Ethanol prices have continued on a downward course since reaching record highs in the middle of 2006 (see chart) as demand continues to boom in the U.S.

Analysts attribute the price trend largely to falling gasoline prices, to which fuel-grade ethanol tags are closely linked, as well as steadily increasing production of fermentation ethanol. Look for further erosion in ethanol rates this year as new fermentation plants come onstream and add to already abundant ethanol reserves.

Demand for ethanol is up. According to the Renewable Fuels Association (RFA), an industry group, U.S. producers churned out 4.9 billion gallons of ethanol in 2006, about 25% more than in 2005 and this year it's expected to grow even more.

New production capacity for the product is expected to mushroom. There are currently 110 ethanol biorefineries in the U.S. with a capacity of more than 5.3 billion gallons, RFA estimates. Some 63 ethanol biorefineries, plus eight expansion projects, are expected to come onstream in the next 18 months, RFA reports, which will add nearly 5.4 billion gallons of new ethanol capacity.

“There is currently plenty of supply out there,” says Spencer Kelly of the Oil Price Information Service, adding that as new ethanol plants become operational in 2007, prices could decline.

While production capacity is important in ethanol pricing, “the biggest determining factor” in market rates for the product is the price of gasoline, Kelly says. In particular, he notes that it is the relative price of ethanol versus gasoline that determines ethanol usage patterns, which in turn affect ethanol pricing.

While ethanol and gasoline rates usually track closely, that is not always the case. In April and May, 2006, for example, gasoline and ethanol prices became decoupled. At that time there was “a very tight supply” of ethanol that sent ethanol tags rocketing from under $3/gallon to as high as $5/gallon, recalls Hank Williams, vice president for fuels at consultants Jim Jordan & Associates, based in Houston. He says this was mostly due to a sudden demand for ethanol as an MTBE replacement, along with insufficient capacity of ethanol plants to meet that demand. During the same period, he adds, gasoline prices showed no similar spikes.

Williams notes that prices for corn, the major feedstock for fermentation ethanol, have been high by historical standards (around $3.50/bushel in the Midwest), but that ethanol producers “are still making money.”

Falling crude oil prices caused gradual retreats in gasoline rates during the second half of 2006, a trend that has continued into this year. In the first two weeks of January, 2007, Nymex gasoline futures came down around 14-16¢/gallon, reports Andy Lipow, president of Lipow Oil Associates of Houston. Lipow calls that decline “pretty substantial” Continued softening of gasoline, plus an “ever-increasing supply” of ethanol due to new capacity, may cause ethanol tags “to come down” in 2007, says Lipow.

How low can ethanol prices go? Right now it costs perhaps $1.70/gallon to produce fermentation ethanol, estimates Williams. So even if gasoline falls further and supplies of ethanol continue to pile up, he says, “there would be a lot of resistance among ethanol producers to go down to that level, much less below it.” Instead, says Williams, producers would probably take “less efficient” ethanol plants out of production before they would resort to wholesale price cutting.