Goldman, Gates Bet Ethanol Boom Won't Repeat '80s-Style Bust. Investors and politicians from Wall Street to Detroit, to Silicon Valley are lavishing money and praise on the fuel made from corn.
Goldman, Gates Bet Ethanol Boom Won't Repeat '80s-Style Bust.
May 25 (Bloomberg) -- A quarter-mile procession of trucks piled high with corn trundles concussively over the ruts on Distillery Road in the farm town of Pekin, Illinois, 163 miles south of Chicago.
The 18-wheelers are about to drop their loads at Aventine Renewable Energy LLC, an ethanol maker that Morgan Stanley bought for $66 million three years ago. Today, that investment is worth about $750 million, according to a company filing, as runaway oil prices spur an ethanol boom.
Investors and politicians from Wall Street to Detroit, to Silicon Valley are lavishing money and praise on the fuel made from corn. Goldman Sachs Group Inc.'s announcement in May of a $26.9 million ethanol investment came after similar forays this year by billionaire Bill Gates and venture capitalist Vinod Khosla, helping boost the shares of ethanol makers fourfold.
President George W. Bush has become one of the fuel's biggest cheerleaders as record gasoline prices threaten Republican control of Congress. In January, Bush, who uses a geothermal heating and cooling system at his Texas ranch, touted the homegrown fuel as his best weapon to end U.S. dependence on Middle East oil potentates. That same month, General Motors Corp. said it would almost double production of vehicles that run on an 85 percent ethanol mix.
The president is promoting an industry that still rests on the wobbly supports upon which it was built three decades ago: federal tax breaks that expire in 2010, surging oil prices that give oil refiners an incentive to buy ethanol and a plentiful supply of corn.
Boost From Congress
Last year, investors say, Congress gave ethanol its biggest boost yet. A provision in the omnibus Energy Policy Act requires Exxon Mobil Corp. and other refiners to almost double their biofuel use by 2012, guaranteeing ethanol distillers a market for the first time.
``The federal mandate put ethanol on a more solid foundation,'' says Dan Reicher, president of New Energy Capital Corp., a Waltham, Massachusetts-based private equity firm with stakes in three distilleries in Indiana and Michigan. ``There's still the risk that corn prices can go up and oil down, either of which could hurt this industry.''
U.S. distillers also count on the federal government to shield them from foreign competition. Congress imposed a 54 cents-a-gallon tariff in 1980 to discourage shipments from Brazil, the world's No. 2 ethanol maker, where production costs are as much as 50 percent lower than in the U.S., the Congressional Research Service says.
Boom, Bust
Refiners imported 21,750 barrels of ethanol a day in February, or enough to meet 6.7 percent of U.S. demand, Energy Department figures show.
Congress last engineered an ethanol boom in the 1970s, and most producers went bust a few years later. The Carter administration, facing oil prices of $13 a barrel, the equivalent of $40 today after factoring in inflation, supported a new ethanol tax break for refiners in 1978.
For each gallon of ethanol they mixed into gasoline, refiners received a 40 cent reduction in the federal excise tax on gasoline. That helped stimulate a 10-fold increase in the number of producers to a record 163 by the end of 1984.
When oil prices crashed, falling to $11 a barrel in 1986 from $37 in 1981, the price of ethanol was no longer competitive with gasoline, and demand plummeted. More than half of the ethanol distillers went out of business. ``Even with a subsidy, nothing was enough to prevent the high rate of market change,'' a U.S. Energy Department history of the era says.
Guaranteed Market
Investors are now funding the biggest expansion of the U.S. ethanol industry since the 1980s. The Energy Policy Act has spurred the flood of investment because it ensures a market for the 97 distilleries regardless of the price. Refiners -- who mix the additive with gasoline to reduce pollution, improve engine performance and stretch supplies -- must increase their consumption by an average of 11 percent each year through 2012.
Today, the U.S. consumes 4.4 billion gallons of ethanol, or the equivalent of 3 percent of all the gasoline used, according to the Energy Department. The federal mandate will boost that figure to almost 5 percent by 2012.
Khosla, formerly with venture capital firm Kleiner Perkins Caufield & Byers, invested an undisclosed amount this year in Los Angeles-based Altra Inc., a new company that's buying a distillery in California. ``Ethanol is a huge market,'' says Khosla, who formed Khosla Ventures to fund alternative energy and computer technology companies. ``I think it can replace all of our petroleum needs or at least a majority.''
Bill Gates
In April, Gates's Cascade Investment LLC invested $84 million in Pacific Ethanol Inc. of Fresno, California, becoming its biggest shareholder. The company is building a 35 million gallon-a-year plant amid the almond and citrus orchards near Fresno that will make Pacific the biggest ethanol maker in California. Pacific Ethanol plans to put up four more distilleries on the West Coast by the end of 2008. Gates declined to comment.
For Gates and other investors, ethanol will likely become a riskier bet after 2012, when the law no longer mandates an 11 percent annual boost in demand. Starting in 2013, it will require biofuel demand growth to match that of gasoline, which the U.S. Energy Department forecasts will be about 1.1 percent a year through 2020.
For distillers to expand rapidly after 2012, the price of ethanol will have to be competitive with gasoline, and that's where the additive has fallen short.
Costlier Than Gasoline
For the past eight years, ethanol has cost an average of 49 cents a gallon more than gasoline, according to data compiled by Bloomberg. Last year, even with oil reaching a then record $70.85 a barrel, it cost refiners $1.61 to make a gallon of gasoline -- less than the $1.80 it cost to buy a gallon of ethanol.
J. Stephan Dolezalek of VantagePoint Venture Partners, a firm with stakes in three Midwest ethanol projects, says the volatility of oil prices makes ethanol an even bigger gamble. Prices rocketed to a record $75.35 a barrel in April from $25.95 in 2001, buoyed by economic expansion in China, India and the Middle East.
``If you're investing on the assumption that oil will remain above $50 or $60 a barrel, that's a pretty risky game,'' says Dolezalek, whose San Bruno, California-based firm also backs research into alternative feedstocks for producing ethanol, such as wheat stalks.
Last year, refiners needed the federal tax break of 51 cents a gallon to make ethanol a good deal. The benefit brought the price of the additive down to $1.29 a gallon -- 32 cents a gallon less than gasoline. That prompted refiners to buy more ethanol as a way to expand their fuel supplies.
Chevron Seeks Investments
``The refineries we talked to said they'll take as much as they can because it's cheaper than refining crude,'' says Benjamin Nazarian, president of Beverly Hills, California-based Omninet Capital LLC, a buyout firm that invested in Altra in April.
Chevron Corp., the No. 2 U.S. oil company, says it's exploring investments in distilleries to guarantee steady supplies for its five U.S. refineries. San Ramon, California- based Chevron would be the first major oil company to invest in U.S. ethanol production since 1980, when Texaco Inc. helped renovate the Illinois plant now owned by Aventine.
Exxon Mobil, the world's biggest oil company, has no interest in making ethanol, a fuel dependent on government assistance, Chairman Rex Tillerson says. ``Pull the subsidies off and see how much ethanol gets made or used,'' Tillerson, 54, says.
Tax Break Extended
In 2004, farm state lawmakers won an extension of the tax break from 2007 to 2010. Charles Grassley, the Iowa Republican who chairs the Senate Finance Committee, tacked it onto the American Jobs Creation Act.
Lawmakers successfully pushed the benefit and the federal ethanol requirements to try to raise corn prices and create jobs in rural communities, says Representative John Shimkus, a Republican from Illinois, the second-biggest corn-growing state.
``Whenever corn drops down below $2 a bushel, I start getting major complaints from the farmers in my district,'' Shimkus says. ``They want more locations where they can sell their corn. Ethanol production is one of those places. It consumes a lot of bushels of corn.''
Bush, whose campaign pledges to support ethanol helped him win seven of the 10 largest corn-growing states in the 2004 election, has made the biofuel a cornerstone of his energy policy. In his State of the Union address in January, Bush said ethanol could free the U.S. from its costly dependence on foreign supplies, replacing 75 percent of Middle Eastern imports by 2025.
Bush's Goal
``I've set a goal to replace oil from around the world,'' Bush told the Renewable Fuels Association, a Washington trade group, in April. ``The best way and the fastest way to do so is to expand the use of ethanol.''
Refiners would have to increase consumption sevenfold to 34.5 billion gallons a year -- well above what federal law now requires -- to meet Bush's goal.
``That doesn't seem very realistic,'' says Paul Lenz, who helps manage $14.3 billion, including shares of Exxon Mobil, at Rydex Investments in Rockville, Maryland. ``It would require so much corn that you'd drive up prices for livestock feed also made from corn, and that's going to have an impact on the food supply.''
Ethanol, a 199-proof form of alcohol sold as moonshine during the Prohibition era in the U.S., is made with the same technique used for whiskey.
Dry, Wet Mills
Most distilleries under construction are dry mills, in which corn kernels are pulverized and mixed with water to make a mash that is fermented and distilled. Producers sell the remaining livestock feed, bringing down corn costs by 30 percent, the Department of Agriculture says.
In a wet mill, which costs about twice the price of a dry plant to build, kernels are soaked in a sulfurous acid mix to separate sugars and vegetable oil. Aventine, a wet mill, says sales of the food ingredients cover 38 percent of corn costs.
The majority of automobiles sold today in the U.S. can't burn fuel containing more than 10 percent ethanol because it's corrosive to valves and fittings in larger amounts.
DaimlerChrysler AG, Ford Motor Co. and General Motors are boosting production of vehicles that can run on a gasoline blend that is 85 percent ethanol, or E85, to capitalize on a provision in the Energy Policy Act requiring federal agencies to beef up their fleets of so-called flexible-fuel vehicles. Chrysler plans to more than double output of E85 vehicles to 500,000 by the 2008 model year.
The upsurge in interest in ethanol began in 2002 as California, New York and 23 other states moved to ban a competing fuel ingredient, methyl tertiary butyl ether, or MTBE.
Replacement for MTBE
In 1990, the Clean Air Act required oil companies to add oxygen-rich ingredients to gasoline in the most polluted cities in 17 states to make the fuel burn more completely and reduce emissions. For U.S. refiners, the cheapest, most plentiful options available were ethanol and MTBE, made from natural gas.
Outside the Midwest, where ample corn supplies and state subsidies had created a flourishing ethanol market, most refiners used MTBE. Throughout the 1990s, MTBE leaked from underground storage tanks, fouling water supplies in 1,515 communities in 28 states, according to the Environmental Working Group, a nonprofit organization in Washington. The additive is a potential human carcinogen, according to the U.S. Environmental Protection Agency.
The bans spurred demand for ethanol, the only substitute available in sufficient quantities to replace MTBE, according to the Energy Department. In one fell swoop, California alone expanded U.S. demand for the grain-based fuel by 580 million gallons a year, or 27 percent.
First Mover
Morgan Stanley was the first Wall Street firm to act on the state prohibitions, thanks partly to Leigh Abramson, 37. He began learning about the fuel-additives business when he moved to Morgan Stanley's private equity group in 1992, two years after joining the parent firm with a history degree from Amherst College in Massachusetts. The buyout unit in 1990 had bought Agricultural Minerals & Chemicals Inc., a producer of methanol, which is used in MTBE.
In 2002, Abramson, then a managing director at the private equity group, flew to Peoria, Illinois, and made the 10-mile drive south to Pekin, where he toured a 107-year-old former sugar beet refinery retrofitted to make ethanol. He and his team spent the next eight months learning about corn fermentation and distillation before buying the plant and a stake in another one in Nebraska.
Morgan Stanley Invests
The price was less than half the $167 million that natural gas transportation company Williams Cos. had paid eight years earlier. Tulsa, Oklahoma-based Williams was eager to pay down debt after Enron Corp.'s collapse deflated speculative energy markets, causing $1.7 billion in losses from 2001 through 2003 at Williams.
Morgan Stanley made the acquisition in May 2003 on the heels of a drought in the Midwest that had pushed U.S. corn prices to a five-year high of $2.86 a bushel. Corn is the biggest operating expense for producers, accounting for about half, or 39 to 68 cents, of the cost of a gallon of ethanol, the Department of Agriculture says.
Private equity firms and banks outside the Midwest and Great Plains avoided ethanol investments in the past because of the volatility of corn prices, which move with the weather, says Daniel O'Neill, director of insurer MetLife Inc.'s $8 billion Agricultural Mortgage Portfolio unit, which oversees $350 million in ethanol investments.
Midwest dry spells, heat waves and floods have threatened corn crops in five of the 17 growing seasons since 1988, elevating grain prices by an average of 35 percent during those periods, based on Chicago Board of Trade futures prices.
Scorching Heat
Weather can make or break a distillery, says Mark McMinimy, an agricultural analyst at Washington-based Stanford Washington Research Group. In 1996, scorching heat and a dearth of rain cracked open 6-inch-wide fissures in fields from Nebraska to Indiana, turning cornstalks into withered, brown sticks.
As grain exporters, animal feed makers and ethanol distillers competed throughout the spring and summer of 1996 for limited corn supplies, prices more than doubled to $5.55 a bushel, the highest in at least a quarter century.
Ethanol producers shut plants and fired workers across the Midwest and fuel output fell 21 percent that year. The Pekin plant halted production for six weeks that year and temporarily laid off 250 workers until corn prices dropped.
``Commodity prices are the biggest risk you face in this industry,'' says Thomas Murray, co-head of loan and debt capital markets at WestLB Securities Inc. in New York.
Ethanol Debt Sale
In February, Murray arranged the biggest U.S. ethanol debt sale in history, a $275 million line of credit for Americas Strategic Alliances LLC, a Dallas-based merchant bank that plans to build three 100 million gallon-a-year producers. Equity investors in the deal include hedge fund firm D.E. Shaw & Co.
MetLife, the largest U.S. life insurer, is investing an undisclosed amount in a planned ethanol mill amid some of the most productive farmland in North America to keep grain-shipping costs low and reduce the risk of crop failure.
The Clymers, Indiana-based plant, which will process about 40 million bushels of corn a year into 110 million gallons of ethanol, is being built in Cass County. Its rich soil produced the third-highest yield of corn per acre in Indiana last year, according to Department of Agriculture figures.
``The most viable deals are where the greatest supply of corn is,'' MetLife's O'Neill says. ``That keeps costs down.'' Corn prices shot up 13 percent in 12 months to $2.49 a bushel yesterday as distillers used more grain and the rising cost of natural gas-based fertilizer caused farmers to reduce plantings.
More Efficient
The 45 distilleries to be built or expanded in the next few years will be larger and more efficient than older plants, making swings in corn prices easier to manage. The average plant two decades ago produced 8 million gallons a year, according to the Energy Department, compared with 57 million gallons for facilities built today.
The amount of energy used has fallen 70 percent in the past 20 years because distillers now recycle the heat and steam used in fermentation and distillation for production of more fuel, according to the Agriculture Department. The overall production cost for a gallon of ethanol ranges from 61 cents to $1.21, less than half of the 1986 figure.
The newest plants also use hardier yeasts, boosting the amount of ethanol derived from each bushel of corn by 12 percent to 2.8 gallons. ``We're seeing much greater efficiency in ethanol production,'' says Reicher, an assistant secretary in the Energy Department in the 1990s whose duties included promoting ethanol research.
West Coast Demand
Lawrence Gross, chief executive officer of Altra, plans to produce ethanol where it will be consumed: in California, the largest U.S. gasoline market.
Gross, 44, the former vice chairman of Internet incubator Idealab!, says ethanol demand on the West Coast has ramped up so dramatically that shipping corn in rail cars from the Midwest will be easier than trying to find spare tankers to haul finished ethanol from the same region.
Altra agreed in April to buy a 25 million-gallon distillery in Goshen, California, and owns minority stakes in two proposed West Coast mills.
Investors reluctant to wager on distillers because of unstable corn prices are backing research into other feedstocks. Goldman Sachs is investing in Iogen Corp., a Canadian company trying to develop enzymes that can break down wheat stalks, wood chips and straw to release the sugary starch needed for ethanol. Royal Dutch Shell Plc also has a stake in the closely held company.
`Breakthroughs'
So far, no one has discovered a way to disentangle the starches and fibers in a cost-effective manner, according to the Energy Department. Goldman Sachs declined to comment.
``The enzymes are where the breakthroughs will come from,'' says David Anderson, who helps manage $900 million at Palo Alto Investors LLC, a hedge fund firm based in its namesake California city. ``We're trying to look three to seven years down the road to see who's got the inside line on creating more ethanol out of existing feedstocks.'' Palo Alto Investors hasn't yet deemed any ethanol or enzyme companies worthy of investment.
Dolezalek of VantagePoint invested in buyout firm New Energy last year. It has stakes in three plants, including one run by Iroquois Bio-Energy in Rensselaer, Indiana. In six to 10 years, Dolezalek expects the distilleries to provide a testing ground for new enzymes for ethanol production that he's also backing.
Boondoggle
``Historically, venture capital has been all about taking a technology that made something way better and cheaper or something you couldn't do at all before,'' Dolezalek says. ``We do this so that what we're making has a home.''
For investors, corn prices aren't the only concern. The tax break for refiners ends in 2010, and although Congress has reauthorized it four times, delegations from New York, California and other states outside the Midwest have railed against it as a boondoggle.
``We shouldn't be subsidizing ethanol,'' says Representative Jeff Flake of Arizona, a Republican who advocates limited government and allowing the market to determine the viability of industries. ``Then again, I'm not running for president in Iowa, so I can speak freely on the subject.''
Omninet's Nazarian says he's bullish on ethanol because oil prices will likely remain high. Oil futures on the New York Mercantile Exchange, the benchmarks for crude prices in the Western Hemisphere, indicate traders expect prices to remain higher than $68 a barrel through September 2010.
Earnings Potential
Nazarian says these prices will push demand for the biofuel well beyond the government mandate and reach 10 percent of the U.S. gasoline supply, or about 16 billion gallons a year.
``Ethanol demand will continue to grow because for refiners, it increases fuel supplies without any need for them to spend huge sums increasing their refining capacity,'' he says.
For now, distilling ethanol is a very profitable business. Net income at No. 1 U.S. ethanol maker Archer Daniels Midland Co. more than doubled in 2005 to $1 billion. It was the biggest annual profit in the 104-year history of the company, which also makes corn-based sweeteners and animal feed. Archer-Daniels- Midland declined to comment for this story.
``The earnings potential for ethanol is enormous,'' says Scott Hood, who helps manage $490 million at Pasadena, California-based First Wilshire Securities Management Inc. First Wilshire is the second-largest shareholder in Andersons Inc., a grain transportation company that's building distilleries in Michigan and an Indiana mill backed by MetLife and New Energy.
IPOs Planned
``We originally bought into them about five years ago because we liked the management and their rail business,'' Hood says. ``The ethanol part came later for them, and now we're even more positive on the company.''
Aventine, which was planning an initial public offering for as early as June, is adding a total of about 500 million gallons of ethanol production in the next few years, a threefold increase.
Morgan Stanley spun off its buyout unit in 2004 into a new company called Metalmark Capital LLC, at which Abramson now serves as managing director. New York-based Metalmark manages the Morgan Stanley Capital Partners funds, which own a controlling 40 percent stake in Aventine. Abramson declined to be interviewed.
VeraSun Energy Corp., the No. 2 ethanol producer, is also planning an IPO later this year. Shares of Atchison, Kansas-based MGP Ingredients Inc. rose 252 percent in the past 12 months, the biggest increase among the six publicly traded U.S. ethanol makers.
``There's a lot of investors clamoring to get into this space right now,'' says Robert Wilder, CEO of Encinitas, California-based WilderShares LLC, creator of the WilderHill Clean Energy Index of 40 publicly traded ethanol, solar power and fuel cell companies. ``It's created a bottleneck with who you invest in because it's not like there are 4,000 ethanol companies out there.''
Whether the companies will be around after 2012 -- when the federal ethanol mandate begins to wither -- is another matter. |
