17 September 2012 Europe Equity Research
Equity Themes Connections Series
1st generation ethanol under pressure
The Credit Suisse Connections Series leverages our exceptional breadth of macro and micro research to deliver incisive cross-sector and cross-border thematic insights for our clients. Research Analysts Mary Curtis 27 11 012 8068 mary.curtis@credit-suisse.com Patrick Jobin 212 325 0843 patrick.jobin@credit-suisse.com Rhian O'Connor 44 20 7888 0300 rhian.oconnor@credit-suisse.com Edward Westlake 212 325 6751 edward.westlake@credit-suisse.com Robert Moskow 212 538 3095 robert.moskow@credit-suisse.com John P. McNulty, CFA 212 325 4385 john.mcnulty@credit-suisse.com Lars Kjellberg 46 8 5450 7926 lars.kjellberg@credit-suisse.com Gustavo Wigman 55 11 3701 6302 gustavo.wigman@credit-suisse.com Richard Kersley 44 20 7888 0313 richard.kersley@credit-suisse.com Mujtaba Rana 44 20 7883 3773 mujtaba.rana@credit-suisse.com
Ethanol’s impact on global cereal demand has risen significantly over the past 10 years. On USDA numbers we calculate that ethanol accounted for 6% of global cereal usage in 2012, up from just 1% in 2000. This is the peak. We review the outlook for the three key determinants of ethanol production, namely legislation, profitability and technological advance. Our main conclusion is that each of these three drivers points towards a relative decline in first generation ethanol production. Specifically, we note: (1) Legislation: the shortfall in the main ethanol legislation (the Renewable Fuels Standard) is that it sets a mandatory supply of ethanol that is in excess of the plausible level of demand for ethanol absent a significant, and immediate, introduction of 15% ethanol blends. This seems unlikely in the face of weak public acceptance of higher blends and the current lack of infrastructure available on the forecourt to provide higher blends. (2) Economics of production: high input costs have undermined the profitability of ethanol producers. We expect profitability to improve (as corn prices come down) but to remain weak given the poor demand environment and need to reduce capacity. (3) Technology: ultimately, we think there will be some displacement from second generation cellulosic ethanol, but additional progress still needs to be made to reduce capital costs and improve the productivity of enzymes. We expect any policy response will, at a minimum, be relatively more favourable to second-generation biofuel producers. We also note that inexpensive natural gas in the US is another (negative) complication for the ethanol producers. The other major backdrop to our investment recommendations is that we expect soft-commodity prices (and particularly corn prices) to pull back over 2013. We forecast average corn prices for next year of US$5.90 per bushel, down from prevailing prices that are close to US$8.00. Investment implications. We assess the implications and outlook for three closely related industries: the ethanol producers, meat and dairy producers and the chemicals sector. On a 12-month view, generally the meat and dairy producers should see significant improvement in profitability (Smithfield rated Outperform). We prefer low cost (Brazilian) ethanol producers (Sao Martinho rated Outperform) compared to the US peers (GPRE rated Neutral). There is a significant potential market for enzymes in second generation (2G) ethanol production. However, we are cautious on the outlook for the enzyme producers (Novozymes, rated Underperform) given the slow development of 2G ethanol and threat from competitors. See our report on 2nd Generation Ethanol technologies titled Advanced Biofuel Enzymes - Game Changing Technology; Still A Few Years Away, published today Click here.
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