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Beware of the Allure of Ethanol Investing

by: Neal Dikeman June 15, 2008 | about stocks: AVR / SUN / TSO / VLO / VSE    
Neal Dikeman

Neal Dikeman

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I am a fan of ethanol. The addition of corn ethanol to our US fuel supply chain has had a significant impact on keeping gasoline prices way lower than they otherwise would have been, and has paid for the subsidies many times over. But that has not translated to gains for ethanol stocks, which are down on the order of 50% over the last year according to the Camino Energy index, and it won't change anytime soon.

As the bellwether US ethanol pureplays are finally down to earth, my predictions have come to pass. Two years ago ahead of Verasun's (VSE) IPO, I blogged an analysis saying I thought Verasun should trade in the $3 to $8 range, depending on the margin, PE, and growth assumptions. The bankers and the market thought I was nuts, treating VSE and Aventine (AVR) which listed near the same time as technology style growth stocks.

The company listed at several times my target range, and then traded way up from there. But as I had predicted, the margin pressures from a range of commodity price movements and the relatively low barriers to entry for capacity additions came to bear. But the fall is probably not over.

I stated then and reiterate now that ethanol companies are basically small refiners with potentially worse economics. And refiners traditionally trade at single digit PEs, and single digit PE. Worse, refiners don't always do well when commodity prices rise or their markets grow fast, as the spreads they make their margin on are often affected as much by relative capacity constraints as the raw commodity prices themselves. In fact, fast moving commodity prices in either direction in either refined products or feedstocks can sometimes bode ill for refining profits, depending on what's happening in capacity.

VSE now trades under $5. Right in the middle of range I predicted it should. And the PEs for VSE and AVR are finally down in the range close to the independent refiners group I follow, Valero (VLO), Sunoco (SUN), and Tesoro (TSO). BUT,and there is a but. The TEV/EBITDA multiples for VSE and AVR, which are way down, are still 2-3x those of the refiners, and the PEG ratios are still richer as well. This likely means more room to fall, or at least languish.

The next wave of venture backed ethanol companies, mostly cellulosic, are beginning to break ground on pilot plants, and given the penchant for certain ethanol crazed venture investors to IPO deals when windows open, it is likely we will see some of these soon. And it is likely that they will be sold to the market the same way, as high growth stocks based on great technology and macro conditions justifying stratospheric PEs on unsustainable margins. Then they'll hit their first commodity cycle, the margins will compress, the bloom will come off the rose, the multiples will come down, and the investors who bought and held post IPO will get crushed.

We've seen it before and we'll see it again. Try not to get caught this time.

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This article has 15 comments:

  •  
    Jun 15 09:04 AM
    I'm not convinced that the technology for cellulosic ethanol will ever be commercially viable.
    Reply
  •  
    Jun 15 10:20 AM
    Ethanol gas may be cheaper and more environmentally friendly (at least say the pundits) but it is certainly not more efficient. Oregon starting using 10% ethanol gas earlier this year and EVERYONE is seeing 15% to 20% less miles per gallon. My brand new Mazda CX-7 which is suppose to get 18-24 MPG city/hwy is more like 16 MPG. The state of Oregon said you could expect about a 1%-3% degragation in fuel efficiency. This is obviously not happening so this may also be having an effect on the stock prices.
    Reply
  •  
    Jun 15 11:02 AM
    in the long run, ethanol will not be viable as a fuel. we'll use hydrogen or something else that doesn't have to be grown or harvested or dug or pumped out of the ground. and this is happening faster than most people realize. in the short run you might make some profit on investing in it if you're very careful and manage to time it right, but not in the long run.
    Reply
  •  
    Jun 15 11:21 AM
    I agree with biomedlives. Additionally, why develop cellulosic ethanol when we can
    REMOVE THE TARIFF ON IMPORTED SUGARCANE BASED ETHANOL.
    Reply
  •  
    Jun 15 12:05 PM
    You were not alone in scepticism about Verasun's IPO
    tinyurl.com/6r5cw2

    On first days trading the shares soared to US$30 a rise of 30%.

    "This puts a value on the company of 200 times its annualized earnings from the March quarter 2006. Compare that with (say) 50 for Google.

    Ethanol either from corn, sugar or so called biomass, is expensive, it has less calorific value than regular gas and is simply another method of keeping Iowa / Indy Congressmen and their constituents (briefly) happy.

    Ethanol has been a hucksters paradise.

    The best way to invest in ethanol is to buy a bottle of Wild Turkey.
    Reply
  •  
    Jun 15 04:29 PM
    We should all be extremely opposed to ethanol ( although I have made $ on fertilizer stocks ).
    It is not something to be a fan of.
    There are 2 problems AND THEY ARE NOT CONNECTED.

    1. Greenhouse gas emissions; they are real and not some R Limbaugh rant.
    2. Reaching peak oil supply, it all does downhill after ~ 2015.

    Ethanol may help with # 2, BUT it hurts # 1, tremendously. Corn and cellulose
    require trucks and energy to transport ( no pipelines). They take farmland out of food production. They require heat sources for their distillation. Have you ever stood near a still ?
    Ethanol burns, giving off the greenhouse gases H2O and CO2.

    And the resulting high prices of corn and basic cereal crops have led to food riots around the world ( Africa, Indonesia, Mexico, Haiti, etc.)
    We, the rich, should not be fans of something which lets us fictitiously lower gas prices at the expense of the lives of the poor.

    We are living in a sea of energy; we are bathed by the sun and living on top of geothermal. Renewable sources - solar, wind, wave, hydroelectric, geothermal, etc. are all available. GE, STO etc. have all invested in these heavily.
    Such sources would let us solve #1 and #2 simultaneously.

    Hey, Ziz I'll join you in a bottle of Wild Turkey anytime.
    Reply
  •  
    Jun 15 11:35 PM
    This guy must be uninformed. It takes more energy to produce ethanol than it replaces. It takes tons of fresh water and natural gas, lowers gas mileage in your car and adds pollution. It sold to you by purchased politicians. Both Dems and Republicans are on the wrong side of this one. They are in good company, so is the author of this article.
    Reply
  •  
    Jun 16 02:01 PM
    You guys don't have a clue. Oil is much higher subsidized than ethanol. Even the so called ethanol subsidies go to oil companies and refineries.
    Ethanol has a better margin than oil, why do you think exxon- mobil are selling all those gas stations?

    Ethanol is cleaner burning than oil.

    Ethanol has superior burn characteristics in internal combustion engines than oil, why do you think they're running it at Indy and soon to follow F1 racing? Ethanol has a much higher octane rating than oil and can easily be used in diesel engines where it would get mpg as good or better than in a gas engine.

    Food for fuel? How about NO FUEL NO FOOD? How are farmers going to grow $2/bushel corn with oil prices at $130/barrel?

    And corn...industrial crop or a food crop? I mean what is ethanol competing with...High Fructose Corn Syrup and corn starch? We should be using HFCS in our food supply? Are these the necessary food supplies that we're missing?

    And exporting corn, why? So we can undercut third world subsistence farmers and drive them off the land? That's the reason for the food riots. You've undercut foreign ag by dumping grain.
    Reply
  •  
    Jun 16 02:15 PM
    I agree with tylakewalker, and while we're at it why don't we grow our own cane, it would give the tobacco farmers a great replacement cash crop. You can't tell me we don't have the climate for it, look at the gulf states. The basic idea of ethanol is distilled plant sugar, which the plant makes from photosynthesis (basically converted solar energy involving a plant middleman). Ethanol involves the plants stored energy not any of the other nutrients in the plants structure, yes I agree nutrient dense corn is not the best. Is there anyone from the rural midwest in here, are there fields sitting idle out there that could be used to supplement the food supply? To listen to the headlines you would think every scrap of field is being used at max capacity. I live in the very rural east and from what I drive by everyday it's business as usual. I would be concerned if we kept planting corn over and over, so as to deplete the soil and its the dust bowl all over again.
    Reply
  •  
    Jun 16 04:58 PM
    Interesting article and comments.
    Reply
  •  
    Jun 16 10:49 PM
    I disagree with Neal's on 2nd generation biofuels. The key difference between corn ethanol refiners and cellulosic ethanol companies is in the novelty of the IP used in the conversion process. Corn ethanol technology has been publicly available for the past decade and few stepwise improvements have been achieved in efficiency or carbon conversion.

    If a vc-backed company commercializes a novel technique of converting cellulose (or another feedstock) into ethanol with dramatically higher conversion efficiency or lower capital requirements, that company will reap the marginal benefit for the life of its patents.

    While in the very long term, the company's rents will decline as their unique access to the technology will fall away, there will undeniably be substantial, if not perpetually sustainable, value in these companies.

    Much like in the drug industry, the key to understanding these stocks is in understanding the period of these extraordinary rents.
    Reply
  •  
    Jul 10 07:44 AM
    Author - can you possibly be stupid enough to believe that the addition of 10% ethanol at $4+ per gallon to produce has kept the price of gasoline "way lower" than it would have been? Without the hidden subsidy from the feds on this fuel, and support from our know-nothing or care-not executive leadership in the White House, from a business standpoint, this stuff wouldn't even exist in gasoline. It's providing us with nothing. By the way genius, were you even AWARE that this miracle product has 30% less energy in it than gasoline which means your gas mileage is reduced by 3% with the current 10% blend? What's that mean? Evey auto manufacturer claiming 30 mpg should be claiming 29 mpg. By the way, at today's prices, it's like adding yet another $.12 a gallon to the price of fuel. Do your homework and then put your brain in gear before you open your mouth.
    Reply
  •  
    Jul 10 02:45 PM
    When you see the vast expanses of viable farm land available in the United States you realize that producing ethanol for fuel is a no brainer. We have always been the greatest agro nation in the world. If Brazil can do it with limited space, mostly jungle, so can we.

    Forgetting the cost of fuel going down for a moment and consider what raising corn, soy, and other ethanol products would do for our nation. Jobs! Farms would need tractors, harvestors, etc. This equipment would need tires, brakes, discs, etc. Then there is a need for transportation. That means more trucks and drivers. Also pipelines which would need pipes, welders, etc. So the chain goes on while we build our economy and do away with foreign oil.
    A two fold win for the US....thats us!
    Reply
  •  
    Jul 10 03:47 PM
    seeking alpha why did your alerts for june 15 come today? the only ethanol production i find interesting is the approach taken by dar and gu. of course ziz seems to have the smartest idea.
    Reply
  •  
    Aug 10 06:31 AM
    Verenium (VRNM) is currently producing cellulose ethanol. This is a proven technology. Look into it.
    Reply
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