A Natural Hedge Against the High Cost of Filling Your Tank

Since I wrote a column on ethanol a month ago (http://moneycentral.msn.com/content/P148882.asp), ethanol stocks haven’t looked back. They’ve continued a sharp ascent that began early this year when President George Bush touted ethanol as a way to reduce our oil dependency.

More recently, ethanol got a boost as a replacement for the additive methyl tertiary butyl ether (MTBE), which until recently was used to make gasoline burn cleaner. The additive may cause cancer, and Congress has declined to offer refiners protection from legal liabilities from the use of MTBE.

For a quick look at charts showing the impressive strength of most of the Ethanol plays, click here (http://rampantspeculations.blogspot.com/).

These kinds of moves have many investors wondering, is it too late to buy?

We got an answer of sorts last week when an insider at Green Plains Renewable Energy (GPRE) bought shares of his company – which is building ethanol plants. It wasn’t a huge purchase. The Great Plains director bought $63,000 worth at $42.17.

But given how much exposure he already has to the ethanol industry and how much the stock has gone up since his company’s initial public offering in March, we will take it as a buy signal nevertheless.

On the surface, it’s pretty easy to guess why he bought the shares. Green Plains Renewable Energy should build at least two ethanol plants in Iowa which could be quite profitable – given the price of gasoline. How profitable? We’ll get to that in a moment, but first a little background.

A Quick Overview

In Brazil, they make ethanol from sugar cane. But here in North America we typically use corn. The corn is first ground into flour and put in a tank with water and enzymes to break down the starch. Next, the mash is mixed with yeast in fermenting tanks. It then gets distilled, and voila! You have “grain alcohol” – exactly the same stuff that may have been responsible for at least one night you’d rather forget in college. (Ethanol makers put in additives at this point, which make it undrinkable.)

A byproduct of this process is “distiller’s grain,” a mash that’s used as animal feed. In its wet form, distiller’s grain only lasts a few days, depending on how hot it is. So unless there’s farm nearby, ethanol makers have to dry the stuff out so it can be stored and shipped.

This matters to investors, because as much as a third of the cost of producing ethanol can come from this drying process. So as an investor, give extra points to companies located close to farms – like Green Plains Renewable Energy and Pacific Ethanol (PEIX), in California. Green Plains Renewable Energy has an edge here because it’s plants will be located in Iowa, so it won’t have to pay much to have corn shipped to its plants.

We typically think of ethanol as an octane enhancer or something used to stretch a gallon of gas. But it’s better to look at ethanol as “gasoline made from corn.” It’s entirely possible that one day lots of cars will run on near-pure ethanol, a substance called E-85 which is a blend of gasoline and around 70% to 85% ethanol. That’s the case in Brazil. Here on this continent, we just need more cars that use the stuff, and more service stations that offer it – no short order.

Green Plains Renewable Energy

For openers, Green Plains Renewable Energy plans to build an ethanol plant in Shenandoah, Iowa for about $83 million. The plant will produce around 50 million gallons per year. Down the road, Green Plains Renewable Energy plans to build at least one more plant, if not more.

In theory, these plants will be profitable, assuming gasoline prices stay high. At roughly the current prices of corn and the natural gas used to cook it, ethanol costs about $1.10 per gallon to make. With gas as high as it is, ethanol recently sold for spot market prices of about $2.80 per gallon.

But will Green Plains earn enough to justify its current stock price? I did some back of the envelope calculations to take a guess – and I think it will. First, I looked at several private companies that already run similar sized ethanol plants, to see how they are doing. (Even though they are private companies, they report results to the Securities and Exchange Commission.)

Here are the key takeaways. A privately-held ethanol producer called Husker Ag owns and operates a plant near Plainview, Nebraska producing about 25 million gallons of ethanol per year and over 160,000 tons of animal feed. Last year it had net income of $10 million on sales of $47.2 million. This shows that these plants can get pretty decent profit margins of nearly 20%.

Another company called Little Sioux Corn Processors manages a 40 million to 50 million gallon plant near Marcus, Iowa – the size Great Plains has in mind for its first plant. For the last quarter of 2005, Little Sioux reported net income of $4.2 million on $23 million in revenue. That works out to $16 million a year. Great Plains has about four million shares. So Little Sioux’s results suggest Great Plains could earn $4 per share – all things being equal – on its first plant. Put a multiple of 15 times earnings on that, and you have a $60 stock price – well above the recent price of $37.50 for Great Plains shares.

Risks

To be sure, these are just rough calculations. What’s worse, predicting the profitability of ethanol production is not so easy.

Here’s why. Little Sioux Corn Processors estimates that corn will account for around 46% of its production costs next year, and 18% will be from natural gas. The prices of both these commodities bounce around a lot, making it tough to get a grip on how profitable an ethanol plant will be.

For example, Little Sioux’s income shot up 36% to $7 million in the last quarter of 2005 compared to $5.2 million in the same quarter the year before. Why? Because costs were lower. Investors pay lower prices for stocks of companies that have that kind of variability in their results.

Hedging machines

To avoid these kinds of swings, ethanol producers are veritable hedging machines. Managers are constantly trying to outwit the market – buying corn and natural gas futures to lock in the cost of next year’s supply, or selling their ethanol forward if they think prices will drop.

You can’t blame them for doing this. But it means that when you own shares in an ethanol company, it’s a bit like owning stock in a Wall Street brokerage with an active trading desk. Results can be volatile, depending on whether managers put on the right hedge or not.

Here’s an example of how wild it can get. A privately-held ethanol producer named Golden Grain Energy, which has a 40 million gallon ethanol plant near Mason City, Iowa, had a great quarter for the three months ending July 31 last year. It earned $6.2 million in net income on $19.8 million in revenue.

But for the quarter ending January 31, 2006, the company barely broke even with just $386,000 in net income on $17.1 million in revenue. What happened? The company lost $4 million on an ethanol derivatives play that went bad. A broken pump shutting down production for a month also hurt.

Too much supply

Another risk -- given all the hoopla over ethanol – is that too much supply comes on line, hurting pricing. As of the end of last year, according to the Renewable Fuels Association, there were 95 ethanol plants in operation in the U.S. An additional 31 new plants and nine expansions were on the way. That will increase annual capacity by a third, to 5.8 billion gallons.

Will there really be enough demand, if this kind of growth continues? It all comes down to whether you think oil will remain in short supply – keeping gasoline prices up. Given the strength of demand from place like India and China, and the difficulty oil companies seem to have in coming up with new reserves, my bet is energy prices will stay high. But no one knows for sure.

The bottom line: Ethanol has been used as a fuel for cars since the days of Henry Ford, but it is still an “emerging” energy source, at least in North America. On top of that, Great Plains is an “emerging” company – having just come public a few months ago. These factors make Great Plains a risky play. On the other hand, it looks to me like ethanol is going to play a big role in solving our energy problems – even if a lot of people don’t realize it yet. So I’d buy Great Plains right here as a play on that trend. Just watch your position size and be prepared for some volatility.

Disclaimer
At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column. Mr. Brush is an independent columnist for this web site.
For more on Insiders Corner disclosure, see the disclosure section in About Insiders Corner: http://www.investorideas.com/insiderscorner/. InvestorIdeas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp. InvestorIdeas is not affiliated or compensated by the companies mentioned in this article.