The ethanol bust

NEW YORK (Fortune) -- Cargill announces it's scrapping plans for a $200 million ethanol plant near Topeka, Kan. A judge approves the bankruptcy sale of an unfinished ethanol plant in Canton, Ill.. And that was just Tuesday.

Indeed, plans for as many as 50 new ethanol plants have been shelved in recent months, as Wall Street pulls back from the sector, says Paul Ho, a Credit Suisse investment banker specializing in alternative energy. Financing for new ethanol plants, Ho says, "has been shut down."

How can the ethanol industry be slumping only two months after Congress passed an energy bill most experts consider a biofuels boon? The answer is runaway corn prices.

Spurred by an ethanol plant construction binge, corn prices have gone stratospheric, soaring from below $2 a bushel in 2006 to over $5.25 a bushel today. As a result, it's become difficult for ethanol plants to make a healthy profit, even with oil at $100 a barrel.

Just look at Verasun (VSE). In the third quarter of 2007, Verasun's gross profit margin shrank from 37% to 12%, as its corn costs rose from $2.05 a bushel to $3.32 a bushel. And, remember, corn prices today are 60% higher than they were back then (whereas wholesale ethanol prices are up only 30%.)

The margin crunch now afflicting ethanol producers is something I predicted when I first wrote about the "Dot-Corn" boom in Fortune last March (see "The Great Corn Gold Rush" ). Here's an excerpt:

[In the summer of 2006] when corn was $2 a bushel and oil was $70 a barrel, ethanol plants were minting money. They averaged $1.06 in profit for every gallon of ethanol sold, according to Credit Suisse. Today, with oil at $60 and corn at $4, ethanol producers typically net an average of only 3 cents...

If corn spikes to $5 -- a real possibility, says A.G. Edwards commodities analyst Dan Vaught -- or oil declines to $50, ethanol's once-fantastic margins would turn negative. That possibility is creating tensions between ethanol producers and corn growers, two groups whose lobbyists are normally attached at the hip.

Looming over all this is a huge catch-22: $4 corn is a result of the 31 new ethanol plants built since 2005, but investors won't keep bankrolling new plants if $4 corn keeps eating up their profits

The shakeout was inevitable. That said, the ethanol business isn't going away, at least so long as the federal government continues to mandate the use of biofuels -- 36 billion gallons a year by 2022, up from 7 billion last year-and impose hefty tariffs on imported ethanol. There is an oversupply of ethanol right now, but the yearly increase in the biofuels mandate means that demand will eventually catch up with supply.

What probably has changed permanently are ethanol economics. The days of cheap corn are over, and the industry's new, lower profit margins clearly favor ethanol leader Archer Daniels Midland (ADM, Fortune 500) over all the smaller producers like Verasun, privately-held Poet Energy and the many, many farmer-owned ethanol cooperatives. ADM's massive 200 million-gallon-a-year ethanol plants simply have better economies of scale than their 50-million-gallon-a-year rivals. And the fact some of ADM's big plants run on coal instead of natural gas makes ADM's cost advantage that much greater.

Of course, I'm not saying anything that Wall Street doesn't already understand. Since the new energy bill was signed by President Bush on Dec. 19, Verasun and Pacific Ethanol (PEIX) are each down 38%.

And ADM? It's up 10%.