Opportunities in Ethanol?

14 Feb

Over the past year, ethanol has become a buzzword that has attracted much media attention and debate. Environmentalists like it because it burns cleaner (I would counter that you get 20-30% less mileage from ethanol than ordinary gasoline). Politicians love it because it is “alternative energy,” a phrase that is sure to garner some good publicity and public support as they look for ways to curb our “addiction to oil.”

Producers love it, since domestic producers are generally protected from foreign producers (such as Brazil) by a $0.54 tariff on imported ethanol that has now been extended to January 2009. Largely because of a 51 cent-per-gallon tax break, ethanol has received about 50 cents more per gallon than gasoline at the wholesale level (right now it’s about $0.45 more).

Who also loves ethanol? Corn growers. That’s right, because corn prices were up over 80% last year and have stabilized at over $4 a bushel. This is a boon for farmers. Lots of them can do well at around $2/bushel…

Let’s do some quick math. A bushel of corn yields 2.8 gallons of ethanol. This amounts to $1.45 per gallon in the cost of corn alone! If this were the business’s only cost, it could still be pretty profitable, but ethanol production is very capital-intensive. They need get the corn to the plant, process the corn and separate byproducts, refine the corn into ethanol (using mostly natural gas), then ship it to the destination, which is done not by pipeline but by rail car. So the producers are captive to suppliers and at the mercy of shipping companies – trains – who are their only viable option.

And they have no control over the selling price of the finished product. Of course, they can use futures contracts and OTC swap transactions to lock in prices and smooth revenues. But the producer itself has no influence on prices. They can’t simply make a “better” ethanol than someone else, no matter what marketing says. As of today, the March ethanol contract on the CBOT was going for $2.00 per gallon. The so-called “crush spread” is about $1.25 at the moment (crush spread = ethanol price times 2.80 minus the price of corn per bushel). So the gross margin on corn is approximately 31%. Not bad. But that’s just the cost of goods sold. Consider all the SG&A and interest expenses these plants have to cover, that $1.25 per bushel can get used up rather quickly.

Anyone downstream of corn production does not so much like ethanol, because it has increased costs substantially. Ethanol demand currently accounts for about 20% of corn production. New plants are coming online soon and will boost that demand significantly – and production is looking to double by 2008 if planned construction takes place. This does not bode well for producers, as corn prices are likely to stay high. On the supply side, farmers can grow on additional acres and convert from existing crops to corn. But the supply of land is limited. Maybe they shouldn’t have sold so much land to developers – corn is now where the money is!

Several of these new plants are likely to be ill-conceived – a response to favorable market conditions this past summer. I recently reviewed a prospectus and projected financials for a new biodiesel plant that it proposed to go up here in Iowa. They’re projecting $2.35 per gallon on the top line for biodiesel to make this work! These projections were prepared in August, when gasoline prices at the pump were over $3.00! I question the assumption that with diesel pump prices to consumers right around $2.50 that they’ll get wholesale rates that high. And the soy oil they’re using as an input costs over $2.20 per gallon right now. Biodiesel is a bit different than ethanol in that there is the same amount of energy in 0.88 gallons of biodiesel compared to a gallon of gasoline and gets a higher tax break. So it actually trades at a slight premium. But making it work with soy oil alone priced above the wholesale price of diesel is a pipe dream.

I typically don’t like purely commodity industries where there are no bargaining powers with suppliers, and who have no pricing power whatsoever. If this were a business not protected by tariffs and tax breaks, it would not exist. But those tax breaks and tariffs are more likely than not to continue, because of the support of politicians from both sides of the aisle.

Given all the press about alternative energy, you might think ethanol companies would be doing quite well. Yet publicly traded ethanol pure-plays such as VeriSun (VSE) seem to reflect declining sentiments about industry prospects. The most difficult questions to answer are also those that are fundamental to an investment decision in this industry – (1) what will gasoline prices do and (2) where will corn prices be? Frankly, I can’t answer either with conviction. But given increasing demand for corn, a crop that has little ability to expand significantly in supply, and increasing capacity coming on line for ethanol production, more likely than not the returns to this industry will fall and the most efficient producers will win out.

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