Valero's Experience With Ethanol, Part 1: Background and Implications

 |  Includes: PEIX, VLO
by: James Shell

This is an interesting enough topic to spend a little time on, and was brought to our attention the other day because of the recent legislation that will increase the amount of ethanol in our gasoline supply....

A year or so ago, Valero (NYSE:VLO) made the determination to get into the ethanol business by buying two producers in the midwest. At this point they are among the largest producers of ethanol in the country, with production capacity of 1.1B gallons per year.

Right now, the nation's fuel supply is about 9% ethanol, and a rough calculation based on Valero's unleaded production says that they are providing about half of their own ethanol "needs'; that is to say, they still need to buy ethanol on the outside, but conceptually you could see if the business was interesting enough they would eventually be tempted to produce as much ethanol as they sell....

So the three questions we all have about this entry into the ethanol business are: (1) How are they feeling about the business at this point? (2) If they had a choice, would they invest more money in ethanol or make an investment in regular petroleum refining capacity? (3) What does all of this imply for the nation's renewable fuel program and energy program in general?

The first question: How are they feeling about the investment.

This is a pro-forma estimate based on some actual data and some assumptions going forward so their actual operating results might be better or worse....

MRQ Annualized Ground-Up
Investment Cost $ 816,000,000 $ 2,448,000,000
Sales Gallons/Yr 1,100,000,000 1,100,000,000
Net Income per Gallon (Cents) 0.25 0.25
Pro Forma Net Inc (annualized) $ 275,000,000 $ 275,000,000
One-Year ROR 34% 11%
One Year ROCF 43% 13%
Click to enlarge

They paid just over $800M for the operations, which they estimate to have been only 35% of what the plants would have cost to build from the ground up, so the above spreadsheet probably reflects what they were thinking when they made the actual decision.

At 100% capacity utilization, which is how they are now running, and at an average net income per gallon of 25 cents (the actual has ranged from 13 to 46 cents over the last 6 quarters) you have to say they have a business that they can be pretty happy about.... and in fact their most recent 10Q suggests that they are actually doing a little better than the above...

Keep in mind that the above estimate is based on hindsight; at the time they made the original decision they did not know for sure what the average margin would be, and to what extent they could use their engineering and operations experience from the refining industry to keep these little plants running....

But you can see that if things keep going the way they are, they have a chance to have a pretty solid business that contributes significantly to the bottom line. The ROCF estimates above are based on their little bit of financial leverage, based on their debt/asset ratio and their average interest rate, which is a bit more than 5%.

A couple more things: What if the margins go down, and start to consistently run on the low end of the range? If you plug a 13 cent margin into the spreadsheet above, which is as low as it has been over the past 6 quarters, they are still looking at a one year ROR of 18% on their original investment, and a bit higher return on a hypothetical investment that is a little bit leveraged.

This is the most key point: You can see for sure that if they had decided to get into the ethanol business and built the plants from the ground up, based on their own estimates, the initial investment would have been much more questionable, and the argument can be made that they wouldn't have done it. Based on the average margins they have experienced over the last 6 quarters, the ROR would have been only 1/3 of what it is probably going to be....and the risk of a potential decrease in margins would have made the ROR in the 6% range which is probably not enough to get the project done.

So based on this set of estimates, which per the above might be better or worse than what they actually do, they have to be pretty happy about it, and also, importantly, the reason they are happy is because the numbers work: their entry price was low enough that the risk was reduced, and the investment is probably going to turn out pretty well from them....or as the old saying goes, you make money on a deal when you buy it, rather than when you sell it....

Keep in mind also that for every winner there is a loser, the former shareholders and creditors of the bankrupt ethanol companies that Valero bought in order to assemble this deal that made the original investment are not so happy.

Next, we will look at the question: If Valero, or anyone else in this business, were going to make an investment, would they do it in ethanol, or would they do it in conventional petroleum refining.....

>> Continue to Valero's Experience in Ethanol, Part 2: Investment Alternatives

>> Continue to Valero's Experience in Ethanol, Part 3: Implications for Energy Policy

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