IT having major impact on farmer-owned ethanol plants

By Anthony Crooks and John Dunn,
Ag Economists
USDA Rural Development

Editor’s note: This is the second of two articles focusing on the
impact that evolving information technology is having on the
ethanol industry. The first article appeared in the September/
October 2005 issue, which is on-line at: www.rurdev.usda.gov/rbs/
pub/openmag.htm . These articles are based on a forthcoming
report: “The Impact of Information Technology on Farmer-owned
Ethanol Plants,” RR 209. Call (202) 720-6483 to order, or
download at www.rurdev.usda.gov. Available in January 2006.


nformation technology (IT) is having a profound impact on the ethanol industry, especially in the financing, construction and operations of ethanol plants. It helps to strip costs out of ethanol plant systems, promotes standardization and mitigates production risks.

Outside investors increasing stake
A better understanding of risks associated with ethanol plants allows the financial community to reduce lenders’ equity participation requirements, to reduce interest rates and the overall cost of capital and invite participation among outside investors. IT has altered our view of the traditional market structure. Economic power now lies in aggregating information assets, not in the physical assets of plant and equipment associated with production.

With regard to IT and the future dynamics of the industry, as IT applications within the ethanol industry continue to evolve, competitive forces will spur efficiencies and dynamic growth. Work activities will increasingly be dispersed across geography, institutions and dimensions as managers and decision makers ask: “What else can be digitized, decomposed and outsourced?”

The balance of economic power within the industry shifts daily from the traditional aggregation of physical asset ownership to the aggregation and integration of information services. However, competitive advantage held today is more easily eroded and replaced. This understanding raises the question: “Will the emerging price-discovery mechanisms (futures market and market transparencies) change the comparative advantage of the information aggregators?”

The dynamic, intellectual-property nature of IT continues to shape the competitive structure of the industry. Where will the talent to continue operations in this environment come from?

Information technology has eroded and distributed the market power once held exclusively by global giants. Enhanced access to inputs and product markets among mid-sized fuel ethanol firms arising from the adoption of information technologies may inspire similar developmental opportunities in rural America.

The notion that firms may achieve competitive advantage from an efficient, internal information system — in lieu of the high levels of vertical and horizontal coordination typically garnered solely from a large size operation — provides both an encouragement for the relative success of mid-sized firms and a developmental template for similar enterprises in rural areas.

Innovation related to new IT is leading to the development of new ethanol products innovation and commercialization.

DDG product development
Land-grant universities and private corporations have worked together to significantly enhance the product value of distillers grains. Researchers, such as Vern Kelly and Jerry Shurson at the University of Minnesota, have served to not only expand existing markets for distillers grains as cattle feed, but have also developed new opportunities in feeding hogs. So, instead of being an afterthought or even a waste product, as distillers grains were once considered, DDG is now a significant component of a plant’s revenue stream.

Early on, some plants were fortunate to have Farmland Industries as one of their investors. Farmland’s feed division helped to market DDG. Farmland also sponsored and conducted research on how best to use distillers grains. Farmland’s feed division has since been absorbed by Land O’ Lakes, which markets DDG and is continuing to do research at its own facilities and in collaboration with universities. Such research is needed, because the ethanol industry redirects about 10 percent of the nation’s corn crop away from the livestock-feeding industry. Every opportunity for distillers grains to be included in animal rations — in substitution for either energy or protein — relieves some of the upward pressure on corn prices as it increases the value of distillers grains. Inclusion rates for DDG in feed have increased for cattle (up to 25 percent), swine (10 percent) and poultry (5 percent), but there is still an excess supply and the price is tracking downward again.

Feed researchers and development groups continue to educate the industry and develop its customer base. However, the product remains a bargain relative to corn, which in turn encourages feeders to pursue substitution opportunities.

Initially, almost 100 percent of the distillers grains that were sold went toward dairy rations. Plant managers soon discovered that drying the wet grains would not only increase the product’s shelf life, but would also improve consistency and quality. Local feeders pressured plants to sell quickly and at a discount. Sometimes the best offer most plants received from feeders early on was paying the freight to haul it off. But now — after years of research, some technological developments and a lot of education — feeders know precisely the value of DDG.

Bio-refineries promise
range of products
The bio-refineries concept is similar to the petroleum refinery concept. Feedstock (biomass, in the case of a bio-refinery) is converted into a wide range of products, based on market consideration and contractual arrangements. The biomass feedstock is typically fractionated into its various components. Those components are then processed into intermediate and final products.

Intermediate products may be combined to produce additional products. The basic concept incorporates multiple products and possibly multiple feedstocks. Flexibility to meet market demands is an important element of the bio-refinery concept.

Bio-refinery feedstocks may include agricultural crops and agricultural residues, trees, grasses, animal wastes and municipal solid waste, organic materials that capture and store solar energy. They may also use various combinations of processing technologies including mechanical, thermal, chemical and biological processes. The products produced are nearly limitless. They include fuels, electric power and heat energy, food and feed, and a host of chemicals including plastics, solvents, adhesives, fatty acids, organic acids, paints, dyes, inks, detergents and more.

The extended view of this concept is to develop bio-refinery complexes or “bio-refinery parks” that produce a wide range of products and which use products produced by others in the park. This concept would aid in the economic efficiencies of collection, storage and handling of feed stocks, production of energy, as well as help support the required transportation and distribution infrastructure.

Further improvements in technology may play an important role in increasing efficiency of ethanol plants. New “up front” technologies that fractionate the grain into starch, pericarp, germ and protein may enable ethanol plants to produce a wider set of byproducts and to increase the market value of the byproducts. This change is expected to increase the energy efficiency of the ethanol plant and reduce other processing costs per gallon of ethanol.

A major concern, however, when developing a new product is the necessity of simultaneously developing a new market. The balance between sufficient production to supply the market — but not so much as to ruin its profitability — is a delicate one. Information technology will be used increasingly to coordinate these activities among the marketing firms and their represented plants.

References
Carr, N., Does IT Matter? Information Technology and the Corrosion of Competitive Advantage, Boston:
Harvard Business School Press, 2004.

Friedman, T., The World is Flat: A Brief History of the 21st Century, New York: Farrar, Straus and Giroux, 2005.

Hale, J.H. III and J. Brown, The Only Sustainable Edge: Why Business Strategy Depends on Productive Friction and Dynamic Specialization, Boston: Harvard Business School Press, 2005.

Novozymes and BBI International, Fuel Ethanol: A Technological Revolution, BBI International Publishing, Grand Forks, ND, June 2004.

Smith, H. and P. Fingar, IT Doesn’t Matter, Business Processes Do: A Critical Analysis of Nicolas Carr’s IT Article in the Harvard Business Review, Tampa: Meghan-Kiffer Press, 2003.



Surviving in a low-price cycle

What does a medium-sized ethanol plant need to survive a two-year period of low prices? With record-high fuel prices, that is obviously not a problem at present. But the market is cyclical, and some day the worm will turn again. Experience shows that the biggest key to surviving a low-price cycle is a strong CEO or, lacking that, a strong board of directors — and preferably both.

The board must be able to draw on its managers to obtain the needed information to run the plant. They need a business plan that is updated each year. They need to have a professional marketer for ethanol and feed. The marketer must understand the customers’ needs (particularly for DDG) so that they can help develop the market.

The board needs a risk-management plan that helps hedge the co-op’s corn and natural gas. It needs to contract the sale of its ethanol and DDG with a built-in “crush margin.” The people developing the risk-management plan should be working to provide a program that will estimate the volatile factors that the plant faces and indicate whether the expected return is enough to validate the risk.

Perfect hedges are not available, but risk-management plans can make use of the new ethanol contract and hedge DDG based on corn and the natural gas contract prices (although a number of plants are pursuing renewable and other energy alternatives to natural gas).

Long-term ethanol purchase contracts are becoming more common. One example is a three-year contract with the first-year basis being the cost of unleaded gasoline, while the basis for the next two years is crude oil price. However, anyone using these contracts would need to be prepared to meet substantial margin calls and have access to adequate capital.

Plants need programs for both preventive and predictive maintenance and to carefully manage their spare parts inventory. An unplanned plant shutdown soon creates cash-flow problems. Maintenance of plants built 5 and 10 years ago is quickly becoming a first priority. Furthermore, facilities looking to cut costs soon realize that maintenance/repair is a significant portion of plant operating expenses.

Many plants now employ IT solutions to take a more proactive stance on their maintenance program. A predictive maintenance program is based on a plant’s history of operating requirements and is derived from a statistically-based estimate of life span (or failure rate) and priority ranking (importance to operations) for each piece of equipment and machinery in the plant. The software dictates the priority of all maintenance work, schedules any required materials/equipment for just-in-time delivery, and documents the entire process.

What factors will expand the market for ethanol? Taking out the mandatory uses, an estimated 30 to 40 percent of current use is discretionary blending. Some market analysts forecast an over-supply and lower prices for the next two to three years. However, if Atlanta were to ban MTBE and if California were to mandate a 5-percent Reformulated Fuel Standard (RFS), mandatory demand would increase in each of these areas by 250 million and 950 million gallons, respectively. An adoption of a 10-percent, mandatory RFS in California could increase demand by as much as 1.9 billion gallons per year.


Fuel ethanol industry structure, past & present

While today’s ethanol industry is fragmented, not long ago it was much more concentrated. In 1990, three major players dominated fuel ethanol production. ADM held 60 percent of the market, Pekin Energy (now Aventine, by way of Williams Bio Energy) and New Energy Co. of Indiana, each held 10 percent.

The entire industry was then comprised of about 20 firms that produced about 1 billion gallons annually. At that time, construction costs were around $2.50 per gallon, conversion efficiency was closer to two gallons per bushel of corn and the average-sized plant required a workforce of about 50.

Structurally, today’s situation is almost a mirror image of the past. The top three firms produce only about 31 percent of the nation’s ethanol and 44 of the remaining 68 firms are farmer-owned. Over 4 billion gallons of fuel ethanol will be produced this year. Construction costs are about 98 cents per gallon. Fuel conversion efficiency is now 2.85 gallons per bushel of corn. A plant requires only 35 full-time staff and is operational for 360 days per year.

The transition from a highly concentrated to a fragmented industry was brought about by several key drivers, including: federal and state policies; natural progression of the industry; classic “production-push” agriculture; farmer ownership; crude oil price spike; low-priced corn; development of venture capital interests; and the formation of trade associations. Each of these factors is examined below.

Federal and state policies
Federal and state policies contribute substantially to the viability of the fuel ethanol industry. As one industry representative commented, “state and federal incentives cover a lot of mistakes. They provide a safety-net.”

Ethanol’s exemption/credit against the federal excise tax on motor fuels is a long-standing industry cornerstone. Programs created under the Clean Air Act Amendments of 1990 enhanced demand for ethanol. These included the Oxygenated Fuels Program, implemented in 1992 to reduce emissions of carbon monoxide, and the Reformulated Gasoline (RFG) Program, which took effect in 1995 to reduce ground-level ozone (i.e., smog). The federal Bioenergy Program (CCC-850), established by executive order in 1999 under the Clinton administration, is a key incentive for new facilities because it offsets part of the feedstock costs incurred to start up or expand biofuels production.

The long-term extension of the excise tax credit in the JOBS Act of 2004, together with the Clean Air Act programs, reduced the “policy risk” associated with establishing and operating an ethanol facility. State policies also have had major impacts on the industry. However, state production incentives tend to be capped at a certain capacity level, which contributes to a fragmented industry structure

The fuel ethanol industry’s rapid growth is due in large part to the finding that methyl tertiary butyl ether (MTBE) is carcinogenic. This eased political fighting between the oil/energy sectors and agriculture. The MTBE phase-out put both parties on the same side of the issue. The Minnesota requirement that gasoline be blended with 10 percent ethanol is regarded as a model state policy. State bans of MTBE, a competing additive used to boost oxygen content in gasoline, expanded ethanol use in recent years. Presently, 20 states have implemented or announced bans of MTBE. Bans in California and New York took effect at the beginning of 2004.

Last August, after more than 5 years of heated congressional negotiations, the Energy Policy Act of 2005 set a renewable fuels standard (RFS) of 7.5 billion gallons by the year 2012. While the implication of the Act will involve an extensive change to fuel regulations, petroleum-refining and fuel marketing, the full economic and environmental effects will only be revealed in time.

Natural progression of industry
To some extent, fuel ethanol is experiencing the “natural progression” of an industry. It has stalled and re-started several times over the years. Several times it was on the verge of death, only to be reborn. The fundamental difference now is the world’s increasing demand for energy.

Those involved in this business for 25 years still have the same dream as the preceding generation that launched the industry. The scope of the uphill battle fought in the industry’s early days probably wasn’t clearly understood. Nevertheless, they witnessed the emergence of a real biofuels industry.

More than a fuel
Ethanol is being viewed as more than a commodity in many rural areas of the nation, where there is emotional zeal about the potential of biofuel to strengthen the rural economy. There is even a sense of patriotism about the part biofuel may play in helping to reduce the nation’s dependence on foreign oil. These strong beliefs may have helped the industry survive difficult straights, when it continued to expand production with only a small clue as to how it would be sold.

The consensus was, “It’s a good idea.” But few had any real vision of the industry’s future. In no small way, ethanol is classic “production-push” agriculture, in which farmers plant seeds without knowing their ultimate yield and pay. Their philosophy has been: “If we build it, they will come.”

Realistically, the industry is not going away. But what will it look like? The consensus is that there will be a substantial, long-term positive growth phase. The only real distinction among ethanol plants in the past 5 years has been between those that made a “nice” return on investment vs. those that made a “fantastic” return.

Farmer ownership
The emergence of “new-generation” cooperatives and farmer-owned ethanol plants in the early 1990s played a critical role in the development of the industry. The cooperative structure provides farmers with the opportunity to collectively raise money to build facilities. Cooperatives also distribute the investment risk over the entire group of investors, thereby reducing the risk to any individual investor.

In addition, because cooperative membership is tied to a right and an obligation to deliver corn to the cooperative, the corn delivery agreements may have helped the cooperative survive market fluctuations better than a privately owned plant faced with purchasing corn in a volatile, open market.

However, it is harder to put together a co-op today because most farmer groups within a 40- to 60-mile grain-hauling radius of a plant (the distance considered economical for procuring feedstock for ethanol) lack sufficient capital to invest the needed equity. Within a 60-mile radius, a co-op can typically raise about $12 million to $18 million through local equity drives for a plant that will cost $45 million to $60 million. Nevertheless, some farmer groups are getting more sophisticated in raising capital; one recent success story involves a co-op that raised $28 million.

Generally, farmers exhaust their ability to raise equity for a new plant, then look to plant builders, ethanol marketers or other outside investors as necessary partners to raise the rest of the needed capital. Recently, a few Wall Street investors have entered the picture to finish the equity drive in some form of partnership arrangement, or to subordinate the debt. In recent cases, farmer-investor groups have assumed more of a minority ownership position in the company.

Crude oil price spike
The most recent boost to the industry has been crude oil costing more than $60 a barrel. Still, there has been a perception that the viability of the industry is based on subsidies. About three years ago, it was difficult to get New York investors to even discuss ethanol. Morgan Stanley was one exception. It was forward-looking enough to pursue some ethanol investments, but virtually all other major investment firms declined to do so.

The only real change since then has been the spike in crude oil price. Now the institutional investors and money-center banks seem to believe in the long-term viability of ethanol as an energy source.

Low-priced corn
Most producers pursued ethanol plants to boost local corn prices. Many ethanol plants were financed on that basis, not the economics of the grain margin going forward. The driving motivation is simply that a $20,000 investment in a local ethanol plant can improve a producer’s corn basis — it becomes a de facto annuity that returns an additional 6 to 12.5 cents per bushel, in perpetuity. This idea drove the financing and building of the 20- to 40-million-gallon plants.

Development of venture capital interests
Farmers recognized the economic incentives and experienced what was called the “backyard syndrome.” What community doesn’t want 5 or 10 cents per bushel more for its corn? Most weren’t sophisticated enough at that time to understand the risk-management issues involved or the operating margins.

Nor was the possibility considered that there might be a better place to locate a plant other than in their hometown, or that perhaps it should be built by somebody other than a general contractor. Basically, the sole consideration was the desire to increase the corn-price basis. The industry production standard grew from 15-20 million gallon plants to 45-50 million gallons, then 55-60 million gallons and now 100 million gallons.

The success of those plants fueled the enthusiasm to build. Most of the plants now being built in Iowa are not farmer investments. Moreover, most investment plans today include intentions to build two or three additional facilities. The flow of investment money from outside agriculture is substantial and increased significantly after the price of oil exceeded $50 a barrel.

Formation of trade associations
The information explosion was also a driving force behind the formation of ethanol trade associations. As more producers became interested in ethanol production during the late ‘90s, they started organizing into groups.

The trade associations recognized benefits of bringing the groups together to provide them with the necessary information. This included production technology, different legal structures, sources and availability of financing, etc.

The trade associations met monthly with several producer groups and watched each evolve through the developmental stages of fund raising, groundbreaking, etc., to full production.

The ability to share information was a prerequisite to a distributed and fragmented model. In order to have multiple facilities and many companies forming, each had to have an understanding about what to do, how to, and when.

By Anthony Crooks and John Dunn












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