AgMRC Renewable Energy Newsletter
January 2009

Cole Gustafson
Professor, Biofuel Economics
Co-Director, BioEnergy and Products Innovation Center
Department of Agriculture and Applied Economics
North Dakota State University
cole.gustafson@ndsu.edu

While financial growth of the corn grain biofuel industry has been relatively straightforward to document and track, defining financial prospects for the biofuels’ next stage of growth, primarily into cellulosic and other advanced biofuels outlined in the Energy Independence and Security Act, 2007 (EISA), is not as transparent.  Several key uncertainties at the firm financial, industry, and capital market level cloud the investment horizon.

Lack of capital

Only a handful of lenders across the country have actively provided credit to the biofuels industry.  Most notable is First National Bank of Omaha.  The portfolios of these lenders are saturated (DeVos, 2008).  New suppliers of credit will be required to foster additional growth of the industry.

Likewise, existing ethanol firms have limited credit reserves.  Most ethanol credit arrangements have covenants which dictate terms of credit advancement and other loan performance behavior.  Most onerous of these is the imposition of “sweeps.”  Sweeps were imposed during the industry’s boom period.  They are designed to accelerate repayment of principal and interest during periods of high profitability.  In essence, both lenders and equity holders share in the prosperity and overall lending risks are reduced.  However, imposition of sweeps constrains equity future growth as firms never get the chance to build equity reserves.  Now when the industry is experiencing marginal profitability but requires significant capital to adopt new technology, firms have only modest equity to form a new borrowing base.  This is especially problematic as new technology is four times as expensive as previous investment costs, although passage of Emergency Economic Stabilization Act (EESA) tax credits is helpful (DeVos, 2007).

Industry uncertainty

Biofuel plants of the future will likely utilize a wide variety of feedstocks and conversion technologies, given the breadth of current research projects under study.  As a result, there is likely to be wide variation in plant size and performance.  Investors are going to have difficulty evaluating new proposals if industry performance benchmarks are unavailable.  Recall growth of the industry to this point was fostered by widely available performance standards (e.g. 1 bu. corn yields 2.7 gal. ethanol) that enabled replication of corn ethanol plants across the countryside.

While federal tax credits have been extended for 1-2 years, uncertainty still surrounds their long term availability—especially in our country’s present financial predicament.  Passage of long-term provisions would alleviate investor concerns.
 
In addition, implementation of 2007 Energy Independence and Security Act (EISA), especially definition of the process for trading of Renewable Identification Numbers (RINs), is still under development (Meyer, 2008).  Specification of the RIN trading process is required to establish and value low carbon fuels.  Premiums commanded by these fuels will be a key determinant of future cellulosic plant profitability.  As mentioned earlier, market values of carbon are not readily transparent and tradable.  Consequently, investors are reluctant to advance equity funds until these values can be capitalized.

Finally, a gap exists between producer costs for biomass collection and a cellulosic plant’s ability to pay for feedstock supplied—without any consideration of transportation cost (Bangsund and Leistritz, 2008; Epplin, 2008).  While a $30-40 per ton cost is usually budgeted as a feedstock cost in a cellulosic ethanol feasibility study, producer supply costs are typically double that value.

Wall Street turmoil

As this is being written, the extent of fallout from the collapse of Wall Street financial markets is unknown.  Given what has already occurred, coupled with passage of the $700 billion package of assistance in EESA, our nation’s economy and credit markets will be affected for some time.  At the recent meeting, Thomas Hoening, president, Federal Reserve Bank of Kansas City indicated that the economic performance of our country may be subdued for the next decade.  When financial market crises have recently afflicted other countries, namely Japan and Sweden, it took nearly a decade to restore investor wealth to pre-existing levels.  Throughout the recovery period, investors were hesitant and capital availability was constrained.

While the length of recovery can be debated, slower economic performance translates into lower demand for products.  Now that the U.S. financial crisis has affected other countries spanning the globe, worldwide demand for oil has likely to decline.   With oil prices now hovering around $35/barrel for light sweet Texas crude oil, they are nearly one-fourth of their high last July.  Consequently, prices of other liquid petroleum products have dropped as well, lowering future profitability of all biofuel plants.

Finally, given worldwide turmoil in financial markets, investors are driving up the exchange value of the U.S. dollar in a “flight to quality.”  Given that the U.S. was the original source of the turmoil and real investor returns have been lowered following expansionary monetary policy, a decline in the dollar’s exchange rate would have been expected.  However, given that financial market problems are of similar concern worldwide, investors have sought out U.S. securities and view them as most stable.

With a rising exchange value of the U.S. dollar, exports become less affordable overseas.  Since a large proportion of agricultural commodities are exported, and are now in less demand, commodity prices have softened.  Therefore, ethanol plants are striving to devise risk management plans in an environment when both input and output prices are rapidly declining. Increasing attention to margin protection will likely result.  Nevertheless, investors will need assurance that newly devised margin risk management schemes will protect biofuel plant profitability and repayment capacity in whatever economic climate eventually unfolds.

If the investment pace in next generation biofuel plants slows, it appears that South American and Mexican firms are ready to fill the supply void in meeting 2007 EESA projections.  Recently announced intentions include:

• ApexBrasil/Unica, $10 million promotion campaign
• Grupo Santos, $12 billion, 60 sugarcane plants
• BP, $60 million sugar to ethanol plant, Gaois, Brazil
• Bunge and Itochu ink Sugar-Ethanol JV in Brazil

Construction of these facilities would rapidly assist the U.S. in meeting its goal of producing 36 bgy of renewable energy. 

Conclusion

The corn grain ethanol industry experienced rapid growth from 2005-07.  U.S. financial markets obliged and supplied credit at reasonable cost and terms which facilitated this expansion. Now, the biofuel industry is being asked to nearly triple production under recently passed federal legislation, the 2007 EESA. 

However, the status of U.S. financial markets is in question.  Both existing first generation and prospective next generation biofuel plants are demanding a large influx of capital to support adoption of new technological innovations.  First generation plants require the innovations to remain low cost producers in highly competitive commodity markets.  Second generation plants seek innovations to commercialize the production of cellulosic and advanced biofuels.  In either case, the ability of financial markets to supply needed credit is unclear due to impediments that have reduced the borrowing capacity of biofuel firms; uncertainty surrounding future industry performance benchmarks, tax provisions, and implementation of current biofuel legislation; and the need for new risk management strategies which protect firm margins in volatile economic times.

References

Bangsund, D. and L. Leistritz. 2008. Supply Price for Switchgrass in South Central North Dakota, Presentation to Northern Plains BioMass Economy: What Makes Sense? Fargo, ND, Sept. 29.

DeVos, Denny. 2007. Statement Before the Energy & Commerce Subcommittee on Energy & Air Quality, U.S. House of Representatives, April 24.

DeVos, David. 2008. “Financing Bio-Fuel Projects." Presentation to Northern Plains BioMass Economy: What Makes Sense? North Dakota State University, Fargo, ND Sept. 29.

Epplin, F. 2008. “Cellulosic Biomass: Harvesting, Storage, and Transportation.” Presentation to Northern Plains BioMass Economy: What Makes Sense? North Dakota State University, Fargo, ND Sept. 29.

Library of Congress, Emergency Economic Stabilization Act, H.R. 1424, Oct. 3, 2008.

Meyer, S. 2008. “Policy Risks: Potential Consequences for Biofuel’s Industry.” Transition to a Bioeconomy: Risk, Infrastructure & Industry Evolution, proceedings, Burton English, editor, forthcoming.