Back To Reality

After the gold rush mentality of 2006, ethanol project developers are facing the harsh realities of fluctuating commodity prices, a struggling economy and scarce capital. Some proposed projects are dropping out, but excellent projects are still getting funded.
By Ron Kotrba and Anduin Kirkbride McElroy | March 10, 2008
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During the peak of ethanol project financing two years ago, the deep-pocketed French investment bank Societe Generale won Project Finance magazine's ethanol deal of the year by arranging a $160 million debt package for Panda Ethanol Inc. Before $177 billion investment firms were writing out checks to large untraditional projects, predecessor plants were painstakingly developed under the farmer-owned co-op model where equity came from producer-investors, and the remainder from a farm bank loan. Despite more recent but now restricted options from large investment firms relatively new on the scene, financing an ethanol plant will remain a challenge much like it always was.

"People who've been in this business for a long time, know we are now back to what is more normal," says Mark Yancey, vice president of project development for BBI International. He's referring to a veritable spending freeze in project financing where equity investors and lenders alike are holding out for that special project with big merits and an ultra-sound balance sheet. "It's going to be difficult raising equity, lenders are going to be very critical of projects and will select only a few per year to finance," he says. It was tough in the late 1990s and early in 2000 to get projects off the ground, and even though much in the industry has changed since then, project development is going back to its difficult financial roots—with some modern twists. "The issue today is the financial markets," Yancey continues. "With all of the turmoil in the banking industry, capital is scarce." And while Societe Generale is still making headlines in 2008, it's not as the heralded purveyor of capital for ethanol investments. Instead, it's trying to figure out how one of its traders managed to lose $7 billion in bad futures.

Whether the United States is already in a recession or on the verge, there's been a clear economic downturn marked by declining dollar values, trade imbalances and mortgage foreclosures. Economist Don Reynolds explains that the steady devaluation of the U.S. dollar (40 percent over the past four years) along with the more recent burst of the housing bubble together affects the entire lineage of investments straight up the chain—starting with the homeowner to the mortgage brokers, banks, corporate investment firms and insurance companies—eventually making it back down the chain to renewable fuels investments. Some say the renewable fuels industry is the next bubble to burst. Others disagree.

"There's still a small amount of profit to be made in ethanol, but it's slim," says Jack Mount, an accountant with Kennedy and Coe LLC. "So as you look at that, and take that in conjunction with the fact that the mortgage industry and the financial sectors are going through a tough time and taking pretty big hits, they're tightening their reins and closing their doors with who they're letting through and willing to finance." Whether the discussion revolves around mortgages or financing an ethanol plant, "it all comes from the same pool of money," he says.

There's still money available in the economy, but the mindset of investors has changed, says Jeff Kistner, vice president of project finance for BBI International. "When we face recession fears in our economy, people invest in commodities. That's why corn, gold and wheat are up. This is complex—you can't just blame one thing for what's going on." While the slowdown in ethanol project financing cannot be extricated from the downturn in the U.S. economy and the scarcity of capital as a whole, there are more industry-specific details to consider in the broader context of a tightening in capital markets.

What a Bank Wants
"In 2006 when ethanol was at its height, we saw the ability to have 25 percent or maybe 30 percent equity," Mount says. Now banks are requiring up to 60 percent equity for fixed asset financing. "The right project can get financing right now but you better be prepared to have a lot of equity because it's hard to raise right now," he continues. Yancey's ratio of equity to debt exceeds 60 percent. "It's really down around 85 to 90 cents a gallon the banks will lend," he says. This means a 55 MMgy plant costing $130 million today would require $46 million in debt and $83 million in equity—that's 64 percent equity versus 36 percent debt. This scenario is not only undesirable because it takes a lot of cash upfront, but it also reduces the return on that equity because it's less leveraged with debt.

Global factors have made banks less able to jump in as aggressively as they once did. "Before the slowdown, some of the bank syndicates were looking at multiple plant financing," says Ed Portaro, vice president of consulting services at Harris Group Inc. With the crunch due to global factors, that's dropped down. There's more of a desire to go after plants on a one-by-one basis, rather than go after the higher dollar financings."

At the same time, some of the Wall Street lenders have put up loan requirements that make it much more difficult to finance ethanol projects, according to Mark Hanson, an attorney at Stoel Rives LLP. He predicts the high finance models will likely fall by the wayside as projects return to regional lenders.

Mark Erickson, president and founder of project development firm CharMark International LLC, questions how quickly banks will come back to the business. "I'm hearing rumors of two or three years before they'll come back because their portfolios are full," he says. "My feeling is maybe no one will ever go back to the traditional form when we get a taste of this ‘new' financing. We're talking to hedge funds and European funds. It's unique, we have the possibility of different financing coming in, they look at it differently than a bank would, and I think it may be positive for the industry. A lot of them are looking more on the merit of the project itself, not necessarily that they like biofuels. They're looking at the return on investment."

In the past two or three years, Kistner estimates that $15 billion was invested in the ethanol industry. "There are a number of plants under construction that have not received a return on that investment yet," he says. Popularity may direct new investment to cellulosic ethanol, especially because it's mandated by Congress. But it has to prove itself first. "Everyone that we're in touch with—lenders and equity sponsors—all want to talk about cellulosic ethanol, especially now that corn ethanol has gotten some negative publicity," Portaro says. "But I think when it comes down to where they're going to put their money, when they start looking at risks and high capital requirements, it's going to be different."

In many ways, the changes in the industry are happening so fast, it can be difficult to diagnose and react to them. "We'll probably be reacting in hindsight for the next three or four years," Hanson says. His colleague at Stoel Rives, Joe Thompson, agrees. "Everyone is kind of stepping back and assessing the situation," he says. This goes for equity investors, farm banks and large corporate investment firms. As far as Wall Street money goes, Thompson tells EPM, "They haven't gone away—they're just looking for the right project with the right feedstock supplies and the right off-take agreements." Nevertheless, "People who want to get into it will do so, whether that's with Wall Street money or the farmer," Yancey says.

Back to ‘Normal'
Clearly, the industry is still coming down from its high in 2006, which affected all aspects of project development. "Project development went at a breakneck pace—almost faster than the industry could absorb it," Hanson says. "You heard about developers starting construction on the first plant and had plans to build three or four more plants when they hadn't even operated one. From a critic's standpoint, the industry expanded extremely rapidly and didn't regulate itself toward capacity and market limitations."

Another project development veteran agrees. "Back in 2006, there was a gold rush mentality," says Larry Ward, vice president of project development for Poet LLC. "There were a lot of people coming into the industry who didn't have a lot of experience. I think they were attracted by very high margins, by the enthusiasm and excitement in the industry and frankly, those times are gone. I think we've seen some realities dealing with margins getting back into more normal types of structures, or in some cases, margins getting very weak. I think for the newcomers who may have not had much experience and weren't familiar with commodities, that drove them away."

Construction costs were another big factor in slowing down the rush to build. This pace will slow down and get back to "normal construction" of 13 to 16 plants per year—the average construction rate before 2006, Kistner says. "I don't think you'll ever see 60 plants under construction in one year again."

Ownership Trends
Yancey and Kistner suggest that financing and construction may get back to "normal," but there may not be a return to normal for other aspects of the business. Ownership models are changing from the farmer cooperative model, although that model is far from dead. In fact, Thompson says co-op law in the northwestern states was a big topic of discussion at the Harvesting Clean Energy Conference held in Portland Ore., in January. "These folks in the Northwest, they wanted to know more about the performance and structure of the cooperative model, and whether or not it makes sense for them," Thompson says. Part of the farmer co-op model's viability resides in the ability to secure feedstock. Even though different entity structures can offer guaranteed feedstock over time, the most basic and guaranteed avenue to this is through the farmer co-op model and its producer-investors. "They're not only the source of their feedstock, they're also investors and therefore have a vested interest in that project," Thompson says. "It's an option we talk about with every project that comes to us—it's typically an LLC or a co-op model."

The co-op model may not be dead, but it's certainly changing. A changing trend for successful project development is the move towards stronger owners and stronger equity groups that have the depth to carry a project through the dips of the commodity market, Portaro says. "Stronger owners are bigger companies that have more financial depth to them," he says. "In equity groups, often that means a local developer will bring in a large equity fund to have a big part of the ownership of the plant. There's still a place for the small owner, but we're starting to see some asset transfers."

While small owners are probably not building on their own anymore, Portaro notes that some of the bigger companies that developed early and had a global plan are probably still able to compete with the new, larger, well-financed companies. One such company is Poet. Ward says project development hasn't changed for his company. He credits this to Poet's consistency and history. "Over time, Poet has grown at a pretty steady, consistent rate—almost in spite of what was going on in the marketplace," he says. "We've had a long track record of success and that has really allowed us to continue with the development strategy that will probably keep going at a rate relative to what we've seen the past few years. While debt markets certainly in general are tighter than before, we still maintain very strong relationships with those that have been with us in the past and working with those and others as we develop our projects for 2008, 2009 and beyond."

Because of these successes, Ward says a number of independent, stand-alone facilities—both in production and under construction—have inquired about forming partnerships with Poet. "It doesn't sound like there are a lot of single-plant, independent projects that are able to raise the capital they might need due to the change in times," Ward says.

Part of Poet's allure is that small-time investors are still welcome—the company hasn't really changed its investment strategy. "Right now one of the benefits Poet still enjoys is we have more than 10,000 farmer and main street investors that have participated in our projects over time," Ward says. "We've always been very aware of allowing and bringing in local participation for all of our plants. We continue with that model today. It has not limited us at all in the availability to find equity for all of our projects."

While some companies will find increased potential for profit through the restructuring of entities to gain economies of scale through mergers—such as the VeraSun Energy Corp. deal with US BioEnergy Corp.—others may simply look the other way. "In talking with some, I've seen them scale back their plans," Thompson says. "Maybe we should go back to the 40 MMgy or 50 MMgy plants, or maybe even smaller plants if we want to build community-based projects."

Hanson predicts that new projects will be smaller, as a rule. "We were getting to a point where new plants were almost exclusively 100 MMgy," Hanson says. "I don't think we'll see nearly as many 100 MMgy plants built by new owners. If it's a new plant with a new group of owners, it will more likely be 50 MMgy. We're going to see more locally-owned 50 MMgy because the financing and risk profile will be a bigger equation than profitability."

There will continue to be 100 MMgy plants developed, but Hanson says they're much more likely to come from the expansion of an existing plant. Existing plants have a lower risk profile, and are more likely to get a loan, because they have operating history, existing staff and feedstock agreements.

The conversation doesn't end with the size or business structure of corn dry mills, especially when upcoming cellulose projects are also being developed. "I think with cellulose we may see a resurgence of farmer-owned projects either added to their existing dry mills or building a new cellulosic ethanol plant," Yancey speculates. He says the biggest cellulose crop out there today is corn stover, and who owns that? The farmers do. "I think it'll be in their best interest to be involved and be invested in those plants. It doesn't exclude that there'll be large corporations involved—they'll be building plants too. But at least there'll be the opportunity for the farmers to get in on the ground level of a second wave of really farm-based projects."

Successful Projects
Obviously, successful projects must make money. "We tell our projects that they need a strong return on investment," Erickson says. "We use a standard of 25 percent annual return. We tell our clients they should re-evaluate doing the project if it's less than that." He questions if some of the traditional, natural gas-powered plants can meet that number, given the cost of natural gas. Erickson says energy cost is a great determinant of a plant's financial success, which is why his company focuses on coal-fired facilities closer to the energy source.

The merits of a project have never been more important in order to proceed through the development stage to construction. Experts say projects need everything in order to move from a proposal on the drawing boards to a plant under construction. Yancey says location, rail and natural gas infrastructure remain the most important factors.

In many ways, nothing has changed in project development, according to Ward. "The fundamentals that were important one year ago, three years ago, five years ago, are the same fundamentals that are important today," he says. "You need to have good sites. It's location, location, location. During the gold rush, I think some people may have lost sight of the fundamentals. And frankly, a lot of the optimum sites are probably gone today relative to several years ago. But the reality is, those fundamentals still exist and you need to look at them. What's the right size, what's the right corn supply, where are the right markets, how can you have a competitive advantage? Those are things that we have looked at historically and they still drive our development strategy."

Having all the ducks in a row is crucial, but these days, it may not be enough. Harris Group is an engineering company that serves five market sectors, including clients in their Process Solutions and Financial Consulting Units. The customers of the Process Solutions Unit are fairly balanced between traditional technologies and next-generation technologies, and the company still sees a lot of activity from people who want to build a plant. "What may be different versus the craze of the summer 2006 is that projects that come to us, as a rule, are better thought out," says Manager of Process Solutions Doug Dudgeon. "Often, they have something that sets them apart from having a cookie-cutter approach. Certainly in 2006, we saw a lot of people that just wanted to get in and get in fast. They didn't have anything that would distinguish their business plan from the next guy."

Differentiation is a big theme amongst project developers. One increasingly popular way to differentiate is in how the feedstock is handled, whether through fractionation, corn oil separation or finding different users for the distillers dried grains. "If it's just a plain, corn-to-ethanol plant, it's going to have a hard time making it through the process unless someone has a lot of financial backing," Portaro says. "The important factors we see are location, strong owner equity group, vertical integration or something different to the project that adds to the revenue streams."

Kistner agrees that cookie-cutter projects don't cut it anymore. "I've always said that good projects will get financing—both debt and equity—just follow the rules," he says. "But today, excellent projects will get financing. It's no longer just finding the right location, technology and developers. It boils down to management that truly understands the industry and teaming up with the right companies. Your management needs to be knowledgeable, work well with vendors and make sure the plant operates as it's supposed to."

Investors and lenders are paying extremely close attention to management experience and capabilities. Management is key—it's the management team that is largely going to determine a project's risk management strategy, which can make the difference between a profitable plant and one destined for failure. "The true producer is going to have an effective management schedule that tries to hedge and keep good, steady profitability and not try to ride out the highs and lows," Mount says. In an environment of scarce capital and choosy investors, projects hoping to close financing and break ground must incorporate skilled management who craft long-term contracts and hedging strategies into their business plan. "A lot more projects are going to have to optimize the performance of the plant," Thompson says.

Market Capacity
"The industry has gotten so large that in the not-to-distant future we'll be bumping up against the E10 saturation and that is a situation we've never seen before," Yancey says.

With current production and gallons under construction (not including proposed projects), U.S. ethanol production exceeds 10 billion gallons a year. With U.S. gasoline consumption at 140 billion gallons a year, E10 across the board would require 14 billion gallons of production. And we're getting close to it.

Many believe the United States can produce anywhere between 12 billion and 20 billion gallons in upcoming years without severe consequence to other markets or global trade. This is addressed in the 36-billion gallon renewable fuels standard (RFS) within the 2007 Energy Bill passed in December; annual corn ethanol production is subject to an indirect mandate cap of 15 billion gallons. Even though that number leaves room for 100 additional 50 MMgy plants, the industry is already starting to see signs of intra-industry competition, such as low ethanol prices, idling plants and bankrupt projects.

When the market capacity is reached, the industry will have to compete against itself. "If there are sustainable profits, then the next 100 million gallons to be built will have to out-compete the existing 100 million gallons of capacity," Hanson says. "So then you look at what needs to close down and what's not profitable. There aren't very many industries that have the discipline not to do that. But if we get to that point, that's when the industry will compete against itself. Right now it's competing against gasoline and capacity."

Portaro and Dudgeon, however, withhold judgment until the plants under construction come on line. This would depress the cost of ethanol to the point where only the least-cost providers could continue operating. "I think that's going to happen with ethanol, but we don't know when," Dudgeon says. "Then it becomes a balance of raw material supply and price, distribution and markets. Some of these plants just might not make it, so then there will be consolidation—that might be the next wave."

Experts differ on the tools necessary to move ethanol beyond current market limitations. Kistner says sufficient distribution infrastructure will help. He says this is a reason for the current slowdown, and doesn't think that we're at market capacity right now. He points to markets within the United States and internationally that are as yet untapped. "Never underestimate the power of production agriculture," Kistner says.

Others think the answer lies in increased fuel blends. "As we approach 14 billion gallons, there's oversupply and there's literally no market," Yancey says. "Ethanol plants would have to shut down and I think there'll be efforts to evaluate higher blends, whether that's E12, E15 or E20." For each percentage point blended above E10, an additional billion to billion-and-a-half gallons can be absorbed into the U.S. marketplace.

In the end, it may be that those in Washington, D.C., determined the market capacity for ethanol when they tied it to the RFS. "The industry is very sensitive and they've seen what happens when you produce in excess of what the blenders need to buy," Hanson says. "There gets to be a lot of downward price pressure when that happens. As we see the RFS increase, that's probably going to be a pretty good determiner of what the market is. There's a significant risk of going above that."

Experts say the RFS will provide a bit of a fervor, but not like some may have expected. "Yes it will help some plants' development, but it's not going to be an immediate effect," Thompson says. "The plants I've talked to are trying to find debt financing and it's going to take a little bit of time before we'll see what these new standards will mean for the industry. Is it three or four months? Maybe. Is it six to nine months? That's probably more likely. It's not going to bring project development back up to what it was in 2006, but it will help reinvigorate the industry."

Mount contributes to this notion. "Government mandates aren't going to open up equity markets unless you have an extremely viable product. So until we get past this point of a tight equity market and some current issues like feedstock inventories and prices, we're going to continue to see the equity markets and financing issues we're seeing now. This means there'll be great reluctance to put money into biofuels in the short term. And in the long term? Biofuels will be here for a long time."

Ron Kotrba is an Ethanol Producer Magazine senior staff writer. Reach him at
Anduin Kirkbride McElroy is an Ethanol Producer Magazine staff writer. Reach her at
Reach both at (701) 738-4962.