Finding Business Success in a Changing Ethanol Industry

Independent producers will require new strategies to stay viable.
By Scott McDermott | June 25, 2013

The makeup of the ethanol industry has changed in the past five to seven years. As we look at some of the largest ethanol companies today, the 12 companies listed in the accompanying chart account for almost 53 percent of ethanol production capacity and comprise about 38 percent of total plants. Of the 12, more than half had little or no presence in the industry prior to 2007, but now account for a quarter of ethanol production. It is almost certain there will be more new faces and changes to the company mix in the next six years.

Independent ethanol companies still number more than 100, operating about 130 plants that account for about 47 percent of capacity. The table shows the dramatic changes in size, capacity and plant numbers; but it masks another important dynamic. It is the makeup of these industry players and the business they do outside the ethanol industry that will have important implications for independent ethanol companies going forward.

There is a growing influence from industries other than ethanol represented by the companies listed, as well as many independents not listed. Some of the outside industries represented among ethanol companies include energy/petroleum, grain/diversified agribusiness, advanced biofuels, cellulosic biofuels, sugar/sugarcane ethanol, food/alternative feedstock, bio-industrial, beverage and industrial alcohol. 

Historically, ethanol processing margins were driven by supply and demand fundamentals in ethanol, energy and corn, plus feed and policy impacts. As more ethanol companies diversify, the economic incentives to expand or contract production are changing. For a growing number of companies, at least part of production decisions will be based on considerations outside the core ethanol-making business. 

One example is the corn wet miller, whose decision to make ethanol is one part of a larger corn-processing optimization equation, including many factors outside the ethanol and petroleum industries. Another is among petroleum companies, where the decisions to make ethanol and invest in their captive ethanol plants are not only based on ethanol margins, but also on blending economics, the prices for renewable identification number (RIN) credits and their obligated volume requirements under the renewable fuel standard, as well as other factors. 

Over time, the implication of these outside influences will be seen more noticeably in the  EBITDA (earnings from the business before the capital structure items like depreciation, interest and taxes) competitiveness of ethanol producers and how those companies respond to difficult margin environments. Between 2008 and 2012, in a pool of plants that grew from 23 to 31, the average range of EBITDA from lowest to highest was 38 cents per ethanol gallon. During that period, the narrowest spread was 24 cents per gallon and the widest spread was 64 cents per gallon of ethanol. Most of the variance in margin spreads today among companies is driven by the difference in business decisions, price volatility and individual hedging activity.

New technologies like corn oil extraction, fractionation, better corn component separation and advanced/cellulosic biofuels technology will give some companies direct EBITDA advantages, while others will fail to monetize new technology and take losses. The earnings diversification and outside business influence will have indirect impacts on EBITDA margins and on the supply and demand fundamentals in ethanol. 

Today, when ethanol supply outpaces demand, margins tighten and plants idle until supply and demand comes back into line and margins improve. This scenario played out from 2012 to the present with average EBITDA margins at 4 cents per gallon of ethanol. Similarly, when ethanol demand outpaces supply, margins expand, plants increase production and idle plants start to produce. Supply and demand comes back into line, and margins compress. This scenario played out through 2011 with average EBITDA margins at 25 cents per ethanol gallon. 

The net effect of increasing outside business influence will likely drive more volatility in earnings, a wider margin spread between low- and high-EBITDA companies and could cause market downturns to be deeper and/or longer because the ethanol production decision will go beyond basic corn, ethanol and coproduct processing margins.

So what does this mean for independent ethanol companies? They will not only have to invest to continue to become more competitive, but they will have to get better at selecting and deploying new technology investments. Some will look to leverage scale economics through mergers or acquisitions to fund performance improvements and new technology, and some may need to look at diversifying or vertically integrating their business in order to be competitive in the longer term. All this points to the importance of returns to management—the board and managers whose leadership and vision is needed to move the business to the next level. 

Oil Refining Proxy
If we use the oil refining industry as a proxy, there were similar dynamics that drove some industry participants to great opportunity and displaced others. Again, looking at the refining numbers and history only tells part of the story. Today, 90 percent of U.S. oil refining capacity is owned by eight companies. The ethanol industry is not likely to scale up to the same degree as the petroleum industry because of grain logistics and the renewable fuels standard. We have seen some scaling, though, as we moved from building 25 MMgy to 55 MMgy to 110 MMgy plants, and we will likely see more in the future. 

The richer part of the petroleum consolidation and restructuring story was the upgrading of low-value byproducts into higher-value coproducts. This evolution of the petrochemical industry brought us polymers, packaging, fibers, lubricants, construction materials, paint coatings, healthcare and pharmaceutical products. These products touch almost every part of our lives today, but the industry was born out of a simple business of providing heating oil more than 140 years ago.

For ethanol companies, the harsh market reality means that some will not make it to this next level. It is imperative that independent ethanol companies assess and understand their position regarding economic competitiveness and value in the marketplace and conduct strategic and tactical planning for attaining the best value for their shareholders. Independent ethanol companies will need to implement a disciplined new-ventures assessment process that goes beyond annual capital-expenditure budgeting. They will also need more robust capital planning to support performance improvements and new technology implementation. 

Almost all operating ethanol companies today still have value commensurate with the investment the owners made, although some have more and some less value. This means most ethanol companies still have options. If independent ethanol companies choose to monetize their business through sale, they should time and plan their exit to maximize their valuation just as they would for any business venture. It is important that you sell when the market is right and before there is a technology innovation that requires capital investment just to maintain your current valuation in the marketplace. 

At some point in the not too distant future, it will not be enough for independent ethanol companies to simply have good financial and plant management. The board and management will have to position the business to be viable and sustainable in a changing market environment. We are pleased to work with many independent ethanol companies that are leading the industry in making such changes to their businesses today. 

At face value, this seems intimidating, but we are still fairly early in this transition so ethanol companies have some time. Unlike industry consolidations where the only option is scale or die, there are great opportunities and numerous options for ethanol companies that engage in taking their business to the next level of improved returns and performance. The biggest risk to independent ethanol companies is not in having the wrong plan, but rather, in not having a plan.

Author: Scott McDermott
Partner, Ascendant Partners Inc.
303-221-4700 
Mcdermotts@ascendantpartners.com

 

 

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