Understanding ethanol
CSFB banker bottomlines it: 'Ethanol is interesting but risky.'
Interview by Peter Petre

NEW YORK (FORTUNE) - Paul Ho is director for global project finance at Credit Suisse First Boston. Credit Suisse is pioneering ethanol financings on Wall Street. He met last month with Fortune senior editor Peter Petre to give an overview of the alternative fuels game.

Where does ethanol fit in the alternative-fuel world?

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There are three major alternative fuels. Ethanol is first. The second is coal-to-gas. This area is appealing because the US has more coal than any other country. With natural gas at $9-$10 per mBTU, so-called syngas is economically appealing. To make it, you use what's called IGCC technology. (That stands for integrated gasification combined cycle.) The recent energy bill includes a $750 million subsidy to get this business going.

The third camp is synfuel, which takes the synthesizing process one step further. It converts natural gas or syngas to liquid, generally diesel fuel. The Germans developed this is World War II, because they had no access to crude oil. They invented a process known as Fischer Tropf, or FT. Two US consortia are now working in this area: Rentech and Syntroleum. There's also a South African angle, as South Africa used synfuel when it was embargoed from oil during apartheid. The big oil company there, Sasol, operates two synfuel plants that have been running for decades. Synfuel is expensive, but with oil at $50 to $60 a barrel, it's appealing. Breakeven is generally estimated at between $25 and $30 a barrel, and the US government is subsidizing this too, both through the energy bill and through a highway transportation bill.

Okay. So let's get back to ethanol.

CSFB has done the most Wall Street deals. They're hard to finance. What has gotten it going is the confluence of high oil prices and the 51-cent-a-gallon federal excise tax rebate that refiners get for mixing ethanol into gasoline.

Before you get too excited, though, you have to understand that ethanol puts investors at the mercy of not one but two commodity cycles: agriculture and oil. And they're not usually in sync. Sometimes they're completely OUT of sync, as in 1996, when gas prices were low and corn was high. But now there is a bumper crop of corn, in spite of the drought in parts of the Midwest, and because of genetically-modified seed and better fertilization and irrigation practices. US farmers now produce 31 percent per acre more than 10 years ago, and 75 percent more than 75 years ago. What's more, corn gets a multi-billion-dollar-a-year federal subsidy, and the politics to keep that in place are very powerful.

So the corn supply looks stable and plentiful. But the ethanol price is still volatile it's a function of the commodity market in gasoline.

Who makes ethanol now?

The industry divides into three camps:

  1. The agribusiness majors, Archer Daniels Midland (Research) and Cargill. Interestingly, ConAgra is not in ethanol
  2. Mom and pop refineries. Typically these are co-ops -- 300 farmers will each kick in $10K-$20K of equity and then get farm-bank financing to build a plant to handle some of their excess corn. These tend to be small plants, financed typically with 50/50 equity and debt, and with capacity in the range of 30mm to 40mm gallons/year.
  3. Private equity players. Two or three years ago, private capital started to come in -- people with big war chests. They typically want to build bigger plants -- like 100mm gal -- to get economies of scale. CSFB did a $185 million institutional loan deal in February to finance Hawkeye, a venture backed by Whitney & Co. in Connecticut. The offering was oversubscribed by a factor of four. Another big deal CSFB did just recently was for Abengoa, the Spanish energy company that is the biggest ethanol producer in Europe. Three years ago it bought High Plains Ethanol, which operates a small plant in the West. Now they're building an 88 M gallon plant in Nebraska. These were the first ethanol project financings in the capital markets.

Is it right to say that ethanol is a hot topic?

Yes. US capacity is growing by 20 percent to 25 percent or more per year -- it doubled in the past four years. Capacity is now four billion gallons/year, with another one billion under construction. (But total capacity is still small compared with the gasoline market, which is 150 billion gallons a year.)

If you go on the Web you'll see dozens of projects being promoted. It's not an easy business. You need to attract equity before you can get financing, but smart-money people are looking for proven managements with track records, and in this business, there just aren't any. There's also fear of overbuilding -- investors got burned in the independent-power-generation bubble of 2000-2001.

And with ethanol, the barriers to entry are scarily low. Ethanol plants not only are much cheaper to build than oil refineries (they cost about $1.5 million per 1 million gallon capacity), but also farmers LOVE having them in their back yard. (Today nobody wants an oil refinery in their backyard -- there's only one project underway, and that's in Arizona, far from the supply or the demand, in the middle of nowhere -- the first new refinery in 30 years!)

What all this means is that supply of ethanol is no problem -- the big question is demand. Ethanol demand right now is influenced by different mandates in different states. Minnesota, at one extreme, has a mandate for E85 fuel, which is 85 percent ethanol. California and many northeastern states have ethanol requirements -- often E10 fuel, which is 10 percent ethanol and 90 percent gasoline. But many sunbelt states require none. Just to get all gasoline to the E10 level would require between four and five times the ethanol production capacity we now have in place. The energy bill mandates production by 2012 of 7.5 billion gallons a year -- but the business could expand much more quickly if there's a voluntary shift to ethanol.

Autos built in the last 10 years can run on anything up to E10 with no modification. Most SUVs and pickups can burn E85.

MTBE is another factor. It is the oxygenate added to gasoline to make it burn cleaner, but a few years ago it was found to be a carcinogen and to be environmentally persistent. California and 19 other states have banned it already; some refiners, like Valero (Research), have voluntarily stopped using it altogether. Its total elimination is considered a matter of when, not if, because the energy bill did not include a liability waiver for refiners who use it. And ethanol is the ONLY alternative.

Let's talk about Brazilian ethanol.

Brazil is the world's largest ethanol producer. They make it from sugar cane, which has the highest starch content of any plant stock. 25 percent of Brazil's transportation fuel is now ethanol. And it's still growing its capacity, because the nation is still forced to import energy. Brazil would be exporting ethanol to the US were it not for a 50 cents per gallon tariff that the power of the US farm lobby makes unlikely to go away anytime soon. China, India, and the EU are all negotiating to import Brazilian ethanol.

Can you make ethanol from anything other than sugar cane or corn?

The No. 1 contender is cellulosic material, i.e. cornstalks that are normally just left to rot in the fields. Farmers like the idea of getting money out of those.

Ethanol's fascinating because you'd be hard-pressed to find an opponent to it. And that 50 cents a gallon excise tax credit is a powerful motivator. It's been around since the 1970s and Congress has renewed it six times. The current one runs until 2012.

Isn't big oil an opponent to ethanol?

Big oil constitutes a risk factor for ethanol producers since it controls distribution. The ethanol producers rely on oil refineries to take their stuff and add it to gasoline. Since ethanol was never mandated up to now, the refiners never needed to take the stuff. But the recent crop of events changed that perception

What does all this mean for investors?

This industry doesn't have much of a track record to extrapolate from, and the supply and demand curves are highly unpredictable. Therefore you don't know what the price points will be. Bottom line? From an investor's standpoint, ethanol is interesting but risky.

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