as corn prices fell back. Thebig upward spike in the ethanol-corn profit margin in the first half of 2006was tied to a surge in ethanol prices to over $3 per gallon when ethanol wasin extremely high demand as a gasoline additive (oxygenate) to replaceMTBE (methyl tertiary butyl ether) which had been phased out becauseof environmental and liability concerns. Ethanol producers in the first halfof 2006 were rolling in profits and ethanol stock prices were high. Ethanolstock prices fell sharply later in 2006, however, when corn prices ralliedsharply to over $4 per bushel.The decision to invest in a corn-based ethanol company depends heavily on an investor’s forecast for ethanol and corn prices. If the investor
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is bullish on ethanol prices and believes that corn prices will stay undercontrol, then an investor could consider buying stock in an ethanol company. But if an investor is concerned that corn prices may rise sharplyor that ethanol prices will fall, then an investor should stand aside fromethanol companies because the company’s profit margin will be headedlower. Ethanol companies employ a range of pricing and hedging strategies to try to protect their profit margins, but hedging typically only goesout two to three quarters and the ethanol-corn spread will eventually catchup with the company’s profit margins.
U.S. ETHANOL INDUSTRY MARKET SHARESArcher Daniels Midland (NYSE: ADM) is the largest producer of ethanol inthe United States with a market share of 16.6 percent as of mid-2007 (seeTable 14.1). However, POET Biorefining, formerly named Broin Companies, has been moving very aggressively in the past year to acquire capacityand has now built up to the second largest market share of 15.1 percent.Of the publicly traded ethanol companies, VeraSun Energy (NYSE: VSE)has a market share of 5.3 percent, U.S. BioEnergy (Nasdaq: USBE) has amarket share of 2.9 percent, The Andersons (Nasdaq: ANDE) has a market share of 2.6 percent, and Aventine Renewable Energy (NYSE: AVR) hasa market share of 1.6 percent. Two other publicly traded producers thatare not in the Top 10 list include MGP Ingredients (Nasdaq: MGPI) witha market share of 1.2 percent and Pacific Ethanol (Nasdaq: PEIX) with amarket share of 0.5 percent. As a side note, most ethanol companies havenew plants coming on line and these market shares are subject to changesubstantially in coming months and years.VeraSun (NYSE: VSE) is the largest pure-play publicly traded U.S.ethanol producer and has moved aggressively to expand capacity. In July,VeraSun announced that it planned to acquire three ethanol plants fromASAlliances Biofuels, LLC for $775 million with production capacity of330 million gallons per year.28 This production capacity is not included inTable 14.1 because the deal has not yet closed. This acquisition will double VeraSun’s present capacity. The cost of acquiring this capacity can bereadily calculated at $2.20 per gallon ($725 million divided by 330 milliongallons per year of capacity), which the company said is just moderatelyabove its own costs of $1.75 to 1.85 per gallon for building a new plant fromscratch. VeraSun also has a productive R&D department and was the firstcompany to announce plans to produce biodiesel from the distiller-driedgrain that is a byproduct of the ethanol process that is normally sold aslivestock feed.29 By processing distiller-dried grains into biodiesel, VeraSun
2701,070976340200190165147120110100
Archer Daniels MidlandPOET Bioreﬁning (formerly Broin)VeraSun EnergyHawkeye Renewables, LLCUS BioEnergyThe AndersonsGlobal Ethanol (formerly Great Lakes Ethanol)CargillAbengoa Bioenergy Corp.Aventine Renewable Energy, Inc.
16.6%15.1%5.3%3.1%2.9%2.6%2.3%1.9%1.7%1.6%
Percent marketshares
ADMprivateVSEprivateUSBEANDEprivateprivateprivateAVR
Ticker
www.admworld.comwww.poetenergy.comwww.verasun.comwww.hawkrenew.comwww.usbioenergy.netwww.andersonsinc.comwww.greatlakesethanol.comwww.cargill.comwww.abengoabioenergy.comwww.aventinerei.com
Web site
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Source: American Coalition for Ethanol (ethanol.org) and Renewable Fuels Association (ethanolrfa.org).
January 12, 2008
Note: Market shares are calculated using the total industry capacity of 6,444.4 million gallons per year determined by theRenewable Fuels Association as of July 2007. These market shares are subject to change quickly as new plants come on line.
Capacity(mln gallons/yr)
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TABLE 14.1 Largest U.S. Ethanol Producers (ranked by capacity)
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will be able to squeeze more revenue and profit out of each bushel of corninput.Aventine Renewable Energy Corp (NYSE: AVR) not only produces itsown ethanol but also runs a big marketing operation that sells ethanol formany other producers for a commission. Pacific Ethanol (Nasdaq: PEIX)receives a large amount of media attention because Microsoft ChairmanBill Gates’s foundation invested in the company in its early stages and because it is based in California and is thought to have the upper hand onsupplying ethanol in California and elsewhere on the west coast. The Andersons (Nasdaq: ANDE) in July 2006 entered a partnership with MarathonOil (NYSE: MRO) to build ethanol plants.30
ETHANOL INVESTMENT CONCLUSIONSThe prospects for ethanol as a replacement for gasoline are bright, particularly when cellulosic ethanol becomes commercially viable. Ethanol currently accounts for only about 4 percent of the U.S. fuel supply, meaningthat there is plenty of room on the upside. Increased ethanol productionhelps support U.S. farmers, reduces pollution, and increases America’s energy independence.The attractiveness of ethanol as an alternative to gasoline from a policy and consumer standpoint, however, does not necessarily mean that investing in ethanol stocks is a good idea. As mentioned earlier, ethanol company profits depend mainly on the spread between ethanol and corn prices,which is volatile and difficult to predict. In addition, there are some significant investment risks for the U.S. corn-based ethanol industry that shouldgive investors pause about investing in U.S. corn-based ethanol producers:
r Corn prices may rise sharply in 2008 and 2009 when new ethanol plantswill demand even more corn.
r The ethanol industry may overbuild capacity and eventually cause aglut of ethanol.
r The U.S. government may eventually drop or dilute the 54-cent importtariff that protects U.S. farmers from Brazilian competition.
r The U.S. government may eventually drop or dilute 51-cent excise taxcredit for ethanol.An even larger existential risk for the biofuel industry is whether it becomes a popular solution as a gasoline and diesel replacement over thenext decade, but then dies out along with the internal combustion engineas more environmentally friendly vehicle technologies such as electric andpossibly fuel cell vehicles take over. It is possible to envision a future where
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(1) electric vehicles take over as electric vehicle technology improves,and (2) governments across the globe effectively legislate away the internal combustion transportation engine because of its CO2 emissions andthe environmental stress caused by producing its fuel. If the internal combustion engine is indeed effectively legislated away through progressivelytighter environmental regulations, there will be no need for any ethanol orbiodiesel fuel (or gasoline for that matter). This may not happen for 10 to20 years, but it is still a very real risk factor for anyone thinking about building a biofuel plant with a 20+ year life or making a long-term investment ina biofuel company.Having duly noted the risks, some investors may nevertheless be interested in investing in ethanol companies, at least for short or mediumterm investment purposes. In that regard, it is useful to consider some investment criteria for choosing an ethanol company stock to buy. The topcriteria for deciding on an ethanol company should be whether the company has a strong likelihood of making research breakthroughs on cellulosic ethanol and quickly becoming a mass producer of cellulosic-basedethanol. The larger ethanol companies that have more R&D resources andthe financial capacity to quickly build production capacity once the lab andpilot plant work are done are the most likely companies to succeed in coming years as the industry migrates from corn-based ethanol to cellulosicbased ethanol. The following list summarizes investment criteria for choosing ethanol stock investments.Ethanol Company—Investment Criteria1. Aggressive R&D research that allows the ethanol company to boostyields on existing products and eventually move to cellulosic feedstock.2. Low production costs through larger scale, access to cheap feedstock,and low transportation costs to market.3. The ability to use sophisticated hedging and storage techniques to max-
imize profit margins.4. A diversified product line that smooths out profits in the event of aplunge in the ethanol-corn profit margin. Global reach and/or involvement in biodiesel is a plus.
COMPANIES SUPPORTING THE U.S.ETHANOL INDUSTRYEthanol companies, and investors in ethanol company stocks, face a significant amount of risk because of the volatility of their profit margins and
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because of the possibility that the industry may overbuild and eventuallycause an ethanol glut. However, the old “pick and shovel” analogy is useful in this regard (i.e., that the hardware stores selling picks and shovelsduring the gold rush made more money than most gold miners).Suppliers to the U.S. ethanol industry fall into several categories. Thesecompanies generally cannot be considered pure-plays on ethanol since revenues tied to the ethanol business are generally a small portion of theirtotal revenues. Nevertheless, these companies can expect to see a continued boost to their revenue and earnings as the ethanol boom continues.The railroads have been big beneficiaries of the ethanol industry becauseethanol is generally transported cross-country by rail. Other categories include suppliers to U.S. farmers such as seed and fertilizer companies andcompanies that sell farm equipment such as Deere & Company and AGCOCorp. There are a host of other companies that could be added to this list,but this provides at least a starting point.Largest U.S.-Listed Railroadsr Burlington Northern Sante Fe Corp (NYSE: BNI)r Union Pacific Corp (NYSE: UNP)r Canadian National Railway (NYSE: CNI)r Norfolk Southern (NYSE: NSC)r CSX Corp (NYSE: CSX)r Trinity Industries (NYSE: TRN)—(largest U.S. manufacturer of tankrailcars)r American Railcar Industries (Nasdaq: ARII)—(manufacturers and repairs tank railcars)Seed Companiesr Monsanto (NYSE: MON)—a big seller of seed cornr DuPont (NYSE: DD)—Pioneer-brand seed cornr Syngenta (Switzerland: SYNN VX)Fertilizer Productsr Agrium (Toronto: AGU CN)r Potash Corp of Saskatchewan (Toronto: POT CN)r Mosaic Co (NYSE: MOS)Farm Tools & Implementsr Deere & Co (NYSE: DE)r AGCO Corp (NYSE: AG)r CNH Global NV, subsidiary of Fiat SpA (Milan: F IM)
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C H A P T E R 15
Trading BiofuelMarketsFeedstock Frenzy
he ability to the trade futures markets that are related to biofuels isanother way to trade and invest in the clean energy world. Tradingthe futures market, however, is a risky game considering the highleverage and volatile market conditions. Yet trading biofuel-related markets opens up another playing field for those investors who are looking toprofit from clean energy. This chapter focuses on five commodity futuresmarkets: ethanol, corn, sugar, soybean oil, and palm oil. Corn and sugarare feedstocks for ethanol, and soybean oil and palm oil are feedstocks forbiodiesel.
T
ETHANOLThe ethanol futures market is still in its infancy. Most of the ethanol inthe United States is currently sold on cash contracts lasting six months orlonger, with the contracts entered into directly between a buyer and seller.The buyer is typically a large gasoline/ethanol wholesaler or retailer andthe seller is usually a company that produces ethanol. There is a looselyorganized over-the-counter spot market in ethanol but it is still relativelysmall. However, ethanol production is growing very fast and that is boosting demand for spot trading and hedging tools. It is only a matter of timebefore an actively traded futures market develops for ethanol.Several U.S. futures exchanges have tried listing ethanol futures, butonly the Chicago Board of Trade (CBOT) has made any headway so far.The CBOT’s ethanol futures contract as of mid-2007 had very low volume275
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and open interest, which means that the CBOT ethanol futures markethas a way to go before it can be considered as a satisfactory investmentmedium for investors. The CBOT in December 2006 launched over-thecounter ethanol calendar swap contracts, which are reportedly starting tocatch on. Those swap contracts provide a mechanism for privately negotiated transactions to clear through the CBOT’s clearing system.The contract size for the CBOT ethanol futures contract is 29,000 gallons or about 1 railcar full of ethanol. There is a futures contract for eachmonth of the year, similar to gasoline futures. The CBOT ethanol contracttrades in dollars and cents per gallon with a minimum tick size of 1/10 cent.As far as price movement goes, each 0.001 cent change in the futures contract is worth $29, meaning a 1 cent move is worth $290 and a 10 cent moveis worth $2,900. There is obviously a large amount of leverage in the contract, since a small change in the ethanol futures price, say from $2.00 to$2.10 per gallon, would result in a gain/loss of $2,900 for an investor holding just one futures contract. Ethanol futures prices can be found at theChicago Board of Trade Web site or at a futures-related Web site such asBarchart.com (symbol code: AK).1Figure 15.1 shows the recent price history for ethanol at the wholesalelevel (not at the retail level at service stations), compared to gasoline pricesfor reference purposes. The chart shows that ethanol prices have traded ina wide range in the past two years, from as low as $1.10 per gallon to ashigh as nearly $4.00 per gallon. A price of about $2 per gallon has been arecent equilibrium level.$4.50$4.00$3.50CBOT Ethanol ($/gal)$3.00$2.50$2.00$1.50RBOB Gasoline$1.004/05
7/05
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Ethanol
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RBOB Gasoline
FIGURE 15.1 Ethanol vs. Gasoline Prices ($/gallon)
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The single most important market factor that drives ethanol prices isgasoline prices. Ethanol and gasoline are fungible products to a large extent, which means that end-users and wholesale blenders can increase ordecrease their usage of ethanol based on its price relative to gasoline. Thefungibility of ethanol and gasoline tends to keep ethanol prices roughlyin line with a constant spread to gasoline prices, except for special supply/demand factors in the gasoline or ethanol markets that may cause thespread to diverge temporarily.From 1998 to 2006, ethanol at the wholesale level showed an average49.2 cent premium to wholesale gasoline prices with a large standard deviation of 28 cents. The 49 cent premium is closely tied to the 51 cent excisetax credit that the U.S. federal government gives to ethanol. If that subsidy is subtracted from ethanol prices, then wholesale ethanol and gasoline prices have been roughly equal over the past 8 years. In reality, asidefrom the tax credit effect, ethanol prices should trade at a discount to gasoline prices since motorists get about 25 percent less mileage from ethanolversus gasoline.While gasoline is an important guide for ethanol prices, ethanol alsohas its own supply/demand dynamics that sometimes cause it to trade atunusual extremes relative to gasoline. For example, during the spring andsummer of 2006, ethanol prices skyrocketed because of very strong demand from blenders who needed ethanol to replace MTBE as an oxygenatein their gasoline mix in order to meet clear air regulations. Ethanol pricesthen fell back later in 2006 as the supply increased and as the ethanol market adjusted to the sharp one-time increase in demand.Gasoline also has its own dynamics that can cause it to move awayfrom ethanol prices. Figure 15.1 shows how gasoline prices in the first halfof 2007 rallied sharply while ethanol prices moved basically sideways near$2 per gallon. Gasoline prices rallied because of strong U.S. gasoline demand, a series of U.S. gasoline refinery breakdowns, and tight gasoline U.S.inventories. At the same time, ethanol prices remained relatively constantas increased ethanol supply easily kept up with demand. As of July 27, 2007,front-month gasoline futures prices (at $2.10 per gallon) were actually trading 14 cents above front-month ethanol futures prices (at $1.96 per gallon).That put ethanol in a very good position since it was cheaper than gasolineat the wholesale level, and even more so after the blenders factored in their51-cent excise tax credit.The strip curve for the ethanol futures contracts can provide an interesting perspective on the ethanol market (see Figure 15.2). A futuresstrip curve presents a time-based graph showing the prices of commodity futures contracts that expire soon as compared with those that expire in the distant future. As seen in Figure 15.2, the ethanol futuresstrip curve on the day of the data snapshot (July 30, 2007) was sloping
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$2.00
$1.90
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$1.70
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Jul-08
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$1.60Aug-07
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FIGURE 15.2 CBOT Ethanol Futures Strip Curve ($/gallon)Source: Chicago Board of Trade.
downward. The downward sloping curve indicates that the market expectsthe huge amount of new ethanol capacity that is currently under construction to depress ethanol prices in the future when those plants start up operations. For example, the longest-dated futures contract for delivery inDecember 2008 was trading 25.5 cents lower (at $1.67 per gallon) than thenearest futures contract of August 2007 ($1.925 per gallon).
CORNCorn is the feedstock for more than 40 percent of the world’s ethanol production, according to Worldwatch.2 The United States, the world’s largestethanol producer, uses corn almost exclusively as the feedstock for itsethanol production.The world’s largest corn futures market is at the Chicago Board ofTrade. The CBOT offers both full-sized corn futures contracts ($100 per1 cent move) and mini-contracts as well ($10 per 1 cent move). The sizeof the full-sized futures contract is 5,000 bushels. The contract is pricedin terms of dollars/cents per bushel. Each penny of price movement (e.g.,from $3.00 to $3.01 per bushel) represents a $50 change in the value of thefutures contract. Corn futures prices can be found at the Chicago Boardof Trade’s Web site or at a futures-related Web site such as Barchart.com(symbol: C).
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$6
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FIGURE 15.3 CBOT Corn Futures Prices ($/bushel)Source: Chicago Board of Trade.
As seen in Figure 15.3, corn futures prices traded in a relatively narrowrange from 1998 until mid-2006. Then, in September 2006, corn prices began a very sharp rally that took the contract all the way up to an 11-yearhigh of $4.37 per bushel by February 2007. That was the highest level seensince 1996 when prices spiked higher on Chinese buying.The rally in corn prices that started in September 2006 was due almost exclusively to strong demand for corn from ethanol producers. Themarkets had not yet recognized the extent of the emerging demand fromethanol producers and U.S. farmers planted a normal crop during the summer of 2006, which turned out to barely be enough to satisfy total demand.The level of corn inventories left over from the summer 2006 crop (i.e.,the carry-over for the 2006–2007 marketing year) fell sharply by 52 percentfrom the previous year to a historically low 947 million bushels.3 That wasthe lowest level of inventories since the 1995–1996 marketing year whencorn prices soared above $5 per bushel.High corn prices in early 2007 made planting corn appear very profitable, however, so U.S. farmers in the spring of 2007 planted a huge corncrop. U.S. farmers planted 92.9 million acres of corn, up 19 percent from theprevious year and the most acres planted with corn in 63 years. Moreover,growing weather during the summer of 2007 was nearly ideal, meaning arecord crop would easily be produced. As of July 2007, the U.S. Departmentof Agriculture was predicting that corn inventories would rise sharply backup to the 1.5 billion bushel area because of the large crop. Corn prices during the first half of the summer responded by falling back sharply to thelow $3 per bushel area.
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The sharp drop in corn prices in the first half of summer 2007 was abig relief for ethanol producers, whose profits had been threatened by therun-up in corn prices above $4 per bushel. Ethanol producers can makea respectable profit with corn prices at or below $4 per bushel, but theywould start to see losses if corn prices were to rally above the low-$5 perbushel area (assuming ethanol prices remain near $2 per gallon).Looking ahead, the problem is that there is a huge amount of newethanol production capacity that will be coming on line in the second halfof 2007 and all through 2008. That means demand for corn from ethanolproducers will continue to ratchet higher through at least 2009. U.S. farmers in 2007 responded by boosting corn acreage by 19 percent, but U.S.farmers are going to have to continue to increase acreage to meet the further increase in demand from ethanol producers.At some point, since there is a limit on how much corn that U.S. farmers can reasonably produce, the ethanol industry is going to hit a limit onhow many new ethanol plants can be built. The ethanol industry is hopingthat equilibrium can be reached in a relatively controlled manner. However, there is a danger that the continued rise in corn demand from ethanolproducers will eventually force corn prices above the low-$5 per bushellevel, at which point ethanol producers will start losing money and willhave to start shutting down plants. This would eventually cut ethanol production back to levels that can be sustained by available corn supply. However, in the meantime, there could be some nasty dislocations for the U.S.ethanol industry. The bottom line is that the U.S. ethanol industry goinginto 2008 and 2009 will be on progressively thinner ice and the risks ofa corn price spike will grow, particularly if any significant drought conditions emerge. There will also be increased risks of an ethanol supply glut,particularly if demand for ethanol does not grow fast enough.
SUGARSugar, like corn, is also the feedstock for more than 40 percent of theworld’s ethanol production.4 Brazil, the world’s second largest ethanol producer, uses sugar almost exclusively for its ethanol production. Brazil usesmore than half of its large sugar cane crop for ethanol. Brazil is the world’slargest sugar producer with 30.9 million metric tons of production in the2006–2007 sugar marketing year (October–September).5 The world’s second largest sugar producer is India with 25.1 million metric tons of production in 2006–2007.Sugar futures trade at the New York Board of Trade (NYBOT), whichis a subsidiary of the Intercontinental Exchange Inc. (NYSE: ICE). The
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FIGURE 15.4 NYBOT World Sugar (#11) Futures PricesSource: New York Board of Trade.
NYBOT’s world sugar #11 futures contract is quoted in terms of cents perpound. Figure 15.4 shows a chart with the history for the NYBOT sugar futures contract. Sugar futures also trade at other futures exchanges aroundthe world.Sugar prices rallied sharply in the latter half of 2005 and posted a 24year high of 19.73 cents/pound in February 2006. Sugar prices on that highwere more than triple their 2004 levels. The 2005 rally was mainly due tostrong demand for sugar from ethanol producers in Brazil, combined withthree straight years of global sugar supply deficits in the marketing years of2003–2004, 2004–2005, and 2005–2006. However, sugar prices plummetedthrough the remainder of 2006 and into 2007 because of sharply increasedsugar production by both Brazil and India. Sugar producers responded tothe high prices seen in 2005 by boosting production, only to see prices fallback quickly. There was a small global surplus of sugar in the 2006–2007marketing year, indicating that sugar producers were more than keepingup with strong and rising demand from ethanol producers.
SOYBEAN OILBiodiesel can be made from a wide variety of vegetable oils and animalfats. Europe produces about 90 percent of the world’s biodiesel and rapeseed (canola) oil is the feedstock used for 80 percent of that production.6The other feedstocks used include soybean oil and sunflower oil. However,
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in the U.S., soybean oil is used as the feedstock in about 85 percent ofbiodiesel production, with other feedstocks including rapeseed oil andother vegetable oils.Soybean oil is produced on a large scale around the world. Global soybean oil production in the 2006–2007 marketing year was 35.8 million metric tons according to Commodity Research Bureau’s CRB Yearbook.7 In theUnited States, soybean oil accounts for 80 percent of margarine productionand for more than 75 percent of total U.S