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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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The Oil Industry’s Cautious Investing

8 Nov

According to a new study by the International Energy Agency and mentioned in the Wall Street Journal today, the world oil industry has “barely increased” investments in oil and natural gas production during the past five years after accounting for cost inflation. That is, just 5% between 2000 and 2005. Well, that’s all fine and dandy, but these companies do have to account for cost inflation because they are the ones who have to pay these increased costs. And these are up 70% between 2000 and 2005. So from the companies’ perspective, they are making increased investments in oil and gas production. And this report also doesn’t seem to be considering efficiency gains resulting from new technologies these companies are using – it simply takes the investment dollar figure and adjusts it for industry cost inflation.

What worries me is that this report could provide Democrats with added leverage in getting some sort of “windfall profits tax” out of these companies. That would be just what we need – more government involvement in private business (yes, this is sarcasm). Where was the government a few years ago when some of these companies were barely making their interest payments? Will they return these windfall profits back to the energy companies when (if) prices decline? It seems like the memories of our legislators are entirely too short. In the past, the oil and gas industry has been one of boom and bust cycles. Now that industry executives have wised up and are wading somewhat cautiously into new investments while prices are high, they may get punished by the government in the form of higher taxes. My advice to those who want a windfall profits tax? Leave the market be and go read up on basic economics.

Chesapeake’s Smart Move

28 Sep

Today Chesapeake Energy (CHK) announced the reduction of about 6% of its daily production volume that is unhedged because of low natural gas prices.

It’s not often that you see a company sacrifice short-term numbers for the benefit of long-term wealth creation. With NYMEX natural gas prices hitting $4.20 (front month) Wednesday, CHK would still realize an over 100% cash operating margin (given cash costs are only about $2/mcfe). Yet management knows NG prices are on the low-end and that Mr. Market is likely to provide them with higher prices in the near future.

Meanwhile, today’s press release updated us on their hedging position, which is even better than reported at year-end:

“The Oklahoma City-based company has locked-in prices averaging $9.24 per thousand cubic feet for about 92 percent of its expected production in the second half of the year. About 80 percent of Chesapeake’s anticipated 2007 production is hedged at $9.92, and about 60 percent of 2008 production is contracted at $9.44.” An enviable position to be in.

Great company. Buy it; the CEO has been doing so at prices higher than today’s.

Disclosure: The author owns shares for clients as well as personally.

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