Evaluating Alternative Diversification Options
It still makes me laugh, since I first heard it in that large auditorium for Econ 101 at the U (that’s Iowa State University): excess profits. In business, there is no such thing, right? Maybe that’s true within the pages of the economics textbook, but in practice, we know better (see Bill Gates or Mark Zuckerberg).
How do you attain excess profits? You invest in a good thing: your time, talents and finances. While surveying the current ethanol landscape, there are numerous avenues available to pitch a road to riches. Let’s get started on a plan for evaluating those investment options.
There is a documented "co-integrating" relationship between ethanol and corn prices, outlined in a paper from University of Illinois economists Mallory, Irwin and Hays titled “How market efficiency and theory of storage link corn and ethanol markets.” The paper shows the relationship between ethanol and corn prices tends to revert to levels implied by an equilibrium long-run level of ethanol production profitability. If the ethanol price is too high relative to corn prices, then either the ethanol price must fall or the corn price must rise. In any one episode, it can be difficult to identify which price will bear the brunt of the adjustment, but history shows that such an adjustment is the norm.
This is not the recipe for excess profits, particularly in well-established commodity markets where brutal price adjustments are tales of legend. But, it is relevant for the myriad investment options that can increase ethanol production at your plant. Although a smart financial manager will say it makes sense to increase output while keeping fixed costs contained, do not ignore the marketplace. If we have learned anything as an industry, it is that 100 plants all oversupplying demand leads to zero—or even negative—profits for all.
Diversification and Price Correlations
Diversification refers to the expansion into another product line or market. "Don't put all your eggs in one basket" is the aphorism. Dropping the basket will break all the eggs. Placing each egg in a different basket is more diversified. There is more risk of losing one egg, but less risk of losing all of them.
By diversifying, one loses the chance of having invested solely in the single asset that comes out best, but one also avoids having invested solely in the asset that comes out worst. That is the role of diversification: It narrows or lessens the extreme ranges of possible outcomes.
Price correlations can be used to evaluate the level of diversification of various products. A correlation coefficient of 1 indicates products highly correlated to act similarly, while a correlation coefficient of minus 1 indicates the products act in mirrored opposition to each other.
In the real world, it is difficult to find reliable negative correlations. Generally, one does well to get close to 0, which means that the prices act independently of each other. The accompanying graphs illustrate this relationship of corn oil and soybean meal prices when examined relative to the prices of ethanol. The illustrated correlations of 0.14 and 0.15 create price activity drastically apart from the behavior of baseline ethanol.
Today, most companies’ ethanol sales represent anywhere from 75 to 85 percent of total revenue. That is a very high concentration. In 2007, corn oil was introduced in the industry. This diversified coproduct with a correlation of 0.14 was a homerun for every plant that installed it. This has helped to lessen reliance on ethanol alone, but still amounts to only about 2 percent of revenue.
Having been in several ethanol company board rooms, I have seen for myself the hardship that a single product production environment creates when margins squeeze or even go negative. A single word describes it best: powerless.
Wet corn milling plants are great examples of diversification for the dry grind ethanol industry. These plants can produce many different products through a very flexible production system. The blend of products produced can be changed daily based on the product returns for each product for that time frame. There are many engineered processes coming to the market to provide this kind of flexibility to the dry grind platform. In addition, there are signs that this can be achieved at dry grind plants for a fraction of the investment capital deployed at wet mills.
The first plants to invest in corn oil were certainly gaining excess profits until the rest of the industry caught up. Is there another corn oil type product out there? If it comes along will you be an early adopter? Or will you cautiously wait until it is 100 percent proven?
Helpful Investment Tools
There are investment tools available to help navigate these various product and investment options. Many plants analyze payback to determine the financial merits of a project. This method has advantages in terms of simplicity, but does not provide a full picture for projects over longer time frames with longer paybacks. More sophisticated projects require analysis beyond simple investment payback calculations.
Net present value models are terrific tools to evaluate large multiyear investment projects. These larger projects can require significant investment but can also provide large cash flows in the future. Net present value models are also ideal tools to benchmark and evaluate projects against one another.
Potential projects also need to be evaluated for operational and market risks. When assessing risk, the required return can be adjusted up or down, depending on the perceived level of risk within the project. Higher risk equals a higher required return. This can help in evaluating two separate projects with vastly different risk profiles.
We executed our own case study to compare two viable investment alternatives that could be available to most any ethanol plant:
• Investment in an add-on biodiesel refinery presenting a second fuel product.
• Investment in processing technology resulting in an enhanced, high-protein feed coproduct.
For each project, we assessed risks, determined capital funds, and estimated the cash generated from the investment once installed. The summary results are displayed in the accompanying table.
The high-protein product was perceived to be twice as risky as the biodiesel project due to both internal operational and external market challenges. The required return was then doubled from 9 percent for the biodiesel project to 18 percent for the high-protein distillers grains. Despite this higher hurdle, the returns expected for the high-protein DDG led to a higher net present value when compared to the biodiesel product.
In addition, the high-protein DDG is a more diversified product with a correlation coefficient of 0.15 versus 0.28 for biodiesel. Note that soybean meal—a similar high-protein feed—was used as a proxy for high-protein DDG, for which there is not an established market. Correlation is rarely an exact science. When creating new products, or introducing new products to new markets, one may need to use proxies of existing products with similar characteristics to complete the correlation.
Efficient capital deployment can create and drive value, creating coveted excess profits. Adding products to an operation with low correlations to the existing product mix can reduce earnings volatility, smooth out earnings, and improve overall performance. Using a framework of robust net present value modeling and product correlation analyses, different potential capital projects can be compared side-by-side to evaluate the best of use of cash. These capital decision tools are available and, with today’s available technology, are easy to use.
This may be the recipe to gain power within the board room, but it must be planned out before the crisis occurs. We are off to find the next breakthrough product that can help reduce our reliance on ethanol and, in turn, the Renewable Fuel Standard. Could it, in fact, be high-protein DDG? Time will tell. Meanwhile, keep searching for those elusive excess profits.
Author: Rob Sauer
Partner, CFO Systems LLC