Is the ethanol boom about to run out of gas? Investors may want to consider the possibility.
A recent shortage of the corn-derived gasoline additive, combined with record-high oil prices, has had refiners snapping up every gallon of ethanol they can get their hands on. In the process, they have bid ethanol prices up to record levels.
Wowed by the substantial profits ethanol-makers are hauling in, Wall Street has been joyfully throwing money at companies that produce ethanol, in a style that recalls the heyday of the dot-com era.
The shares of industry leader Archer Daniels Midland Co. have doubled over the past 12 months, for example, as investors cheer the surging profit in the company's ethanol segment.
But there are signs of froth as well. Pacific Ethanol Inc., a Fresno, Calif., company that is constructing ethanol plants but has yet to produce a drop of product, saw its stock price quadruple over the course of five months this year. Pacific shares have since given up some of their gains, but investors who got in during 2005, including the $84 million buy-in by Microsoft Corp. Chairman Bill Gates, still are way ahead.
The gold-rush mentality also has caused major producers to undertake initial public offerings this summer, sometimes at ambitious valuations, and more producers are hoping to get their own IPOs off the ground soon.
In recent weeks, however, investors have been taking a harder look at the rush to capitalize on ethanol's promise, and ethanol producers' shares have come under pressure.
Skeptics contend that the boom has sown the seeds of its own bust. High prices have spurred a wild rush to construct new production plants, they say, and as that additional capacity comes on line, what they see as a price bubble will burst. If that happens, the ethanol industry's brief fling with vast profit margins will be over.
Ethanol producers "are likely seeing the peak of their margins now," Bear Stearns analyst Ann Duignan told investors in a recent report. But while producers' high profit margins--selling ethanol for more than twice what it costs to make it--"are not sustainable and will likely decline," she said, "we still forecast strong gross margins in the [coming] six to 12 months."
For investors, it is the uncertainties beyond the next 12 months that make the ethanol sector so hard to call. The industry remains a potentially lucrative energy-sector play, and it's highly unlikely the ethanol business will return to the relatively sleepy status of a few years ago.
But it's also a complex marketplace, where pricing and profit are routinely skewed by such factors as federal alternative-fuel requirements, the size of the annual corn harvest and the gyrating world price for a barrel of oil.
Such issues lend twists and turns to the story of how a low-glamour Corn Belt product like ethanol came to sudden prominence on Wall Street. They also help explain why there's disagreement over the industry's future profitability.
With the exception of ADM and a handful of other players, the industry has been fragmented. Many ethanol plants were built by farm co-operatives mainly interested in establishing a nearby buyer for their corn.
It wasn't until last year that outside events began to push the industry into overdrive. Importantly, federal legislation required refiners to significantly increase their use of renewable fuels in coming years.
In effect, the government was promoting ethanol as a substitute for gasoline, encouraging refiners to blend ethanol with their gas to reduce the nation's dependence on foreign oil.
Ethanol provides about 3.5 percent of the nation's gasoline needs. But some observers think that portion could grow to as much as 10 percent in coming years.
It is the beneficial confluence of two commodity prices that has sent ethanol producers' profits so high. As skyrocketing oil prices have sent gasoline prices dramatically higher, the price of ethanol has naturally followed. But the price of producing ethanol hasn't similarly risen, because corn prices have been fairly stable. The breadth of that "crush spread" is fueling the industry's boom.
The ethanol industry has moved swiftly to capitalize on its good fortune. First out of the gate with an IPO was VeraSun Energy Corp., a Brookings, S.D., producer that is a distant second to ADM in ethanol market share. VeraSun raised $420 million through its $23-a-share offering in June, and its stock closed its first day of trading up 30 percent.
Within weeks, Aventine Renewable Energy Holdings Inc. of Pekin, Ill., raised about $390 million through its own offering. The IPO was done at the high-end price of $43 a share, but the stock closed down on its first day of trading and has moved lower since.
Even though VeraSun and Aventine shares now are trading lower than their offering prices, more IPO hopefuls are waiting in the wings.
In Iowa Falls, Iowa, ethanol producer Hawkeye Holdings Inc. is hoping to raise more than $500 million through its planned IPO. And US BioEnergy Corp. of Inver Grove Heights, Minn., jumped on the bandwagon this month when it filed documents covering a planned offering worth up to $300 million.
The turbulent ethanol sector may present even more than the usual amount of question marks about IPOs. The principal concern is whether all the new capacity being planned will flood the marketplace and depress prices, or whether the market is so vigorous that it will absorb all the ethanol that comes online.
The U.S. has about 100 ethanol plants, with a capacity of 4.8 billion gallons per year. The 38 new plants under construction will boost that to 7.4 billion gallons in coming years, and a further 4 billion gallons of capacity is in the planning or proposal stage.
The "current large returns available to build new ethanol plants are attracting large amounts of capital," Credit Suisse told investors in a recent report, adding that "the danger of overbuilding is a real one."
"There is significant concern in the industry that there's too much money available for infrastructure investments," echoed Bear Stearns' Duignan, and, as a result, ethanol prices "are expected to fall rapidly" beginning in mid-2007.
But energy and natural resources analyst Jacques Rousseau of Friedman Billings Ramsey contended in a recent report that ethanol's "growth story has miles to go."
Although ethanol production in the U.S. is growing fast, he said, "demand should essentially keep pace with the rise" in capacity. That suggests "ethanol prices should remain strong" in coming years, he said.
Rousseau said that over the past six months investor sentiment toward the ethanol sector "has gone from enthusiastic to euphoric to, now, somewhat skeptical."
But Aventine's strengths as a low-cost producer are being undervalued, he contends, while VeraSun stands to benefit from how far advanced its new-capacity projects are in comparison with many rivals.
Rousseau initiated Pacific Ethanol at a "market perform" rating, calling the company's strategy of building plants near major West Coast consumer markets and shipping corn to those plants from the Midwest "a unique but unproven business model."
James P. Miller is a staff reporter for the Chicago Tribune.