In this report from JP Morgan North American Equity Research, analysts Ann Duignan, machinery, Terry Bivens, packaged foods, and Jeffrey J. Zekauskas, chemicals, layout several near-term scenarios for the health of the U.S. ethanol industry.
Ag Equipment & Corn Production Summary
Agricultural Equipment Manufacturers. Given the potential for lower than projected corn demand for use in ethanol, we remain cautious on the outlook for farm cash receipts. The correlation between cash receipts and equipment sales results in an R-squared of 0.78, and we therefore forecast slowing equipment sales as go through 2009 and into 2010. As a result, we remain cautious on Deere (DE–$29.65; N), AGCO (AG–$17.09; N), and CNH Global (CNH–$8.74; N).
Corn Production & Prices. U.S. corn acreage for the 2009 growing season (or the 2009-10 marketing season) is estimated to be flat at 86m acres. Crop yields are expected to rise from 153.9 bushels per acre to 156.9 bushels per acre, lifting US corn production by 260bn bushels. U.S. corn demand is expected to increase by 450bn bushels over the same period, mainly due to demand for fuel ethanol.
There is little risk, in our view, that 2009 ethanol blending mandates could not be met by existing installed operating capacity or by debottlenecking opportunities for the more efficient producers. Accordingly, we view the possibility of corn demand being negatively affected by a shortfall of ethanol production as a lower-probability scenario.
Importantly, the USDA forecast for season average corn prices of $3.60/bushel (relative to $4.10 for the 2008 growing season) provides an incentive for farmers to plant corn. We note that near-month corn prices are at approximately $3.90 per bushel. Given the level of government subsidies to farmers (~$12.4bn in 2008, a portion of which is "countercylical" payments inversely related to crop prices), the ethanol mandate is likely to be enforced, in our view, and corn prices are likely to remain above the $3/bushel mark, all things being equal.
FULL TECHNICAL ANALYSIS
We note that December 2008 ethanol production volumes of 854 m gallons have ramped up consistently from January 2008 levels of 664 m gallons despite difficult production economics for the non-integrated ethanol producers. At the end of December 2008, annualized ethanol production volumes have already reached a run rate of 10.25bn gallons, relative to the year-end 2009 mandate of 10.5bn gallons. We expect monthly ethanol production volumes to ramp-up through the course of 2009.
Growth and profitability for non-integrated ethanol producers could be challenging given installed capacity levels and cash margins, while ag dependent industries may continue to benefit from growth in corn demand to support the increase in ethanol blending mandates.
At 30% of total usage, the ethanol industry is critical to the U.S. agricultural industry. While integrated producers, such as Poet, ADM, and Cargill, are less dependent on near-future corn prices and are likely operating at profitable levels, many non-integrated ethanol producers and blenders are barely making money.
Current nameplate operating capacity could potentially lead to a mandate gap of 140m gallons relative to the 2009 mandate of 10.5bn gallons. To fill that gap, several possibilities exist.
Ethanol Production Capacity Shutdowns
Approximately 2 BGY of ethanol capacity — 15% of the total — is currently idle. As of February 5, the RFA estimates that the ethanol industry has ~12.375 BGY of total ethanol capacity, but only 10.469 BGY of operating capacity. Additionally, 2.066 BGY of capacity is under construction. Since February 5, we estimate at least 110 MGY of additional capacity has been idled. This suggests that current operating capacity is closer to 10.36 BGY. This compares to the 2009 RFS mandate of 10.5bn gallons and represents a potential mandate gap of 140m gallons. We recognize that if the economics become more favorable, there is ample capacity to meet 2009 and 2010 mandates (10.5bn gallons and 12.0bn gallons, respectively).
VeraSun's bankruptcy alone took 1.14 BGY of capacity offline. In October 2008, VSE filed for bankruptcy, as it had locked in high input costs, i.e. corn, and could not secure financing. Of the 16 plants that VSE manages, the company announced on January 20 that it has shut down 12 plants representing 1.14 BGY of capacity and ~9% of total industry capacity. The remaining four operating plants have 450 MGY of capacity. The idle plants, however, could quickly be brought online when they are sold to a third party.
On March 19, Valero Energy Corp., the largest U.S. oil refiner, announced it will enter the ethanol business after a US Bankruptcy Court judge approved its $477 million bid for seven plants and other assets of VeraSun Energy Corp.
The acquisition, approved by bankruptcy Judge Brendan Linehan Shannon in Wilmington, Del., gives San Antonio-based Valero plants that can produce 780 million gallons of ethanol a year, Valero said yesterday in a statement. That would provide an assured supply of the corn-based gasoline additive used to help meet standards enforced by the Environmental Protection Agency.
Valero will pay $350 million for a group of five plants in South Dakota, Iowa, and Minnesota, and an Indiana development site, Sioux Falls, S.D.-based VeraSun said in a statement Tuesday. Valero also will purchase an Iowa production plant for $72 million, a Nebraska facility for $55 million and other assets.
In February, Pacific Ethanol announced it is suspending 110 MGY of capacity. The company halted a 50 MGY plant in Burley, ID and a 60 MGY plant in Stockton, Calif. Last month, the company announced it shutdown production of its 40 MGY plant in Madera, Calif. In total, the company is now idling 150 MGY of capacity, which leaves just one fully owned plant operational. Of note, in December 2007, it also halted construction on a 50 MGY plant in Imperial Valley, Calif.
Ethanol Producer Economics Remain Tough
Dry mill producer margins for non-integrated producers remain weak. Our analysis suggests that at current ethanol and corn prices, producer variable margins are about 5%. Although corn and natural gas costs have come off their 2008 peaks, so too have ethanol prices, which are now ~$1.54/gallon in Chicago. DDGS prices are estimated at $123/ton. While producers are slightly profitable today on a variable margin basis, there could be more downside risk, as we are moving into a period of seasonally higher corn prices.
Wet mill producer margins are better but far from strong. Wet mill producers are suffering from the same headwinds as dry millers—an ethanol price contraction which is outpacing the abatement of cost pressure. Unlike dry millers, however, wet millers are seeing less downward pressure on byproduct revenue. DDGs, the dry milling byproduct, have fallen, while the aggregate price of wet milling byproducts — corn gluten feed, high protein corn gluten meal, and corn oil — are proving more resilient. The result is a recent widening of the margin spread between the two processing methods. The variable contribution margin for wet millers, however, remains relatively low, with little, if any, room for absorption of labor and fixed costs (wet milling capital costs are generally 50%-70% higher than for dry millers).
Ethanol prices are down 37% from their peak, but remain at a premium to gas. Since July 2008, ethanol prices have fallen 37% vs. wholesale gas prices, down 61% from their peak. As a result, ethanol is now trading at a premium to gasoline.
Currently, based on an average U.S. rack prices (i.e., the price the blender pays — which is higher than spot prices, which is what the producer is paid), ethanol is trading at a $0.53/gallon premium to gasoline, above the blender's credit of $0.45/gallon, implying that blenders lose $0.08/gallon of ethanol blended (or about $0.01/gallon of gasoline at a 10% blend). In a normal market, blending would decline until gasoline prices recover and blenders could make money.
Scenario Analysis: Impact of Ethanol on U.S. Corn Demand
Our estimate for current nameplate operating capacity is about 10.36bn gallons. In the 2008-09 marketing year (September 1, 2008 through August 2009), the U.S.DA is currently forecasting 3.6bn bushels of corn Used for ethanol vs. 3.03bn bushels for the 2007-08 marketing period. The U.S.DA forecasts 4.1bn bushels for the 2009-10 marketing year. We think there could be some downside risk to both estimates given the continued weak ethanol production economics. The RFA estimates ~2 BGY of capacity is idle, and more could be at risk as the year progresses. However, applying efficiency improvements to existing facilities through, for example, better enzymes could offset lower production.
Scenario #1: Production for remainder of 2008/09 is 10% below December 2008 production levels.
In December 2008, the ethanol industry produced 854m gallons of ethanol (10.3bn gallons on an annualized basis) and consumed an implied 311m bushels of corn. In our first scenario, if the industry produces 10% below December 2008 levels for the remainder of the year as a result of additional plant shutdowns, 18 we could see monthly ethanol production of 769m gallons, representing 280m bushels of corn. This would result in 9.5bn gallons of ethanol in the 2008-09 marketing year and corn Used by ethanol of 3.45bn bushels, which is 150m bushels lower than the current U.S.DA estimate of 3.6bn bushels. Stocks-to-Use in this scenario would potentially reach 16% vs. the current 15% in the U.S.DA estimate.
Scenario #2: The 2009 10.5bn gallon RFS ethanol mandate is achieved.
In order for the U.S. ethanol producers to meet the 2009 mandate, the industry would have to bring 280 MGY of nameplate capacity back online. In this scenario, if producers add 35 MGY of operating capacity per month in the 2008/09 marketing year, then the ethanol industry would consume about 3.74bn bushels of corn vs. the current USDA estimate of 3.6bn bushels in the 2008/09 marketing year, which could lower corn inventories by 140m bushels. Our Scenario #1 results in corn ending inventories increasing by 150m bushels to 1.94bn bushels vs. the current U.S.DA estimate of 1.79bn bushels. This would likely put downward pressure on corn prices.
How To Meet the Mandate
With estimated current operating capacity at 10.36 BGY and the 2009 mandate of 10.5bn gallons, the potential mandate gap is ~140m gallons. The industry will likely try to fill the gap Using a combination of:
- Applying Renewable Identification Numbers, or RINs, generated in 2008 to the 2009 RFS mandate:
- Increasing imports, but only if economics make sense;
- Increasing consumer prices for gasoline to ensure that the industry is viable;
- Increasing production via efficiency improvements, plant restarts, or incremental capacity additions if the economics are compelling.
What is an RIN? A RIN stands for Renewable Identification Number. It is a credit that is associated with each gallon of ethanol produced, can be traded, and is expires after two years. Based on the Renewable Fuel Standard mandate, refiners must have a certain number of RINs each year. Refiners can acquire the RINs when they blend ethanol with gasoline, or purchase them from other parties.
RIN credits will likely help refiners meet the 2009 mandate. The RFS mandate for 2008 was 9bn gallons, and the industry blended 9.2bn gallons in 2008, representing an excess of ~200m gallons.
Although RINs can be carried over into a new mandate year, the number of RINs is capped. According to the EPA, "no more than 20% of the current year obligation can be satisfied Using RINs from the previous. year."
The 2009 obligation is 10.5bn gallons. Thus. the 2009 cap for RINs generated in a prior year is 2.1bn. Given the potential excess of ~200m RINs from 2008, we would expect that these excess credits could be Used to help meet the 2009 mandate.
If refiners don't already have these RINs, there is a cost to acquire them. 2008 RINs are currently trading at ~$0.11, and 2009 RINs are trading at ~$0.16. Interestingly, RIN prices are significantly less than the loss on physical blending. If RINs are Used in 2009 rather than ethanol blending, the ramifications are that the industry could consume 73 m fewer bushels of corn.
Imports could also help fill the gap if economics improve.
In 2008, U.S. ethanol imports totaled ~518 m gallons of ethanol. Imports could fill the gap in 2009 if the economics improve. Production costs in Brazil are currently about $1.00 per gallon, and shipping costs to the U.S. historically have been close to $1.00, resulting in landed costs close to $2.00 per gallon. Direct imports from Brazil have a U.S. import tariff of $0.54/gallon. The implied total landed costs are $2.54/gallon vs. current spot ethanol prices in New York of $1.67/gallon, implying a blender loss of $0.87/gal blended. Eliminating the tariff would make the economics more compelling. However, it is not clear to U.S. that the political will exists in the current environment to displace U.S. jobs with imports.
Consumer prices rise to ensure industry profitability.
In order for the industry to be economically viable long term, everyone in the supply chain has to make money. One way to do this is to set the price of ethanol independent of oil prices and at a level such that everyone makes a margin. At 10% gross margin, spot ethanol prices would have to increase to ~$1.63/gallon from the current Chicago spot price of $1.54/gallon.
Blending economics would also have to improve. Despite a $0.45 blender's credit, the premium of rack ethanol (the price the blender pays, not spot prices) to rack gas prices is ~$0.53/gallon or a $0.08 loss per gallon of ethanol blended. In order to ensure that producers make a 10% margin and blenders make a $0.02/gallon margin, the net ethanol price for blenders would have to be ~$1.60/gallon. At a 10% ethanol blend (E10), this would represent an increase of $0.16 vs. $0.14 for 10% of regular gasoline, for a $0.02 increase at the pump. In other words, gas prices would have to increase to $1.93 to ensure profitability throughout the supply chain, or 1% higher.
Investment Conclusions
Agribusiness. The implications for agribusiness operators is mixed. The potential for lower than expected corn demand could result in sustainable low corn costs in the near to medium-term. This would benefit corn sweetener processors, as input costs remain low while the negotiated price hikes remain in effect through the year. Those who process corn into ethanol, however, will continue to suffer a profit squeeze. And more comfortable corn inventory levels, combined with lower prices, will likely blunt corn-merchandising profits.
For Archer Daniels Midland (ADM– 27.81; N), which participates in all three of the aforementioned activities, we believe the puts and takes have a neutral net effect on earnings. We believe that the market is prudently expecting low profits from ADM's bioproduct business (which includes ethanol) and any upside in corn sweetener processing may be offset by downside to its merchandising profits.
Agricultural Equipment Manufacturers. Given the potential for lower than projected corn demand for use in ethanol, we remain cautious on the outlook for farm cash receipts. The correlation between cash receipts and equipment sales results in an R-squared of 0.78, and we therefore forecast slowing equipment sales as go through 2009 and into 2010. As a result, we remain cautious on Deere (DE–$29.65; N), AGCO (AG–$17.09; N), and CNH Global (CNH–$8.74; N).
Packaged Food. Packaged food manufacturers stand to benefit from the potentially lower than expected corn demand and accompanying low prices. We estimate that, on average, corn accounts for roughly 1.6% of COGS for the packaged food names under our coverage. But higher corn inventories will likely pressure the prices of substitute grains such as soybeans and wheat. We estimate that total grain and grain derivative inputs account for 9-10% of packaged food COGS on average. The companies with the highest exposure to grains include Kellogg (K– $36.99; OW) at 24% of COGS, General Mills (GIS–$52.60; OW) at 15%, and ConAgra (CAG–$14.81; N) at 13%.
Ag Chemicals, Seed Producers, and Fertilizer Manufacturers. We believe seed & crop chemical producers Monsanto and DuPont and fertilizers companies including Mosaic and Potash would benefit from increased U.S. corn demand related to fuel ethanol production. Growing corn demand is typically met with an increase in planted corn acreage requiring higher volumes of seeds, chemicals, and plant nutrients. The demand can also be met with higher crop yields requiring the use of higher-value insect resistant seeds and the application of optimal levels of herbicides and plant nutrients. We rate DuPont (DD–$19.49), Monsanto (MON–$79.11), Potash (POT–$76.76), and Mosaic (MOS–$42.08) Overweight.
U.S. corn acreage for the 2009 growing season (or the 2009-10 marketing season) is estimated to be flat at 86m acres. Crop yields are expected to rise from 153.9 bushels per acre to 156.9 bushels per acre, lifting U.S. corn production by 260bn bushels. U.S. corn demand is expected to increase by 450bn bushels over the same period, mainly due to demand for fuel ethanol. There is little risk, in our view, that 2009 ethanol blending mandates could not be met by existing installed operating capacity or by debottlenecking opportunities for the more efficient producers. Accordingly, we view the possibility of corn demand being negatively affected by a shortfall of ethanol production as a lower-probability scenario.
Importantly, the U.S.DA forecast for season average corn prices of $3.60/bU.S.hel (relative to $4.10 for the 2008 growing season) provides an incentive for farmers to plant corn. We note that near-month corn prices are at approximately $3.90 per bushel. Given the level of government subsidies to farmers (~$12.4bn in 2008, a portion of which is "countercylical" payments inversely related to crop prices), the ethanol mandate is likely to be enforced, in our view, and corn prices are likely to remain above the $3/bU.S.hel mark, all things being equal.
We note that December 2008 ethanol production volumes of 854 m gallons have ramped up consistently from January 2008 levels of 664 m gallons despite difficult production economics for the non-integrated ethanol producers. At the end of December 2008, annualized ethanol production volumes have already reached a run rate of 10.25bn gallons, relative to the year-end 2009 mandate of 10.5bn gallons. We expect monthly ethanol production volumes to ramp-up through the course of 2009.
Enzyme Producers. Novozymes (NZYMb.CO–Dkr432; N) is the leading global enzyme producer, with a market share in fuel ethanol enzymes in excess of 55%. Revenues from fuel ethanol enzymes represented Dkr1,385m (~$250-275m) or 17% of total sales in 2008. We estimate revenue growth based in local currency to be 10% for Novozymes' Technical Enzymes business in 2009, which includes fuel enzymes. Our estimate is based on ethanol production growth of at least 10% from 9.5bn gallons (assuming that RIN credits of an estimated 0.5bn gallons are utilized) to 10.5bn gallons. We believe that installed and operational capacity of 12.4 and 10.5 BGY, respectively, as estimated by the RFA, are sufficient to support the 10.5bn gallon ethanol blending mandate in 2009. In our view, the efficiencies of nameplate capacity can be lifted by an estimated 10-20%. We believe that integrated ethanol producers, such as Poet and ADM, could play a future role in absorbing excess capacity of less efficient producers. We note that ethanol producer Poet is Novozymes' largest customer, representing an estimated 35% of fuel ethanol enzyme sales, or approximately DKK 450-500 m (~$75-100 m). We rate Novozymes Neutral for year-ahead performance, reflecting its premium multiple of 12.5x EBITDA based on 2009 estimates and relative to a peer group of 7.5-10x.
This report was excerpted from a larger report from JP Morgan North American Equity Research entitled "Alternative Energy: How Can Renewable Energy Survive?" issued on March 18, 2009.
