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(Corrects 4th paragraph to remove reference to subidies for corn ethanol and import restrictions, which expired at end-2011)
By Robert Campbell
NEW YORK, July 12 (Reuters) - Soaring corn futures and stagnating oil prices spell disaster for the U.S. ethanol sector this summer. A repeat of the industry's financial troubles from a few years ago cannot be ruled out.
US corn futures have soared as evidence has mounted that drought conditions will devastate this year's crop. Front-month corn futures have jumped 15 percent since the end of June.
Oil, meanwhile, has found upside resistance at the $100-a-barrel mark. Gasoline prices have probably already hit their year-high, since the peak demand season is already underway.
That's bad news for ethanol. Although the industry is protected by a legally mandated minimum market, Congress hasn't mandated minimum profit margins for the otherwise much-coddled sector.
So, even though ethanol prices have surged relative to gasoline, margins for producers remain mired in negative territory.
(Graphics: ethanol vs gasoline: r.reuters.com/zyc49s)
ethanol margins: r.reuters.com/bad49s)
Indeed, as ethanol prices approach those of gasoline, fuel blenders have little incentive to add more ethanol into their product than necessary.
So ethanol producers are squeezed on both ends. Soaring corn boosts costs, while soaring ethanol prices shrink their market.
Poor profitability has already prompted producers to reduce output. US ethanol production fell to 821,000 barrels per day last week, according to the Energy Information Administration.
That's 51,000 bpd less than the same week in 2011 and a continuation of this summer's reversal of the spring trend of l output exceeding year-ago levels.
Surging costs and falling production have prompted equity investors in weaker firms to flee fearing a repeat of the wave of bankruptcies that claimed many undercapitalized ethanol firms during the financial crisis.
But this time the shakeout might be more orderly. Bigger firms like Archer Daniels Midland and oil refiner Valero have a larger role in the sector now.
Plant shutdowns are likely to claim the least efficient operators.
The real question for investors will be how long this situation lasts. Is it a bump in the road caused by a bad harvest or is it a sign of bad things to come?
Forecasts for oil prices in 2013 have started to come down as analysts tally the effect of slower global economic growth on the market.
Yet at the same time there may be little relief for corn prices until the next harvest.
That's bad news for ethanol producers, who depend on oil prices outpacing corn for their margins.
Ironically, the return of poor profitability for ethanol producers comes as recent steps to expand the market for the fuel have finally born fruit.
After lengthy study, the Environmental Protection Agency has allowed fuel blenders to increase the proportion of ethanol in gasoline to up to 15 percent.
The first station selling this blend of fuel has just opened in Kansas.
But surging ethanol costs will undermine the industry's chief competitive advantage over petroleum-based fuels: price.
Unless corn-based ethanol is substantially cheaper than petroleum-based gasoline, fuel blenders will have little incentive to boost blends beyond the minimum amount set by mandate.
Longer term, the industry's future also looks more challenging.
Already legislative support for corn-based ethanol is weakening. Lawmakers axed a credit for fuel blenders at the end of last year.
The renewable fuels mandate will only continue to expand the market for corn-based ethanol through 2015, when it will be capped at 15 billion gallons a year.
Investor interest in the sector has also likely been dampened by another round of heavy losses. That could ultimately undermine the ethanol industry's main selling point to rural politicians: job creation.
That comes at a bad time.
North America's oil production boom and increased energy efficiency have done far more to cut the United States' dependence on foreign oil imports than ethanol has done recently.
And with government finances stressed by a decade of deficits, there's a lot less money to throw about supporting politicians' pet causes.
An industry created by politicians is likely to have a hard time growing without their support.
Ethanol needs legislators to force open fuel markets by mandating consumption and it needs financial help to get experimental biofuels out of the laboratory.
Increasingly, the risk is that the industry may not get that support. (editing by Gunna Dickson)