2011 Threatens to Repeat 2008-’09 in Ethanol Economics

High corn prices and lower ethanol prices will squeeze independents out
By Rob Carringer | June 10, 2011

Since its introduction as an alternative to fossil fuel-based gasoline in the 1980s, ethanol has proudly worn the patriotic green alternative badge to shipping dollars overseas for oil. And as more ethanol-friendly engines are built and governments mandate ethanol blended gasoline, both demand and production for the corn-based fuel is at all-time highs.

Despite continued government support through tax credits and the federal fuel mix standard, it’s not all roses for ethanol producers, however. The industry receives criticism for those tax breaks, for using too much of the nation’s heartland water supply and for driving up the price of corn and thereby food, among other flak. Now because of the commodity squeeze, the nation’s 200-plus ethanol plants face another dim prospect in the face of rising commodity prices: A return to the bankruptcy-ridden years of 2008-’09  and the continued shift in the ownership mix from small independents to major food and oil conglomerates.

Margin Squeeze
In 2007-’08, 137 ethanol plants were either built or expanded, according to the Renewable Fuels Association. All of those plants were built on the promise of $1 per gallon profits available at the time. Investors built a $200 million plant that produced 100 million gallons per year, with plans to recoup their investment within a short period and enjoy substantial profits thereafter.

Immediately, the scenario crashed. With all of the capacity, the demand on corn rose and so did prices of what comprises about 85 percent of the cost of producing a gallon of ethanol. Scores of ethanol producers filed for protection under the bankruptcy code in 2009-’10. The industry did not contract as expected, however, as the plants emerged from bankruptcy under new ownership and kept producing.

Already this year, three plants—Levelland/Hockley Ethanol in Texas, Clean Burn Fuels in North Carolina and Southwest Georgia Ethanol—have filed for bankruptcy reorganizations. They won’t be the last. Here’s why. In an industry known for running on thin margins, those margins have been reduced to pennies on the gallon and even losses on some days. Corn is threatening the $8 per bushel mark while ethanol is selling for $2 a gallon. As the industry heads into the next few months, the stocks of corn remaining from last year’s harvest are dwindling, which may cause prices to climb higher. A plant that I am familiar with was making 22 cents per gallon last October. In April it made 4 cents per gallon.

The prospect of margins improving is not bright. One driver behind ethanol price is volume. The industry was driven by the 10 percent mandated blend in all U.S. gasoline, so as gasoline sales go, so goes ethanol. With the continued political upheaval in the Middle East, oil prices have risen and taken gas prices along. As gas prices increase, people drive less and consumption goes down and with it less ethanol is used. As a result, ethanol inventories are rising steadily, month by month, putting pressure on prices. According to the RFA, there is now a 25 day reserve, compared to a 2010 average of 16.6. To be sure, farmers planted more corn this year, but it will have little impact. Any lower prices in 2012 will be too late for many ethanol producers, many of whom are staggering under heavy debt loads. Fitch Ratings Ltd. has also warned of problems in ethanol, fearing bondholder activism in the industry.

The government could decide to increase the blend of ethanol to gasoline from 10 to 15 percent, driving up the market 50 percent.  The EPA’s efforts to implement the higher blend standard were temporarily derailed in Congress this year and only applied on a voluntary basis for owners of newer vehicles, so there’s no immediate help there.

Tough Choices
Of the 200-plus ethanol plants in the U.S., well over 100 of them are smaller independents. Conglomerates such as Archer Daniels Midland Co. and Cargill Inc. can expand market share at bargain prices in bankruptcy sales. I also expect the large oil companies to get more into the industry this year as demonstrated by Valero and Murphy Oil purchases last year. By producing ethanol, they control one more component of their supply chains. The largest ethanol player is a private company, Poet Inc. While not a part of a conglomerate, the family-owned business had the financial strength to buy and refit the former Altra Biofuels Cloverdale, Ill., plant bringing its total to 27 plants.

Restructuring Options
It is unlikely new investors will come into struggling ethanol investments with hundreds of millions in bank debt. If companies are operating with substantial debt, they need to restructure that debt to remain competitive in the marketplace with all the other companies who have already done this. They have few options and can restructure in three ways.

First, they can restructure out of court by gathering up all their secured creditors and resizing their debt to a level reasonable for the amount of cash flow the company produces. The lenders will want equity in return for downsizing their debt. This will be a long and difficult process to gain agreement. Companies should act now before they run out of cash and have to shut down to force decisions.

Secondly, restructuring can happen in court. In bankruptcy, a company can restructure its balance sheet and exit bankruptcy via a plan of reorganization whereby the secured lenders will reduce their debt levels but take equity in return. Odds are the existing equity players will lose most if not all of their position in the highly levered companies. The company can sell itself via a bankruptcy asset sale. The sale proceeds would be used to pay down the debt in priority sequence. The buyer would then own the company’s plant as of the closing free of the original debt load.

Third, the company can toss the keys back to the bank group. The current owner agrees to the lenders foreclosing on the equity of the company and taking it over. This process can be cumbersome and varies often state by state. Many lenders aren’t comfortable with this procedure and steer the company toward the bankruptcy court.

None of the prospects is attractive.  Many of these 110-million-gallon plants costing $200 million to $250 million have been valued at $75 million in recent bankruptcy sales. The pain will be shared by others, including by most ag banks with ethanol loans.

Ethanol as a Cautionary Tale
Many investors have jumped into the renewable energy space with the hopes of making money from breakthrough technology. While these investments can be an admirable example of the American Dream, it is wise to understand the dynamics in your marketplace. The ethanol business operates between two commodity markets, corn and gasoline, either of which can pressure margins. Any commodity business requires an enormous amount of capital and diversified holdings to withstand the swings of supply and demand.

People in the ethanol business thought they could go in small with one plant and make a fortune, but it isn’t turning out that way. Conglomerates continue to purchase the investor’s expensive assets for a small percentage of the cost. New investors need to understand the challenge of scale when competing in a business where the profits are measured in pennies.

Author: Rob Carringer
Managing Partner, CRG Partners
rob.carringer@crgpartners.com