The Battle for California’s Ethanol Market

by Debra Fiakas CFA

For all the fuss, investors might think California’s ethanol market is another Gold Rush.  The Midwest-based ethanol producers are up in arms over California’s attempt to set standards for renewable fuels sold in the state.  My recent post, describes legal maneuverings by South Dakota-based ethanol producer Poet, LLC and others to block a ‘carbon intensity’ standard imposed by the California Air Resources Board (CARB).
  
Under the CARB standard the carbon intensity of alternative fuels includes elements for power and other inputs as well as transportation and distribution.  The formula CARB is using give Midwest suppliers of ethanol a significantly higher carbon content rating than just about every other alternative fuel category.  

In 2012, the U.S. produced approximately 13.8 billion gallons of ethanol.  About 85% of that production originated in the Midwestern States.  California’ ethanol market is the largest in the U.S. and represents the majority of sales by Midwest-based ethanol producers.  Poet and its peers in corn country cannot afford to let its market share in the Golden State.

If Midwest ethanol producers believe they are disadvantaged by the California low carbon standard, it stands to reason there must be others that will benefit.  The renewable diesel and biofuel producers are noticeably absent from the legal fray.  Nor have any of the California-based ethanol producers had anything to say.

Winners and Losers…

 We identified algal-based renewable diesel developer Sapphire Energy and Neste Oil (NEF: MU) as two parties which have already made some moves toward the California market.  Neste Oil claims it is the largest producer of renewable diesel in the world, with operations in the U.S. and Europe.  Neste just signed an off-take agreement with Cellana, Inc., a cultivator of algal oils with operations in Hawaii and California.  In March 2013 Sapphire landed an off-take agreement with oil refiner Tesoro Corp. (TSO:  NYSE).  Tesoro is buying an undisclosed amount of algal-based oil produced at Sapphire’s New Mexico plant.  Tesoro has two refineries in California at Martinez and Los Angeles and just recently bought another refinery from BP (BP:  NYSE) located in Carson.  Do not expect Tesoro or Neste to begin blending algal-based renewable diesel until 2014 at the earliest.

Even if these algae cultivator partners were already producing at scale, the situation does not present an accessible investment opportunity for minority investors like you and me.  Sapphire Energy is a private company that appears to have all the financial support it needs from venture and other institutional investors.

Cellana, which used to be known as HR BioPetroleum, is currently working on a Series A financing that could be open to qualified investors.  Royal Dutch Shell had been a joint venture partner until HR BioPetroleum bought out its stake in 2011. Cellana has made disclosures of government funding sources, but has kept mum on investors.   The company was founded by two University of Hawaii scientists, Dr. Mark Huntley and Dr. Barry Raleigh who are also members of the board of directors.  An offering circular will no doubt provide details on financing requirements and the magnitude of any revenue sources, if there are any at this point in Cellana’s development.

More Winners…

Algae is not the only potential beneficiary of California’s attempt to strain out the carbon content of transportation fuels used in the state.  The post “Sorghum Power Ball” on December 4, 2012 followed sorghum’s designation by the U.S. Environmental Protection Agency as an advanced fuel.  Pacific Ethanol (PEIX: OTC/BB) had recently announced that California-grown sorghum provided 30% of the feedstock used in its ethanol production in third quarter 2012.

At the end of 2012 California-based Aemetis, Inc. (AMTX:  OTC/BB) announced its intentions to transition from corn feedstock to sorghum at its Keyes, California ethanol plant.  Integrating a combined heat and power system into its process creates enough efficiency to qualify Aemetis’ sorghum-based ethanol as a renewable fuel with a lower carbon rating.  The plant has a 60 million gallon production capacity.

Both companies could benefit if CARB prevails in legal battle over its low carbon fuel standard.  What is more both are accessible to investors in the public secondary market.  Now that we have established there is wind at the backs of these companies that could drive revenue and profits, let see how much it will cost.

Pacific Ethanol shares have a beta measure near 3.90, indicated a long position in PEIX would be a cheap, but exciting roller coaster ride.  This puts a bit of pressure on an investor to pinpoint enterprise value.  In 2012, the company lost $20.8 million on $848.8 million in total sales.  Indeed, Pacific Ethanol only produced an operating profit in the year 2011 when sales topped $900 million.  Sales in the first quarter 2013 recovered and if that pace is maintained the company could deliver another $900 million in total sales for the year 2013.  Unfortunately, it looks like management has become a big spender as operating expenses were significantly higher in the quarter, putting into doubt a profit even on $900 million in sales.   PEIX shares are trading at 0.20 times assets, most of which are tied up in the ethanol-making plant and equipment.  These plants have been proven to have value even in bankruptcy and we think this stock might be undervalued in terms of asset value.

With such a short history, valuing Aemetis is even more challenging.  However, AMTS is priced more like an option on the company’s business strategy and management’s ability to execute on the growth plan.  Thus a long position in Aemetis is contingent on an investor’s confidence that competitive conditions in California will continue to favor local producers  –  at least in part.  The other part of the bull-case is the qualification of management.  Aemetis is still run by its founder Eric McAfee, a farmer-venture capitalist.  He is also co-founder of Pacific Ethanol and left when the company went public in 2005.  McAfee has a string of solar power and alternative fuel investments.  

Debra Fiakas is the Managing Director of Crystal Equity Research, an alternative research resource on small capitalization companies in selected industries.

Neither the author of the Small Cap
Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.