Biofuels Retrospective: What Lessons Apply to Future Due Diligence?

And now for something completely different…  Last week I gave a presentation at Renewable Energy World 2012 as a member of a panel entitled “Biomass Due Diligence: How Your Project Can Learn from Failure to Better Ensure Success.”  I provided the following retrospective on the biofuels experience and a few recommendations on improving due diligence.

The Boom

In mid-2006 87 biodiesel plants were operating (33 since the beginning of the year) and 77 were under construction. Similar activity was happening in ethanol.  E85 was selling at 40 cents a gallon less than regular unleaded, and B20 was selling at par with diesel.  Interest in new plant construction (and investment) was so high that plant process providers and E&C firms had over a year backlog – some 2 years.

The reason for this boom period was not difficult to determine: profits in biofuels, especially ethanol, made these new plants seem like money machines.  Margins for both are shown below:

A year later, ethanol margins dropped, in part because by the end of the year there was more ethanol produced than there was distribution capacity to handle it.

The Bubble Bursts

Early in 2007, the relationship between feedstock costs and sale prices for biodiesel flipped to upside down even with federal subsidies.

By the end of 2009:

  • 47 Biodiesel plants and 37 ethanol plants were idled
  • Subsidies expired
  • Soy based biodiesel, except in states with additional subsides or for export (“splash and dash” phenomenon) never returned to profitability since 2007
  • Plants were being sold for cents on the dollar

So what happened?

Before we look at what happened, a basic understanding of cost/revenue relationship for this business is important.

The basic business model for biodiesel is rather straightforward:

Cost of feedstock + cost of processing chemicals (methanol) + O&M + Fixed Costs

must be greater than or equal to:

Biodiesel sales price + blender credit rebate + glycerin sales price

In February 2012 this equation yields the following results:

  • Costs:  ($4.00/gal soybean oil+ $.31/gal O&M + $.50/gal debt) = $4.81/gal
  • Revenues: ($3.14/gal B100 + 0 rebate + $0.05/gal glycerin) = $3.19/gal
  • Net Loss/Gain: ($1.62/gallon)

Note that 83% of the Cost of Goods Sold and 100% of the revenue are subject to both commodity volatility and government subsidy.   The only real control most producers had was over operating costs and some degree of risk mitigation through hedging.

The boom was created by federal subsidies.  For all practical purposes a biodiesel “industry” did not exist prior to 2005. In 2004 the Energy Policy Act was passed containing numerous biofuel tax credits and grants.  A partial list of federal supports include:

  • Biodiesel
    • Biodiesel Excise Tax Credit
      • $ 1/gal per gallon blended
      • Began in 2004: lapsed all of 2010, revived in 2011, ended 12/31/11
  • Small Producer Tax Credit
    • $ 0.10/gal, ended 12/31/11
  • B100 Income Tax Deduction
  • $ 1/gal to dispenser of pure biodiesel to vehicles
  • Ethanol
    • Excise Tax credit
      • .45/gal per blended gallon, ended 12/31/11
  • Small Ethanol Producer Tax Credit
    • $0.10/gal, ended 12/31/11
    • Biofuels
      • Improved Energy Technology Loan Guarantee
      • Advanced Biofuel Production Grants and Loan Guarantees
      • Advanced Biofuel Production Payments.
      • Ethanol Infrastructure Grants and Loan Guarantees
      • Value Added Producer Grants
      • Commodity Credit Corporation Production Incentives

These do not include state programs, some of which were more lucrative than federal.

The impact of subsidies is readily apparent in the following charts.

Agricultural Unintended Consequences

Once various agricultural commodities were impacted by subsidies, both in the crops themselves and from anticipated biofuel related demand, a number of “unintended consequences’ occurred.  When farmers saw these kind of returns in corn, they shifted from soy beans to corn in the 2007 planting season.

The reduction in acreage devoted to soy beans, the anticipated explosive demand from biodiesel and an increase in exports to China resulted in soy oil prices shooting up, peaking mid-year 2008.  And by the way, so much glycerin was being produced that its market became so depressed that it began to be regarded as a waste with disposal costs, rather than a revenue stream.

Referring back to the cost/revenue equation for biodiesel: when soy oil prices grew much faster than heating oil (the futures commodity used to hedge diesel fuel), once costs exceeded revenues, the differential just got worse.

 As can be seen below, except for a very brief moment in 3Q08, costs have exceeded revenue from 2006 to present.

Ethanol production, however, continues, and even with the loss of subsidies, at pretty much breakeven.  The heady days of huge margins are over, but production plants can continue to operate.

So where do we stand today?

  • Approximate total investment in ethanol plants, $ 9 to $12 billion; biodiesel $2 to $4 billion (since 2005)
  • Ethanol projected to breakeven for foreseeable future
  • With the federal $1/gal blender credit no longer available, the biodiesel industry’s long term health is questionable

Lessons Learned

For future biofuels, and biomass projects, it is strongly recommended that:

Due diligence:

  • Employ risk based due diligence that:
    • Identifies the nature of and quantifies the scale of all risks involved
      • Commodity risk – in biofuels, impact is on both expense and revenue
      • Government policy risk – assume overnight loss of support!
      • Technology risk – might your economics be eclipsed?
      • Clearly assesses all project management competency limitations – do you have the depth to fully appreciate farming, commodity trading, wholesale fuels blending and distribution – and curb your appetite to what you know!
      • Never rely on commodity cost projections out beyond a year or the available hedging horizon
      • Examine and test the details behind the metrics (e.g., gallons/acre)

Feedstock Control

In addition, if the project is buying feedstock or selling product, hire a strong hedging consultant and amass sufficient working capital to maximize hedging on the expense and sales sides.

If at all possible, disconnect from commodity feedstock markets using strategies others are already employing in the market:

  • Consider new feedstocks: micro & macroalgae, jatropha, carinata, cellulosic, switchgrass, etc.
  • Unlock value in wood residues; bagasse, MSW; waste gases
  • Add value to corn starch; cane syrup


And finally, good advice from Vinod Khosla:

“Subsidies bring cash flow forward but seldom create your market or build your business. In order to succeed, your product must be price competitive without subsidies.”

From Hill Street Blues:

“And be careful out there…”

Smart Grid 2012 Predictions: Something Missing?

In the previous post 8 different sets of predictions for the smart grid in 2012 were synthesized, and one prediction that the 8 sets seemed to miss was identified: customer engagement services will be a growth opportunity. In fact, it was remarkable how limited was any discussion of customers in the prediction sets. Take a look at the word map below that highlights the frequency of words among all of the 51 predictions and see if you can find “customer.”

This is all the more remarkable in the face of headlines like:

“Smart Grid Backlash: Michigan Opens Smart Meter Investigation”

“Smart Grid Consumer Pushback Spreads to Florida, Returns to Maine”

“Signatures Gathered to Put Smart Meter Issue to Naperville Voters”

And there are plenty more stories about customer concerns and pushback to smart grid. Further, a Zpryme customer survey indicated that 69.9% of customers were not knowledgeable about the Smart Grid and 85.8 % had not received any information about Smart Grid from their utility or didn’t know if they had (“HTU” stands for High Tech User):

The Consumers Electronics Association found very similar results in its survey last year.

So it’s very clear that end users need education, and that without that education greater resistance to smart grid implementation is likely.

And then there is the knee-jerk attitude found among some utility managers and smart grid vendors, best summed up in the following quote:
“… most (residential) customers …have such tepid interest in what smart grid can do for them. They don’t care because they have never cared. They’ve never had to think about their electricity supply, and asking them to engage with their utility via demand response, rooftop solar or time-of-use rates presupposes that they have an interest in power in the first place. They simply do not perceive a need to change.”

They don’t believe customers are interested in participating in better management of their energy, and this belief unfortunately gets reinforced when the utility approach to engaging the customer is to overwhelm them with statistics and meter readings. When properly approached, however, several studies have indicated that customers do, indeed, want to have a direct role in managing their electricity and respond to demand management programs such as time of use pricing. Tendril uses an interesting segmentation of residential customers as they relate to the smart grid:

Another segmentation done by the Smart Grid Consumer Collaborative developed 5 categories:

In summary:

  • Customer engagement does not seem to be high (or at least as high as it should be) on the list of priorities in smart grid implementation.
  • Some utility and vendor managers believe that customers don’t care, and that biases their approach.
  • Failure to make the compelling argument guarantees customer pushback.
  • Properly conducted customer engagement using behavioral techniques generates meaningful results. (Opower has coined the term “Information-based energy efficiency.”)
  • One size does not fit all when it comes to communicating with customers and segmentation is important.

So what do we conclude from all of this? My opinion is that unless careful adoption of customer engagement approaches become a trend for 2012, more customer, and by extension, more regulatory pushback will occur. In addition, since the smart grid industry is plagued by a variety of confusing messages to consumers, and since “smart meters” have become synonymous with “smart grid” because of these confusing messages, problems with smart meter programs will negatively impact other smart grid programs.