It’s All in the Risk

FROM THE OCTOBER ISSUE: The ethanol industry has been conservative on risky investments since its most recent downturn, experts say. But innovating, expanding and diversifying are important and can be done prudently.
By Lisa Gibson | September 17, 2017

Events from the past tend to affect how people forecast the future, says Robert Sauer, director of CFO Systems LLC. That’s particularly true of the ethanol industry, as producers try to look forward and make decisions about investments into new technologies or expansions for their plants. The industrywide period of tight cash flow around 2014 is still fresh on some minds, deterring from bold risk taking.

Justin Mentele, manager at K-Coe Isom, says grain prices were high then and there was plenty to worry about. “We as an industry got stuck in the fact of no investment is worthwhile if gains aren’t short-term. These are by no means bad metrics to look at, but if they’re the only metrics we look at, we’re missing the point.”

There’s some great technology out there that can take the industry to a whole new level, Sauer says, but the price tags are large so the risks could be, too. “I think if you’re a plant trying to improve your results in the next couple of years and wondering what you can do to do it, and what you can control, I think your options are to probably take some risks — some somewhat significant risks — otherwise you’re going to get what the market keeps giving you in a commodity world.”

Shying away from risk is hurting the industry, Sauer says. But he also cautions that if a plant chooses to make an investment in a new technology, expansion, etc., it has to be the right one.

Post-2014, producers aren’t interested in investing if the payback period is longer than two years, Mentele says. “We always need to be good stewards of cash for the owners, by all means, but not having a year or two-year payback period doesn’t mean that I kill the idea for a project. … To truly evaluate whether or not we should invest, we have to look much, much deeper.”

Factors to Consider 
While return on investment and the payback period should be the first — and, again, last — factors to consider when making an investment decision, Mentele outlines other internal and external components that come into play, too.

Markets are likely the largest external factor to consider and they’re impacted by government, regulations, supply, demand, etc. Ethanol is dependent on both domestic and international markets. “We’ve had more supply than demand lately in ethanol, so we’re leaning pretty heavily on the foreign markets,” Mentele says.

Domestically, producers need to look at both federal and state-level regulations for ethanol markets. Internationally, major destinations include China and Brazil, but that could change — Brazil recently approved a 20 percent tariff on U.S. ethanol volumes above 600 million liters (158.5 million gallons) per year. Producers are starting to explore new markets with unknown risk. “What’s scary and fun at the same time is that there are a number of energy markets that leaders of the ethanol industry have worked with and we’re starting to get into,” Mentele says. “And we don’t really know what those risks are.”

Legal and vendor risks should be considered, too, Mentele says.

Internal risks revolve around people. “I think we look at these a little less in-depth than we do the external risks,” Mentele says. “We look at these haphazardly.” Consider the people working in the plant. What do they want? Let them in on the discussion. “If nothing else, they may see an issue that we don’t.” It’s also important to determine if the plant has the people who can operate and maintain any new equipment that comes along with the investment.

Company perception is important, too. Get an idea of what opposition the investment could face. “We all know that anything we do that has a negative perception — either in the industry or in our communities — takes years and years to make better,” Mentele says. Figure out what the hot-button issues might be and get ahead of them.

The Decision Tree
Deciding whether to make a significant investment is all about communication, says Ron Pagel, business development manager for Power Engineers Inc. It’s crucial to make sure all players are at the table and have a say in the decision from their unique points of view. “We all have essentially the same goal, but different perspectives,” he says. “We all come at it with our preconceived notions driving our decisions.”

For example: A finance representative will want longevity; a marketing person will want salability; a manager or operator wants to make as much product as possible; a maintenance employee wants to ensure he or she can repair any new equipment properly; construction staff wants to be able to build the new system without taking the plant offline; and a safety representative wants to make sure it’s safe. Bring them all in on planning, Pagel emphasizes. A well-rounded capital projects team can determine how to execute projects to benefit everyone.

Plants don’t have the depth of personnel they once had, Pagel adds. Ten or 15 years ago, plant staffs included someone to handle projects, but they’re running thinner today and putting an entire project on one person’s plate isn’t feasible. “A team environment makes more sense. You can split the load.”
And with an all-inclusive project team, the plant owner has all the pieces of the puzzle, and the details make sense from all perspectives. “When everybody’s on board, that’s when you pull the trigger and say, ‘Here’s the construction date.’”

If the whole team evaluates the risk and still determines the investment is worth it, it offsets some of the angst moving forward, Pagel says.

Often, an investment decision revolves around diversification. And it’s a good goal, Mentele and Sauer agree. Downturns like the one that hit the ethanol industry around 2014 are cyclical, but it’s unknown how long a downturn will last, Sauer says. Diversification in a downturn is a “monstrous advantage,” he adds.

“I think it’s right to be cautious, but there are some new markets that can really change some of the ethanol plants’ revenue streams,” Sauer says. “From a CFO’s perspective, that’s a really strong reason to try to counsel these plants to get into some markets.” Of course, new markets come with risks and maybe their own downturns. “But if I can diversify away from being so dependent on ethanol, I think that’s a wise strategy.”

But diversification doesn’t always mean simply a new revenue stream, Mentele says. “With investments, we always talk about diversifying because we have a different revenue stream. However, what we don’t pay attention to is that the revenue stream is still within the same group of business that we have.” Don’t go outside the wheelhouse and invest in hotels, Mentele says, but look at new products and new locations. “Within the plant that I have, what other revenue streams can I have that can open up new and different markets to allow us to have some synergies within what we already do?”
Looking Forward
“We are good historians,” Mentele says. “We’re very good at saying, ‘This is what happened in the past, so this is what I’m going to do.’ And the problem is, in today’s world, if we’re looking back to identify what we’re going to do in the future, we’re going to miss the mark more times than not. We have to be better at identifying what we believe future trends to be, to make the right decisions for our companies. … We have to be much better forecasters.”

Investments generally aren’t “sure things,” Sauer says. But not making investments, and doing nothing, is a risk, too. “Sometimes the best thing you can do to secure your plant’s future is to take some risks,” he says.

“In anything we do, there’s risk,” Mentele says. “But if we can set a realistic model that’s forecasting what we believe is going to happen in the future, yes, we still may get it wrong, but we’re going to be a whole lot more comfortable with the fact that we did what we thought was best for our company and for our owners. If you look back at all those different impacts the proper way, you’re going to be very happy with your decision.”

Author: Lisa Gibson
Managing Editor, Ethanol Producer Magazine