulosic” and other non-corn sources of ethanol but most experts believe mass commercialization of non-corn based ethanol production in the U.S. is many years away.

So, ethanol producers need to decide where they will get the energy they need to run their refineries. There are a handful of companies constructing ethanol facilities that run on renewable fuels or waste products. However, most ethanol refineries that are in operation or on the drawing board operate on natural gas.

The current level of ethanol production is already having an impact on natural gas markets. R. W. Beck estimates that the 107 grain ethanol refineries operating at year-end 2006 directly consumed approximately 118 billion cubic feet (Bcf) of natural gas.(1) This is roughly the same amount of natural gas that the all the homes in the state of Minnesota consume each year or enough natural gas to heat over 1.5 million homes.

The natural gas industry has noticed the emerging demand for natural gas from grain ethanol refineries. Several natural gas pipeline companies in the Midwest have cited increased natural gas consumption from ethanol facilities as a driver for new natural gas pipeline construction in the “corn belt” where the majority of ethanol production is located.

There are over 50 additional ethanol refineries under construction in the U.S. The new refineries are expected to take annual ethanol production capacity to 8.9 billion gallons in a few years. R. W. Beck estimates that direct natural gas consumption from ethanol refineries would rise as well to over 200 Bcf per year. That would roughly equal the amount of natural gas that all the homes in the state of New Jersey consume each year or enough natural gas to heat nearly 3 million homes.

Since the U.S. consumes approximately 150 billion gallons of gasoline each year, even higher levels of ethanol market penetration are certainly possible over time. Current energy bills in Congress call for expansion of ethanol use to 36 billion gallons per year. While not all of that would be from corn based ethanol, the level of natural gas consumption to support such an industry could be well above 500 Bcf per year. Only 12 states consume over 500 Bcf of natural gas per year.

The demand growth from ethanol refineries is coming at a challenging time for the natural gas industry. U.S. natural gas prices have increased over 60% since the start of this decade. The U.S. Energy Information Administration reports that natural gas wellhead prices averaged less than $4/MMBtu from 2001 to 2003 and from 2004 to 2006 have averaged approximately $6.40/MMBtu. In response to higher prices, drilling rig counts and gas well completions have increased dramatically but U.S. natural gas production has barely changed. U.S. natural gas producers say that they face difficult challenges and may not be able to increase U.S. natural gas production very much even with higher prices. They report that costs are increasing even faster than natural gas prices, new fields tend to produce far less gas per well than old areas, and decline rates across the board are getting steeper every year.

It seems certain that the U.S. will be forced to rely on increasing imports of natural gas but Canada – our “go to” source for incremental supply during the 1990’s - is facing the same difficulty with flat or declining domestic gas production and growing demand. The growing global market for liquefied natural gas (LNG) is certainly a promising source of supply given that 96% of the world’s proven natural gas reserves are located outside of North America. However, just as with the global oil market, there needs to be recognition that LNG suppliers will look to sell to the highest price market and European and Asian demand for natural gas is expected to be strong. Furthermore, a quick review of the top LNG export countries notes several in the top 10 with recent security or instability issues (including Indonesia, Algeria, and Nigeria). A similar review of the top countries in terms of natural gas reserves (#1- Russia, #2 - Iran, # 9-Venezuela) highlights that reliance on LNG will bring its own set of geopolitical risks.

These challenges to U.S. natural gas supply further underscore the critical need for a wide scale transition to “cellulosic” ethanol refineries that are powered by biomass or other alternative fuels.

In addition, as Congress continues to debate how far and how fast to push ethanol use one thing should be clear: Unless Congress and other policy makers start to do much more to encourage incremental domestic natural gas production, all natural gas consumers – including the growing numbers of corn based ethanol refineries – should plan on seeing higher natural gas prices.

Note:

(1) This calculation assumes that on average 25,000 Btu of natural gas was required to produce a gallon of ethanol in the U.S. Dry grain ethanol refineries consume approximately 35,000 Btu of natural gas per gallon of ethanol while wet grain ethanol refineries consume about 1/3 less natural gas. In addition, there are a few ethanol refineries that do not operate on natural gas. Note that this only takes into account the direct consumption of natural gas at the ethanol refinery and does not address the natural gas required for the fertilizer used in corn production or other natural gas needs along the entire production chain.