Keith Schaefer, editor and publisher of Oil & Gas Investments Bulletin, has built an impressive track record of foreseeing structural changes in the energy industry. Schaefer knows when to take or refuse opportunities in the volatile ethanol industry, as he demonstrates in this interview with The Energy Report. And he knows how to bide his time while waiting for catalytic moments—the singular events that can make all the difference between survival and extinction for a junior oil and gas company struggling to raise above the fray in the fracking fields.
The Energy Report: Keith, why do you say that there is an ethanol "renaissance?"
Keith Schaefer: Ethanol is one of the most volatile sectors in the energy complex. The industry almost went bankrupt during the crash of '08. It rebounded; 2010 and 2011 were fantastic years for ethanol, with great profits. Then, the drought of 2012 caused corn prices to soar and ethanol profitability collapsed. But here we are a mere year later, enjoying the largest bumper crop of corn in American history. Corn is the main input price for ethanol; its cost determines the rate of profit. With corn locked into low costs for a few quarters, ethanol companies are minting money.
TER: Are ethanol prices always at the mercy of the weather?
KS: Well, yes, but there have been very few droughts in the last 15-20 years, so the swing over the last two years in crop sizes—and therefore pricing and profitability for ethanol—is not normal. I don't see weather as a big statistical factor over the long term. But in the short run, prices will continue to fluctuate in tandem with drought-reduced crops or bumper crops.
TER: Are costs stable in the chain of ethanol supply, from the farm to the storage facility to the distribution networks?
KS: There is not a lot of existing corn storage capacity for the bumper crop excess, but the ethanol industry is building up more storage capacity. The distribution system is tightening, however, because ethanol and corn are shipped in railcars. Due to the large price differential between American oil and international oil, the Brent/WTI spread, the oil companies are renting most of the available tankers to move fossil fuel product. That has negatively impacted the availability of tankers to move ethanol, and there is an actual shortage of ethanol in some areas. I view that as a bullish factor for ethanol going into 2014.
TER: Do you like any particular ethanol companies?
KS: The company that needs to be on everybody's radar screen is Green Plains Renewable Energy Inc. (GPRE:NASDAQ). It is hitting new highs close to $20/share. It was just included in the S&P 600. Green Plains is producing a billion gallons of ethanol per year. To put that in context: The U.S. produces 13 billion gallons per year, so Green Plains has one-thirteenth of the ethanol industry. It is the largest independent ethanol pure play. It has one of the top management teams in the entire business—a very competent, smart set of players. They hedge out a huge amount of their production, as much as possible.
TER: Is hedging a good idea?
KS: Oil can be hedged out two, three or four years. Due to supply variability, ethanol cannot be hedged out more than nine months. And as the new corn crop gets ready for reaping, there is no visibility beyond three months. It is an incredibly volatile sector.
But, right now we have about an eight-month pathway of visibility with unbelievable margins. Including the byproducts—corn, oil and distiller's grain—the margin for ethanol, which is commonly called the crush spread, is higher than forty cents per gallon.
To put that in context, Green Plains produces a billion gallons, so do the math: Forty cents a gallon times a billion gallons is $400 million ($400M) in cash flow. A conservative multiple of five times cash flow generates a valuation of $2 billion ($2B) for a company with only 35 million shares out. The numbers have quickly become very compelling.
Now the reality is that Green Plains is not going to realize that kind of margin because it is such an active hedger. It is willing to mitigate risk by taking a reduced margin. But the large players in the ethanol spot market are just rolling in cash.
TER: Prices in the domestic ethanol market are related to oil supply, politics and also to environmental concerns. Is hydraulic fracturing becoming more sustainable?
KS: Fracking is definitely becoming more sustainable as time goes by. Thanks to pressures from the environmental industry, the oil industry has responded with the creation of food-grade fracking fluid, for example. There is an increasing consensus that fracking does cause micro seismic events, and high-quality baseline studies are being done to assess how best to respond to that issue. Popular opinion polls show that fracking is increasingly accepted by the American public. But, for years, the industry missed the boat on how to sell fracking to the public—particularly on how to calm down fears of poisoned drinking water. Frankly, the industry is still a bit behind on that issue, but it is coming around and slowly adjusting to directly addressing these fears, as opposed to dismissing the concerns outright and just saying, "Well, we create lots of jobs."