July/August 2011

Ethanol Industry … Running on Empty?

At one time, investors 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.

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 are 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 flack. Now because of the commodity squeeze, the nation’s 204 ethanol plants must confront another dim prospect in the face of rising commodity prices: A return to the bankruptcy-ridden years of 2008-2009 and the continued shift in the ownership mix from small independents to major food and oil conglomerates.

You Can’t Make Money

In 2007-2008, 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. You built a $200 million plant that produced 100 million gallons per year, with plans to recoup your 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% of the cost of producing a gallon of ethanol. Scores of ethanol producers filed for protection under the U.S. Bankruptcy Code in 2009-2010. 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 during the past two months. 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 the price 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% 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 lower pressure on prices. According to the RFA, there is now 25 days’ worth in 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. Ratings agency Fitch 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%, driving up the market 50%. The EPA’s efforts to implement the 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.

The Choices Facing Ethanol Producers

Of the 204 ethanol plants in the U.S., well more than 100 of them are smaller independents. Conglomerates such as Archer Daniels Midland and Cargill 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. While not a part of a conglomerate, the family-owned business had the financial strength to buy and refit the former Altra Biofuels Cloverdale, IL, plant. POET has 27 U.S. plants.

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

* Out of Court. They can gather up all their secured creditors and resize 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.

* In court or in a bankruptcy proceeding. 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 also sell its self 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.

* Toss the keys back to the bank group. The current owner could agree to a foreclosure where the lenders foreclose on the equity of the company and then take 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 are 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

Many investors have jumped into the renewable energy space with the hopes of making money from breakthrough technology. While these investments admirable examples of the American Dream, it is wise to understand the dynamics in one’s 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.

Rob Carringer is a managing partner of CRG Partners, an international turnaround management firm. He has served in multiple bioenergy assignments and has filled interim c-level roles as well as Chapter 11 trustee roles. He is a Certified Turnaround Professional and a member of the Turnaround Management Association. He earned his Bachelor’s and Master’s degrees in industrial engineering at Penn State University.