Ethanol nears death's door

It wasn’t that long ago that Ballard Power (BLD:TSX) was going to go to the moon, along with Stuart Energy, Fuel Cell Technologies, etc. A few good and bad ideas have come and gone since those days of 2000/01, but the latest bad idea certainly has to be putting another dollar into corn-based ethanol investments. Around here we are always dubious of business plans with negative gross margins (“so, you want to raise capital to have the right to show up tomorrow and continue to lose money?”). According to Raymond James’ research team, at least a quarter of ethanol producers are in that “negative cash margin” category. All thanks to $7/bushel corn. (oh, and maybe some temporary oversupply):

“Ethanol production economics last week reached their worst levels since at least 2001, with the crush spread ending the week at only $0.14/gal and the cash margin for a typical plant entering negative territory. The main culprit, as before – only to an even greater extent – is record corn prices, which surpassed $7.00/bushel for the first time ever last week. As discussed in our June 9 industry brief, “Corn Market Update: Dark Cloud Over Harvest; Corn Spikes to New Record”, the heavy amount of rain covering the Corn Belt has led to a significant downshift in market expectations for this year’s corn crop, and with inventories already at low levels, upward pressure on prices has become severe.

Our current corn price forecasts of $4.95/bushel in 2008 and $5.15/bushel in 2009 are far below the futures curve, and while we are still reassessing these forecasts, there is little doubt that the modest levels of profitability we had anticipated for ethanol producers under our coverage seem too optimistic given the corn price environment that has materialized in recent weeks. This is most clearly illustrated by the fact that the estimated cash margin for a typical ethanol plant at the end of last week was actually negative. While logistics and other cost advantages can help, particularly for the newer and larger production plants that tend to be operated by public ethanol producers, we would conservatively estimate that at least 25% of the 8.8 billion gallons of current industrywide production capacity is currently experiencing cash margins that are negative. Unless profitability metrics improve at least slightly in the coming weeks, taking margins out of the red, we believe that plant shutdowns are almost certain, and not just in isolated cases. This raises the prospect – barely conceivable just a few months ago – that Washington may have to suspend or reduce the Renewable Fuel Standard (RFS) because the industry becomes unable to produce adequate volumes required under the mandate. This is truly uncharted territory.

The silver lining is that roughly 20% of U.S. corn supply is used by the ethanol industry, and a sudden shutdown of a large amount of ethanol capacity would naturally reduce corn demand, ultimately helping bring prices under control. This would be a textbook example of demand destruction, and the “threshold of pain” for the ethanol industry appears to have been reached given the negative cash margins. But even if corn were to correct 15% to the ~$6/bushel level, the outlook for the crush spread and hence ethanol company profitability would still be bleak. As such, we continue to be cautious on the ethanol space, including Aventine Renewable Energy (AVR/$4.70/Market Perform), BioFuel Energy (BIOF/$3.12/Market Perform), Pacific Ethanol (PEIX/$2.31/Underperform), and VeraSun Energy (VSE/$4.81/Market Perform).”

I suspect that gasoline mandates are going to keep some sort of a floor under enthanol for years to come, but with hundreds of millions of additional capacity still in production, we can all figure out why Bill Gates is dumping his Pacific Ethanol shares, loss and all.

Ethanol isn’t going away, but much shareholder wealth will be flushed this year. Partly supply, partly U.S. government largess, and then there’s the price of corn. And that was before the crop failures.

MRM