Verasun Energy (OTC:VSUNQ)

TOP CONTRIBUTORS

Avinash Gandhi

Jonathan Kolb

www.zacks.com

VeraSun Energy was one of the largest ethanol producers in the U.S.; its total production capacity represented 7% of the U.S. total, and its merger with U.S. BioEnergy would have allowed it to triple its capacity by the end of 2008. However, the company declared bankruptcy in October 2008 because it placed bets on rising corn prices via derivatives trading once bushel prices hit $8 in June 2008. During the financial crisis of 2008, however, when commodities prices fell and the value of corn dropped by half, the company was left illiquid, and was forced to declare bankruptcy.^[1]

The Company focuses primarily on the production and sale of ethanol and its co-products. VEC owns and operates five ethanol production facilities in the United States, with a combined ethanol production capacity of 560 million gallons per year (MMGY). As of March 4, 2008, its ethanol production capacity represented approximately 7% of the total ethanol production capacity in the United States. In addition to producing ethanol, VEC produces and sells wet and dry distillers grains as ethanol co-products. During the year ending December 31, 2007, the Company produced approximately 376.1 million gallons of fuel ethanol and 1.2 million tons of distillers grains. On August 17, 2007, VEC acquired ASA OpCo Holdings, LLC. On March 31, 2008, VEC completed its merger with US BioEnergy Corporation.

Ethanol has received heavy support from the U.S. government as an alternative to gasoline. Blending subsidies make the production of corn-based ethanol profitable, while import tariffs keep international ethanol producers (like those in Brazil) from competing. The Energy Independence and Security Act of 2007 requires ethanol production to increase fivefold by 2022, and VeraSun, as one of the largest producers in the nation, was in a position to take advantage of the fuel source's demand growth.

Ethanol's momentum could slow or disappear, however, if the terrible publicity that corn-based ethanol has been receiving in the press leads the government to back away from ethanol as a fuel source. Ethanol production has driven up corn prices, which in turn increases the price of food. Ethanol also ultimately uses more oil than an energy-equivalent amount of gasoline (because corn uses oil as a fertilizer), making it less carbon-efficient and more petroleum-dependent than gasoline.

Furthermore, running a car on ethanol requires a different type of engine that most cars in circulation don't have, so making the switch from gas to ethanol will be very difficult, as it would require replacing millions of vehicles. Though a few automakers are producing flex-fuel vehicles and ethanol companies are teaming up with refiners to bring the fuel to pumps around the country, there is (as yet) no legislative support for these costly infrastructure changes and the mandated 36 billion gallons is less than 25% of the 160 billion gallons of gasoline used in the U.S. every year, making private industry unlikely to take the transition seriously. VeraSun competes with companies like Pacific Ethanol, ConAgra, Nova Biosource Fuels, Verenium Corporation, and Bluefire Ethanol. Nathan,Fair enough, but let's say that our feramrs are getting even 800 gallons per acre, that's still 9 Yellowstones or roughly 19 million acres. No matter how you slice it, that's a heck of a lot of land. Also, my point about the effect on food supply was more related to the garagantuan amount of food farmland needed to make biofuels based on the RFS. EPA's calculations about the effect on food prices have always been their weakest argument. Even ballpark calculations in this respect are exceedingly difficult.In the end, as I see it, the major point about shifting away from food-based biofuels is really important and it would not be that difficult to mandate a phase out after 2022. At that point, all of those corn ethanol facilities could easily be converted to cellulosic ethanol facilities. Heck, they could even shift to only using corn STOVER at that point and let the grain go into the grain supply chain. Doesn't that just make sense? You avoid all the food vs. fuel issues regardless of what they may or may not be. In most cases avoidance is not the best policy, but in this case it sure as hell is.

Trends and Forces

VeraSun Benefits from Heavy Legislative Support for Corn-Based Ethanol

There are corn ethanol subsidies in place that paid the industry $7 billion in 2006 (and more in 2007). Of these subsidies, companies like VeraSun benefit directly from federal blenders subsidies of $0.51 per gallon - totaling $2.5 billion in 2006^[2]. In 2007, the average price at which VeraSun sold its ethanol was $1.99 per gallon, while the company produced its ethanol at a cost of $2.25 per gallon^[3]. Without the subsidy, the company sees a loss of $0.26 per gallon and with it, the company turns a profit of $0.25 per gallon. Thus the government subsidy is necessary for VeraSun to make a profit with its current production methods.

In December 2007, Congress passed the Energy Independence and Security Act of 2007, which mandates that renewable fuels production (read: ethanol) in the U.S. should increase from 2007 levels of around 4.7 billion gallons per year to 36 billion gallons per year by 2022. Though 21 billion gallons per year of this target are required come from cellulosic ethanol and other "advanced biofuels"^[4], that still leaves 15 billion gallons (at least) for the corn-based ethanol industry to produce every year - twice the estimated production for 2007^[5]. A federal tariff on imported ethanol of $0.54 per gallon should leave this demand to be met by U.S. companies - like VeraSun. Mandated production increases and heavy corn-based ethanol subsidies make VeraSun's industry very lucrative, though highly dependent on government support for continued success.

Corn-Based Ethanol Gets Bad Press for Raising Corn Prices and Requiring Oil to Produce

Since the Energy Policy Act of 2005, ethanol has been celebrated as the next big biofuel. With oil prices shooting up in recent months, reaching $100/barrel at the New Year, consumer and government demand for alternative fuels has been increasing. As oil prices have risen, however, so too have corn prices, due to greater appetite for both corn-based fuel and corn-based food products to feed an ever-expanding global population. VeraSun's average payment for a bushel of corn rose from around $3.32 in the second quarter of 2007 to $4.60 in the new year^[6], depressing its margins and making its fuels less price-competitive with gasoline.

Rising corn prices, aside from making ethanol much less cost-efficient, cause prices for many other foods to rise - corn is a major animal feedstock, forcing meat prices up, and high-fructose corn syrup is found in pretty much every mass-produced food product. Corn prices haven't just shot up on their own, however; petroleum is used as a corn fertilizer, making corn's price directly related to oil's price. Demand for corn shot even further through the roof because of the emerging ethanol market; it was the increased production of corn-based ethanol, demanded by the Energy Policy Act of 2005, that led 20% of all corn produced in the U.S. to go to ethanol production in 2006 - a rate that was surpassed in 2007^[7]. There is only enough corn in the U.S. to produce 15 billion gallons of ethanol per year^[8] - and some of that has to go to food production as well.

All these problems have led to a wealth of bad press for corn-based ethanol; "The Clean Energy Myth", or some variation on it, has become a ubiquitous headline for newspapers and weeklies in recent months. As corn prices continue to rise, driven by oil prices and capacity constraints, VeraSun's margins will shrink; the backlash from the bad press related to ethanol's problems could ultimately harm the long-term prospects of the fuel source, as Congress may retract or amend its energy bills or U.S. consumers may simply not buy E85 cars when they are released.

High corn prices also crunch VeraSun's margins, and can affect their production capability. For example, after flooding in Iowa during June, 2008, the company announced that it would delay the opening of two ethanol plants because the high price of corn would cause the plants to lose the company money.^[9]

VeraSun Went Bankrupt Because Corn Prices Fell

Many ethanol companies, ironically, are also exposed to falling corn prices, because of hedging against price cuts. Verasun went bankrupt in October 2008 because the company placed bets on rising corn prices once a bushel hit $8 in June 2008. During the financial crisis of 2008, however, when commodities prices fell and the value of corn dropped by half, the company was left illiquid, unable to pay off its derivatives.^[10]

VeraSun Must Keep its Fingers Crossed for a Shift in the Auto Industry

Currently, American cars can run on a mix of 90% gasoline and 10% ethanol, though there isn't nearly enough corn-based ethanol being produced at the moment to meet this capacity. Part of the goal of the government's support of ethanol is to increase ethanol production and use to a scope well beyond that of the standard 10% blend. E85, a blend of 85% ethanol and 15% gasoline, is the big hope for the biofuels industry, and for VeraSun, who sells its own brand of E85 at 150 retail stations around the nation, because the widespread adoption of E85 would grow the level of ethanol demand almost as high as that of oil (for gasoline). There are, however, a number of blockades to the widespread adoption of E85 in the U.S.:

• E85 cars have been shown to run with an almost 50% reduction in miles per gallon - though this is measured in miles per gallon of E85, not of total gasoline^[11].
• There are over 247 million cars in the U.S.^[12], but very few of them are "flex-fuel" vehicles, which are compatible with E85. The prospect of replacing all of these with flex-fuel vehicles is staggering, and the automotive industry is dragging its feet at the idea of having to develop cost-efficient vehicles that are E85 compatible.

Without solutions to these obstacles, ethanol and cellulosic ethanol have no hope of being considered "replacements" for petroleum.

Competition

VeraSun's production capacity for corn-based ethanol, at 560 million gallons per year, represented 7% of the U.S. total in 2007^[13]. The company competes with a number of other biofuels companies - and the market is expanding quickly.

• Aventine Renewable Energy Holdings - Aventine produced 10% of the country's ethanol in 2007, and takes advantage of a large marketing network and economies of scale to increase its margins.
• Pacific Ethanol - Pacific Ethanol won $24.32 million from the Department of Energy to build the first cellulosic ethanol pilot plant in the Northwestern United States. The plant is expected to have a capacity of 2.4 million barrels per year - a full million more than Verenium's pilots'^[14]. Currently, Pacific Ethanol is the largest manufacturer of corn-based ethanol on the west coast.
• Nova Biosource Fuels and ConAgra - ConAgra has agreed to have Nova use its animal wastes to produce biodiesel, and will purchase 130 million gallons of this biodiesel each year from the companies' joint venture to sell on international markets^[15]
• Verenium Corporation - Though Verenium started as an agricultural, industrial, and medical enzyme engineering company, it recently became heavily involved in researching enzymes to produce cellulosic ethanol, and will soon start construction of a 1.4 million gallon-per-year pilot plant in Louisiana and a 1.4 million liter-per-year pilot plant Osaka, Japan^[16]. The company hopes to start construction in early 2009 on a 30 million gallon-per-year plant in the Southeast U.S.
• Bluefire Ethanol - Bluefire uses "acid hydrolysis" to convert wood waste, green waste, paper, urban trash, rice and wheat straw, and other feedstocks that would generally be thrown into a landfill into cellulosic ethanol.

Notes

1. ↑ Financial Times: Lex: "Ethanol producers"
2. ↑ zFacts.com: "Subsidies for corn ethanol"
3. ↑ VSE 2007 10-K, Calculated by dividing operating costs by gallons produced
4. ↑ HR 6 Energy Bill Summary
5. ↑ Denver Post: "Not enough corn to fill Bush’s ethanol tank"
6. ↑ "The Price VeraSun Pays For Corn"
7. ↑ "Corn can't save us: Debunking the biofuel myth"
8. ↑ Denver Post: "Not enough corn to fill Bush’s ethanol tank"
9. ↑ SeekingAlpha: "Corn, Ethanol and Water"
10. ↑ Financial Times: Lex: "Ethanol producers"
11. ↑ Wikipedia: E85
12. ↑ http://en.wikipedia.org/wiki/Passenger_vehicles_in_the_United_States
13. ↑ VSE 2007 10-K, Page 3
14. ↑ Pacific Ethanol News Release: "Pacific Ethanol Wins DOE Cellulosic Energy Grant"
15. ↑ Seeking Alpha: "Look Out For Winners In the Transition from Petroleum"
16. ↑ Verenium News Release: "Verenium Corporation Announces Milestone Payment to the University of Florida for Cellulosic Ethanol Technology License"
17. ↑ VSE 2007 10-K, Calculated by dividing operating costs by gallons produced
18. ↑ PEIX 2007 10-K, Calculated by dividing cost of goods by gallons produced
19. ↑ AVR 2007 10-K, Page 42, Calculated by dividing cost of goods by gallons produced