The Ethanol Sector Is Rapidly Deteriorating

Source: By Tristan R. Brown, Seeking Alpha • Posted: Monday, April 6, 2020

The corn ethanol operating environment took a drastic turn for the worse last week.

Collapsing demand for gasoline and, by extension, ethanol caused stocks to reach a new record and production margins to move further into the red.

The sector’s various trade groups have requested a bailout from the Trump administration on the grounds that more than 20% of production capacity has already been shuttered.

Conditions in the sector will worsen before they improve. Not all ethanol producers are equally able to survive in this operating environment. Those that do can expect a major demand rebound in 2021, though.

The operating environment for corn ethanol producers is fast becoming catastrophic. 90% of Americans now find themselves under “stay-at-home” orders from their local governments. Many of the remaining 10% are likewise engaged in strict social distancing measures in accordance with White House guidelines that are in effect until at least April 30. Gasoline demand had already plummeted by 27% YoY at the end of March and is expected to decline further given this expansion of social distancing nationwide. Demand for ethanol, which is directly linked to gasoline consumption until the end of 2020, is well below even its earlier decade low, let alone its normal levels for this time of year (see figure).

The reduction to ethanol production volumes has lagged that of demand in recent weeks, causing ethanol stocks to set yet another record volume (see figure). Ethanol blending declined by 35% in the first four weeks of March whereas production only declined by 20% over the same period. The volume of ethanol stocks was already at a record level even before the COVID-19 demand destruction occurred, meaning that production margins had no slack going into the crisis.

Ethanol production margins have turned negative in response, with those at a hypothetical Iowa corn ethanol production facility having averaged -$0.04/gallon in March (through March 27) (see figure). Actual production margins for many facilities will be still lower. This is especially true for those that are located outside of the Midwest; whereas these facilities were often sited near major urban centers to take advantage of the locations’ higher ethanol prices, the destruction of transportation fuel demand has affected these coastal cities before the rest of the country.

Sources: CARD, EIA (2020).

At first glance the ethanol operating environment is bad – worse even then the Great Recession, when margins fell to zero – but not as terrible as it was in the aftermath of the 2012 Midwest drought. This is true when viewed strictly from the perspective of production margins. Margins alone do not provide a good indication of the impacts that the current operating environment will have on ethanol producers’ earnings, however. In fact, today’s margins would be lower still but for the fact that the sector began to rapidly shutter capacity in the last two weeks of March. According to a letter that was recently sent by industry trade groups to the White House, approximately 3.5 billion gallons of U.S. capacity, or more than 20% of the country’s total, had already shut down as of April 3. This number could increase by up to another 3 billion gallons if ethanol demand experiences the same reduction that gasoline demand has.

Rather than just look at margins, then, investors should examine what researchers at the University of Illinois Urbana-Champaign call the “shutdown price.” This value, which the researchers calculate for a “representative Iowa ethanol plant”, is the ethanol price point at which the facility cannot generate a profit. The shutdown price is currently the same as the market price of ethanol, meaning that even Iowa facilities with their corn cost basis advantage cannot be profitable under current conditions. The shutdown price will be higher for many other facilities, which is why so much capacity has already been shuttered (with more almost certain to come).

While negative production margins pose a major headwind to the sector, the bigger challenge being faced is reduced production volumes. Producers such as Pacific Ethanol (PEIX) and, to a lesser extent, Green Plains, Inc. (GPRE) had high interest expenses relative to their cash reserves going into 2020; the former had enough cash to cover just four quarters of interest expenses, for example (see figure). Even the low margins that prevailed in 2019 were not so low as to prevent both companies from recording some positive quarterly operating cash flow results. Shutdowns will instead leave these producers with no cash income available for the purpose of debt service.

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Reduced production volumes also present a major headwind to ethanol logistics MLP Green Plains Partners (GPP), which derives its income more from throughput volumes than from throughput margin expansion. The MLP’s distribution coverage ratio had already declined to 1x in Q4 2019 due to the shuttering of some production capacity by its sponsor Green Plains, Inc. This distribution is at risk under the current operating environment given that a much larger volume of production capacity is being shutdown industrywide in Q1 and Q2 2020.

Not all ethanol producers are equally exposed to this operating environment, however. The Andersons (ANDE) operates multiple segments, of which the ethanol production segment is but one. Corn planting conditions and harvest volumes are important drivers of its earnings and, at least so far, strong expectations for both have been relatively unaffected by the COVID-19 pandemic. REX American Resources (REX) does not have the safety via diversification that The Andersons benefits from. Rather, its advantage is a complete lack of debt and a large cash reserve (see figure). REX American Resources could survive even an extended period of low demand without difficulty as a result.

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The differences between the companies can be seen in the performance of their respective share/unit prices in 2020 to date. Whereas The Andersons is down 33% and REX American Resources is down 46% over the period, Green Plains, Inc. and Pacific Ethanol have both experienced share price declines exceeding 60% (see figure). Even the 21% rally that Pacific Ethanol experienced on April 3 should be interpreted as a bearish signal given that it was prompted by the news that the ethanol sector had requested a bailout from the Trump administration. Whereas other producers’ share prices declined on the news since it showed investors just how poor the operating environment currently is, Pacific Ethanol was priced for bankruptcy even before March. Its rally, then, was because investors viewed the bailout request as increasing the probability that it would avoid what had seemed to be inevitable insolvency.

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The ethanol sector continues to benefit from a tailwind that has yet to fully make its presence known. Ethanol demand in 2021 will return to 2019’s volumes due to the specific rules by which the annual blending volumes are established. Furthermore, while this tailwind will not directly benefit ethanol producers in 2020, I expect it to do so indirectly given the ability of biofuel blenders to “bank” blending credits into the subsequent year. That said, I do not expect that all ethanol producers will successfully avoid bankruptcy in the absence of a bailout while they wait for demand to rebound, especially if social distancing measures remain in place after April 30.