Do bigger ethanol plants
mean fewer farmer benefits?

By David Morris

Editor’s note: Morris is an economist with
the Institute for Local Self Reliance. The
views expressed are the author’s own and
do not necessarily reflect those of USDA.

he structure of the ethanol industry influences the degree to which its growth benefits farmers and rural areas. An industry dominated by small- and medium-sized farmer-owned plants creates more wealth for farmers and their communities than does one characterized by a smaller number of large facilities owned by national and international investment groups.

Between 1979 and 2005, the ethanol industry has experienced four major structural upheavals. In the beginning, it consisted of a vast number of tiny production units. The doubling of oil prices in 1979–1980 inspired farmers to build such plants. The availability of a federal 100-percent loan guarantee for plants with production capacities less than 1 million gallons a year allowed them to finance such plants.

This “stills-on-a-hill” era peaked in 1984, with 163 very small ethanol plants in operation (some sources estimate as many as 176). The industry then violently contracted, a result of crude oil prices falling to $8 a barrel and a successful, concerted negative publicity effort by major oil companies.

In a single year, 1985, almost half of all ethanol plants (but only a small fraction of production capacity) went out of business. By 1990, only 56 plants remained. More than half produced less than 5 million gallons a year.

In the late 1980s and early 1990s, the ethanol industry was dominated by 100-140-million-gallon-a-year wet mills. These were built primarily to serve the expanding high fructose corn sweetener market. Archer Daniel Midland (ADM) dominated the HCFS market. As a result, ADM dominated the ethanol market, accounting for about 75 percent of the ethanol industry’s output in 1990. Indeed, in the early 1990s, the words ethanol and ADM became virtually synonymous.

Rise of farmer-owned plants
The 1990s witnessed the next structural shift in the industry: the rise of farmer-owned plants. By the late 1990s, the vast majority of new ethanol plants were farmer-owned. By 2002, these were producing, collectively, more ethanol than ADM. Some 25,000 farmers nationwide had become shareholders in ethanol facilities.

The average size of new plants grew from 15 million gallons a year in the mid-1990s to 30 million gallons a year by 2002. States such as Wyoming and Minnesota redesigned their cooperative laws to enable more outside investment while retaining farmer control. Many farmers chose the limited liability corporate (LLC) form as a way to access the capital required.

In 2004, a new era dawned on the ethanol industry when the nation’s first 100-million-gallon dry mill opened in South Dakota. Within a year, at least 15 more 100-million-gallon dry mills were under construction or planned. A doubling of oil prices, an extension of ethanol’s generous federal financial incentives and the passage by Congress of a mandated doubling of the ethanol market by 2012 all combined to make ethanol an attractive investment. It is likely that in the next 3 years, 75 percent of new ethanol production will come from large, non-farmer-owned plants.

Some farmers view absentee-owned plants as an inevitable — and even a welcome — development. South Dakotan Dan Endres, who had owned shares in two farmer-owned ethanol plants and became a principal owner of a company building several 100-million-gallon plants, comments: “VeraSun’s experience indicates that the farm-ownership model may need to adapt as the ethanol industry gravitates to large plants. Such operations are increasingly financed by six to eight principal investors, without the need to deal with hundreds of small-scale farm-investors.”

In mid-2005, several leading firms in plant construction, engineering and marketing formed a new entity, US Bioenergy, a holding company that will purchase and provide services to a number of ethanol plants. The minimum investment for shares in the holding company is $5 million. Investors anticipate making a significant profit in 2 to 3 years when the company goes public.

Industry evolution poses challenges
The evolution of the ethanol industry into one dominated by large plants where investors profit not from the sale of ethanol, but from receiving the appreciated value of the plants when they are sold, challenges policy makers who are trying to address agricultural, as well as energy, objectives.

Expanded ethanol production, of course, benefits farmers and rural areas in the same as will any new crop-processing facility. Supporters argue that a more concentrated structure is necessary to raise the billions of dollars required to significantly expand ethanol production. Larger plants can produce and transport ethanol more cheaply. And larger increments in capacity allow the industry to expand more quickly.

These are valid points. But there is another side to the rise of large absentee-owned plants that concerns many. They significantly restrict the possibility of widespread farmer ownership and control. That begins to sever the link between ethanol production as an energy strategy and ethanol production as an agricultural strategy.

Bigger plants do indeed lower unit production costs. But while the savings are considerable when the size of the facility increases from 10 to 30 million gallons a year, the additional reductions from increasing the size of the facility from 30 to 100 million gallons are modest. Capital savings may be on the order of 2-3 cents per gallon; labor savings are about the same. Reduced transportation costs from using unit trains might be about a nickel a gallon.

Large plants do not, of course, guarantee lower costs. There are diseconomies of scale. A large plant can strain local suppliers. Reporter Peter Rohde of Inside Fuels and Vehicles reports that a new 100-million-gallon ethanol plant in South Dakota raised the basis price of local corn by 30 cents per bushel. This increased feedstock cost wiped out any savings generated from reduced capital, labor and transport costs.

But let’s say that making ethanol in a 100-million-gallon facility does reduce the cost by 10 cents a gallon less than that of a 40-million-gallon facility. We know from experience that this savings will not show up at the pump. The consumer will not benefit. The question is, will the farmer or the rural area benefit? Or, to pose the question more pertinently, will they benefit as much as if there were three smaller facilities rather than one large facility?

Advantages of smaller plants
As noted above, farmers and rural areas benefit when more manufacturing and processing facilities move in or when the demand for a specific crop increases. Farmers who do not own a share in an ethanol plant benefit from the increased selling price of their crop. Studies indicate that increased local ethanol production raises the price of corn by about 10 cents per bushel. Farmer-owners of ethanol plants, on the other hand, have received as a dividend, over the years, 30-40 cents per bushel.

For farmer-owners, the ethanol plant becomes a hedge. When corn prices decline, the production costs of ethanol decline. Thus, at least a portion of the income lost to the farmer on the sale of the raw material is made up from the increased profits in the sale of the processed material.

A 100-million-gallon, absentee-owned ethanol plant will return to the farmers in the area around the plant about $13 million less than three farmer-owned plants each producing 33 million gallons per year.

According to Iowa State University (ISU), the 5–year average after-tax return for a typical ethanol dry mill is 23 percent. In comparison, ISU estimates that 70 percent of Iowa’s counties averaged returns on farmland of 2.5 percent or less (in 2002). In fact, one community banker in Minnesota told a National Corn Growers Association task force he considers financing stock purchases by farmers in processing plants a far less risky and potentially much more profitable investment than lending money to farmers to buy land.

With regard to the impact on the non-farm community, large plants, especially when they are part of a chain owned by one corporation, spend a smaller portion of their money locally on purchasing and management, on accounting and legal services and on advertising.

Possible alternatives
What should be done? To date, public policy, at least at the federal level, has rarely taken into account the size or ownership structure of ethanol plants. I am aware of two exceptions. A program that gave free surplus grain to ethanol producers who were expanding or beginning production, rewarded small producers more than larger producers. And since the early 1990s, there has been an additional 10-cent-per-gallon small producers credit that has been limited to facilities with capacities of less than 30 million gallons per year.

The 2005 energy bill, however, increased the definition of “small” to 60 million gallons, a ceiling that qualifies about 90 percent of all ethanol facilities.

The federal biofuels incentive, of course, has no ceiling. Moreover, it targets the consumer and the intermediary supplier, not the ethanol producer.

So what should be done? One concrete step would be for the government to convert the federal excise tax exemption into a direct producer payment. This was done at the state level by Minnesota in the late 1980s. That payment could be limited to plants under a certain size and a higher incentive would be given to farmer-owned facilities.

To date, the issues of scale and ownership — at least at the federal level — have not been addressed. One reason may be that, until recently, farmer-owned, modestly scaled biofuels refineries seemed to have become the norm. That is no longer true.

The remarkably rapid growth of large scale, non-farmer and distantly owned plants should lead policy makers to engage the question and make a conscious decision. The question before them is how to design a strategy that not only maximizes the use of biofuels but also maximizes the benefit of that expanded use to the cultivator and the community in which the cultivation and harvesting occurs.

November/December Table of Contents