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Ethanolís 2008: Moving Forward by Looking Back
by Jonathan Eisenthal

Some have described 2008’s dismal ethanol finances as a “perfect storm” that brought together simultaneous record high corn prices, plunging ethanol prices, and the collapse of banking and financial industries that meant credit dried up just when it was needed most.

And one of the great virtues of ethanol plants, from a public standpoint – big industrial facilities that will not relocate – became something of a millstone in that lenders, stuck with failed ethanol companies, had few if any buyers to sell to, amplifying the reluctance of banks to lend to the industry.

There are varying answers to the question of how to prevent such a debacle from flattening any more ethanol companies. Some say continued consolidation is inevitable. Timing played a key role in the survival of this round. Existing or well-capitalized players with relatively smaller debt loads could ride out the storm, while the newer entrants into ethanol, in hindsight, overpaid in order to get their plants built while the rush was on, and huge debt structures toppled them when the credit crisis arrived.

In a phrase, it was “irrational exuberance” that brought so much pain to the ethanol industry, and indeed to the entire U.S. economy, according to industry expert Tom Waterman.

Waterman, who has observed and written about the energy business for 25 years, publishes “The Ethanol Monitor” and plans to publish a book about the industry: “Ethanol and the United States, an Industry and a Nation at the Crossroads.”

“There was a big rush to build ethanol plants, no doubt about that, and the market got overpopulated. The rush caused the construction costs to rise, a lot of debt was taken on, and there wasn’t enough profit to go around,” said Waterman, giving the big picture of 2008, simply. “Now, those who have made it this far will probably survive.”

In January 2006, the U.S. ethanol industry had existing production capacity of 4.34 billion gallons per year (bgy) and 1.93 bgy under construction, but by the next year, when 1.15 bgy of that construction came on line, the capacity under construction jumped to 6.13 bgy. Passage of the Energy Independence and Security Act into law in December 2007 continued the exuberance: 2.5 billion gallons of new capacity went on line in 2008 (totaling 7.89 bgy production rate), and another 5.54 bgy remained in the offing. Only in 2009 did the construction rush slow, and yet new projects still represent a little more than two billion gallons in capacity.

The IBT commodities report “Pressures on Fuel Ethanol Capacity” from November 18, 2009 states that when that is added to January 2009 nameplate production capacity of 12.48 bgy, we will see 14.55 billion gallons of ethanol per year coming from U.S. plants. That’s more than 10 billion gallons of new capacity since 2006 – a 235 percent increase.

Is there another industry in the U.S. that has doubled its output in the past four years?

All this capacity depressed margins at the same time that corn prices went skyward, reaching $8 a bushel in mid 2008. While ethanol prices followed oil’s absurdly skyrocketing price (to a height of $147 a barrel), the added capacity could be incorporated and sales were still profitable – everyone was winning. Until the market realized there was no reason for either $147 a barrel oil, nor $8 corn. The speculative capital left the industry as fast as it had entered, like the rushing ebb after a spring tide, leaving many in the industry high and dry.

By one count, 15 ethanol companies have sought bankruptcy since December 2007, encompassing as many as 46 ethanol refinery locations. Some of those locations remained in operation, and after changing ownership, most are now on line, and indeed, the tide appears to have turned again – for the time being.

Many of the remaining players, large and small, came right up to the edge of the cliff and stared into the void, but managed to hang on. Redfield Energy, a 53 million gallons per year (mgy) plant 70 miles west of Watertown, South Dakota, was one such plant. In the fall of 2008, things became critical.

“We had paid every principal and interest payment, but at the time we needed a certain amount of working capital. We dropped below the levels in our bank covenants, the banks were getting scared and they asked us to raise more working capital,” recalls Ron Frankenstein, chairman of the Redfield plant board. “Other ethanol plants had gone through that same thing. This was a time when share prices were very depressed relative to what people had paid for them. We were concerned, but we got the job done.”

The company – about one-third of the owners are farmers who hold about half of the company’s equity in Class Type A Stock (requiring delivery of grain according to shares) – has recently worked out an agreement with South Dakota Wheat Growers, a full service elevator group, to provide all corn needed by the plant. This allows their corn producers to utilize marketing programs no longer available at many ethanol plants.

A predictable washout

Some industry observers recount how the debacle came about, and the fact that it could have been foreseen.

“When you talk about soaring input prices and crashing ethanol prices as ‘the perfect storm,’ it’s an excellent way to describe it,” said John Christianson, whose Willmar, Minnesota-based CPA firm Christianson & Associates PLLP specializes in the renewable fuel industry. “It started with the mind-blowing run in commodity prices. That was from the last part of 2007, into the third quarter of 2008, through September 2008.”

The ingrained frugality and conservatism of farmer-owners, along with good timing, made the difference for many a smaller plant when things got to the toughest point, according to Randy Doyal, CEO of Al-Corn Clean Fuel in Claremont, Minnesota, a 45 mgy plant built in 1995. Al-Corn and many other small farmer-owned plants focused on paying off loans and building cash reserves because they could see the overbuilding of the industry looming. As a result, these older plants didn’t have the kind of debt charged up by companies owned publicly, or owned by absentee-investors with less direct knowledge of agriculture and a too-rosy view of commodities markets.

“It was the debt load that made it very tough for the newer companies to get through this,” Doyal said. “At these new companies, the debt level was so much greater on a per gallon basis, which is the best way to think about it. If you contracted and built a plant in 2005, it cost a dollar or $1.25 per gallon of capacity to get it built. By 2007, it was $2.50 – ethanol projects would have twice the cost. Local groups or investors weren’t coughing up that much more equity. Banks and Wall Street were throwing money at ethanol, cost be damned. A lot of facilities got built at very high cost. Having to operate a facility with that kind of debt load when margins go negative becomes impossible. You watch it start to eat up your balance sheet, your working capital, you can’t get loans – it became impossible to stay in business.”

Christianson has taken it on as a personal goal to improve real-time data for the industry, and his company’s Biofuel Benchmarking service helped 50 ethanol companies keep tabs on their fundamentals as prices of inputs and product saw major shifts on a daily basis.

“The graph shows that the ethanol price was rising and held above $2.56 a gallon from June through September of 2008,” Christianson said. “It is difficult even today to lock in prices forward. You can lock in as a factor to RBOB or some other measurement on the exchange, but it remains difficult to lock in contracted sales of ethanol a long way out. Did it lead to this perfect storm? Many ethanol plants had a risk management plan that locked in corn as it was rising during the end of 2007 and the beginning of 2008. They knew they had their corn procured, and ethanol was rising, so life was good. Then, in the second and third quarters of 2008, things changed.”

The prices ethanol plants paid rose from $3.80 to over $6 or $7 per bushel. With yields averaging 2.8 gallons per bushel, profit on $2.56 per gallon of ethanol zeros out at $7.16, with only the distillers grains coproduct to keep things positive. Still, the plants eked out sustainable margins until June 2008, according to Christianson, when the grind margin for the ethanol plants plummeted.

The margin between the cost of the corn and the price of the ethanol and distillers grain products reached its lowest point in the third and fourth quarter. The average grind margin of the 50 plants participating in Christianson & Associates benchmarking service fell to less than a dime per gallon of product. With the 24 cents per gallon average cost of operating the plant—firing the steam turbines, paying the employees, and keeping the lights on – plants with large debt faced serious trouble.

“So we see net losses for the four quarters ending 9/30/08 through 6/30/09,” Christianson said. “The industry as an average began to see profitability again in the third quarter of 2009. The four quarters of losses were compounded by the fact that the losses created cash flow shortages, and the credit markets had dried up, so there was no one willing to add exposure into the biofuels industry… which turned out to be a tough financial answer for many ethanol plants.”

Of course, there were those who saw this coming. Wells Fargo Economist Michael Swanson began saying at the height of the 2005 ethanol boom that ethanol producers would build more and more capacity until all profitability from ethanol was gone.

Mark Lakers, president of Agriculture and Food Associates, an investment bank based in Omaha, observes: “Purely from an academic point of view, and from a strategic point of view, this is fairly highly predictable. If you want to stay in the ethanol industry longer than the next five years, you’ve got to be very smart in where you are in relation to the industry. Or you will lose your money. All your money. “

“We have an ethanol client that has no debt, has cash in the bank and is looking for investments,” Lakers said. “They are very disciplined, a there’s a very good chance they will survive. They also know that maybe there is a time to exit.”

Lakers, who has devoted much of his professional career to studying industry consolidation, says benchmarking will separate those who survive (at least until a profitable sale or IPO) from those who washout.

“There is technology evolving that is making operations more efficient, more profitable, lowering cost,” Lakers said. “Things like fractionation and biorefining... access to those technologies exists only for those who have the cash to buy them. This is one of just five or six things that we’ve seen in the consolidation of other industries, whether it’s brewing beer or making pork or producing ethanol.”

For the moment, the worst appears to be over for the industry as a whole. The November 2009 announcement of bankruptcy by Otter Tail Ag Energy in Fergus Falls, Minnesota may represent the final chip that falls in this washout round. Officials there have made positive comments about where their reorganization will put them.

“That’s where planning comes in,” Waterman said. “Anything can happen and often does. You are always one weather event away from escalating corn prices. What a lot of people jumped on – these bankruptcies and reorganizations – they said ethanol was falling apart, but that was not true. Ethanol was not any worse than any other industry. No one was immune. It gets overblown by the ethanol industry’s opponents .”

Current tallies put the number of operating plants around 180. Most ethanol concerns are making money now, many enough to put positive numbers to annual financial statements for 2009. But Waterman is not shy in placing blame for why ethanol, and every other business for that matter, stumbled so badly in the past 18 months—deliberate distortions of the oil market through futures contracts, and then later all commodities futures, not only crushed the ethanol businesses, but made a hash of the entire economy. He notes that four of the last five economic downturns have come as a result of oil shocks.

Commodities speculation becomes a poison to the economy

So why did the commodities markets turn toxic? As Waterman will tell you, America’s energy futures markets began once deregulation allowed producers, consumers, and traders of oil to make arrangements to reduce risk. He describes how the first successful U.S. energy contract, a heating oil contract offered on NYMEX in the late 1970s, succeeded by helping producers manage the risk of very low prices, while also helping the consumer avoid paying very high prices. For traders, acting as go-betweens and making a little money on the volatility spread, the contracts meant avoiding the wrong timing of the highs and lows.

Each party to a futures contract becomes a hedger, Waterman notes. Starting in 2005, the nation’s largest banking firms, using capital in the form of index funds, took an interest in energy contracts as hedges for their institutional and large investors – people who had no direct stake in these markets.

In 2008, speculative hedgers brought vast sums of money into the market.

An academic observer of the commodities meltdown, Professor Michael Greenberger of the University of Maryland Law School points to the Senate’s permanent subcommittee on investigations findings: “The total value of the speculative investments in commodity indexes has increased an estimated tenfold in five years, from an estimated $15 billion in 2003, to around $200 billion by mid-2008.”

Waterman and a number of other experts are not shy about assigning the blame, not only for the inverted price picture in the ethanol industry, but also for bringing on the worst economic crisis since the Great Depression.

“The financial collapse of 2008 took shape right in the commodities futures market and is all about how it can be manipulated, and I know the CFTC (Commodities Futures Trading Commission) is going to say they can’t find manipulation… this is beyond them,” Waterman said. “CFTC defines manipulation as a planned operation that causes an artificially high price, yet large purchases in a short period of time can also quickly distort prices, but the CFTC would never classify it as manipulation.”

Is objective analysis still objective when the company that publishes the information knows how it will affect the market and the company can position itself to profit from the change?

“Several investment banks made predictions about rising oil prices, but the one that seemed to make headlines was Goldman Sachs,” Waterman said. “When they predicted $150 per barrel oil by mid-year 2008, the market jumped by several dollars the very next day. Nothing fundamental had changed, and yet this simple statement created a feeding frenzy. A lot of people got very wealthy and consumers paid the tab.”

Many will argue the mortgage crisis precipitated the economic downturn.

“Did the mortgage crisis drive the Japanese economy down?” Waterman asks. “Japan was crushed by escalating oil prices. We should never forget that four of the five recessions since the 1960s have been caused by an oil shock of some sort. Yet none of them were on the scale of what we witnessed in 2008.”

Waterman and others feel the need for reform of commodities futures markets is critical, but they remain skeptical of the government’s ability to have an effect.

“The CFTC is limited in that its personnel are trained to observe and audit,” he said. “They can spot trends, find manipulation, but how do you establish rules to limit the herd mentality? Limiting investment firms (participation in commodities trading) would be a good first step.”

Greenberger echoes Waterman’s observations that index funds run by the major banking firms, not only took up huge positions in the commodities futures market, but took advantage of the hysteria they could create with reports about the limits of world oil reserves. In one instance the price per barrel of oil jumped by more than $18 following one such “analysis.” That was on September 22, 2008. Greenberger notes that the entire cost of a barrel of oil in January 2002 was $18.

Greenberger charts the course of oil over 18 months: “We have seen dizzying volatility in crude oil prices during the last 18 months. With no underlying change in supply and demand, the price of crude oscillated from $65 per barrel in June 2007 to $147 in July 2008 to $30 in December 2008 and back up to $72 in June 2009.”

Among other effects, this huge influx of speculative money and the amplified volatility it caused made it impossible for “physical hedgers” – the producers, traders, and consumers who actually needed the oil or corn or other commodities – from using futures contracts to manage their risk any more.

In Congressional testimony on August 5, 2009, Greenberger quotes the work of Congressman Bart Stupak, Chairman of the House Energy Committee’s Subcommittee on Oversight and Investigations: “In 2000, physical hedgers – businesses such as airlines and trucking companies that need to hedge to ensure a stable price of fuel in future months – accounted for 63 percent of the oil futures market. Speculators accounted for 37 percent. By April 2008, physical hedgers’ share of the same market had dropped to 29 percent, with speculators now controlling an astonishing 71 percent of the oil market. The market was taken over by swap dealers and speculators.”

All the cash that was exiting real estate and the Wall Street derivatives that backed the mortgages on all these price-inflated properties suddenly needed a new home. Commodities provided little more than a stop on the way, but that massive influx and outflow bent and then broke commodities trading, and the rest of the economy with it, Waterman says.

“Speculation started in energy, but it quickly moved to all commodities ,” Waterman said. “I am not an economist, but when it’s all added up, it will be energy prices that produced the biggest recession since the Great Depression. Before the crisis, a family of four spent 7 percent of their income on energy, and then that spiked up to 20 percent last year. Follow that with runaway unemployment. No wonder we have the mess we are in, and we are far from out of it. If energy prices should take off again, we will see double-dip recession – it will make the double dip in the early 1980s look like a rally, and people will not buy anything. I’m afraid Washington could miss this completely.”

Waterman remains skeptical that commodities trading will ultimately respond to reform. Strict rules here could simply shift speculative swaps to the ICE in London or some other forum. And Lakers says that wherever traders find an opportunity to trade, they will. It’s nothing new and it means that only the smart will survive in the ethanol industry, Lakers said.

This is the first in a two-part article that examines the 2008-2009 financial crisis in ethanol. The second part asks experts to discuss ways to prevent the pitfalls that afflicted so many companies during this period.

 
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The American Coalition for Ethanol publishes Ethanol Today magazine each month to cover the biofuels industryís hot topics, including cellulosic ethanol, E85, corn ethanol, food versus fuel, ethanolís carbon footprint, E10, E15, and mid-range ethanol blends.
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