Closing the Distribution Infrastructure Gap

By Thomas Young | May 09, 2008
Higher prices at the pump and dire warnings about climate change have not caused significant lifestyle changes in the transportation choices made by most Americans. The seemingly conflicting issues of U.S. appetite for unlimited energy and a belief in the benefits of bolstering its energy independence will keep biofuels in the spotlight for many years to come.

That's good news for the ethanol industry. Supply and demand are strong. In 2007, 134 plants produced more than 6.5 billion gallons of ethanol, up from less than 2 billion gallons produced in 2000. The rapid expansion of the industry has been phenomenal. As ethanol supply and demand continue to increase, the industry faces several hurdles.

One of the largest hurdles at the present time is simply how to get the increasing quantities of ethanol to the end user. Strong supply and demand are great for any product, but if the producer can't efficiently move the product to the user, demand can evaporate. Because ethanol is produced predominantly in the Corn Belt states of the Midwest while demand is strongest in the heavily populated coastal regions of the United States, getting the product from producer to user has emerged as a significant hurdle to overcome to keep the industry on its strong forward trajectory.

One might wonder why this is such a problem when so much petroleum is moved through a well-established pipeline system that has performed safely and efficiently for many decades. Why not just move ethanol the same way? The problem is two-fold. First, ethanol cannot be easily transported in petroleum pipelines because it picks up impurities that prevent proper blending with gasoline at the distribution end-point. The second issue is that pipeline infrastructure is sparse in the Midwest, where the bulk of ethanol plants have been built over the past decade.

That leaves transport by rail, barge or truck. Today, approximately 75 percent of ethanol is moved by rail, with the remainder by truck and barge. The growth in ethanol production and subsequent increase in the volume of ethanol, corn and distillers grains being shipped by rail has occurred at the same time during which the railroads are experiencing congestion due to the increase in rail traffic across many commodities, notably coal, grain and intermodal.

The unit train is the most efficient way to transport bulk commodities such as ethanol by rail. This involves loading a minimum of 80 railcars with one product for transport from one origin point to one destination point, with an expedited (usually 24-hour) turnaround time at the destination. The challenge for unit train operations is finding adequate infrastructure on both ends of the supply chain to support such operations. Currently, a limited number of terminals in the United States are capable of receiving unit trains of ethanol. These terminals are operated by companies such as Motiva Enterprises, Kinder Morgan, U.S. Development Group and LogiBio, among others.

In today's ethanol marketplace, the construction of transportation infrastructure is challenged to keep pace with ethanol production capacity, leaving a transportation gap that is challenging the industry. Developing a rail-served ethanol distribution terminal is often a complex, costly and time-consuming undertaking. These attributes, combined with an industry that is buffeted by change in multiple arenasfrom politics to perceptions to technologytend to make potential investors wary of funding these projects. However, over the past several months, an increasing number of petroleum distribution companies, investors and developers appear to be willing to face these challenges, as the potential return-on-investment for properly-planned projects can be very attractive.

Project Planning
Perhaps the greatest challenge is that the distribution end points are typically located in dense, urban industrial centers where real estate is more expensive and the permitting environment is more complex than in the rural areas that host most ethanol production facilities. Therefore, developing a successful ethanol distribution infrastructure project requires understanding the needs of the host community and building appropriate mitigations into the initial development plans, as well as complying with federal, state and local permitting requirements. In addition to community and permitting coordination, the commercial issues require a significant amount of coordination.

The commercial development of an ethanol distribution project typically includes several steps. First, one must determine the market need through coordination with petroleum companies that blend ethanol from the distribution terminal into their gasoline. Second, one must determine the "all-in" costs of transport and handling that will be required to receive and distribute product through a terminal. This requires coordination with transportation and distribution providers (terminal operators, railroads, pipeline distribution, trucking and barge companies) to estimate these costs. Once the market needs and the transportation and handling costs are estimated, there must be coordination with ethanol producers or traders as to who will supply ethanol to the terminal.

With demand for ethanol showing a decade-plus record of rapid expansion and continuing federal pressure to bolster energy independence through legislative mandates for alternative energy including biofuels, one might ask why more distribution projects are not coming on line. The answer partially lies in the inherent, or at times perceived, risks that an investor must endure during the period of time that is required for permitting and project development.

A major concern for potential investors is identifying the right market. Generally, there is a perception that each market has a fixed amount of demand for ethanol distribution infrastructure. Therefore, most believe that each market can absorb only so many viable ethanol distribution projects. There is a risk that a project that made good financial sense at the feasibility stage may become untenable when other projects move into development in the same market, thereby potentially decreasing the projected throughput volumes.

However, there is also an upside to this situation. With increased ethanol distribution infrastructure in a market, there is the potential for increased acceptance and use of ethanol in that market. Due to the increased efficiency of receiving ethanol, petroleum companies would have an increased incentive for discretionary blending of ethanol. There is also the possibility of increased blending proportions of ethanol into gasoline, which would increase ethanol demand.

Another set of risks is based on several unknowns in the future of ethanol. There is the inherent risk of cellulosic ethanol plants being built within close proximity to these rails and barge-based terminals, thereby potentially competing to deliver ethanol to the same set of customers. Also, the potential to develop technology that will allow ethanol to be shipped via existing or newly-constructed dedicated pipelines is a risk that must be calculated by potential investors of terminals dependent on receiving ethanol via rail or barge.

While both of these risks must be estimated and calculated into project viability plans, the notion of fixed ethanol demand for each market should be questioned, as mentioned above.

While many hurdles exist, there has been recognition across the industry of a deficiency, or gap, in the logistics chain. Whenever there is a gap in a growing market, there are opportunities for investors and developers to find solutions to bridge this gap. As companies become more comfortable with the longer-term outlooks for their ethanol marketplace and better understand how to overcome the challenges of developing these projects, we expect to see a significant increase in ethanol distribution infrastructure projects coming on line over the next several years. The industry is hopeful that this infrastructure will pave the way for further increases of ethanol usage across the United States.

Thomas Young is a management consultant with Omaha, Neb.-based HDR Inc. Reach him at thomas.young@hdrinc.com or (617) 357-7721.