Efficient Markets and Ethanol Spreads: Pacific Ethanol

Mar 27, 2014 by Thiago in Finance

update: $20MM in debt paid down disclosed in the CC should read $10MM. I am expecting them to use warrant proceeds to help pay down debt based on guidance provided for debt management.

I find this post to be quite ironic considering my last post was on efficient markets.

Pacific Ethanol is my second ethanol investment, after investing with GPRE, but by far my largest position on the market. I picked up PEIX late in December and added more in January. I have been trading around this position at opportune times. PEIX is an ethanol company located in the west coast, which is a minority among ethanol producers who typically locate themselves close to the corn fields of the midwest.

They have four plants:

Item Madera Facility Columbia Facility Magic Valley Facility Stockton Facility
Location Madera, Ca Boardman, Or Burley, ID Stockton, Ca
Opening Q4 2006 Q3 2007 Q2 2008 Q3 2008
Status Idle – Q2 2014 Operating Operating Operating
Capacity 40 40 60 60
Primary Energy Natural Gas Natural Gas Natural Gas Natural Gas
Estimated WDG Capacity 293 293 418 418

Their total capacity comes in at around 160MM gallons per year with the idled plant but following Q4 2013 , they announced it will reopen for Q2 2014 bringing their active capacity to 200MM gallons.

The ethanol industry is highly volatile and since the bumper corn crop of last summer ethanol margins have exploded. PEIX earned $0.55 EPS in Q4, on the backs of historically low feedstock costs, higher co-product revenue and a higher premium than normal for west coast ethanol. Traditionally the ethanol industry has had to rely on the RFS, and last year when the EPA lowered the mandate amount the industry’s stock price fell into a free fall. However, the market currently is trading independently of government subsidies and is enjoying some of the best margins in their history. PEIX recent history is quite dark, they have gone bankrupt and are currently in the process of buying their plants back from their bondholders. In December they increased ownership to 91% and I suspect on the back of their current FCF they will buy the remaining portion out this quarter. Due to this, they literally cannot afford to hedge production. GPRE and REX both had relatively disappointing earnings for Q4 from their hedging activities and all indications point to further hedging losses in Q1.

Pacific Ethanol being on the West Coast traditionally means they have to pay a larger amount for corn shipping. They have averaged about $1.15-1.30 per bushel in shipping costs, and as of Q3 have started to pay a basis. At last check the basis for Q1 was $0.37. This is somewhat offset by higher west coast ethanol pricing of 20 cents, but as of Q4 this premium has ballooned to about $1 per gallon providing huge windfall profits. This is increasing their margins significantly and is due primarily to congestion in the train infrastructure caused by weather and Bakken oil production. Midwest suppliers are wary of shipping ethanol to the coasts because there is risk they may not get those rail cars back, allowing the west coast basis to persist. New capacity in light of the transportation infrastructure and memories of the overcapacity of the 2008/2009 boom will not be likely any time soon, with no producers making any announcements.

 

PEIX is however in a fairly unique position. Due to its bankruptcy, 9% of its capacity is still owned by its bondholders and can be purchased back for $0.32/gallon, representing a huge discount to actual new capacity which would cost somewhere around $2.00/gallon. They also have the idled Madera plant which will go from a $1.5MM expense to adding $10MM EBITDA. This is assuming $0.30 gallon margin, which you will see shortly is not very representative of the current environment.

I have put together a model comparing past earnings to projections based on PEIX’s reporting and current pricing from the USDA/CBOT. The model is not very well organized but captures all of the data I have gathered and shows projections going out for the next two reporting periods. I assumed 0.1mcf of natural gas per gallon that I got from CARD. I understand that PEIX uses much less gas due to the production of WDG, however this number seemed to be a fairly good number to be representative with past earnings periods. The first thing you will notice is that the revenue and COGS are much lower for estimate periods. This is because I stripped out their third-party distribution business and focused only on internal production. The assumption here is that it is cash flow positive, and historically they make over $4MM on this business so that is conservative.

March 28 PEIX Earnings Model

March 28 PEIX Earnings Model

You will see that current earnings are certainly astronomical. I made certain assumptions due to warrant exercising, as at current prices they will all be in the money. As long as PEIX hasn’t hedged production, based on current corn and natural gas prices they are making record profits that for the current foreseeable future are sustainable. There are risks such as the situation in Ukraine affecting corn pricing, Brazil changing blending limits and the domestic rail network, but even if current margins get cut in half this will be a record year for PEIX. If current YTD margins stay in stable, PEIX is looking at $8 EPS which would price the stock at a severe discount of 1.5X PE. Taking a more realistic stance and assuming that margins retrace back to late 2013 pricing, $4EPS is certainly in play.

I look forward to comments, as I have a hard time understanding the current trading of PEIX equity given the publicly available information, and what management disclosed in the Q4 call ($20MM debt payed down YTD as of the third week of February). Management should be buying back shares at the current time, and managing dilution versus paying down debt. With their current earnings power, they should be able to negotiate much lower interest terms. Trading PEIX stock has been very good to me, and I nailed Q1 earnings, but recent trading action has been very difficult to understand given the reaction on Q4 earnings. I believe that on confirmation of Q1 earnings, PEIX should deserve a higher multiple and should start seeing sell-side analyst coverage. Will the market notice before then?

 

Disclosure: I am a CFA institute member, and a professional engineer in the energy field. I am long PEIX stock, options and/or ethanol futures. I was not paid to write this article and it was purely an exercise in training. This does not constitute investment advice and should not be taken as such.