Ethanol: Wall Street Meets Main Street
By Todd E. Alexander and Jonathan L. Phillips
The ethanol industry is in a period of extraordinary growth that is in large part driven by a ban on methyl tertiary-butyl ether, or “MTBE” — an ethanol substitute — and the availability of tax subsidies and credits at the state and federal levels. The industry has also benefited recently from a decline in the price of its primary feedstock — corn — and a substantial increase in the price of ethanol.
The combination of these factors has created favorable returns for producers, which naturally has translated into heightened interest from institutional investors, private equity houses and the money-center banks.
The fundamental issue for the future financing of the industry is whether these sources of capital will be able to satisfy their internal criteria for investment within an industry built to satisfy the needs and the requirements of farm coops and rural development banks.
The industry had its roots as a means for domestic corn producers to hedge the price of corn against the price of ethanol. Ethanol facilities themselves have tended until now to be owned by farm coops, who raised their equity from individuals and their debt on a project basis from rural development banks, municipal bonds and government agencies. These facilities did not benefit from long-term feedstock or offtake contracts, nor did they have long-term hedging plans in place to safeguard them from corn and ethanol commodity risks.
This environment has created a fragmented industry full of small facilities with limited access to equity and debt and without the specializations necessary to negotiate hedging mechanisms and other contractual nuances necessary to facilitate project financing.
At the same time, ethanol production in the US is booming. It increased by 32% from 2002 to 2003 and by 91% since 1999 when California first announced its plan to ban MTBE as an additive to gasoline. MTBE has now been banned in California, New York and Connecticut, and it is estimated that this ban alone will account for 1.4 billion gallons of increased annual ethanol demand, or roughly the industry’s entire production in 1998.
This growth has continued into 2004. In May, the industry set an all-time monthly production record of 221,000 barrels per day, according to data released by the US Energy Information Administration. It was the eighth consecutive all-time monthly production record.
The federal government has made two important incentives available to ethanol producers. The first is a subsidy of up to $7.5 million per project under a bioenergy program run by the US Department of Agriculture. The bioenergy program is fully funded through fiscal year 2006 and is designed to encourage the use of “farm products,” such as corn and other grains, for use in the production of energy. A producer’s right to payment is based on the volume of year-over-year increases in its use of feedstock.
The second is a federal excise tax credit. The tax credit was first enacted in 1978 and has now been extended five times. It has two important blender incentives: a partial exemption from the gasoline excise tax and an income tax credit. The excise tax exemption is currently equivalent to 52¢ (reduced to 51¢ in 2005 and 2006) per gallon of ethanol for specific ethanol blends. The income tax credit usually equals the excise tax exemption and is based on gallons of ethanol purchased; however, the credit is classified as income to the producer effectively offsetting a portion of the gain. For this reason, most producers elect to use the excise tax exemption rather than the income tax credit. Both benefits are scheduled to expire in 2007, although a bill extending both through 2010 has passed both houses and is currently stalled in a House-Senate conference committee.
At the state level, 36 of the 50 states have incentives to encourage production or use of ethanol. Of these 36 states, 22 have incentives supporting ethanol production and 32 have incentives supporting the use of ethanol as fuel. Developers of ethanol facilities may also have available to them tax-increment financing, property tax abatements and other similar support from states and municipalities.
A Shift in Paradigm
The ethanol industry began as a cottage industry that provided a means for domestic corn producers to hedge their own corn crops by producing relatively small quantities of ethanol and other by-products. These early days in the industry were marked by local coops raising equity from hundreds of individuals through significant effort. The equity was at best leveraged on a project basis at a 1:1 ratio, and debt was only available from limited sources with fairly short maturities, such as rural development banks, municipal bonds or government agencies. Because rural coops were developing the initial projects with limited financial resources, these projects were limited in size and capacity. To this day, farmer-owned ethanol plants comprise the single largest segment of ethanol producers, representing approximately 40% of US capacity.
The existing model is changing. Given the tremendous need for capital to satisfy the growing demand for ethanol and reported returns on equity in the 25 to 40% range, it seems unlikely that the farm coop model will continue to dominate the industry.
There are four emerging trends that we have recently seen that are likely to alter the make-up of the market substantially. The first is plans by existing corporate participants to increase their production. Examples of this include the Archer Daniels Midland Co. announcement that it is expanding its production capacity at four plants and the Cargill proposal to import ethanol from Latin America for the first time.
The second is proposals by developers to construct new facilities with annual production capacities of at least 80 to 110 million gallons, which is a significant departure from the 10 to 30 million gallon facilities generally favored by farm coops. These larger facilities will allow the developers to capitalize on economies of scale, but require greater access to equity and debt and more sophisticated funding sources to capitalize on leverage while maximizing returns.
The third is interest in siting facilities on either of the coasts where there are fewer existing facilities and demand is highest. This would reduce the cost of ethanol transport and, for the first time, require a large portion of the feedstock to be shipped from the corn belt.
The fourth is investment in the ethanol industry by companies not traditionally focused on the agricultural sector. Examples of this include the acquisition by Morgan Stanley Capital Partners of the ethanol production facilities, marketing operations of Williams Bio-Energy, and the acquisition by Abengoa of High Plains, one of the largest ethanol producers in the US, as well as an interest in another facility developed by Baard Renewables.
Traditional funding sources in the project finance community will probably provide a significant share of the debt and equity required for these new ethanol facilities because of their ability to accept construction risk, use complex financing structures and supply large sums of money with long maturities for non-investment grade companies.
Nevertheless, several obstacles remain. Without a doubt, the biggest of these obstacles is the inability of ethanol producers to enter into long-term fixed price contracts for feedstock, typically corn, and offtake, typically ethanol and other co-products produced during the ethanol production process. This inability to use long-term contracts effectively to fix the differential between the cost of a facility’s feedstock and its primary revenue sources is further exacerbated by the non-corollary nature of the price of feedstock and ethanol.
Although prices for both corn and ethanol are relatively volatile, no one appears to have yet devised a cost-effective way to hedge the price of feedstock against the price of ethanol on a long-term basis. Under present conditions, an ethanol producer cannot purchase forward contracts for corn for more than six to 12 months without paying a significant premium, which effectively squeezes a facility’s operating margins. Likewise, the purchase of forward contacts for ethanol or, alternatively, unleaded gasoline, which is closely correlated, have historically become prohibitively expensive more than six months forward.
This inability to demonstrate fixed operating margins has severely curtailed the ability of most ethanol facilities to attract capital from institutional investors, private equity houses and money-center banks. It has also created an industry of hedge specialists dedicated to the ethanol industry, fostered failed attempts by insurance companies to craft insurance coverages that would protect policyholders from excessive swings in the price of corn and ethanol, and encouraged efforts by ethanol producers to enter into long-term, fixed price contracts directly with farmers for their feedstock.
Ethanol producers have at least two other means of partially mitigating changes in the price of their feedstock through the use of dry or wet milling facilities. A dry ethanol facility produces dried grains with solubles — called “DDGS” — as a co-product. DDGS is sold as cattle feed where it is mixed with corn, soy and other products. The fact that DDGS is a substitute for corn means the price of DDGS tracks the price of corn closely. Thus, as the price of corn rises or falls, so does the price of DDGS. This provides an effective hedge of approximately 30% of corn price fluctuations. A wet mill facility, although significantly more expensive to construct, has the benefit of being able to shift production among several core products and co-products, including ethanol, corn sweeteners, corn germ, corn gluten meal, fiber and stillage and other industrial starches. As the prices for corn and ethanol move divergently, operators are able to switch production to other higher-value outputs to offset market shifts.
Ethanol producers and their financing sources should also be able to mitigate risks by applying customary project financing techniques.
The following is a summary of some of those more commonly used. One technique is a pledge by the borrower of its rights to receive payments under the bioenergy program. These funds can then be used to either create an additional reserve for the lenders or to fund any reserves fully that may have been drawn prior to receipt of the bioenergy payment. A second is the coupling of a cash sweep with an amortization schedule that has a majority of the interest expense and principal repayment occurring in later years. This allows the borrower to prepay the loan if market conditions remain favorable while providing the borrower with a cushion if market conditions deteriorate. In fact, lenders using this structure often create a stepup in interest rates if the loan is not prepaid on an accelerated basis. A third technique that is widely used is a working capital facility provided either by a relationship bank or by the ethanol off-taker. This has the twin advantages of allowing the borrower to purchase feedstock during times when spot prices are below those budgeted and providing the borrower with a temporary cushion when its margins are squeezed. A fourth technique is the use of subordinated debt or preferred equity to increase the project’s senior debt service ratio. This allows the borrower to better match its debt and equity with the risk appetites of the various funding sources.
Will the new players invest?
There is no doubt that the ethanol market has entered a phase of tremendous growth and that institutional investors, private equity houses and money-center banks are all considering investments in the ethanol industry. Their ability to minimize the variability of their returns through the use of hedging techniques, different milling technologies and structured finance will ultimately determine whether they will be willing to invest in this industry.