Ethanol may be supplied faster than demand

SIOUX FALLS, S.D. — VeraSun Energy Corp.’s debut on Wall Street showed investors’ early excitement about ethanol, but some analysts say the burgeoning industry faces risks of oversupply, volatile commodity prices and a dependence on government subsidies.

The nation’s 97 ethanol plants are producing about 4.5 billion gallons of the corn-based fuel per year, according to the Renewable Fuels Association, and 33 plants under construction would boost annual capacity to 6.4 billion gallons within a few years.

The clean-burning, high-octane fuel, has risen from obscurity in recent years because it’s viewed as a way to help the United States cut its dependence on foreign energy sources.

However, Daniel Welt, a Standard & Poor’s credit analyst in New York, said the industry’s quick expansion likely will push capacity beyond base demand by 2008.

“There’s really no mechanism that we say would protect this industry from excess supply,” Welt said. “And, in fact, supply has been growing much faster than the mandated minimum requirement.”

The renewable fuels standard, passed as part of the 2005 energy bill, stipulates that 4 billion gallons of renewable fuels such as ethanol be used nationwide in 2006, increasing incrementally to 7.5 billion gallons by 2012.

If all of the new plants start producing by 2008, production could surpass what the government requires for that year by as much as 1 billion gallons.

“The question is: Is production going to outstrip that mandated level and how much demand will you get in other markets,” said Spencer Kelly, an ethanol analyst for the Oil Price Information Service in Rockville, Md.

Although nobody is predicting ethanol will replace gasoline, trade groups point to potential growth of the E85 market to help push demand beyond what the government requires. The 85-percent ethanol blend, which runs in specially made flexible fuel cars, are gaining popularity in the Midwest but have been slow to catch on elsewhere.

Welt said a realistic best-case scenario would be if ethanol could someday capture 10 percent of the country’s fuel market.

The federal government currently refunds 51 cents per gallon of ethanol to the companies that blend it with regular gas. And 14 states have their own subsidies for general ethanol production.

Kelly said he expects ethanol’s political support to continue.

“Investors are always worried about a product that relies on subsidy from the government or tax breaks that can change,” Kelly said. “But I think people are starting to get to the point where they expect the 51-cent per gallon blending credit to continue.”

The subsidy, which would expire in 2010 if it’s not renewed, helps keep ethanol’s price competitive with gasoline when oil prices drop, Welt said.

“We think that for an industry to be viable long-term, it should be able to weather the entire commodity cycle, not just the top of the commodity cycle,” Welt said.

Traditionally, the subsidy has brought the per-gallon price of ethanol below that of gasoline, but unusually heavy demand for the corn-based fuel as of late means refiners get no financial benefit for mixing it with their fuel, Welt said.

The wide gap can be pinned to refiners’ use of ethanol as an additive as they phase out MTBE, which allows gas to burn more cleanly but carries some health risks, he said.

Most refiners stopped using MTBE in May because Congress refused to grant them protection from lawsuits. Ethanol is filling the void, and that will keep supplies tight for at least 6 to 12 months and maybe much longer, Welt said.

As a credit industry guideline, S&P would place most ethanol projects and the companies seeking long-term financing for them into the highly speculative B-grade category, said Elif Acar, an analyst with the ratings company.

A typical ethanol company finances itself with 70 to 80 percent debt, Acar said.

“To get out of that category, you really have to structure yourself tight,” she said.

South Dakota-based VeraSun, the nation’s second-largest ethanol producer, raised $419.75 million in its initial public offering this week that will allow it to build two more plants and increase its presence in the Upper Midwest.

VeraSun priced 18.25 million shares at $23 and they skyrocketed to $30 by market close on Wednesday. The company’s shares have fallen in the days since its IPO.

Another risk in the industry, Welt said, is its dependence on commodities whose prices can change quickly, and there’s no natural correlation between the price of corn and oil.

The industry is booming amid high fuel prices and low corn prices, Acar said, but companies have no protection from a downturn.

“These companies don’t have long-term hedges in place that will protect their margins against a drop in the ethanol price or an increase in the corn price,” she said.

Although Welt sticks to the credit side of the industry, he does worry that investors on the equity side might be setting their expectations too high with the current, yet temporary, high profit margins.

Kelly said ethanol is carrying an almost gold rush mentality.

“It’s a good time to have an IPO in the industry, because the profits are huge based on the spot prices you’re seeing,” he said.