Date April 2018
By the numbers
- The U.S. Grains Council reported that the U.S. recorded its highest monthly ethanol export ever in February 2018 of 218.7 million gallons. The U.S. has exported approximately 768 million gallons of ethanol to date in the 2017/2018 marketing year, representing a 6% increase from last year’s record setting pace.
- Given the sizable expansion in ethanol production capacity and only mediocre growth in demand, a market correction for ethanol is anticipated in the next year to two years. However, this correction will be less severe than that of 2012-13 according to information provided by CoBank.
- Ethanol producers have been struggling with marginally sustainable profit margins for some time; this can be attributed to excess supplies of ethanol and low prices for some ethanol byproducts.
Industry outlook is cautious: The general consensus is that the long-term outlook for ethanol is cautious due to a combination of factors. As a result of ongoing low margins, two of the largest ethanol producers in the U.S., Green Plains, Inc. and Archer Daniels Midland Co. have been converting fuel ethanol capacity into beverage and industrial alcohol production and idling some plants. To put it simply, some producers are shifting away from fuel ethanol production to other ethanol products in hopes of improving margins. In addition to low margins, it appears flex fuel vehicles (vehicles that can run on E15 and higher blends of ethanol to gasoline and are thought to be a driver for increased ethanol consumption) are losing ground to electric vehicles.
In terms of maintaining during a correction, ethanol producers that have access to a reliable local corn supply as well as plants that have access to multiple modes of transportation (e.g. rail, truck, and water) giving them more marketing flexibility with both ethanol and distiller’s dried grains with solubles (DDGS), can expect to better weather a downturn according to information compiled by CoBank in 2017. Additionally, producers that have invested in efficient technology and are producing more than 2.8 gallons per bushel will have a more favorable outlook. This forecast is based upon the assumption that there will be no impactful legislation or trade policy changes, which may have a broader effect on production.
Crush spread an Indicator of financial health: The crush spread is a financial metric that ethanol producers routinely use to monitor their financial health. The crush spread is the difference between the combined sales value of the ethanol and the DDGS that can be extracted from a bushel of corn and the cost of the bushel of corn. The crush spread is used to gauge the relative costs of production. When the margin exceeds processing costs, ethanol producers tend to process more corn into ethanol. When the margin falls below processing costs, ethanol producers tend to scale back their operations and idle plants. A narrowing corn crush spread occurs when the price of corn rises relative to the sale prices of ethanol and DDGS. When this occurs, the spread becomes less positive (or more negative). A widening corn crush spread occurs when the sales price of ethanol and DDGS rise relative to the price of corn. When this happens, the spread becomes more positive (or less negative).
Ethanol crush margins have come down over the past year, driven primarily by a decrease in price for DDGS, a byproduct of the ethanol distilling process used primarily for livestock feed.
National Energy Legislation drives change: The Energy Independence and Security Act (EISA), which was signed into law in December 2007, significantly increased the prior Renewable Fuel Standard (RFS). The revised RFS (RFS2) significantly increases the mandated use of renewable fuels, rising incrementally each year to 36.0 billion gallons by 2022.
In February 2018, the USDA Economic Research Service released updated 10-year agricultural projections through 2027. The report indicates ethanol production is expected to increase during the beginning of the 10-year projection period, but decline throughout the rest of the decade, returning to 2016 levels by the end of the projection period. The report predicts the RFS volume requirement for biomass-based diesel will be maintained at 2.1 billion gallons per year throughout the next decade.
Under the provisions of EISA, the EPA has the authority to waive the mandated RFS requirements in whole or in part. To grant a waiver, the EPA administrator must determine, in consultation with the Secretaries of Agriculture and Energy, that there is inadequate domestic renewable fuel supply or that implementation of the requirement would severely harm the economy or environment of a state, region, or the U.S. as a whole. There is currently a significant amount of legislation pending on the subject of renewable energy. Included are the Leave Ethanol Volumes at Existing Levels (LEVEL) Act (H.R. 119), which would freeze renewable fuel blending requirements under the RFS2 at 7.5 billion gallons per year, prohibit the sale of gasoline containing more than 10 percent ethanol, and revoke the EPA’s approval of E15 blends and H.R. 777 that would require the EPA and National Academies of Sciences to conduct a study on “the implications of the use of mid-level ethanol blends.” Also included are H.R. 776, which would limit the volume of cellulosic biofuel required under the RFS to what is commercially available and H.R. 1315 that would cap the volume of ethanol in gasoline at 10 percent. Additionally, the RFS Elimination Act (H.R. 1314) was introduced, which would fully repeal the RFS. Senator Ted Cruz (R-Texas) has been a vocal proponent of the RFS Elimination Act and has voiced strong opposition to the biofuels sector in general, which he feels is having a damaging effect on oil-and-gas refiners.
All of the noted bills have been assigned to a congressional committee, which will consider them before possibly sending any on to the House of Representatives. No legislation affecting the RFS or ethanol has been introduced in the 2018 Senate session to date.
However, one major defeat for the ethanol industry took place in July 2017 as a federal proposal to make fuel containing higher blends of ethanol available on a year-round basis failed to advance from a Senate committee. Senate Bill 517, introduced in March 2017, would have allowed for increased availability of fuels with 15 percent ethanol (E15) or greater. Various boating interest groups have argued for some time that marine engines are incompatible with E15 fuel. The Clean Air Act currently places limitations on sales of E15 fuel blends during summer months. Alternatively E10, or fuel blends with 10 percent ethanol, were exempt from the Clean Air Act limitation. Bill S. 517, which was presented to the Senate’s Environment and Public Works Committee, will not continue through the legislative process, meaning current limitations on E15 will remain in place.
Due to the high volume of legislation surrounding the energy space and its ability to impact if, how, where, and at what price a product is sold, lenders with energy extraction machinery and equipment or energy production-based raw materials as part of their portfolios should continue to monitor pending legislation as any changes may impact values.
Complex nature of equipment necessitates special valuation approach: A “business overlay” approach is absolutely necessary when valuing ethanol facilities to capture the full income-generating value of the equipment. It considers the overall cash flows and value of a company as a whole. An income approach, or cash flow approach, is a common method to value entire companies. The value of company assets that are known, such as working capital and real estate, are subtracted from the company value to derive a value available to the remaining assets. The residual value essentially determines whether the residual assets are providing an adequate return for the company. If they aren’t, then economic obsolescence exists. In general, this “Fair Market Value in continued use” needs to be supported by the going concern earnings capacity of the business that the machinery and equipment supports. In deriving the residual value (or available return on) the remaining assets, Gordon Brothers’ appraisers will consider all information available concerning the company, its assets, and industry trends affecting the company’s cash-generation ability.