The ethanol industry continues to garner top headlines, and is clearly a long-term growth story in the making. We're joined today by senior alternative energy analyst
Matthew Thurmond for his thoughts on the progress in this industry.
The last time we discussed the ethanol industry, you were bearish. Has your outlook changed at all?
No. I am still bearish on the prospects of domestic ethanol producers. Stock prices have come down, which I will discuss here shortly, but they would have to fall even further for me to reconsider my ratings. While I can foresee a scenario where these companies perform well, I can also predict several where they don't. For example, what if the massive ethanol capacity build out continues through '08 and there is a resulting supply glut? Then ethanol pricing will fall. What if corn prices continue to rise or oil prices fall? Then margins get squeezed. These are very real risks. This is a commodity industry with very little barriers to entry. All you need is capital, really, and a plant location near corn and transportation. Then you can bring 100 MM GPY of capacity online in less than 2 years.
So I will sum it up. I'm still bearish. There are risks of oversupply. There are low barriers to entry and commodity price swings could hurt margins.
Is the main hurdle for ethanol stocks simply the low barrier to entry - basically that any company who can source corn can compete?
That is one of the two. The second is what I just mentioned, that the companies are subject to the volatile price spread between corn and oil.
I would say that the main barrier to entry besides having the capital and a management team, is acquiring a competitive plant location. Many of the best have already been taken. I am not convinced however, that a lack of available locations will impede growth anytime soon.
Can you give an overview of your coverage base in the industry? And how has it performed recently?
Sure. I cover three ethanol producers: Aventine Renewable (AVR), U.S. BioEnergy (USBE), and VeraSun (VSE). All three of these companies are pure play domestic ethanol producers with market caps of between $500 million and $1 Billion. Performance over the last three months has been very weak. The stocks have lost nearly 10% each, on average. Year-to-date the stocks have fallen even more sharply, about 40% on average. Much of the sell-off has been due to higher corn prices and the resulting margin pressure.
Operationally, the company's are actually doing well. Many plants have come online ahead of schedule. Others are operating above nameplate capacity. Manager's in the industry are beginning to innovate more as well and are gaining production efficiencies.
Unfortunately, like Warren Buffett is quoted as saying, When a management with a reputation for brilliance tackles an industry with a reputation for poor fundamental economics, it's the reputation of the industry that stays intact.
Some say it would be too early to peg today's domestic ethanol industry as one with poor fundamentals. But I believe it will be very competitive and volatile. This will make it difficult for producer's to earn high returns on equity.
In terms of competition, wouldn't Brazil's sugar cane ethanol outperform domestic types of ethanol?
Brazil's ethanol industry has been a hot news item lately, and for good reason. Ethanol in Brazil is made lower-cost by using native sugar cane whereas the U.S. version is made more with more expensive corn. U.S. producers can compete because of a $0.51 per gallon tariff levied on Brazilian ethanol imports. So to answer your question: yes, Brazilian ethanol can outperform. In fact, Brazil may become the low cost international provider of ethanol.
This clear potential has attracted investor attention. Interested parties run the gamut from agriculture-products industry leaders like Archer Daniels Midland (ADM) and Cargill, to capital flooded financial bellwethers like hedge fund star George Soros and banking giant Goldman Sachs (GS).
Though current owners in Brazil are reluctant to sell out, the longer-term likelihood is that large offerings will lure sellers. The country's largest producer, Cosan (CZZ), recently cashed in on the investor demand and raised just over one Billion to began trading on the NYSE.
For industries such as these, there tends to be a longer arc for earnings performance. Where do you see the ethanol industry in, say, the next 5-10 years?
Long-term, this is a touch industry to predict. The Brazilian tariffs will need to continue indefinitely for the domestic producers to remain competitive. The government will need to continue increasing ethanol mandates for overall demand to keep climbing. Oil prices will also need to remain historically high and corn will need to flat line.
Over the long-term, the government talks of developing ethanol from cheaper feedstocks such as switchgrass. If this technology is developed, corn based producers will be the higher cost provider and profits will fall. If no competing feedstock is found, corn based ethanol will probably continue to supply a small portion of the nation's overall fuel as long as subsidies continue. Expansion will be limited by available farmland and rising corn prices. At this point, the industry would probably operate like others in the agricultural products sector. Low barriers to entry would constrain returns on equity.
So to sum up your view, the most likely long-term scenario is that corn based ethanol will be a low return industry?
That's right. If oil prices were to continue making significant jumps, corn-based ethanol may become a more economically viable fuel and returns for current producers would jump sharply. This is what many of the bulls are betting on. At this point however, stocks of ethanol producers do not seem to offer favorable risk-adjusted returns.
