Are We at the Bottom of the Ethanol Barrel?

Includes: AVR, PEIX, VSUNQ
by: Hard Assets Investor

By Brad Zigler

One of the best scenes from the 1980s hit film "Back to the Future" was the setup for its sequel: Doc Brown drops banana peels and beer - can and all - into the Mr. Fusion Home Energy Reactor that powers his time-traveling DeLorean before zooming off for future adventures.

According to the script, Mr. Fusion was supposedly created in 2015. Don't bank on that actually happening, though. The best we can hope for, with our present technology, is to turn corn into ethanol for blending in motor fuel. Or turning kitchen grease into biodiesel. No banana peels or cans of Budweiser.

The U.S. government has mandated that 36 billion gallons of biofuels be produced domestically by 2022, of which 15 billion gallons will be ethanol. That's more than a fourfold increase from present-day production levels. Plainly, the Feds are in a hurry to get to the future.

The trouble is that U.S. ethanol production relies upon corn. And that, some say, is putting the squeeze on corn supplies. About a quarter of the domestic corn crop is now diverted to ethanol production.

For ethanol, it's all about the squeeze. Corn is squeezed - "crushed" in industry parlance - into the fuel additive, and by-products, at a growing number of plants throughout the nation's growing region. Ethanol refining starts out a lot like booze making. Corn is first ground, then mixed with water and enzymes, before being cooked to break down the corn's starches into sugar. The mash then goes into fermentation tanks where yeast converts the sugar to alcohol and carbon dioxide. The resulting alcohol is filtered out and the solid remnants dried into an animal feed known as distillers' dried grains and solubles [DDGS].

The reliance on corn as a feedstock has turned out to be a liability for ethanol-minded investors. Between 75% and 80% of the variable cost base in ethanol production, not surprisingly, is the input cost of corn. Corn, as readers know, has been on a tear, rising 31% so far this year after a 16% hike in 2007.

Every 10-cent increase in the bushel price of corn, in fact, equates to a 5-cent loss in the corn crush margin.

Corn Crush?

The corn crush measures the difference between the sales proceeds of finished fuel ethanol and the price of its corn feedstock. With current technology, one bushel of corn can be converted into 2.75 gallons of ethanol. To determine the potential refining profit, the prices of finished ethanol and corn must be rationalized. Ethanol, like the gasoline with which it is blended, is priced in dollars per gallon while corn is priced by the bushel. To reduce ethanol to corn terms, multiply the ethanol price by 2.75. The feedstock corn price is then subtracted from the converted ethanol price to obtain the crush margin:

Corn crush = [(Price of ethanol x 2.75 ) - Price of corn]

Using this method, you would have priced the corn spread between $8.42 and 53 cents over the past year. The wide spot was June 2006 when corn was cheap at $2.35 a bushel. Ethanol sold for $3.94 a gallon back then.

Margins bottomed out in September 2007, wrung by a double whammy of a 61% collapse in ethanol prices and a 58% bump up in corn prices.

Though corn prices continued upward to the $6 level, the corn crush actually improved as ethanol prices head upwards to top $2.60 a gallon. The crush is now over 96 cents.

Before you get your hopes up and rush out to buy shares of ethanol refiners, keep in mind that corn costs aren't the only variables in the ethanol equation. Between 20% and 25% of nonfixed refining costs arise from natural gas, which is used to cook the corn mash. A $1 per million BTU move in the cost of natural gas generally results in a 9.6 cent-per-bushel shift in the corn crush margin. Figure in the recent rise of natural gas prices and the crush margin shrinks to 50 cents per bushel before fixed costs.

Corn Crush

That makes the recent bounce in the share price of Pacific Ethanol Inc. (NASDAQ GM: PEIX) all the more surprising. Since the beginning of the year, Pacific's stock followed the corn crush margin southward, losing 64% of its value. On Monday, though, the Sacramento, Calif. renewable fuels producer posted surprisingly robust results. Excluding a one-time impairment charge, first-quarter profits of 6 cents per share astonished analysts who'd been expecting a 9-cent loss.

Though Pacific's average sales price decreased 4 cents a gallon from last year's first quarter, revenue surged 61% to $161.5 million, nearly $7 million more than Street estimates. As a consequence, Pacific Ethanol shares shot up more than 60% Monday to $5.14, on volume 13 times its recent average.

Pacific's move triggered sympathetic stirrings in other pure-play ethanol stocks. Verasun Energy Corp. (NYSE: VSE) skipped $1.16, or 19% higher, to $7.35. Aventine Renewable Energy Holdings Inc. (NYSE: AVR) jumped $1.24, or 26%, to $6.05.

Earlier this month, Verasun posted a 257% first-quarter revenue increase and an earnings swing to 8 cents per share, while Aventine announced year-over-year revenue growth of 17% in its first quarter.

Ethanol Producers

Do these numbers presage a bottoming in the ethanol sector? Trading in the next few days will confirm whether ethanol producers have truly turned their fortunes ‘round or are just experiencing a dead-cat bounce.