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Lenders, Investors Eye Ethanol’s Future

Biofuel Survival Strategies for a Challenging Market” was the title of a conference and Webinar hosted this week by Chadbourne & Parke, LLP, New York, which represents developers, investors and lenders participating in U.S. and international biofuels financings. The event featured perspectives from lenders and investors in the ethanol industry.

Asked what the ethanol industry will look like in the next two years, the experts agreed that consolidation will continue. One lender predicted that some oil companies will enter the industry. He added that debt and equity investors might shy away from future second generation ethanol projects because of losses incurred in the corn ethanol industry in the last several months.

However, an investment banker commented that second generation ethanol producers could potentially enjoy a $1.00 per gallon tax credit which would boost assets on both debt and equity sides.

Another panelist pointed to current political discussions about carbon reduction policies and that because cellulosic ethanol has a much lower carbon footprint than gasoline, the ethanol industry could have good market potential ahead. But, until unstable capital markets are restored to health, it would be difficult to get those plants built, he added.

Todd Alexander, partner, Chadbourne & Parke, indicated optimism about the long-term health of the ethanol industry. He estimated that there is about 13 billion gallons of annual production capacity in the U.S. and that this year, the Renewable Fuel Standard (RFS) mandates a demand of just 11.1 billion gallons. “We estimate that 20% of existing production capacity is off line either as the result of negative margins or insolvencies. That should bring the market into equilibrium,” Alexander said. “By 2012, we will have 15.2 billion gallons as a mandate, which should help create some stability in the industry.”

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With the current ethanol crush spread (the difference between ethanol revenues and corn prices), however, a lot of plants are now operating in negative territory and many of the plants still operating are doing so with only slightly positive margins, Alexander said.

In 2006 when margins were good, capital was flowing easily into the market. The private equity industry looked for ways to capitalize on that high crush spread. Two years later, with rising corn prices and extensive build out of the ethanol industry, that was no longer the case.

Alexander also showed a chart illustrating the past year (March 2008-February 2009) in publicly-traded ethanol stocks. “This gives you an indication of what the investment community thinks of the equity values of the publicly-traded ethanol stocks today,” he said.

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Mark Habib, associate with Standard & Poor’s (S&P) Corporate and Government Ratings, followed with a discussion of the ratings criteria used for valuing secured debt in today’s ethanol industry. S&P considers external and internal factors when rating ethanol stocks, he said. External factors are largely beyond the producer’s control. They include crush spreads which drive cash flow; and regulatory support.

In addition to low margins, the industry still relies quite a bit on regulatory support, such as the RFS and the Volumetric Ethanol Excise Tax Credit (VEETC). Therefore S&P assigns a high degree of risk to the sector, Habib said. The VEETC has been reduced to $.45 per gallon and both the VEETC and the import tariff will be subject to renewal risk within the next two years. There also have been some challenges to the RFS and it is subject to policy objectives, he noted.

Internal factors considered in ratings include fixed costs (debt service obligations and fixed operating costs); plant efficiency; liquidity; construction; hedging and commodity basis.

Liquidity can be managed, but is subject to a variety of risks, Habib said. Credit markets may tighten when greater liquidity is most needed as was the case with VeraSun Energy, which filed for Chapter 11 last fall.

Some companies may turn to borrowing base revolvers for help, but when commodity market prices are low like they are now, this may be of diminished use, Habib said.

Ethanol producers who are mitigating risk through engineering, procurement, construction (EPC) contracts with strong liquidated damages provisions, creditworthy counterparties, active management, contingency, and so on carry less construction risk.

Today, crush spread margins have compressed to historical lows and future margins remain unpredictable due to volatile commodity markets, Habib said. Liquidity will be critical until margins improve.

“Prices have moved to a production cost determination rather than substitution price correlation [correlation with corn rather than gasoline],” Habib said. “This creates a commodity dynamic where less efficient producers are likely to exit until production falls in line with demand set by the RFS mandate and discretionary blending.”

The exit of uneconomic producers could return the ethanol market to equilibrium, Habib said, noting that remaining suppliers could benefit from improved pricing. On the other hand, some companies could purchase assets out of a bankruptcy and effectively “leapfrog existing producers in financial competitiveness” if the debt burden can be removed and other financials cleaned up.

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