The U.S. biofuels industry-both ethanol and biodiesel-are well into a full-scale restructuring. Many companies are sitting idle, struggling with limited cash, ceasing operations, evaluating restructuring options or selling assets. Few, if any, players are prospering in the current environment.
This article reviews the recent, short-lived building boom, surveys the current state of the industry, assesses how the industry ended up in this situation, outlines a rationale for future growth and maps out the road ahead.
The Biofuels Boom
Prompted by federal policy, the phase-out of MTBE (Methyl tert-butyl ether)-and the general push by investors into renewable energy, ethanol and biodiesel plants of all sizes, locations and technologies-sprang up across the United States. The ethanol industry went through a capital-intensive building boom, and production capacity grew from 4.3 billion gallons in 2005 to 12.5 billion gallons in 2008. The industry produced more than 9 billion gallons in 2008, representing 6-7 percent of the gasoline consumed in the United States. An estimated $20 billion was invested in the industry-of which approximately $10 billion was debt.
While the biodiesel industry did not experience the same boom, production capacity increased rapidly. From 75 million gallons in 2005, production capacity jumped to 2.6 billion gallons in 2008, though some of this figure was not commercial-quality capacity. The industry produced 700 million gallons in 2008, representing 1-2 percent of U.S.-consumed diesel. Except for a few well-capitalized players, most of the plants were smaller in scale and did not raise significant amounts of debt.
Cost of Volatility and Biofuels Today
After several years of rapid growth, the biodiesel and ethanol industries now face significant financial and operational challenges. Financial models that underpinned major investments and loans are now irrelevant. Most of the industry is back at the drafting board re-evaluating assumptions, rewriting business plans, recapitalizing balance sheets and ultimately restructuring businesses and debts. There have been at least a dozen bankruptcies in the last few months, including Aventine, Gateway Ethanol, Ohio Ethanol, Freedom Fuels, Nova Biosource and VeraSun, while other companies have quietly restructured or closed plants. If the current conditions persist, additional bankruptcies and plant closures will follow.
The primary culprit of this dramatic reversal of fortune is the spread between fuel and feedstock. For ethanol, this is the spread between the price of corn and gasoline. For biodiesel, this is the spread between soybean oil and diesel fuel. In January 2006, the gross margin of converting corn into ethanol was $1.50 per gallon and the gross margin of converting soybean oil into biodiesel was $0.75 per gallon (inclusive of the federal tax credits). These margins sent a strong economic signal for investors and lenders to fund projects to the point where ethanol and biodiesel production exceeded federal mandates and market demand. This overproduction caused the biofuels industry to become a price taker unable to maintain margins.
To exacerbate the declining margins, volatility further disrupted these markets. The price of crude oil increased by nearly 50 percent, going from $100 per barrel in January 2008 to $147 per barrel in July 2008 and then declined 80 percent to around $30 per barrel by the end of 2008. Corn prices more than doubled from an average of $3.40 per bushel in 2007 to $8 per bushel in the futures market in mid-2008 but fell by 50 percent to $4 per bushel by the end of 2008. Soybean oil prices more than doubled between January 2007 and March 2008 to exceed $0.55 per pound, peaked at $0.72 per pound in mid-2008 and fell more than 50 percent to close the year around $0.32 per pound. It is tough for any business to survive, much less prosper, with that kind of price volatility for 70-80 percent of its cost of goods.
If margin decreases and price volatility did not derail business plans at biofuel companies, the closing of the capital markets window and deteriorating financial conditions undermined ambitious business plans premised on access to capital. The debt in the capital structures of many biofuel companies is now becoming the catalyst for restructurings and the sale of assets.
Important Advances for Biofuels
Despite today's financial troubles, the industry has solidified important gains over the past several years that will provide returns to the restructured and recapitalized survivors.
- Market acceptance: Consumers and business tested and adopted the new fuels;
- Industry acceptance: Major players such as car and engine manufacturers as well as fuel distributors tested, accepted and then supported the new fuels;
- Industry creation: There is now a biofuels industry comprised of scientists, operators, suppliers, customers, entrepreneurs, policymakers, investors and lenders who will continue to innovate and move the industry forward; and
- Identification of hurdles and challenges: The scrutiny of the industry has focused on energy efficiency, feedstock availability, standards and performance issues, but the market is already seeking the next round of solutions for these issues.
The Road Ahead for Biofuels
The industry should emerge from this fork in the road and continue to grow. Here are the key requirements for that growth:
- Culling the herd: The plants with the weaker economics due to location, plant design and technology will not survive. Completed and half built plants are currently mothballed, being scrapped or sold for a fraction of construction costs.
- Industry reorganization. Asset repricing, the entrants of new players and fresh capital will eventually create an environment for attractive economic returns.
- Second-generation feedstocks. There are limits to domestically grown corn and soybeans. Price barriers and environmental concerns will limit industry growth that is tied to these feedstocks. Global research and investments are already underway to develop and commercialize the next generation of feedstocks-cellulose, jatropha and algae.
- Development of integrated businesses. Companies will vertically integrate from feedstock to the end users of the products that will drive additional efficiencies into the business.
- Independent industry gets co-opted by more-established players. A major oil company just outbid a leading agricultural processing company for ethanol assets in the VeraSun auction. In biodiesel, established players such as ADM, Cargill and REG will continue producing biodiesel. The biofuels industry needs to integrate further into the existing energy industry.
- Continued government support is critical. Without the federal tax credit and the Renewable Fuel Standard, the fledgling industry will not survive. While the industry will have to find a way to outgrow this support, for now it is critical.
- Consumer and industry support. The related industries, such as automotive and engine manufacturers, must continue to support biofuels. Consumers and business have shown a willingness to test and adopt the new fuels. This demand will have to grow to support the growth of biofuels production.
For several reasons, a robust, evolving biofuels industry should play an important role in the U.S. economy over the next decade. First, biofuels stand to contribute to the strategic goal of reducing the nation's dependence on importing about three-quarters of its oil. Second, with advances in feedstock and technology, the next generation could yield environmental benefits by displacing fossil fuels. Third, domestic biofuels investments have multiplier effects on local, rural economies. Finally, with a rationalized industry and repriced assets, the industry offers the prospect of economic returns for investors.