Ethanol holds promise, but faces some big challenges

Corn prices are up, companies have hedged prices at high levels, and more players may be getting into the market; but governments are fuelling demand for ethanol with rising mandates for its inclusion in gasoline.

What a difference a month makes: When the U.S. Department of Agriculture released its November monthly crop report, the news wasn't good for the ethanol industry.

A slow harvest and rainy weather during the growing season forced the USDA to drop its forecast for corn production by 1 per cent, although this year's harvest will still be the second highest on record. Most importantly for the ethanol industry, which mostly relies on corn as the cheapest way to make its fuel, the revised forecast predicts prices for corn will rise by 6 per cent.

The reason? High demand, partly because of ethanol producers, who last year used one-third of corn produced south of the border.

For investors considering the ethanol industry, corn prices are only one part of the profit equation, says Darrel Good, an agricultural economist at the University of Illinois. Regardless, a 6-per-cent price hike is bad news for the industry, he says. However, higher corn prices can be offset as long as gasoline prices and ethanol prices remain high, he adds.

Government subsidies and mandates are other factors that have a huge impact on ethanol producers' profits, because they provide a ready market for the fuel, says Dr. Good and other experts.

But there is a down side to those government-led mandates: As demand for ethanol grows, more players will try to enter the market. And as industry capacity increases next several years, ethanol prices will be under pressure.

“There are multiple parts to the equation in terms of determining profitability,” says Tom Graves, a New York-based equity analyst at Standard & Poor's. “Corn is a significant input cost, but we also have to look at that in relation to what price they are able to get for the finished product, the ethanol.”

With corn currently hovering at roughly $3.75 (U.S.) a bushel and ethanol about $1.95 a gallon, he says “ethanol producers should still generally be able to be profitable.”

Ethanol producers south of the border get a lot of help from the U.S. government, mostly in the form of mandates for blending ethanol. Each petroleum company is given a mandated quota of how much ethanol they have to blend into gasoline – which works out to about 10 per cent ethanol in gas sold for automobiles. By comparison, Canada will make 5-per-cent ethanol mandatory starting in September, 2010.

Those mandates, Dr. Good says, will continue to rise as the U.S. government boosts “green energy.” However, the government is demanding that future increases be from cellulosic ethanol, which is made from inedible plant fibres, like stalks and grain straw – instead of a food-oriented product like corn. Dr. Good estimates that producing cellulosic ethanol costs twice that of corn-based ethanol. While growing cellulosic materials may be cheaper than growing corn, it is much harder to break cellulosic fibres down into their component sugars and so processing costs are higher.

Petroleum companies are given a subsidy for blending the ethanol into gasoline that works out to 45 cents per gallon in the form of a tax credit. Some states provide other incentives, but federal subsidies go to the gas companies, not the ethanol producers.

But in Canada, the federal government's subsidies go to producers, says Gordon Quaiattini, president of the Canadian Renewable Fuels Association. The $1.5-billion, nine-year program allows ethanol plants to receive these benefits for seven years, on a sliding scale that starts at 10 cents a litre.

In the United States, the ethanol industry is also anxiously awaiting a decision from the U.S. Environmental Protection Agency, which is looking into whether automobiles can run efficiently if gas contains 15 per cent ethanol, a change the ethanol industry lobbied hard for.

“There is a big debate on how an automobile engine will function with ethanol up to 15 per cent,” Dr. Good says. “The EPA said they would make a decision by Dec. 1, but now it looks like that deadline will not be met.”

Investors weighing a leap into the ethanol industry have to be prepared for volatility because the investment is focused on commodities. There are fluctuations, not just in corn prices but gas and ethanol prices.

About 18 months ago, the price of corn was almost double what it is today. Some ethanol producers, worried that corn prices would go even higher, hedged corn prices, Dr. Good says.

“They bought corn at what they thought might turn out to be a low price, but in fact they ended up buying large quantities of corn near the height of the market. Subsequently, both corn prices and ethanol prices declined quite sharply. They locked into what turned out to be a very large negative margin.”

Following this turn of events, VeraSun Energy, the second largest ethanol producer, filed for bankruptcy protection. It was followed by two other major players, Aventine Renewable Energy Holdings Inc. in April and Sacramento-based Pacific Ethanol Inc. (PEIX-Q0.35----%) in May.

Mr. Graves says that while “ethanol economics look okay now,” he believes the industry could be a victim of its own success. “I think there's a threat going forward that more capacity could come on stream, putting some pressure on ethanol prices.”

Mr. Graves follows a number of large multinational firms that produce a number of agricultural products, including ethanol. One of the largest players in the ethanol market is Illinois-based Archer Daniels Midland Co. (ADM-N31.40----%) , which announced earlier this month that its first-quarter profit fell 53 per cent to 77 cents a share. However, those results were better than expected, Mr. Graves says.

He believes that the company will benefit from “a relatively large U.S. harvest of some major crops, like corn” and from improved economic activity overall in 2010.

Mr. Graves has a hold on the stock, saying “it's worth holding onto.” His 12-month target price is $34; the stock closed Tuesday at $31.26, just off its 52-week high of $33.

In the case of Bunge Ltd. (BG-N63.02----%) , another multinational that produces ethanol, Mr. Graves has a sell rating, with a target price of $58. It closed Tuesday at $62.68. His concerns with Bunge relate to their fertilizer division and to “the adverse impact of currency fluctuations.” The company, which reported earnings in October, “came in a little less that we anticipated.”

In Canada, the largest producer of ethanol is privately held GreenFields Ethanol Inc. The second-largest producer is Suncor Energy Inc. (SU-T38.01-0.93-2.39%) . The oil giant was one of five Canadian energy companies that had its ratings increased last week by Bank of America Inc. But its new “buy” rating stems from its investment in oil sands, not from its involvement as an ethanol player in Canada. Of 23 analysts tracking Suncor, 17 have buy rating, 4 have holds and 2 are sells, according to Bloomberg.

source: theglobeandmail