Tighter Markets Provide Opportunities, Challenges

By Todd Taylor | October 06, 2008
When this article was originally written in August, VeraSun Energy Corp., Aventine Renewable Energy Inc. and other large ethanol producers were in relatively good financial condition. However, since mid-September, VeraSun, Aventine and many other plants have experienced severe financial difficulties whose ramifications remained unknown at press time. Despite these companies' worsening circumstances, the underlying point of this article and the examples used remain valid for other ethanol plants that are struggling to thrive, not just survive.

After several years of impressive growth, the soaring expansion of the ethanol industry has been brought back to earth. As a result, ethanol producers are experiencing the strain of reduced profit margins. To weather this business cycle and come out stronger, savvy ethanol producers must take steps to assess and improve their situation. Those that do not may not make it to the industry's next upswing.

Several options are available for ethanol producers feeling the pinch in today's industry climate. The most basic step is to cut costs and increase revenue. The least appealing, obviously, is liquidation. Between these two extremes lie other options, such as adding new technologies, refinancing company debts or finding a buyer. An analysis of how other producers are dealing with market changes can offer important lessons for you to determine your own route.

A Multifaceted Response
An example of an ethanol company that has developed a multifaceted response to the tightening of margins is VeraSun Energy Co., one of the largest ethanol producers in the nation. By 2008, VeraSun had the capacity to produce 870 million gallons of ethanol annually, and had ambitious plans to expand its market share significantly. According to the company's 2007 annual report, by the end of 2008, VeraSun projected that it would be operating 16 refineries and have capacity to produce 1.64 billion gallons of ethanol annually.

However, market trends have forced a reassessment of that expansion. VeraSun cut its costs by delaying the opening of new 110 MMgy production facilities in Hankinson, N.D., Welcome, Minn., and Hartley, Iowa. After analyzing its options, the company chose to delay commencing operation at each facility until "the outlook for ethanol selling prices and overall margins improve[d]." On July 22, the Hankinson plant began production after roughly a month delay. On Aug. 14, VeraSun announced start-up of the Hartley facility. At press time, the Welcome plant was not operating. Though the company remains optimistic about the future of the ethanol production industry, short-term analysis suggested it could protect assets and shareholder value by avoiding the high cost of starting up and operating these new plants in a climate where ethanol was "being sold at a deep discount to unleaded gasoline."

VeraSun has nonetheless continued with production at its other facilities and with the construction of other projects, such as new production facilities in Janesville, Minn., and Aurora, S.D. This continued construction reflects VeraSun's strategy of identifying ways to increase revenue while reducing costs. The Aurora project, for example, is an oil extraction facility scheduled to be completed this fall and expected to yield 7 MMgy to 8 MMgy of corn oil annually, extracted from the distillers grains created during ethanol production. The oil will then be sold on the biodiesel market and "is expected to generate increased revenues and improved production economics," according to Pete Atkins, VeraSun vice president of corporate development.

VeraSun's approach to handling the changing ethanol market goes a step further. In addition to cutting costs and finding new revenue streams, the company has refinanced in order to achieve additional liquidity. According to a June 2 press release, VeraSun entered a new revolving credit facility with UBS Investment Bank allowing maximum borrowings of $125 million, up from a previous secured revolving credit facility of $30 million. Every business expansion carries some inherent risks, especially during an economic downturn, but by refinancing its credit, VeraSun is attempting to manage its risks by maximizing its available funds in order to be sure it can achieve continued expansion in the face of current market difficulties.

VeraSun's proactive approach combined a number of strategies, but most important was VeraSun's strategic approach to analyzing its situation and addressing potential trouble before it became a crisis.

Other Alternatives Available
Another alternative to consider is looking for a buyer. For some producers, the market downturn has raised the difficult question of whether to continue operations in the face of financial stress or merge with another producer to achieve financial stability. Millennium Ethanol LLC chose the latter when it was purchased by U.S. BioEnergy Corp. in the spring of 2007. Formed in 2005 in Marion, S.D., Millennium Ethanol was affiliated with a large South Dakota farmers' cooperative, Fremar Farmers Co-op, and was founded with the support of hundreds of local investors. The company's founding vision was to support the local rural community and be a low-cost ethanol producer. Nevertheless, Millennium merged with the much larger U.S. BioEnergy in 2007, before it had even completed the construction of its 100 MMgy production facility.

At the time, U.S. BioEnergy was one of the larger ethanol producers in the nation, with eight facilities and production capabilities of 700 MMgy after the merger with Millennium.

(U.S. BioEnergy has since merged with VeraSun). Though founded on the principle of supporting local farmers through community investment, when the opportunity to consolidate with one of the largest production companies in the United States presented itself, Millennium Ethanol decided to go forward with the merger. The company executives examined their strategic options while keeping in mind their fiduciary duties and recognized a chance to "gain access to geographic diversity, management resources and cutting-edge technology... while also gaining access to capital resources and... capitaliz[ing] on the economies of a larger scale," according to Steve Domm, Millenium Ethanol chief executive officer.

While Millennium may have been strong enough to survive and thrive independently, in the end, the board and members decided to sell and U.S. BioEnergy paid more than $133 million in cash and stock for Millennium Ethanol, most of which came in the form of 11.5 million shares of U.S. BioEnergy stock, according to a report in Minneapolis/St. Paul Business Journal.

In order to make these hard decisions, companies such as Millennium need to know where they stand in the marketplace, through benchmarking and other tools that employ hard data to analyze options and carefully assess their options.

Smaller Producer Remains Poised
Smaller producers can develop similar strategies for dealing with the market downturn. Central Minnesota Ethanol Co-op successfully weathered similar market difficulties just as the company began production about nine years ago. CMEC was formed in 1994 but spent five years constructing a plant before finally opening its 15 MMgy facility in March 1999. Unfortunately, production commenced during a time of historically low ethanol prices, and substantial construction cost overruns had left the thinly capitalized company highly leveraged. In an industry climate where margins were slim, the company's revenue was insufficient to service its debts.

CMEC decided that its best chance of survival was to engage its lenders in conversations about refinancing. CMEC had some negotiating power because, unless producing ethanol, the value of the property and equipment on which liens could be asserted was minimal. With the help of an experienced attorney, the company was able to restructure a large portion of its secured debt and was in negotiations to do the same with other lenders when ethanol prices began to climb. Because it had carefully weighed its options when facing financial stress, CMEC was able to survive long enough to thrive in that next wave of industry growth.

Today, CMEC has a reputation for being forward-thinking. The facility was first in the nation to install biomass gasification technology in 2006 in an effort to become fully energy independent. CMEC is researching the feasibility of creating a chemical catalyst-free cellulosic ethanol plant in collaboration with SunOpta BioProcesses and has applied for a grant to develop technology that will facilitate the extraction of moisture from wood chips used in the gasification unit for water needs during ethanol production. When times got tough for CMEC, it fought hard to survive and is now implementing new technologies and processes to enhance revenues and ensure its survival for the future.

Worst-Case Scenarios Happen
For producers that are slow to respond to market changes, especially those that have turned a blind eye to their troubles, strategies to avert disaster may not be available. Such producers may find themselves unable to finance new revenue-generating strategies, obtain refinancing or find a buyer on favorable terms. Then, facing mounting debts and forced to seek a buyout, such producers will have few choices left. Such was the case for Central Illinois Energy, which was bought out from bankruptcy in March 2008.

CIE was formed to build and operate a 37 MMgy cooperative ethanol production facility in Fulton County, Illinois. Construction began in the spring of 2006 and was projected to cost approximately $90 million, $13 million of which was to go toward start-up costs and working capital. CIE was funded, in part, through the investment of 250 local farmers, with the goal of continued economic benefits for the surrounding community. Substantial additional funding came from lender Credit Suisse.

However, by December 2007, with the plant nearly finished, construction and start-up costs for the production facility had gone up to $130 million. Investors ran out of money, unpaid contractors abandoned the job site and CIE declared Chapter 11 bankruptcy. It was later revealed that the financial problems at the facility went unnoticed due to unorthodox bookkeeping. According to CIE's bankruptcy attorney, the CIE plant manager had been drawing money from three separate accounts (for the operating company, holding company and cooperative) to pay bills, depending on which account had sufficient funds at the time, according to the Canton, Ill., Daily Ledger.

CIE was bought out by a consortium of lenders for $80 million, roughly the amount of the company's outstanding debts. CIE's senior lender, Credit Suisse, was a part of the consortium of lenders, along with Whitebox Advisors, a Minneapolis hedge fund, that bought out CIE. The buyers formed a new entity, New CIE OpCo LLC, and are responsible for $22 million in mechanics liens and the expense of completing the construction of the plant, an estimated $25 million. The original CIE investors lost all of their investment.

CIE is a valuable example of the importance of having systems in place for the early detection of financial difficulties. Much like CIE, Wyoming Ethanol LLC and its parent company, Renova Energy, filed for Chapter 11 bankruptcy at the end of June, citing increasing costs of constructing a 20 MMgy facility in Heyburn, Idaho. Ethanex Energy Inc. and Convergence Ethanol Inc. went a step further and filed for Chapter 7 liquidation bankruptcy in March 2008 and December 2007, respectively, leaving nothing behind for the equity investors.

Unfortunately, many industry experts expect to see more small to mid-size ethanol companies facing severe financial stress as a result of current market pressures. Don't let yours be one of them. Learn from the experiences of other producers.

Todd Taylor is the lead shareholder in the biofuels group at the law firm Fredrikson & Byron. Reach him at ttaylor@fredlaw.com or (612) 492-7355.