Anyone who bought shares of Pacific Ethanol (Nasdaq: PEIX) in November 2006 has received an 80% loss of their investment, and the reason seems to be that there is too much of the stuff just sitting around.
Ethanol was supposed to be the answer to the U.S. gasoline problem. But so far, after a huge bump in the early part of 2006, it has turned into a major bust.
According to the New York Times "companies and farm cooperatives have built so many distilleries so quickly that the ethanol market is suddenly plagued by a glut, in part because the means to distribute it have not kept pace. The average national ethanol price on the spot market has plunged 30 percent since May, with the decline escalating sharply in the last few weeks."
The distribution story should come as no surprise, given the fact that ethanol cannot be moved along conventional pipelines due to its proclivity to leak through the normal infrastructure that transports oil, gasoline, and other fuels.
The same thing is true of other storage facilities such as the traditional tanks that are buried under gas stations.
One professor, Neil E. Harl, an economics professor emeritus at Iowa State University who lectures on ethanol and is a consultant for producers, told the New York Times that the ethanol boom may be over, and that this is a "dangerous" time for investors.
Of course the one big question is where was professor Harl 10 months ago before the 80% plunge in PEIX shares.
According to the Wall Street Journal "Financing for new ethanol plants is drying up in many areas, and plans to build are being delayed or canceled across the Midwest, as investors increasingly decide that only the most-efficient ethanol plants are worth their money."
So what's likely to happen? According to the Journal, Archer Daniels Midland (NYSE: ADM), the biggest producer of ethanol is likely to survive, while the rest of the field will see mergers, acquisitions, and bankruptcies.
Perhaps more problematic are the political implications of ethanol's boom, which has been partially fueled by the Bush administration's support for the fuel, and the support of large amounts of government subsidies.
According to the Journal, these subsidies are at least partially responsible for the rise in food prices witnessed over the last 12 months.
So how much of a glut is there? According to the Journal "U.S. ethanol production rose to 4.8 billion gallons last year, up from 1.7 billion gallons in 2001, according to the Renewable Fuels Association, a Washington trade group. The number of ethanol plants increased to 119, up from 56 in 2001. And there are 86 more plants under construction," yet according to the New York Times "companies are already shelving plans for expansion and canceling new plant construction."
A look at the situation from the producers' point of view is interesting. Ethanol prices are falling, while corn prices, significantly due to the demand for ethanol, are rising. This puts the ethanol producer between a rock and hard place, with rising raw material prices and falling product prices.
In fact, ethanol production is already far ahead of expectations, as Congress mandated a consumption level of 7.5 billion gallons per year by 2012, while the industry already has a capacity of 7.8 billion gallong which is projected to reach 11.5 billion gallons by 2009.
And making matters worse, there is a shortage of special ethanol shipping railroad cars and barges, while, according to the Times "Gasoline wholesale marketers have been slow to gear up ethanol blending terminals, in part because they had to invest simultaneously in equipment to manage low sulfur diesel and tougher product specifications."
Furthermore, "Stiff blending regulations in some southern states like Florida have also been an impediment to ethanol. And so far, only about 1,000 of the 179,000 pumps at gasoline stations around the country offer E-85, a fuel that is 85 percent ethanol and 15 percent gasoline, intended for the five million flex-fuel vehicles on the road that can run on high ethanol blends."
Conclusion
Ethanol is at a critical juncture in the United States. The capacity to produce the fuel has far outpaced expectations while the transportation, distribution, and retailing networks have not kept pace.
The high demand for corn has delivered a whole new set of problems, not the least of which has been rising food prices, as government subsidies have been redistributed, and acreage has been diverted to the production of corn.
Furthermore, the potential for other environmentally related issues, such as water shortages, soil erosion, and fertilizer runoff, could also begin to seep into the political discussion.
The bottom line, as with any other capitalistic endeavor, it seems as if the ethanol boom is about to reach a climactic first stage where the weak producers are taken out of the market.
As with the Internet boom, there came a bust. And just as Ebay, Amazon, and Yahoo survived, it's likely that ADM and a handful of others will weather this storm.
What usually follows a boom, is a bust. After the bust, though, when the survivors consolidate the marketplace, what usually comes is higher prices.
The Journal sums things up with two interesting vignettes:
'Panda Ethanol Inc., a Dallas energy company that said last year it would build an ethanol plant in Hereford, Texas, that would use cow manure to power the plant, is slashing expenses in an effort to ride through the "great deal of uncertainty in the marketplace," the company said in August.'
Meanwhile 'Dallas-based Earth Biofuels Inc. said in its most recent filing with the Securities and Exchange Commission that its losses and its "limited financial resources" raise doubt about its ability to continue as a going concern.'
Chart Courtesy of StockCharts.com
From an investment standpoint, we suggest watching shares of Pacific Ethanol (above) and Verasun Energy (NYSE: VSE), below. Any rally in the stock might mean that somebody with deep pockets might be knocking at their door.
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