05 February 2007 00:00 [Source: ICB Americas]
Billions are being spent to more than double production capacity of ethanol in the US. Is the big biofuels gamble worth the risk?
To call it a field of dreams would not be hyperbole. The heartland of the North American continent is notable for the many vantage points from which one can look and see nothing but corn, in flat vistas stretching for hundreds of miles. The view so enthralled Soviet leader Nikita Krushchev that he ordered his country to plough under its fields of wheat and plant corn.
The disastrous harvest that followed led to Krushchev's ouster.
The passage of more than four decades has done little to diminish this crop land's hold on the imagination. Ethanol, made in the US mainly from corn, is currently propelling a boom in the hinterland. Used as a fuel additive since the 1930s, ethanol production had already received a boost from the government's rapid phaseout of MTBE, a carcinogenic gasoline additive, but with tax incentives and goals encouraging its use an alternative fuel, and the price of gasoline hitting new records almost daily, demand has blossomed.
The significance of these developments, over the past year at least, has not been lost on investors.
About $950m in aggregate was raised in three high-profile IPOs (initial public offerings) in the latter part of 2006.
With crude oil trading at over $70/barrel and corn cheap, the first of these, VeraSun Energy, the second-largest ethanol producer in the US behind Archer Daniels Midland, was first out of the gate in early June, with an IPO that priced above range at $23 per share to raise $420m.
But it pays to be first. Despite VeraSun's initial success at raising money, it has lost ground ever since, closing the year at $19.75, near its all-time low of $14.88 and way south of the $30.75 high it has attained so far.
When Aventine Renewable Energy Holdings, the country's fourth-largest ethanol producer, priced its IPO two weeks after VeraSun, it hit the top of its range at $43, raising about $390m. But it soon lost steam, its shares falling 10% on IPO day.
Similar concerns led Hawkeye Holdings to pull its planned IPO in November. By December, the remaining IPO of 2006, US BioEnergy, was priced well below its forecast, raising $140m, or only about half the amount originally floated, at a 13% discount.
Wall Street analysts pointed out that the new production capacity the offerings were bringing on stream hit these companies with investor worry that the sector was being oversupplied, a sentiment that gained traction as the price of gasoline at the pump fell.
Glut worries notwithstanding, the IPOs were only the tip of the iceberg as far as investment into biofuels is concerned. Around $1.5bn was raised by IPOs and secondary offerings of biofuel companies in the second quarter of 2006 alone, up from $75m in the last three quarters of 2005. This number is in turn said to be dwarfed by overall biofuel capital investment, whether by independent developers, financial companies or agriculture or energy companies.
Or take the latest industry capacity/output figures. The month of October 2006 saw US ethanol production equal the previous month's record of 330,000 bbl/day, with demand reaching even higher, to 391,000 bbl/day, up from October 2005's 278,000 bbl/day, according to the Renewable Fuels Association.
Estimates show ethanol production at 4.9bn gallons for 2006, a figure that is poised to double over the next year or so. There are 110 grain ethanol biorefineries in the US, which can produce more than 5.3bn gallons of ethanol. An additional 79 construction projects are under way that will add nearly 6bn gallons.
Much of the credit for this acceleration belongs to the US federal government. With hotly contested presidential elections the recent norm in this country, ethanol incentives are in effect a valuable farm subsidy enabling the political parties to court electoral votes from smaller states and at the same time tout more lofty goals such as energy independence and renewability, meaning that these regulations are unlikely to go away any time soon, at least with 2008 looming.
The renewable fuels standard, passed as part of the 2005 energy bill, stipulates that 4.7bn gallons of renewable fuels such as ethanol be used nationwide in 2007, increasing incrementally to 7.5bn gallons by 2012. The federal government also refunds 51 cents per gallon of ethanol to the companies that blend it with regular gas, and many states offer their own subsidies.
But, even as companies scramble to take advantage of these incentives and market opportunities, there are many that are predicting an oversupply situation.
"We expect that ethanol consumption will increase 25% in 2007 to nearly 6.5bn gallons," says Banc of America Securities analyst Eric Brown, adding that despite his "optimism on ethanol volume growth, [he is] more cautious on ethanol producers. We expect producer margins to erode as the result of falling ethanol prices and rising corn costs. In particular, we believe that oversupply will depress ethanol's premium to gasoline to 20 cents/gallon by Q4 2007 from historical levels of roughly 50 cents/gallon."
"In addition to ethanol pricing, ethanol margins would be negatively impacted by higher cash corn costs, which have increased 48% to $3.21 since 2005," he says.
Demand, on the other hand, is expected to continue to increase. At the federal level, Brown expects Congress to increase the Renewable Fuel Standard from its current level of 7.5bn gallons by 2012 to 12bn-15bn gallons. In addition, he also predicted that "more states will raise ethanol blending mandates up to the maximum limit of 10% ethanol by volume."
Also, ethanol promoters are looking to the newly seated Congress to pass several major pieces of legislation in support of ethanol, including the extension of the ethanol blenders' tax credit.
But Moody's Investors Service's John Rogers sees a bleaker short-term scenario.
"The amount of new capacity coming on stream is tremendous," he says. "It will take over the next 12 to 24 months before you get to the point where prices reflect this. Traditionally, ethanol has priced a little bit lower than gasoline, but we've been way above that for a while."
"I would assume that a lot of the smaller plants, those with 50m gallon capacity," will come under pressure, "given the fact that they're independent," he says.
The smell of success
Shakeout or not, many companies in the West and Midwest continue to bet the ranch on a bullish future for biofuels.
Panda Energy International, a Dallas, Texas-based company, raised $90m in a private share placement in November and additional money through a "reverse merger" arrangement with an existing public company to finance a 100m gallon annual capacity plant in Hereford, Tex. In addition to Hereford, the company plans five other facilities of similar capacity according to an unspecified time frame.
Including Hereford, most of these plants will use cow manure instead of natural gas to power its process, recycling some of the ethanol refinery by-products to feed to the cows themselves.
"We put it in one end of the animal and take it out the other," says Panda's Michael Pentak, who like many of his compatriots in mid-America is bullish on biofuels.
"Of course, there are certain risks involved," he admits, adding that "America is dependent upon foreign oil and the places where we import our oil from, like the Middle East, are not the most stable or friendly."
"The risks we are taking are certainly calculated risks," he says. "We feel good about the ethanol space or we wouldn't be in it."
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