Lessons Learned From Past Downturns

Protecting shareholder value during periods of margin stress.
By Scott McDermott | May 14, 2013

Due to the continued challenging economic climate, we now see a new level of stress for many ethanol companies. The challenging downturn that began in 2012 has continued into this year. Although there has been some relief as of late, most analysts are projecting tight margins in the second half of the year, or at least until new crop harvest (assuming we get a good corn crop). This will be the fourth challenging margin period the industry has faced in the past 20 years. Independent ethanol companies have learned a lot about maneuvering through tough markets over the years, and this has helped protect shareholder value.

The ethanol industry entered 2012 expanding production to new heights. The increased production, as well as a shift from being a net exporter to net importer, caused U.S. ethanol stocks to build and start to pressure ethanol production margins. The oversupply of ethanol, the end of the blending credit and the short corn crop this past harvest have again deteriorated the financial condition of some ethanol producers. Fortunately, companies are better positioned than in the past. Many have learned from the mistakes made in the previous downturns.

The worst downturn in ethanol was in the mid-1990s (Period 1) when the U.S. had a very severe drought and ethanol had heavy competition from methyl tertiary butyl ether (MTBE). The lack of pricing power against MTBE as an oxygenate substitute caused over half of the capacity to be idled, restructured or sold during this period. Period 2 in the early 2000s was difficult, but, instead of a sustained downturn like the mid-1990s, there was a mix of bad and good margin months. Ethanol companies had learned to idle or slow the business during negative margin months to minimize losses and most ran during stronger months. This allowed the companies to preserve cash through the downturn. The other important lesson that many plants learned from the mid-1990s challenge was to avoid selling in distressed periods.

In Period 1, the independent ethanol companies that were forced to sell saw plant values cut in half. The industry was much smaller then, at about 1.4 billion gallons of production capacity, which included wet mills and dry-grind ethanol plants. Even though the average ethanol producer had earning power of about 90 cents to $1.10 per gallon, these plants were sold for 50 to 60 cents per gallon or even idled permanently in some cases. The low plant values could be attributed to a lack of potential buyers, the size of the industry, the lack of lenders and the fear the industry would not come back.

A number of companies that had liquidity problems in Period 2 were not forced to sell because they learned to raise additional capital instead of selling in a crisis. These capital injections from debt, equity or both saved these independent ethanol companies from destroying shareholder value. Many also learned that their options for debt are very limited in times of distress. The banks lending to the industry only extended credit to very low-leveraged and well-run ethanol companies. The banks were unwilling to lend if there was even marginal risk they would not be covered in a forced liquidation.

We also saw mergers and bankruptcies play some role during these periods. The mergers, however, were not mergers of “equals.” They usually entailed material dilution of the existing shareholders. Several companies took on equity partners rather than lose the asset through foreclosure, the thought process being: if the bank is going to force a sale of the business and the likely market value would be at or below the debt against the asset, the company would be better off diluting its equity with an equity partner rather than losing everything in a bank-led sale. Although this is not a common occurrence, there are numerous examples of independent ethanol companies that have lost everything because they were unwilling to consider this option.

The downturn after the 2006 ethanol margin boom (Period 3) exposed new challenges for the ethanol industry. The industry was two-thirds the way through a 10-fold expansion, from about 1.4 billion to almost 15 billion gallons of capacity, when prices and margins came crashing down from all-time high corn and ethanol prices. Corn prices at the time were approaching $7 per bushel and ethanol prices were approaching $3.50 per gallon when the prices fell as fast as they had risen. It wasn’t negative margins that caused distress in this period, it was the collapse in prices and margins.  When margins compressed, all weaknesses of the new ethanol companies were exposed.

By 2007, the rush to build plants and the strong global demand for construction materials drove construction costs from well below $2 per gallon for a 100-plus million gallon plant to $2.30 to $3 per gallon on an installed basis. The expansion in margins and fervor to build plants brought in new and inexperienced lenders, which also drove up leverage on these higher-cost facilities. A number of the plants sold under distress in 2008 and 2009 were very competitive plants. The challenges for these companies were the relatively high capital costs and high debt levels to be serviced in a lower-margin environment. Operating plant values again approached the 50-cent-per-gallon level, which brought a number of new companies into the ethanol industry.

The other two challenges exposed during Period 3 were poorly structured contracts and over-extended hedging positions. A number of companies were long corn or did not have the adequate liquidity to support margin calls in their hedging program. The speed and the size of the fall in prices caught many off guard. For some, many millions of dollars of financial damage occurred in a matter of days and weeks. A number of independent ethanol plants were again able to endure this stress because they had strong balance sheets or capital infusions. Others weren’t so fortunate and were forced to sell.

The second challenge exposed in the dramatic margin compression was in poorly structured and poorly written contracts that many independent ethanol companies had written in order to get their projects from concept to construction. Many companies are still working through these challenging contracts today. The challenges include high priced or uncompetitive origination and marketing contracts, extremely long-term contracts, partnerships or contracts that were one-sided and/or created dependencies that put the company at a disadvantage, contracts that did not consider counterparty risk, and contracts that companies simply did not understand. Many ethanol companies have spent considerable time and resources restructuring, canceling or fighting these contracts. They are now much better at vetting and negotiating mutually beneficial agreements.

The final area where many independent ethanol plants have made material progress toward building or preserving shareholder value is their relentless pursuit to improve the core business. These improvements have come from better management and better intelligence used to run the business. Most ethanol plants today have at least some understanding of their cost competitiveness or what we at Ascendant Partners Inc. refer to as EBITDA (earnings before interest, taxes, depreciation and amortization) competitiveness. Most are constantly looking for ways to improve plant efficiencies, origination programs, product marketing and logistics. They constantly assess the adoption of new commercial technology and the upgrading of coproduct streams.

All of these lessons have positioned independent ethanol companies to not only endure, but to thrive during this period of compressed margins. We have seen very few forced sales in this fourth period relative to earlier downturn cycles. The independent ethanol companies have used the lessons learned over the past 20 years to maneuver through the current tough markets. Although we will certainly see distressed sales, we will likely also see more consolidation strategies that allow companies that choose to exit the business to receive value commensurate with their earnings and others that merge, partner or adopt new technology to position the business for greater value in the future. 

Author: Scott McDermott
Partner, Ascendant Partners Inc.
303-221-4700
Mcdermotts@ascendantpartners.com

 

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