Beyond The Correction

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Within three years, the ethanol industry has gone from boom to bust. Many ethanol plants are generating red ink, and a number of ethanol companies have shut down operations or filed for bankruptcy. A recent, stark example was Valero Energy‘s recent announcement that it planned to buy five of VeraSun Energy‘s operating ethanol plants for about 25 cents on the dollar. VeraSun is currently working through Chapter 11 bankruptcy proceedings.

As a result, those in the ethanol and related agribusiness industries, as well as investors — whether invested in the handful of public ethanol companies or privately owned ethanol plants and companies — wonder about the outlook for the ethanol industry.

Before I attempt to answer that simple but complex question, let me first revisit my historical perspective on the future of the ethanol industry to provide some context.

My outlook since the start of this latest ethanol boom in early 2006 has changed very little: The ethanol industry’s business model was and is unsustainable. The ethanol buildup would trigger irrational exuberance in spite of guaranteed markets in the form of the renewable fuels standard and federal and state subsidies.

The result? A dot-com boom/bust in the corn fields, followed by a dramatic industry consolidation, leading to the selloff of distressed plants for no more than 25 cents to 50 cents on the dollar.

In my mind, the key to building a viable long-term biofuels industry has always been market-driven sustainability. That is, a market without the need for long-term subsidies that can exist in a volatile oil pricing environment, in which costs would have to be driven down to levels competitive with oil as low as $25 to $30 per barrel.

Unknown Severity

I could have never forecasted the severity of the current global economic meltdown, which has contributed to the freefall in oil prices from a high of $147 per barrel during mid-2008 to current $30 to $45 per barrel levels. But it had been my view that oil prices at $50 to $60 per barrel and rising in mid-2006 — let alone $100+ in the first half of 2008 — were unsustainable. The dramatic surge in oil prices was being driven by the synchronicity of global economic growth, fueled by global financial liquidity and the impact of global financial speculation on crude oil as a financial asset class.

My experience as a Wall Street analyst during the 1970s, watching the impact of the first and second oil crises when oil jumped from $3 to $36 per barrel in two stages, taught me that it takes time for energy/oil supply increases and demand decreases to adjust to a quantum jump in oil prices.

As a side note, consider this: Crude oil prices never reached $100 per barrel in the late 1970s and early 1980s, which was the consensus forecast at the time. Similarly, we never reached $200 per barrel last year, the forecast that many oil experts were championing in early 2008.

‘Energy Independence’ And Ethanol

I want to make it explicitly clear that I have been and continue to be a fervent believer in the long-term strategic value of renewable energy, in which biofuels could play a major role to enhance U.S. energy security and potentially redefine U.S. competitive position.

In my opinion, those who have waved the flag of “energy independence” to support the buildup of ethanol have severely underestimated the dramatic implications and market changes necessary to accomplish such an aggressive goal. Taking this one step further, there is a real question over whether the goal of “energy independence” is in the country’s best interest from a resource allocation perspective, given the dynamics of energy globalization.

Second, whether you are talking about ethanol currently produced from corn or potentially from cellulosic ethanol, the challenge of creating a sustainable and market-driven industry has been approached much too simplistically.

The development of a successful and profitable ethanol industry has lacked a focus on risk analysis to mitigate potential risks from an economic, business, and investment perspective, let alone a higher standard that is necessary when it comes to enhancing U.S. energy security.

The strategic bet being made by the government and the American public is that biofuels will become a major sustainable source of our transportation fuel supplies, which will reduce our
energy security risks.

In my view, this strategic bet requires a higher standard of success in comparison to the risks taken on in the development of other embryonic industries whose success or failure does not impinge on U.S. national/economic security.

Whether one is talking about corn-based ethanol or cellulosic ethanol, business strategies are needed to deal with a combination of expected oil price volatility (which ultimately determines ethanol prices), as well as potential volatility in crop/biomass prices. This expected volatility is due to the interdependence of global energy markets and crop markets, especially since the U.S. is a major exporter of all the major row crops that dominate U.S. agricultural acreage.

If the U.S. is to be successful in developing and creating a sustainable market-driven biofuels industry in which ethanol plays a major role, the industry needs a makeover — not only to develop long-term sustainability, but also to provide a very favorable long-term investment environment for both public and private companies including farmer-owned ethanol companies.

In addition, while initial subsidies and significant government-funded R&D support are clearly needed to develop cellulosic ethanol, successful long-term investment will occur in company business models that do not need long-term subsidies to assure sustained profitability, taking into consideration broad volatility in oil/ethanol prices and biomass/ag-related raw material prices. 

Risk Mitigation Is Key

Viable Biofuel:
Three Big Factors

The challenges to creating a large-scale, low-cost, cellulosic-based ethanol industry are significant, and will take a long time to develop despite best industry efforts.

A corn-based, cellulosic-based, or mixed feedstock-based ethanol company will require a business model to create a low-cost position, including the following three factors:

1. Multiple plants geographically dispersed with large, flexible, regional feedstock procurement capabilities.
2. Vertical integration with feedstock flexibility and risk mitigation supply/pricing strategies
3. Feedstock supply and procurement strategies to mitigate regional, weather-induced feedstock supply risks. This includes risk tied to “natural variability,” which could be intensified by larger global warming-driven erratic weather impacts. — Sano Shimoda

Significant challenges are ahead for the industry in terms of scientific and technological hurdles that must be overcome. However, my simplistic view on the future of biofuels is that economic solutions will be found to solve these very difficult challenges, such as the conversion processes of biomass into ethanol.

The real hurdle to developing a sustainable biofuels industry is the need to structurally change industry and business strategies to be able to profitably deal with potential volatile price risks and unintended consequences.

The approach companies have had to ethanol development has in many respects been too simplistic. In a commodity-based business two areas of strategy are paramount: strategies for aggressively driving down costs and strategies for mitigating potential risks to create long-term sustainability. Both are lacking in the approach to ethanol. In fact, what we are doing now is trading one risk — the risk of crude oil supply disruption from unstable Middle East or other foreign oil sources — for another risk — the impact of weather risks on regional corn/ag residue/plant or crop-based biomass feedstock supplies for the ethanol industry.

Whether or not you are a believer in global warming as a cause of erratic, non-typical weather patterns, the risks to crop/biomass/ag residue production from “natural variability” in weather patterns has been understated as a potentially significant risk to the U.S. biofuels strategy. Proactive strategies to minimize this risk will require dramatic structural changes in U.S. government policy and agribusiness strategy.

In the world of corn-based ethanol, what if there was a drought in a regional section of the Midwest (for example, Northwest Iowa or Southwest Minnesota have a high concentration of ethanol plants), that resulted in localized corn supply shortages for individual ethanol plants, let alone sky-high corn prices? When you look at ethanol plant concentrations and resultant overlapping corn draws for current plants in many parts of the Midwest (and the existing transportation/supply infrastructure), many ethanol plants would be forced to shut down, jeopardizing supplies and leading to potential ethanol shortages, a surge in prices, and would ultimately reduce the availability of fuel nationwide.

In the case of cellulosic ethanol, there is a similar risk of regional, weather-induced supply disruption, but there are other formidable challenges to reaching economic viability. These include high production costs, high harvest/transportation/supply logistics costs, and weather impacted supply constraints on cellulosic feedstocks.

Even if scientific advances can create competitive biomass conversion economics, the harvest/storage/transportation costs are extraordinary high, given volume/mass considerations, and the simple fact that harvesting most crops will occur only once a year.

Consider that just as corn prices were bid up from late 2006 through early 2008 by the surge in incremental ethanol demand, tightening global supply/demand balances, and the impact of the oil price surge (which has a indirect influence on corn prices), the price of ag residues could be bid up to prices substantially above current estimates used for cellulosic plant economics.

Consider that corn stover as a potential biofuel feedstock is not a valueless entity — it has significant fertilizer and land erosion value. Growers would demand significantly larger price premiums than are currently forecasted to recapture this lost value.

Another factor to consider is the evolution of agronomic practices around next generation seed developments. Seed companies are commercializing advanced stress traits such as drought tolerance, which will change the economics of crop production in both current and marginal growing areas. Significant competition for this marginal land, driven by changing per acre profit dynamics, could create significant unintended consequences in terms of volatile, market-driven biomass/ag residue/energy crop acquisition costs for cellulosic ethanol plants.

Long Live Corn Ethanol?

In my view, corn-based ethanol could have a much longer life than most people think. Following what I would expect will be near-term industry consolidation, individual companies may redesign their business models to create long-term, market-driven sustainability.

There is the potential for single-plant based ethanol companies to survive and prosper based on innovative R&D cost strategies, as well as unique business models and strategies to mitigate market price volatility and risks.

Just as occurred with the dot-com boom and bust, a few well-positioned companies with well thought out strategies and unique business models — think Amazon, eBay, and Google — demonstrated the power to create very successful companies. The challenge for ethanol companies and the industry is to develop new, evolutionary industry/business models to create long-term, sustainable profitable growth, and for some to take advantage of an expected period of dramatic industry consolidation.

Shimoda is founder and president of BioScience Securities, Venice, CA.

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