Renewed energy: US crop report inflection point for small ethanol
By Brian Baskin

HOUSTON (Dow Jones)- The fortunes of small U.S. ethanol producers, who as recently as a year ago reaped outsized profits, may now be so fragile that they hinge on the next crop report.

Like conventional refiners staring down $100-a-barrel oil, ethanol producers are grappling with $5-a-bushel corn. While both have seen high feedstock costs eat into profits, a glut in the much newer ethanol market has made it more difficult for biofuel manufacturers to raise the price of their product to compensate.

For many smaller producers, survival could depend on a U.S. Department of Agriculture crop outlook due at the end of the month, said Sal Gilbertie, senior vice president of energy and renewable fuel derivatives at Newedge.

"It'll be a life-threatening blow," if the report supports higher corn prices, Gilbertie said during a speech to an energy trading conference at the University of Houston last week.

The resulting fallout could spark a round of consolidation that many ethanol industry watchers say is sorely needed. Oil refining has also benefitted from decades of consolidation and is now dominated by large players that can weather a few months or years of tight margins. The ethanol industry by contrast is home to many small, private holding companies, most operating just one or two plants. With oversupply a constant threat as the U.S. figures out how to integrate ethanol into the wider market for gasoline, a few temporary setbacks may not necessarily be a bad thing for the industry as a whole.

Planting Season

By the end of 2008, ethanol producers are expected to reach an annual output capacity of at least 13 billion gallons, according to Bank of America. That far outstrips a U.S. mandate for 9 billion gallons.

A similar combination of soaring production capacity and stagnant demand in 2007 led to a 14% drop in ethanol prices and 43% increase in corn costs for Verasun Energy Corp. (VSE), which after completing the acquisition of a rival will own about 11% of the nation's ethanol production capacity. The company's fourth-quarter net profit was off 81% from the year before, and its stock is off more than 50% since the start of the year.

Analysts largely see Verasun as able to muddle through the current downturn in the ethanol industry. For smaller companies facing the prospect of stable or declining ethanol prices, the USDA's crop reports have taken on extra significance.

The closely watched March 31 prospective plantings report, for example, details how many acres U.S. farmers intend to devote this year to major crops, including corn. Industry analysts expect a roughly 5% drop in planned corn acreage, after a massive increase last year. The big 2007 corn planting took away land from other crops, especially soybeans, driving up prices enough to again make them competitive with corn this year.

Last year's surprise jump temporarily sent corn prices sharply lower, before tight supplies of grains worldwide and voracious demand from the U.S. ethanol industry pulled costs back up.

Analysts see the 2008 report having a large impact as well. But in a twist that unsettles both farmers and ethanol producers, prices have become notoriously harder to predict since the ethanol boom began in 2006, said Mike Duffy, a professor of economics at IowaStateUniversity.

"The way I describe it to farmers I meet with, is that the whole world changed for agriculture about 18 months ago," Duffy said. "As far as price relationships, all of that changed, and we still don't know where it's all going to settle out."

Survival Of The Fittest

For an ethanol plant owner, the first rule of surviving high corn prices is that more capacity tends to be better.

"The old joke about size does matter is certainly the case here," said Dan O'Neill, senior vice president at Northland Securities, a Minneapolis bank that finances new mid-sized and large ethanol plants.

After size, "plants that are more efficient, those that have long-term contracts for feedstocks...are not as exposed to commodity risk," he added.

So far, reports of ethanol plants shutting down are few and far between. Alchem Limited stopped production at its 10 million-gallon-a-year facility in North Dakota late last year, citing corn prices. More common are announcements of delays in the construction of new plants - even large, high-tech facilities with strong financial backing that could be expected to push through tough times.

Agricultural giant Cargill Inc., for example, in February indefinitely postponed plans for a 100 million-gallon-a-year ethanol plant in Topeka, Kan.

"New construction even on that scale just doesn't make good economic sense at the moment," said Jay O'Neil, senior agricultural economist with the International Grains Program at KansasStateUniversity.

O'Neil sees the current bust as self-correcting, as smaller ethanol producers either shut down or sell out to the bigger players. That, in turn, should help bring ethanol supplies more in line with expected demand, he said.

The industry is extremely fragmented compared with conventional refining. Farmers, who pioneered ethanol production by building small plants in the 1980s, still own about one-third of facilities, according to the Renewable Fuels Association, a trade group.

"The market is saying it's got all the ethanol it needs for the moment," O'Neil said. "Is this going to kill the ethanol industry? No."

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