Chadbourne participated in a briefing about the US ethanol market in New York in March hosted by WestLB. The following are edited excerpts from the briefing. The speakers are Tom Murray, managing director and co-head of the loan and debt capital markets group at WestLB, Todd McGreevy, a senior consultant with Muse Stancil, Rohit Chaudhry, a partner in the Chadbourne Washington office, and David Black, president of Americas Strategic Alliances.

MR.MURRAY: Several high-profile individuals like Bill Gates are interested in ethanol development. Gates has invested $84 to $85 million in an ethanol company called Pacific Ethanol. Richard Branson, the founder of Virgin Airlines, is also interested in investing in ethanol.

The main drivers behind the current interest in ethanol are high oil and gasoline prices and the need for ethanol as a replacement for a fuel additive called MTBE.MTBE is being phased out due to its contamination of ground water.

There is significant political support in the United States for ethanol production. George Bush has been promoting ethanol in a series of political events this year. The Energy Policy Act last August set a renewable fuel standard of 7.5 billion gallons a year by 2012. To meet that, we calculate that more than $5 billion will be required for production capacity and several billion more will be needed for support infrastructure.

Now, that being said, the other side of the coin is that there is a fair amount of uncertainty about how this industry will evolve. There are inherent risks such as commodity price mismatch risks between the corn or grain supply and the ethanol output. The large banks and private equity funds are trying to figure out now how to play in the ethanol space.

Some of the open questions that are being asked are: Is ethanol going to be limited to the role of a fuel additive? Will it develop into an economically-viable alternative to gasoline like it has in Brazil? Who in the industry is going to make a profit? Will most of the profit go to the plant owners, the raw material suppliers, the marketers, the transportation providers, technology suppliers or the construction contractors?

Then, finally, what type of plant should one build? Should one build a dry mill, which most of the US plants are? Or should one build a wet mill? Another question a lot of people ask is whether to build in the corn belt or to build a destination plant. Most ethanol plants that have been built to date have been built near the grain source, but many projects under development are destination plants in places like Texas, California and the northeast.

Risks and Possible Mitigants

The first and foremost issue for anyone thinking of providing financing for a plant is the commodity price risk. There is a lack of correlation between the grain supply and the ethanol price. Also, if a significant reduction in oil prices were to occur, it would cause ethanol prices to fall since ethanol is basically a direct substitute for gasoline. Ethanol is profitable currently because oil is expensive. Some of the experts believe the break-even price is somewhere around $25 to $30 a barrel of oil. Oil prices below that figure would make ethanol an uneconomic investment.

There are also legislative risks. The US government allows an excise tax credit, but it will remain in effect only until December 2010. The credit is an indirect subsidy of 51¢ a gallon, provided to the blenders. If the credit is not renewed, it could result in a decrease in the price of ethanol, thereby having a negative impact on the ethanol industry. The US collects duties on ethanol imported from other countries. This helps domestic producers, but there is always a risk that the duty will be suspended.

There are concerns about overcapacity. Many lenders remember the overcapacity in the power sector and how they were caught holding loans to projects that could not repay the loans after prices collapsed. This is a concern on their minds as it relates to ethanol.

Lenders address the risks on the commodity price side by using conservative financial structures that require significant equity and equity-like debt as well as leveraging. There are mandatory cash sweeps that ensure the debt will be repaid in five years, notwithstanding the fact that the useful life of the plant is 20 or 25 years. We are also seeing management services provided by sophisticated players like Cargill and ADM to help mitigate some of the commodity price risk. These mitigants are not enough to allow the capital markets to open to this space.

Some of the other things that are being talked about are tolling contracts with investment-grade counterparties. There are oil and agricultural companies who are talking about providing a contract that would tie the price of grain supply to the ethanol output. That would obviously be a welcome structural change that would open up the debt market to ethanol financing.

There is the potential for vertical integration — of getting the grain supply in ethanol production.We have heard that probably too much land is likely to be required for that to be feasible. However, the concept of grain price subordination to operating and maintenance expenses and debt service is something that may be possible if we have creditworthy suppliers willing to enter into this type of arrangement. We have not seen this yet in the ethanol space. It is something that was implemented early on in merchant power plant financings.

Another option is to integrate the ethanol plant with a co-product plant. This is called a wet mill. In a dry mill, about 85% of the revenue comes from ethanol sales and 60% or more of the operating cost is the cost of grain. That leads to a pretty big mismatch. If you were to integrate a corn fractionation facility or a vital wheat gluten facility into an ethanol project, then your grain cost could effectively be covered by your co-products. The remaining risk could be covered by hedging against ethanol prices.We have not seen that yet as a lender, but many of the large agribusinesses like ADM and Cargill have built these types of facilities.Wet mills are more expensive to build.

There has been a lot of discussion about producing ethanol from cellulosic and waste material. That would limit the commodity price risk to the output side. Currently, such processes are too expensive. It costs more than $2 a gallon to produce ethanol from cellulosic material.

As for possible mitigants of the legislative risks, it is important to note that ethanol plants are profitable on a standalone basis given current oil prices, even without any government support. However, if oil were to drop below $25 a barrel, then additional support would be needed from the government.

We, as a lender, are not too concerned about the overcapacity risk in the short and medium term.We think that the contractors and technology providers serving the sector have too limited a capacity to make overbuilding possible. However, in the long run, overcapacity is a concern and will require vigilance to investors and lenders to prevent.

Trends

I think one trend that we will see is consolidation of the industry. Many plants today are owned by small farmer cooperatives and small developers.We expect pure ethanol companies with larger size and more scope to move into the market. Also, the large agricultural concerns and oil companies may decide to roll up ethanol plants in an ethanol subsidiary.

We think the move from use of grain to less valuable materials, including cellulose materials and waste, as a feedstock is still probably five to 10 years away because of the technological advances that are needed to make use of alternate feedstock economically viable. However, it is important to note that the current generation of grain-based plants can be converted to consume cellulosic feedstock with only minor modifications. All the money pouring into grain-based plants today is not money that will be lost if we develop technology to produce ethanol from cellulose material.

One question on a lot of people’s minds is whether ethanol can become a competitive alternative to gasoline. It is a viable alternative in Brazil where ethanol represents more than 50% of vehicle fuel. There are already service stations in the Midwest that provide E85, which is a blend of 85% ethanol with 15% gasoline, and we have flex fuel vehicles that can consume anywhere from zero to 100% ethanol and anywhere in between.

What is required for long-term success of the ethanol industry is continued high oil prices, which would drive the necessary investment in research and needed infrastructure, or continued temporary government support to accelerate the pace of technological advances. Keep in mind that the excise tax credit runs to the end of 2010.That is another four and a half years to enjoy the benefits of the government support.

Finally, and on a somewhat controversial note,many supporters of the ethanol industry argue that the true price of oil is actually higher than the $70 being charged today on world markets.That’s because the price does not take into account the vast amount of money the US government spends to secure a steady supply of oil from places such as the Middle East. If you taken into account this cost of securing the supply, then the true cost of oil is closer to $200 a barrel. If we could take some of that money and use it instead to advance ethanol, it would go a long way toward the energy independence that we are seeking.

Market Outlook

MR. McGREEVEY: My topic this morning is the “Ethanol Market Outlook 2006 and Beyond.” Ethanol has been part of the US fuel supply for decades. It has been used as an octane and volume extender, primarily in the Midwest where the bulk of the corn supply is located. In the early 1990s, it also found a new niche as an oxygenate for reformulated gasoline.

The US ethanol industry has been in a tremendous upward swing, essentially since 2000, due mainly to the decline in use of MTBE because of the groundwater contamination issues about which Tom spoke and the recent run-up in prices in global fuel markets.There are 96 ethanol plants in operation in the United States.Total aggregate capacity in the United States is 4.3 billion gallons. we are running virtually neck and neck with Brazil for the title of world’s leading ethanol producer.

The Energy Policy Act last August will create significant new demand for ethanol for two reasons. The first is a renewable fuel standard in the bill. It calls for a stepped-up level of ethanol blending beginning in 2006 at four billion gallons a year, ultimately rising to 7.5 billion gallons a year by 2012. This means that the ethanol output must double in size over the next five to six years. The same legislation will also hasten the departure of MTBE from the gasoline pool because the legislation did not provide for any protection for MTBE producers or lenders for liability for groundwater contamination.

Another provision that is ethanol related in the energy bill is the removal of the oxygenate requirement in reformulated gasoline. There has been speculation that this might limit the amount of ethanol blending. However, it is our opinion that removal of the oxygenate requirement will not lead to a reduction in the amount of ethanol blending. However, it could cause some shifting in where ethanol is blended. A good portion of the reformulated gasoline that requires oxygen is consumed today along the Atlantic seaboard and in California.We believe that there could be some shifting of ethanol back to the Midwest closer to where most ethanol is produced.

The US Environmental Protection Agency has not yet issued rules to implement the renewable fuel standard. How it will be implemented remains unclear. Figure 1 (page 40) is a map that shows where all the ethanol plants are located currently. Most are in the upper Midwest. However, a number of plants are beginning to appear on the periphery; Tom called these “destination plants.”

Ethanol, has been limited historically to an extent by a lack of infrastructure for blending. The blending infrastructure is now being added at a very rapid pace, particularly in the northeast, as MTBE is phased out.We believe MTBE will completely exit the gasoline pool by the end of 2006 due to previously-mentioned liability concerns.

Another significant demand driver for ethanol is the organic demand growth for gasoline, which historically has averaged close to 2% a year and should continue to grow at a rate of between 1.5% to 2% a year in the future. The recent run-up in gasoline prices is not restraining the growth in gasoline demand, and so we believe that the market will continue to absorb the price increases and grow at close to its historic growth rate. Demand growth of 1.5% to 2 is the equivalent of approximately adding one large refinery every year in the US and, as most of you know, not a single new refinery has been constructed in this country in more than 30 years.

The primary mode of transportation today for long haul deliveries is by rail. Truck deliveries are more expensive and are primarily used for short-haul deliveries from a central translocation facility to the final terminal where the ethanol is blended.Water-borne transport would be more economical; however, very few ethanol plants are near enough to large rivers to enjoy the benefits of waterborne transportation.

Figure 2 is a rail map, and it shows that the eastern half of the country is far more connected by rail than the western half. It means that ethanol producers located on the eastern side of the corn belt have many more options in terms of where they can deliver their ethanol. That said, the west is a more mature market. It has had ethanol blending since 2004. The eastern side of the country still has a number of markets that are blending MTBE.We believe demand growth in the east could be as much as a 1.5 billion gallons a year in the next couple of years.

I turn now to trends. Figure 3 (page 44) is our forecast of ethanol prices. The ethanol market will become increasingly competitive over time. In order to remain competitive, producers will have to do everything they can to lower costs, and they can do that through a variety of means. One way is by reducing transportation costs. Tom touched on destination plants. Ethanol producers are also improving yields to squeeze more ethanol out of a bushel of corn. Five years ago, the average yield was about 2.5 gallons per bushel. Today, it is more than 2.7 gallons, and there are plants that are yielding close to three gallons per bushel.

Another area where producers are looking to save costs is by finding ways to replace natural gas with other fuel. There are a number of alternative fuel sources that include renewable fuel such as wood chips, distillers grains, or in the case of at least one plant we know of in west Texas, where the owners intend to use cow manure as their primary fuel. In the more distant future, producers will be switching to cellulosic feedstocks like switch grass, corn stover, and other wood products. However, the technology is still in its infancy, and we do not expect to see much impact from it for another 10 years.

Financing Challenges

MR. CHAUDHRY: Let me give everyone an idea of the number of transactions in the market. In 2005 alone, approximately 30 to 40 projects either commenced construction or commenced operations. There are probably more than 100 projects currently under development. Clearly all 100 of these will not end up getting financed.

My focus this morning is on some of the hurdles that producers must overcome to get financing.

One is a lack of a deep-pocket sponsor. This is both an opportunity and a barrier. It creates opportunities for private equity firms. A recent trend is the large number of private equity firms that are chasing some of the existing ethanol opportunities. However, a lack of deep pockets makes it more difficult to get financing for a number of reasons. If you have a deep-pocket sponsor, some risks in the deal that

cannot be allocated to third parties can be addressed by contingent equity support from a creditworthy sponsor. That option is not available when there is no deep pocket. Private equity firms are usually unwilling to provide contingent equity support to address project-related issues. As a general matter, banks derive some level of comfort knowing that a creditworthy sponsor is standing behind a project.

The absence of that, in the ethanol sector, makes financing that much harder. It is not an insurmountable issue, but something to keep in mind.

Also, a sponsor without deep pockets must raise its entire capital structure in the market — senior debt, subordinated debt and equity. While this has been done successfully by developers in the ethanol sector, it takes longer to close the deal and can lead to complicated intercreditor discussions.

The financing for ethanol projects came in the past largely from agricultural banks. Today, it is coming increasingly from New York banks, institutional investors and the capital markets. At the same time, the projects are becoming bigger. There are more 100-million and 120-million gallon facilities compared to the 30-, 40- and 50-million gallon facilities that existed earlier. Those still exist, but there’s a trend towards bigger facilities. There is also a trend toward developers combining two or more facilities in one financing package, resulting in larger financings. As the financing sizes have increased, there has been a natural migration from agricultural banks to Wall Street financings.

Generally, there are higher hurdles to clear to obtain financing from Wall Street sources than from agricultural banks.

Another recent trend is the shallow construction market. There are just not enough contractors and process providers for the number of opportunities that exist. This makes it difficult to get on a contractor’s schedule to commence construction any time in the near future. It is also leading to higher construction costs; contractors who are in such demand can afford to charge more. This, in turn, requires developers to raise more equity in the market or to increase the leverage of the project, which may make it more difficult to close financing.

Another consequence of demand-supply economics that favor the contractor side is that it is getting more difficult to get contractors to accept risks that are typically borne by contractors in a project financing in the New York market. This can be an obstacle to financing.

Commodity price risk is probably the biggest issue on which lenders focus. By and large, ethanol projects have not had long term, fixed-price offtaker contracts or long-term commodity hedges. That is starting to change slowly.We are starting to see medium- or longterm offtake contracts with some of the big oil and gas companies in the most recent deals. Absent such arrangements, ethanol deals are evaluated on a merchant basis. Also, the lack of correlation between the price of corn and the price of ethanol makes it difficult to lock in a “crush spread” that might give a lender comfort that its loan will be repaid.

Another concern for lenders is finite regulatory support. Ethanol production in this country depends on government support. As already mentioned, the two main forms of support are the renewable fuel standard and the volumetric ethanol excise tax credit. The amount of government support is finite. Many ethanol financings are structured around the expected excise tax credit expiration in December 2010. They contemplate low scheduled amortization coupled with high cash sweeps. These cash sweeps are stepped up to higher levels if the excise tax credit is not extended by a certain date prior to its scheduled expiration. As this date approaches without an extension, new financings will become harder to arrange. That said, high oil prices make the excise tax credit less consequential.

It is important to keep in mind that the ethanol industry is still in an infant stage. The ethanol industry has been around for a while, but it has only recently been transformed with the spike in activity, the increasing size of projects and the changing structure of financings. One things that is common to infant sectors is rapid change. If the price of feedstock spikes, or the price of oil drops, the picture could change rapidly. It remains to be seen how things will play out in the future.

Finally, let me talk about recent policy developments affecting the ethanol market. The renewable fuel standard requires that at least four billion gallons of renewable fuels be used in 2006, ramping up to 7.5 billion gallons in 2012. Figure 4 shows the ramp up from 2006 to 2012. From 2013 on, the Environmental Protection Agency is required to establish a new standard. A minimum of 250 million gallons per year of cellulosic ethanol must be included in this new renewable fuel standard starting in 2013.

The renewable fuel standard requires that there be a mechanism for trading ethanol credits. The idea is not dissimilar to what exists currently for trading sulfur dioxide credits. Once trading is implemented, it ought to provide refiners the flexibility to use ethanol where it makes most geographic and economic sense.

Another important policy measure is the excise tax credit. The credit is 51¢ for each gallon of ethanol blended with gasoline. The credit is claimed by blenders. Blenders currently pay 18.4¢ for each gallon of gasoline-ethanol mixture, but can claim a tax credit or refund for each gallon of ethanol used in the mixture. So, if a blender produces gasoline with a 10% ethanol blend, it would be entitled to a 5.1¢ credit for each gallon of gasoline. This measure is currently scheduled to expire in December 2010.

Another existing incentive is a small producer tax credit. A small producer is someone who produces up to 60 million gallons per year of ethanol. Small producers are entitled to a $1.5 million income tax credit — 10¢ per gallon for up to 15 million gallons of renewable fuel a year. This measure is currently scheduled to expire in December 2008.

With respect to MTBE, there are two things of note. One is what Congress did not do and the second is what the states actually did.What Congress did not do is it did not provide liability protection for MTBE producers. This helps boost the demand for alternatives to MTBE, such as ethanol based ETBE. Also, many states — I believe 25 now — have actually banned MTBE. This boosts the demand for ethanol in these states.

Finally, the US protects domestic producers with import tariffs. There is a 54¢ tariff for each gallon of ethanol imported into the United States. This helps protect the US ethanol industry. There are certain exceptions to the tariff, such as the Caribbean basin initiative, which allows ethanol up to a certain amount to be imported into the US from countries that are in and around the Caribbean basin without the import tariff being imposed.

ASA Deal

MR. BLACK:My company, Americas Strategic Alliances, is a merchant banking and investing firm that has been putting a lot of effort into biofuels.

When we started looking at ethanol 18 months ago,80% of plants were owned by small companies that owned a single ethanol plant. It was a very fragmented industry consisting of 40- to 50-million gallon facilities. There was only one 100-million gallon plant, and that was under construction. We could see the opportunity for an institutional player in such a market.However,we needed to get comfortable

with the demand dynamics. In doing so,we spent a lot of time researching and talking to participants in the industry, and we concluded that escalating oil prices and instability in the Middle East would lead to increasing demand over time for ethanol.We were also struck by how most existing plants are in communities of 5,000 or 15,000 people, and putting a 100- or 120-million gallon facility in a community of that size, with $150 to $200 million in annual revenue and with the trickle-down effect on the community — is a win-win situation. Ethanol also helps the environment.

Our first project was three 100-million-gallon-a-year fuel-grade ethanol plants. The plants will also produce 320,000 tons of distillers grains.We spent about three months looking at the plants.We looked at more than 20 potential sites for them in excruciating detail. The three sites we selected were on the outer edges of the corn belt.Two are in Linden, Indiana and Bloomingburg, Ohio and will serve the east coast destination markets. The third project, in Albion, Nebraska, is well positioned with rail access to the west coast. Construction began in November on our Albion and Linden facilities, and we expect to be producing ethanol by May 2007. Construction in Bloomingburg, Ohio will begin in April.

Corn represents 55% of the cost to produce ethanol. Natural gas represents another 10% to 15% of the cost. So, 65% to 70% of the costs are focused around commodities. Our approach to financing was to team with Cargill, a world leader in agriculture. Cargill will be providing 100% of our corn supply and hedging our corn risk. It will also be supplying 100% of natural gas and hedging our natural gas exposure.

The other risk side of the equation is technology.We selected a construction firm, Fagen, that has built two thirds of the ethanol plants in the United States, and it was the contractor for the only 100-million gallon plant in operation. Fagen used ICM technology that at that time was, and still is, one of the most efficient technologies for producing ethanol.

With the lower technology risk and the lower commodity risk exposure, we were able to attract institutional equity and subordinated debt. American Capital Strategies, Laminar Direct Investments, which is an affiliate of DE Shaw, and US Renewables Group stood beside us through equity and subordinated debt financing, and they continue to stand beside us for future project developments.

What makes our project attractive are its low cost, competitive advantage, and use of state-of-the-art technology. All this was important in the lenders’ review of our project. Our three plants are ranked as the first, second, and fourth lowest cost producers in the markets that they will serve, and that is without consideration of the risk management around the projects but rather solely on an infrastructure and location basis.

Another key advantage is main line rail access and closer proximity to our markets, with Cargill managing the logistics and providing us with favorable freight and lease rates. This resulted in lower distribution costs. Once our project is constructed, we will be the second largest ethanol producer in the country behind ADM. This provides us with not only critical mass, but also geographic diversification.

ASA intends to grow its presence within the ethanol business to a billion gallons a year over the next two or three years.

MR.MURRAY: The financing for the ASA project was a $275 million dollar senior debt financing. It was two times oversubscribed.WestLB raised about $550 million in commitments, which is a sign of the growing interest in this market from the large banks and institutional investors.