One can say that business is the opportunity to convert risk into reward. In the past 18 months, 16 ethanol companies representing more than 50 plant locations found reward totally beyond their grasp, got overtaken by risk, and filed for bankruptcy protection. The question for those who hope to succeed in today’s ethanol industry is whether the rules of the game have changed, and if so, what’s the appropriate way forward?

Ethanol Today asked a number of industry veterans to distill lessons from the fiscal bloodletting of 2008 and 2009. None of the wisdom is really new, but the economic challenges of this year-and-a-half have brought these rules of thumb into sharper focus.

To capture the overall change in strategy, John Christianson likes a baseball metaphor.

“Ethanol companies need to hit more singles – get that grind margin more consistent – instead of hitting some homeruns, with a lot of strikeouts,” said Christianson, who has developed one of the most well-respected benchmarking database software systems for ethanol companies, a key service provided by his Willmar, Minnesota-based CPA firm, Christianson and Associates, PLLP.

Along with greater consistency of (smaller) positive margins, our ethanol industry experts point to benchmarking as the only way to make the cold, hard, brutal fact of consolidation work in your favor.

Some ethanol companies created leadership structures that would be more responsive to risk – it’s not enough to assume profitability follows simply from maximization of production. Other ethanol companies sought balance; while it is notoriously difficult to forward-sell ethanol, the notion of obtaining a quantity of grain and then quickly marketing all the ethanol it would produce seems in hindsight like the sensible approach. Still other companies are seeking strategic relationships, particularly in the marketing area, to serve them better and help lay off some of the risk.

And in a triumph of poetic justice, farmer-owned companies capitalized on their experience and actually picked up a bargain in the midst of the general distress in the industry.

Don’t fear the Reaper – know, accept, even be the Reaper

Investment banker Mark Lakers, one of a handful of experts who predicted the extent of the ethanol industry’s financial challenges in 2008 insists, however, that these have always been the rules observed by the winners of the game. He goes further and notes that every maturing industry in 20^th century America consolidated – shrinking from hundreds of major players down to a handful.

Ethanol can’t expect to be exceptional, according to Lakers, who is president of Agriculture and Food Associates, a specialty investment bank based in Omaha that does transactions for investors in renewable energy, agriculture, food manufacturing, and related industries.

The smart players will do everything in their power to understand where they stand relative to the competition, in order to build or maintain the value of their company, with the object of selling out at the right time, Lakers believes.

“Benchmarking,” Lakers said. “If you aren’t doing that – if your board won’t – I would get out, sell as soon as possible… 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.”

Lakers, who considers himself a student of industry consolidation, notes that in the past few decades some people became very wealthy by selling their beer companies to Anheuser-Busch. It’s all a matter of timing. The 200 beer companies in 1970 are now Anheuser-Busch with 60 percent of the market, Miller with 25 percent and a dozen other companies sharing out the rest, he said.

“Contrary to what people say, no one is smart enough to say either when (consolidation) will happen, or at what rate,” Lakers said.

There are five or six drivers of consolidation, and perhaps at the top of the list would be new technology and the cash to buy it. Companies so favored will be able to produce more ethanol and coproducts at lower cost and so achieve a higher rate of return over the longer term.

With the entrance of Valero, the nation’s largest oil refiner, consolidation in the ethanol industry can no longer be denied. Houston-based Valero, a massive consumer of ethanol, purchased seven plants from bankrupt VeraSun Energy in March 2009, and then won approval to buy two more VeraSun plants and a Renew Energy plant. When the dust settles, Valero will own 1.1 billion gallons of ethanol production capacity. Two years ago it owned none.

Ethanol industry experience becomes a kind of capital

One might wonder how the principals of Guardian Energy convinced the banks to do what they did. The banks sold the 110 million gallon per year (mgy) Janesville, Minnesota plant to a group of six farmer-owned ethanol companies in a financing that featured a debt-to-equity ratio of six-to-one.

The answer is experience. Randall Doyal, CEO of Al-Corn Clean Fuel in Claremont, Minnesota and interim CEO of Guardian Energy during the acquisition, has 28 years experience in the ethanol industry, 14 of them running Al-Corn. The managers of the other companies also brought lots of experience into the deal.

In contrast, when Al-Corn went online in 1995, and the dry-grind ethanol industry was largely unproved, the banks required a 50-50 split of equity and debt.

“AgStar Financial was the lead negotiator for the banking group,” Doyal said. “They knew most of us (ethanol company managers in the Guardian group), knew our experience, knew our balance sheets inside and out, and they were very comfortable with that level of expertise. I’m not sure all the banks in the group had that same level of comfort. They had just been stung by the ethanol industry and here an ethanol group wanted to take over the note. But at the end of the day we were able to convince them it was a good deal. AgStar, the leader of the group, really helped everyone feel good about the deal.”

The Guardian Energy model represents a number of strengths, Christianson believes: depth of industry knowledge, diversity of locations and even technologies among the six owners, and the heavily discounted purchase price (well below construction cost).

“These bankruptcy sales have created a group of plants within the industry with different cost structures,” Christianson said. “It can be an advantage to own a well-capitalized plant with a lower cost structure.”

Guardian Energy was a one-off deal with each of the six companies participating in ownership according to its own sense of what it could afford and its own appetite for risk, Doyal said.

“Folks with big, strong balance sheets and lots of capital reserves could have done the project all on their own, but didn’t, maybe because they didn’t want to put all their marbles in one thing,” Doyal said. “Going forward, our group has learned a lot. If another opportunity came along we would consider it.”

How to hit more singles

Christianson and Associates PLLP has developed its Biofuels Benchmarking System, a software database that has attracted 50 ethanol companies who input financial and operational data and can gauge how they are performing in terms of profits, costs, and efficiency. In the near future the system will also measure environmental footprint factors.

“When you break it down, 70 to 75 percent of the ethanol company’s cost is the feedstock. Companies are looking at the need for real-time data, especially analyzing their grind margin ,” Christianson said. “This kind of data is a necessity in order to make good business decisions . The other thing we are seeing is companies reviewing their business processes to ensure that they have proper decision making, consistent with good internal controls and consistent with good data being generated. What’s happening is that they are realizing the impact of their risk management policy. It needs to be one that is adhered to and that is effective. Plants are now building their working capital with the positive cash flow generated during the middle two quarters of 2009. They are building working capital because they know it’s not easy to get from their lender. We are seeing healing. They are being much more effective at managing their balance sheets. The thinking process is, not only does this decision make me the most money, but how does it affect my cash flow, how will it impact my business position? This shift is good. It will benefit the plants in the long run. By using the Biofuels Benchmarking program plants are asking themselves, how do we get better? They are spending time analyzing and improving their plants.”

Being more responsive to risk, keeping inputs and output in balance

Just as financial conditions hit their worst, Glacial Lakes Energy was bringing its new plant in Mina, South Dakota, a 110 mgy plant, on line. That facility doubled the company’s output. Its Watertown plant produces approximately 110 million gallons annually.

“We began the hedging and buying and creating of corn contracts for the new facility, and that’s where we got caught on the wrong side of the market. Most everyone we talked to anticipated that corn prices would continue to go up as did we,” said Jim Seurer, CEO of Glacial Lakes Energy, recalling the period in mid-2008. “We didn’t have ethanol locked in and we were long corn. As a result, we had to take some pretty heavy hits. We didn’t have the ability to lock up forward ethanol sales with our current marketer at the time. On top of that we had production problems at the Mina facility. All the negative events seemed to come to a head around August and September 2008.”

With the mounting difficulties, financial and technical, Glacial Lakes could see that it needed a new approach in order to protect the investment of its 4200 shareholders, most of them farmers from South Dakota.

The management and board put their heads together and designed an entirely new structure of committees to help direct the company’s operations, including a new risk management committee.

“We formed our new risk management committee about a year ago,” Seurer said. “Previously, the risk management committee was made up primarily of management, and there wasn’t much focus or leadership, so we tapped four board members who had familiarity and expertise with the process of risk management to serve on the committee.

“We also adopted a strategy to ‘stay even,’ to buy corn and sell ethanol at same time and not get too imbalanced, to hopefully lock in both products at a positive margin,” Seurer said. “To accomplish this, we knew it was critical that we find an ethanol marketer who would allow us to pick deals so we could sell our own ethanol. Previously we had been part of a pooling arrangement, and this strategy just didn’t work. Now, when we purchase 100,000 bushels of corn we can go out and sell the roughly 300,000 gallons of ethanol that will come from it, and be mostly balanced.”

The approval by Glacial Lakes Energy’s banking group was the real stamp of approval, Seurer feels. The banking group insisted on a new structure before any more hedging could take place.

“The new risk management committee has created more focus and better governance on behalf of the board ,” Seurer said. “We, as management, are able to use the talents of the board members and the time they have – the end result is a better team effort to manage this critical process of our business.”

The committee meets every two weeks, and also benefits from new talent brought into the senior management ranks – the company CFO and its new Director of Grain Commodities, both whom have prior risk management experience.

“We meet and talk about strategies, how far out there can we go,” he said. “We look at market conditions, talk about strategy, and we do the various analyses required by our new risk management policy. The committee put it together, and it has been accepted by our bank group… which we believe is a validation that we are on the right track. I believe with 95 percent certainty that we are on the right track.”

Strategic relationships

The six companies that bought the Janesville plant didn’t just find each other for this opportunity. Al-Corn, Golden Grain Energy, KAAPA, Heartland Corn Products, Central Minnesota Ethanol, and Chippewa Valley Ethanol are all owners together of the marketing service they share called RPMG. In 1996, unsatisfied with their ethanol marketer, Heartland and Al-Corn began developing what would become Renewable Products Marketing Group. This company has become the third or fourth largest marketer in the U.S., according to Doyal.

Short of starting one’s own marketing service, many ethanol companies will be shopping around for a better fit in their marketing service going forward.

“Plants are demanding more transparency from their marketing services,” Christianson notes. “They are demanding to know what their positions are, what the marketer is selling their product for, so they can manage their grind margin. Companies are realizing they need to know what they are making on their product out into the future, so they can manage that grind margin. The market will push the marketers in the direction of transparency because the ethanol plants need that information and they are going to demand it.”

Redfield Energy, LLC, an ethanol company 70 miles west of Watertown in South Dakota produces around 53 million gallons per year. The farmer owners found out the hard way that the risk was too much for them to handle on their own.

“When corn was seven dollars we should have shut down and sold the corn,” said Ron Frankenstein, an area farmer who serves as chairman for Redfield. “We owned all that valuable corn and then the market crashed. Everyone thought the only direction the market would go was up. Everything has a correction.”

After living through that pain, Redfield found what they feel is an excellent strategic partnership: South Dakota Wheat Growers, a full service elevator group, has taken over a hundred percent of their grain-supply needs.

“For various reasons, farmers do not deliver corn to the ethanol plant regularly, week by week,” Frankenstein said. “We soon learned that we were purchasing three-quarters of our feedstock from the elevator. Farmers always want to sell high and the ethanol plant wants to buy low… Under this new arrangement with South Dakota Wheat Growers our corn suppliers enjoy all the benefits of dealing with an elevator. They can sell months in advance… For an ethanol company not too flush with working capital, we learned we couldn’t be buying inputs too far in advance. We don’t buy too much more in inputs than we have sold in output. The real ace in the hole for Redfield Energy is our location on the western fringe of the Corn Belt where corn consumers enjoy anywhere from 10 to over 40 cent-per-bushel lower corn costs.”

The most fundamental relationship for an ethanol company is with its financial underwriters.

“For an ethanol plant, good communication is the most essential point with their lender,” Christianson said. “They have to make sure that they are communicating regularly. At this point, the lenders are looking at management – they are asking themselves do we think this management group can make this a success? Do they have the discipline to do the risk management? Do we agree with the business plan and the strategy? For instance, is the ethanol company looking at continuing leverage, or deleveraging its plants?”

Another key issue in the lender-ethanol company relationship is liquidity.

“Most plants now are looking at building their working capital to get to a comfort level, both for themselves, and for the lender,” Christianson said. “Prior to 2007, lenders typically sought covenants that stated ethanol companies had to maintain ten cents a gallon of production capacity in working capital. That went to fifteen cents. Now, since the economic downturn, most banks consider 25 cents per gallon to be a healthy level of working capital.”

Finding the right strategic partners for marketing and banking, fine-tuning risk responsiveness, adopting a strategy that makes for positive margins more consistently over time and build the value of the company – either to woo future buyers or to become the one who can buy other companies – these are the old rules that look brand new after the ethanol financial rollercoaster of 2008 and 2009.