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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17 September 2012
Key charts S Am ex Brz 1%
Brazil 25%
Europe 5%
Figure 2: US ethanol fuel production (1980 to 2011) US Ethanol Fuel (Gallon millions)
Figure 1: World ethanol fuel production in 2011
Asia 4% Canada 2% Africa 0%
US 63%
16000
35%
14000
30%
12000
25%
10000
20%
8000
15%
6000
10%
4000
5%
2000
0%
0 1980
-5% 1985
1990
1995
2000
US Ethanol Fuel Production
2005
2010
Annual growth (3 yr MAV)
Source: F.O.Lichts, Renewable Fuels Association, Credit Suisse
Source: F.O.Lichts, Renewable Fuels Association, Credit Suisse
research
research
Figure 3: % of US and world corn and cereal production
Figure 4: US ethanol production, legislated targets and
used to produce ethanol
potential E10 (10% ethanol blend) demand
45%
40
42% in 2012
40%
US Ethanol production (1980 - 2011) First generation mandate according to the RFS Total bio-fuel mandate according to the RFS The E10 trajectory
35
35%
25% 20%
14% in 2012
6% in 2000 and 14% in 2005
15% 10%
Billions of gallons p.a
30
30%
6% in 2012
25 Supply
20
2012 ethanol production on track to deliver 13.6bn gallons vs the 13.2bn RFS mandate
15 10
5%
5
0% 1980
1985
1990
% US corn for ethanol
1995
2000
% world corn for ethanol
2005
Demand
0
2010
1980 1984 1988 1992 1996 2000 2004 2008 2012E 2016E 2020E
% world cereals for ethanol
Source: USDA, Credit Suisse research
Source: RFS, EPA, Credit Suisse estimates
Figure 5: US vs Brazilian ethanol prices
Figure 6: US ethanol vs corn prices
4.5
4.5
900
4.0
4.0
800
3.5
3.5
700
3.0
3.0
600
2.5
2.5
500
2.0
2.0
No longer worth importing ethanol from the US
1.5 1.0 0.5 Jun-06
Apr-07
Feb-08
Dec-08
US Ethanol price
Oct-09
Aug-10
Source: Thomson Reuters, Credit Suisse research
Equity Themes
Jun-11
Brazilian ethanol price
Apr-12
400 Profit erosion
1.5 1.0 0.5 Jun-06
300 200 100
Apr-07
Feb-08
Dec-08
Oct-09
US Ethanol price (US$/gallon, lhs)
Aug-10
Jun-11
Apr-12
Corn price (US$/bushel, rhs)
Source: Thomson Reuters, Credit Suisse research
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17 September 2012
Summary Ethanol production now accounts for a significant proportion of global cereal production (6% in 2012 compared to only 1% in 2000). However, we expect this to be the peak in relative production for three key reasons: (1) Legislation. For H1 2012, US ethanol producers were already producing at or above the mandated level of production under the Renewable Fuels Standard while demand for ethanol is limited by the 10% blendwall and slow implementation of 15% blends. We do not expect the mandate to be waived (the EPA should rule on this by November 13) but there is clearly waning appetite for further measures to support the ethanol industry. (2) Profitability of the US and Brazilian ethanol producers should improve if input costs fall in line with our forecasts but in the US profitability is likely to remain fairly weak given the poor demand environment and excess capacity in the industry. (3) Technology. Ultimately, we think there will be some displacement from 2nd generation cellulosic ethanol, but additional progress still needs to be made to improve the productivity of enzymes. We expect any policy response will, at a minimum, be relatively more favourable to second-generation biofuel producers. The other major backdrop to our investment recommendations is that we expect softcommodity prices (and particularly corn prices) to pull back over the course of 2013. Specifically 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 per bushel. In the table below, we summarise our main investment recommendations for key sectors impacted by the production outcome of the ethanol industry and soft commodity prices. 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) and we are cautious of the fertiliser stocks given their high correlation to soft commodity prices. Within the chemicals space, we are cautious on the outlook for the enzyme producers (Novozymes rated Underperform) given the slow development of 2G ethanol and threat from competitors. Figure 7: Short and long-term outcomes for the Ethanol industry Short-term Catalyst
Results
Poor ethanol profitability (1) Production of ethanol continues to fall. in the US
High cost ethanol producers. Fertiliser stocks (highly
Meat/dairy producers
Not our central scenario. (1) It depends by how much the waiver is cut and for how long but we can assume the supply of ethanol and RINs would fall sharply. (2) Ethanol prices rise relative to gasoline prices. (3) Corn prices fall (all other things being equal).
Petrobras losses
Potential losers
Low cost ethanol producers
(2) Ethanol prices rise relative to gasoline prices. (3) Corn prices fall (all other things being equal).
RFS waiver
Potential winners
correlated with crop prices). Ethanol producers. Fertiliser stocks (highly
Meat/dairy producers
correlated with crop prices).
(1) Domestic gasoline prices in Brazil are allowed to rise. Petrobras. (2) Brazilian ethanol prices increase in line with the rise in Brazilian ethanol producers gasoline prices. (Sao Martinho). (3) Sugar prices rise relative to corn as more cane is Brazilian crop producers (SLC directed towards ethanol. Agricola).
Long-term trends Weak end demand for first-generation ethanol
Even assuming E15 is widely adopted; l-term demand for ethanol looks relatively weak given falling demand for US gasoline. This keeps pressure on the profitability of ethanol producers given prevailing high ethanol capacity. Growth in Advanced bio- Not as quick as the EPA envisage in the RFS mandate fuel production but still a development that adds to ethanol supply and undermines the business and environmental case for first generation production.
Meat/dairy producers
US conventional ethanol producers.
Advanced biofuel producers. nd 2 Generation Feedstock & Enzyme supply chain. Meat/dairy producers.
US conventional ethanol producers.
Source: Credit Suisse research
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17 September 2012
Ethanol production Conventional bioethanol (or first generation ethanol) is an alcohol made by fermenting the sugar components of plant materials such as corn and sugarcane. The main application of bioethanol is for use in transport fuel as a substitute for fossil fuels. For the full year 2011, global ethanol fuel production came to some 22.3 billion gallons, down fractionally on the 2010 world ethanol output of 22.9 billion gallons. Figure 8: World Ethanol Fuel Production over the last 5 years
25.0
22.9
22.3
2010
2011
20.0
Billions of gallons
20.0 15.0
17.3
In 2011, ethanol fuel production came to some 22.3 billion gallons, down fractionally on the 2010 output of 22.9 billion gallons.
13.1
10.0 5.0 0.0 2007 Africa
US
2008
2009
Europe
S Am ex Brz
Brazil
Asia
Canada
Source: F.O.Lichts, Renewable Fuels Association, Credit Suisse research
The US is the largest producer of ethanol: 13.9 billion gallons was produced in 2011 accounting for some 63% of world production. Brazil was the second largest ethanol producer last year at 25% of the global total. Asian production is dominated by China (555 million gallons in 2011). Canadian production in 2011 came to some 462 million gallons. Figure 9: World Ethanol Fuel Production in 2011
S Am ex Brz 1% Europe 5%
Brazil 25%
The US and Brazil are by far the biggest ethanol producers
Asia 4% Canada 2% Africa 0%
US 63% Source: F.O.Lichts, Renewable Fuels Association, Credit Suisse research
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Brazil: 25% of global ethanol production in 2011 Brazil has a significant history in ethanol production. Most of the Brazilian ethanol is a product of domestically grown sugar cane. Sugar cane has a greater concentration of sucrose than corn (by about 30%) and the sucrose is also much easier to extract than is the case for corn. Brazilian ethanol is widely used in the country as transport fuel. ANFAVEA (the Brazilian automobile association) estimates that more than 12 million flex-fuel vehicles are now part of the national fleet (~18% of the total fleet). Flex-fuel engines in Brazil are able to work with all ethanol, all gasoline or a mixture of the two. Consumers regularly shift consumption depending on relative prices.
Brazilian Ethanol Production (Litres Millions
Figure 10: Brazilian Ethanol Production (1993 to 2011)
30,000
20%
25,000
15% 10%
20,000
Brazil has a significant history in ethanol production. This is almost entirely produced from domestically grown sugar cane
5%
15,000
0%
10,000
-5%
5,000
-10%
0 1993
-15% 1997
2001
Brazilian Ethanol Production
2005
2009
Annual growth (3 yr MAV)
Source: UNICA, Credit Suisse research
US: ethanol production has seen significant growth in the last 10 years US ethanol production, mainly derived from corn, has grown significantly over the last 10 years. Data from the Renewable Fuels Association show that US ethanol production grew at a CAGR of 11.8% between 1980 and 2000, but this leapt to 21.5% post 2000.
US Ethanol Fuel (Gallon millions)
Figure 11: US Ethanol Fuel Production (1980 to 2011)
16000
35%
14000
30%
12000
25%
10000
20%
8000
15%
6000
10%
4000
5%
2000
0%
0 1980
US ethanol production has grown by a CAGR of 21.5% over the last 10 years
-5% 1985
1990
US Ethanol Fuel Production
1995
2000
2005
2010
Annual growth (3 yr MAV)
Source: F.O.Lichts, Renewable Fuels Association, Credit Suisse research
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17 September 2012
A key driver of the growth in the US ethanol industry has been (a) high average oil prices along with low ethanol prices providing attractive blend economics along with high (>30%) returns on ethanol production investments, and (b) the Renewable Fuels Standard legislation introduced by US President Bush in 2007 that mandates the level of ethanol production to the year 2022. Similar to Brazil, most of the US ethanol production is used in transport fuel. However, unlike Brazil, the ethanol blend in US gasoline is mainly limited to 10% given a lack of infrastructure to support 15% (or higher) ratios. (More on this below.) This rapid growth in US ethanol production over the last 10 years has meant a significant increase in the proportion of the US corn crop used in the production process. Latest data from the USDA suggests that ethanol demand will account for 42% of this year’s corn crop up from 14% in 2005 and 6% in 2000. Since the US is one of the world’s largest producers of corn (38% in 2011), this means that on the latest USDA estimates 14% of the world corn crop this year is set to be allocated to the production of US ethanol. This equates to 6% of world cereal production, given the very high weight of corn in world cereal output. Figure 12: % of US and world corn and cereal production used to produce ethanol
45%
42% in 2012
40%
6% of world cereal production is currently used to produce US ethanol fuel
35% 30% 25% 20%
14% in 2012
6% in 2000 and 14% in 2005
15% 10%
6% in 2012
5% 0% 1980
1985
1990
% US corn used for ethanol
1995
2000
% world corn used for ethanol
2005
2010
% world cereals used for ethanol
Source: USDA, Credit Suisse research
Cane ethanol production more efficient than corn ethanol Other things being equal, corn cannot compete with cane on an economic basis as an ethanol feedstock. Brazilian cane yields up to 150 metric tons of harvestable biomass per hectare (MT/ha). By contrast, Midwest corn yields of harvestable biomass are 12 MT/ha. Cane growers harvest nearly the entire cane plant, resulting in a large quantity of leftover harvested biomass after the sugars have been fully extracted. This bagasse is combusted to produce electricity. Corn harvests just collect the grain-bearing ears and leave the stalks and leaves on the fields, depriving corn ethanol producers of a similar source of revenue, absent a new harvesting and collection system.
Cane ethanol is a much more efficient and economically viable proposition than corn-based ethanol
The lack of electricity generation capability places corn ethanol at a disadvantage to cane ethanol in terms of lifecycle emissions. Cane ethanol's dependence on biobased electricity results in a lifecycle GHG reduction of 50% relative to gasoline, while corn ethanol only achieves a reduction of 20% due to its reliance on either natural gas or coal for power. The bottom line is that Brazil uses a disproportionately smaller land area than the US does to produce ethanol. Specifically, we estimate that in 2011 the US used 73 million acres to produce 13.9 billion gallons of ethanol (an average 180 gallons an acre) compared to Brazil, which used 7 million acres to produce 5.6 million gallons of ethanol (800 gallons an acre). The main limit to greater ethanol production from Brazil is the profitability of ethanol production given government price fixing for fuel (more on this below).
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17 September 2012
Determinants of ethanol production There are three main, but interwoven, drivers of ethanol production: (1) legislation – a key driver of production particularly in the US; (2) the economics of production – essentially determined by the relative prices of the inputs (corn and sugar) compared to the price of gasoline; and (3) technological developments that impact the costs of production and are key to the eventual delivery of second generation ethanol (that target the economic production of ethanol from the cellulosic component instead of dextrose, for instance). We look at each of these in turn in the three sections below. Our main conclusion is that each of these drivers point towards a decline in first generation ethanol production as economics remain challenging, incremental demand growth is partially met by second-generation biofuels as technologies improve, regulatory support mechanisms waiver, and technical blending limitations confront the industry.
(1) Legislation Former US President, George W. Bush, renewed the Renewable Fuels Standard (RFS) in December 2007. Under this directive, US fuel companies are set minimum limits on the amount of conventional ethanol that is required to be blended into gasoline each year until 2022. The legislation also sets requirements on the production on advanced biofuels (fuels that meet more stringent greenhouse gas thresholds than conventional corn ethanol). The advanced category also includes a subcategory for second-generation (cellulosic) biofuels. Figure 13 below details the full amount of ethanol production mandated by the EPA under this Renewable Fuels Standard. First-generation ethanol production has actually run ahead of the mandatory levels for much of the last 3 years given favourable blend economics. We estimate that conventional ethanol production is running at an annualised rate of 13.55bn gallons so far this year compared to the 13.2bn gallon requirement for 2012 (excluding exports).
The main piece of legislation supporting the ethanol industry is the Renewable Fuels Standard
Advanced biofuel production has fallen short of the requirement, as few technologies exist in the US to produce advanced ethanol from conventional corn. Many US fuel companies therefore met their obligation by importing Brazilian cane ethanol, which meets the advanced ethanol requirements. Figure 13: Renewable Fuel Standards: mandated US ethanol production (bn gallons) Year
2008
First generation biofuel requirement 9.0
Total Advanced biofuel requirement n/a
Total renewable Actual first fuel requirement generation ethanol production 9.00 9.00
2009
10.5
0.60
11.10
10.60
2010
12.0
0.95
12.95
13.23
2011
12.6
1.35
13.95
13.90
2012
13.2
2.00
15.20
13.55*
2013
13.8
2.75
16.55
2014
14.4
3.75
18.15
2015
15.0
5.50
20.50
2016
15.0
7.25
22.25
2017
15.0
9.00
24.00
2018
15.0
11.00
26.00
2019
15.0
13.00
28.00
2020
15.0
15.00
30.00
2021
15.0
18.00
33.00
2022
15.0
21.00
36.00
YTD annualised numbers show that first generation US ethanol production is already ahead of the RFS target for 2012
Source: EPA; *2012 actual production based on annualised number for the first 32 weeks of the year
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17 September 2012
Data from the Renewable Fuels Association also shows that conventional ethanol capacity is already very close to the 15 billion gallon per annum target that the EPA has established as the requirement for 2015 to 2022. This suggests the scope for first-generation capacity growth in the industry is extremely limited. Figure 14: US Ethanol Production Capacity Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
81
95
110
139
170
189
204
209
3,644
4,336
5,493
7,888
10,569
11,877
13,508
14,907
Total Ethanol Plants Production Capacity(mgy) Plants Under Construction Capacity Under Construction/Expanding (mgy)
Jan-12
16
31
76
61
24
15
10
2
754
1778
5635.5
5536
2066
1432
522
140
18
20
21
21
26
26
29
29
States with Ethanol Plants
Source: RFA, Credit Suisse research; mgy = millions of gallons a year
The shortfall in the ethanol legislation is that it appears to set 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. Ethanol can be blended with gasoline up to a maximum level of 10% (this constitutes the so-called E10 fuel, or what is often called the “blendwall�). On our estimates, 10% of 2012 gasoline consumption comes very close to the EPA target of 13.2 billion gallons. Hence, on the YTD annualised numbers, US ethanol supply is already running ahead of US ethanol demand (although ethanol production has slowed quite quickly over the last couple of months as costs have escalated sharply in the face of the drought and the run in corn prices).
We estimate 2012 demand for ethanol is 13.2bn gallons
Looking ahead, US gasoline consumption is projected to decline over the next two decades as more efficient engines are adopted. The wave of cheap energy supply that is available in the form of shale gas is another complication for bio-fuel demand. This indicates that the ethanol market will decline as well so long as public opposition and lack of infrastructure to E15 prevents its widespread adoption (and that includes cellulosic ethanol as well as corn ethanol).
The forecast decline in US gasoline consumption implies a decline in demand for ethanol unless higher blends are adopted
Figure 15 illustrates the gap between potential ethanol demand (assuming E10 remains the main ethanol blend) and required ethanol supply. Even without any growth in second generation ethanol production, the market looks set to be in increasing oversupply over the next 10 years. Figure 15: US Ethanol production, legislated targets and implied E10 demand limits
40
US Ethanol production (1980 - 2011)
Billions of gallons p.a
35
First generation mandate according to the RFS Total bio-fuel mandate according to the RFS
30
Even without any growth in second generation ethanol production, the market looks set to be in increasing oversupply over the next 10 years
The E10 trajectory
25
Supply
20
2012 ethanol production on track to deliver 13.6bn gallons vs the 13.2bn RFS mandate
15 10 5
Demand
0 1980
1984
1988
1992
1996
2000
2004
2008
2012E 2016E 2020E
Source: RFS, EPA, Credit Suisse estimates
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17 September 2012
Hence, various solutions have been put forward to improve the supply/demand imbalance in US ethanol production to support the future of the industry. However, in each case, the obstacles around implementation are considerable, which ultimately suggests the problems around the supply/demand balance will persist. (a) E15 and beyond In October 2010, following a review of engine efficiency and performance using higher ethanol blends, the EPA granted a waiver to allow up to 15% (E15) blends to be sold for cars and trucks with a model year of 2007 or later. In January 2011 the waiver was expanded to authorise use of E15 to include model year 2001 through 2006 passenger vehicles. The EPA decided not to grant a waiver for E15 use in any motorcycles, heavyduty vehicles, or non-road engines (such as boats) because the testing data did not support such a waiver.
E15 has been authorised by the EPA
However, the waiver has been unpopular in various circles. In December 2010 several groups, including the Alliance of Automobile Manufacturers and the American Petroleum Institute, filed suit against the EPA. The suit has not been successful: the federal appeals court recently rejected the claim and ruled that the groups did not have legal standing to challenge the EPA's decision to issue the waiver for E15. However, above and beyond industry resistance and the public acceptance of E15, there is an acute practical barrier to its commercialisation due to a lack of infrastructure. Most fuel stations do not have enough pumps to offer E15 or to store it, and few existing pumps are certified to dispense it. Hence, the Obama Administration set the goal of installing 10,000 blender pumps nationwide by 2015. These pumps can dispense multiple blends including E85, E50, E30 and E20 that can be used by E85 vehicles. The USDA issued a rule in May 2011 to include flexible fuel pumps in the Rural Energy for America Program (REAP). This ruling provided financial assistance, via grants and loan guarantees, to fuel station owners to install E85 and blender pumps.
however, lack of infrastructure means it is hard for consumers to buy; blenders remain concerned about liabilities
Widespread adoption of E15 certainly adds to demand for ethanol but is still not sufficient to offset the projected supply. As we illustrate in Figure 16, supply of ethanol will be in excess of demand by mid-2015E assuming full adoption of E15 and that the total mandated level of ethanol is produced under the RFS. If E15 is eventually adopted, the uphill battle will quickly have to shift to E20 or E25. Figure 16: US ethanol demand and supply projections
35
Billions of gallons p.a.
30
First generation ethanol mandate Total bio-fuel mandate E10 demand E15 demand
25
Supply Demand
20 15 10 5 2012E
2014E
2016E
2018E
2020E
Source: RFS, EPA, Credit Suisse estimates
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17 September 2012
(b) Higher ethanol blends and more options for US consumers will likely alter the pricing dynamics of ethanol, resulting in lower ethanol prices, all else being equal There is a secondary, yet very important, implication of ultimately introducing higher (and varying) blends of ethanol. Blenders currently charge essentially the same amount for E10 that 100% gasoline would sell for, taking the difference between less-expensive ethanol and gasoline as a margin. But in theory consumers should require a 29% lower price for E85 ethanol than gasoline given the lower energy content (reducing fuel efficiency) in ethanol. Brazilian consumers already make these purchasing decisions and effectively purchase less ethanol if the price exceeds ~70% of gasoline. In the US, the consumer has had few opportunities to price discriminate based on the level of ethanol present in purchased fuel. If higher ethanol blends are introduced (E15, E20, E85 etc), and if consumers are given more choices by using mixing pumps, there will be increased attention about the impact of ethanol on fuel pricing. Ethanol’s discount to gasoline would need to increase to sustain demand. Figure 17: Energy Content of Ethanol BTUs per Gallon Gasoline
114,500
Energy Content Difference Relative to Gasoline 0%
Ethanol (E10)
110,660
(3)%
Ethanol (E15)
108,740
(5)%
Ethanol (E85)
81,800
(29)%
Ethanol (E100)
76,100
(34)%
Source: US Department of Energy, Credit Suisse research
(c) Oxygenate Requirements provide an absolute minimum level of demand, but are far lower than RFS mandates; suggesting little support in today’s environment Ethanol’s use as an oxygenate (increasing oxygen content in the fuel) provides a floor for ethanol demand in the United States. However, our analysis suggests that oxygenate requirements are unlikely to fill the void created by the absence of an E15 mandate. Also, in a worst-case scenario where the RFS mandate is waived or otherwise modified, oxygenate requirements do not support the current level of blending. The US Clean Air Act requires blenders to achieve at least 2% oxygen (by weight) in reformulated gasoline (RFG). Since regular gasoline does not have any oxygen content, RFG is required in cities with high pollution to reduce smog levels. RFG accounts for ~30% of total gasoline demand in the country and is used in 17 states and Washington DC.
Oxygenate requirements are not sufficient to backstop RFS-mandated volumes
Traditionally MTBE (methyl tert-butyl ether – C5H12O) was widely used as an oxygenate due to lower prices and oxygen content of 18.2% by volume. Its use however has declined in the past decade due to groundwater contamination and potential health risks (it is highly soluble in water and renders it non potable). Ethanol (C2H50H), which has higher oxygen content (34.7%), is now used to meet the oxygen requirements (see Figure 18). Note that methanol and gasoline-grade tertiary butyl alcohol (GTBA) are also used as oxygenates which have higher oxygen content but do not contribute towards RFS mandates. Assuming 100% of oxygenate demand in RFG is met by ethanol, a 2% oxygen blend (weight of gasoline) implies an ethanol blend of ~5.4% by RFG volume. However, recall that ~30% of gasoline is sold as RFG, implying a net ethanol blending requirement of 1.6% in the US. This 5.4% and 1.6% blend requirement is substantially lower than the ~10% requirement under RFS today.
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17 September 2012
Figure 18: US Oxygenate Blending Inputs 900 800
Thousand Barrels per Day
700 600 500 400 300 200 100 0 Jan-93 Jul-94 Jan-96 Jul-97 Jan-99 Jul-00 Jan-02 Jul-03 Jan-05 Jul-06 Jan-08 Jul-09 Jan-11 Other
MTBE
Ethanol
Source: IEA, Credit Suisse research
(d) Car capabilities may improve but competing technologies are also on the agenda In May 2011 the Open Fuel Standard Act (OFS) was introduced to Congress. The bill (currently in committee) would require that 50% of automobiles made in 2014, 80% in 2016 and 95% in 2017 be manufactured and warranted to operate on non-petroleumbased fuels, which include existing technologies such as flex-fuel, natural gas, hydrogen, biodiesel, plug-in electric and fuel cell. Given the limited complexity involved with producing flex-fuel vehicles, several auto makers have already been selling vehicles capable of running on higher blends of ethanol. Over the past 14 years, more than 10 million Flex Fuel Vehicles (capable of running on E85) have been produced in the US. Of the total vehicle fleet in the US, nearly 4% are flex fuel vehicles according to NREL.
Future car manufacturing is more likely to support greater blends of ethanol in gasoline
(e) Protectionist measures phased out at the end of 2011 Since the 1980s until the end of 2011, US ethanol producers were protected by a flat rate of 54 US cents per gallon import tariff, mainly intended to curb Brazilian imports of ethanol to the US. In addition, from 2004 until the end of 2011 blenders of transportation fuel received a tax credit of 45 US cents for each gallon of ethanol they mixed with gasoline (regardless of the feedstock). Additionally, potential producers of cellulosic ethanol could receive tax credits of US$1.01 per gallon (which expire at the end of 2012). These measures were designed to give the US ethanol industry breathing space to become sufficiently well established and cost effective. However, both the import tariff and blending tax credit expired at the end of 2011 after Congress chose not to extend either into 2012. Arguably, the tariff had been obsolete since 2009 due to the fall in the value of the dollar vs the Brazilian real and it was expected that RFS2 RINs (Renewable Identification Numbers) would make up the revenue difference caused by the expiration of the subsidy.
The import tariff and the tax credit for US ethanol expired at the end of 2011
(f) RFS compliance certificates, called Renewable Identification Numbers (RINS), protect margins to sustain production, assuming an oversupply situation does not exist Renewable Identification Numbers (RINs) are the compliance certificates for the Renewable Fuel Standard (RFS) mandate. Every gallon of biofuel that is produced generates a RIN. At the end of the year, obligated parties to the legislation must provide an appropriate number of RINs to meet their compliance levels. If, for instance, a company does not blend enough ethanol they can purchase RINs from another party who may have
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17 September 2012
excess RINs. This naturally creates a market for RINs with observable pricing. The value of the RIN, in a perfect market, should insulate producers from periods of high input costs or low fuel prices, effectively establishing a premium for the ethanol to protect margins. RINs are an important, and in our view sensible, way to encourage production of advanced biofuels which may have high initial production costs or need to mitigate feedstock pricing risks. The RIN credits are designed to insulate biofuel producers from just the sort of situation that corn ethanol producers are currently experiencing, but since the market has too much ethanol production capacity, and because excess blending occurred in prior years, RINs will not fully protect producers’ margins. Producers have been willing to slash prices to negative levels since capacity investments are sunk costs (caring mainly about marginal economics). Additionally, obligated parties can use 20% of excess RINs from prior years (which they saved from over-blending ethanol since the economics were favourable) to meet the current year’s production. This has meant that RIN values have remained well below the level required to compensate ethanol producers for current losses. Figure 19: E12 RIN prices (Renewable Identification Numbers produced in 2012)
10 9 8
US$ cents
7
2012 RINs have rallied as US ethanol production has been curtailed
6 5 4
RINs have failed to compensate producers for the shift in corn vs gasoline prices as ethanol production has run ahead of the mandated target this year, the industry has excess capacity, and surplus RINs from 2011 can offset this year’s obligation
3 2 1 0 3-Aug-11
3-Oct-11
3-Dec-11
3-Feb-12
3-Apr-12
3-Jun-12
3-Aug-12
Source: Company data, Credit Suisse research
(g) The mandate itself can be waived—a recent bid to waive the ethanol mandate to cut corn prices has already been voiced In the face of the drought and sharp increase in corn prices, livestock producers and senators have petitioned the EPA to waive at least part of the ethanol mandate. Specifically, 25 US Senators (both Republicans and Democrats) asked Lisa Jackson, administrator of the EPA, to halt or lower mandates on how much ethanol the country must use this year and next. The senators’ August 7 letter followed an August 1 petition from a bipartisan coalition of 156 members of the House of Representatives. The EPA has announced a 30-day comment period on the issue, and is expected to issue a decision by November 13.
November 13 is the deadline for the EPA decision on whether to waive the ethanol mandate
Our view is that there will be no waiver (partial or otherwise) for four key reasons: (i) The mandate was not cut in 2008 despite pressure from crop pricing. Essentially, the EPA must show undue economic hardship for the economy. Pressure for meat and dairy producers has not been shown to constitute economic pressure. (ii) Farmers are one of the most powerful lobbying groups in the US and are in favour of keeping the RFS in place. Anything that would even temporarily reduce the price of corn would directly hurt farmers. Additionally, during an election year when each party is trying to win key battleground states, changes that hurt farmers’ livelihoods look unlikely.
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17 September 2012
(iii) Concessions have already been made. The US Government has already cut the (45c/gallon) tax subsidy and import tariff (54c /gallon) for ethanol blenders and importers (end 2011) – further pain for the industry would hurt investment in second generation bioethanol which is seen as the solution to the “fuel vs. food” problem (currently not cost competitive due to expensive enzymes). (iv) A waiver for 2012 would not reduce consumption. All else being equal, blenders today are over-blending relative to the mandated volume. Additionally, blenders have excess compliance certificates from 2011 that can meet any requirements for 2012. Thus, the mandate itself is not the primary driver for current production and demand levels, as blenders could cut back significantly and still be in compliance with RFS.
(2) Economics of production Profitability in ethanol production is largely determined by the prices of gasoline (ASP benchmark) relative to corn and sugar (input costs). In the US, corn prices have significantly outperformed ethanol and gasoline prices. This has substantially undermined the profitability of the ethanol producers. As illustrated in Figure 21, the gap between US corn prices and US ethanol prices is at a multi-year high. The crush spread remains at its lowest levels for more than three years and futures indicate the economics are likely to deteriorate even further (Figure 22). Figure 20: US ethanol vs US gasoline prices
Figure 21: US ethanol vs corn prices
4.5
4.5
900
4.0
4.0
800
3.5
3.5
700
3.0
3.0
600
2.5
2.5
500
2.0
2.0
Discount is an incentive to blend
1.5
1.5
1.0
1.0
0.5 Jun-06
0.5 Jun-06
Apr-07
Feb-08
Dec-08
US Ethanol price
Oct-09
Aug-10
Jun-11
US Gasoline price
Source: Thomson Reuters, Credit Suisse research
Apr-12
400 Profit erosion
300 200 100
Apr-07
Feb-08
Dec-08
Oct-09
US Ethanol price (US$/gallon, lhs)
Aug-10
Jun-11
Apr-12
Corn price (US$/bushel, rhs)
Source: Thomson Reuters, Credit Suisse research
Figure 22: US Ethanol Crush Spread in $/gallon, unless otherwise stated. Crush Spread defined as Ethanol less corn (at 2.8 gallons/bushel) plus price of Distillers Grains (DDGs) $1.60
Crush Spread ($/gallon)
$1.40 $1.20
Forwards suggest even lower production economics
$1.00 $0.80 $0.60
Gross crush spread <~$0.60 results in operating loss for ethanol producers; anything less than $0.90 does not jusitify capacity investment
$0.40 $0.20
Jan 09 Feb 09 Mar 09 Apr 09 May 09 Jun 09 Jul 09 Aug 09 Sep 09 Oct 09 Nov 09 Dec 09 Jan 10 Feb 10 Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10 Oct 10 Nov 10 Dec 10 Jan 11 Feb 11 Mar 11 Apr 11 May 11 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11 Nov 11 Dec 11 Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12 Nov 12 Dec 12 Jan 13 Feb 13 Mar 13 Apr 13 May 13 Jun 13 Jul 13 Aug 13 Sep 13 Oct 13 Nov 13 Dec 13
$-
Forwards
Crush Spread ($/gallon): Ethanol - Corn + DDGs
Source: Company data, Credit Suisse estimates
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17 September 2012
Moreover, US ethanol prices have failed to keep pace with US gasoline prices over the past year (Figure 24) due to excess ethanol production. Indeed, data from the RFA shows that ethanol production was running well ahead of 10% of gasoline demand for much of the last 12 months and that it is also ahead of the RFS mandate (13.2bn gallons) for 2012. Figure 23: Ethanol production as % gasoline demand
Figure 24: Ethanol relative to gasoline: relative prices and production 1.3
12.0% US ethanol production running well of E10 demand
11.5%
13.0%
US ethanol production as % gasoline demand
1.2
11.0% 10.5%
12.0%
1.1
11.0%
1.0
10.0%
0.9
9.0%
0.8
8.0% Ethanol relative to gasoline 7.0% prices 6.0% May-12 Sep-12 Jan-13
10.0% 9.5%
Capacity cut back brings latest production numbers down to 9% of gasoline demand
9.0%
0.7
8.5% 8.0% 2010/06/04
2010/10/04
2011/02/04 2011/06/04
2011/10/04
2012/02/04
Source: Thomson Reuters, Credit Suisse research
2012/06/04
0.6 Jan-10
May-10
Sep-10
Jan-11
May-11
Sep-11
Jan-12
Source: Thomson Reuters, Credit Suisse research
More recently, however, US ethanol prices have moved up (closing some of the gap with gasoline prices) as domestic ethanol production has slowed. Roughly two dozen of the nationâ&#x20AC;&#x2122;s 200 ethanol plants have gone idle this summer. Ethanol production has now slowed to 9% of average daily gasoline demand. Gasoline futures continue to hover at around $3.00. As long as ethanol is lower than gasoline, it makes economic sense to blend to at least 10%. Ethanol stocks to annual usage are currently running at 5.9% (ethanol stocks stand at 777 million gallons according to the RFA). If supply of ethanol remains at 9% and demand remains at 10% of total daily gasoline consumption, it will take a total of 214 days for stocks to be run down to zero. At this run rate for the remainder of the year, we also calculate that total ethanol production for 2012 will come to almost exactly the 13.2bn gallons that is mandated under the RFS. In Brazil, ethanol production also remains a loss-making operation for mills due to the government policy of holding gasoline prices artificially low in the domestic market. The sell-off in the real against the US dollar in recent months and the run-up in oil prices has meant that Petrobras has been selling imported gasoline and diesel at less than cost. (Petrobras posted its first net loss since 1999 in the second quarter of this year.) The prevalence of flex-fuel vehicles effectively means that ethanol and gasoline compete for the same market share, hence Brazilian ethanol prices have been held back while production costs have surged in recent years. Not surprisingly, therefore, mills in Brazil have favoured sugar production as much as capacity will permit this year, given the better profitability in refined sugar than in ethanol production. Cane processing for sweetener this season has come in at 48.7% compared to 47.1% last season.
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17 September 2012
Figure 25: Brazilian ethanol vs sugar prices
4.0
35
3.5
30
3.0
25
2.5 20
2.0
15
1.5
10
1.0 0.5 Jun-06
5 Apr-07
Feb-08
Dec-08
Oct-09
Brazilian Ethanol price (US$/gallon, lhs)
Aug-10
Jun-11
Apr-12
Sugar price (USc/lb, rhs)
Source: Thomson Reuters, Credit Suisse research
However, demand for fuel in Brazil looks set to be strong. And with gasoline production close to its limit of around 420,000 b/d and no major refining capacity coming on line in 2013, the solution will likely be either gasoline/ethanol imports or incentives to raise ethanol production. This probably means the Brazilian government will ultimately have to raise domestic gasoline prices soon in order to bring them into line with international prices. Figure 27: Brazilian gasoline priced at discount 150%
3.50
125%
3.00
100%
2.50
75%
2.00
50%
1.50
25%
1.00
0%
0.50
-25%
0.00
-50%
US Gasoline
Brazil Gasoline
Source: CEPEA, FactSet, Credit Suisse research
Nov-02 May-03 Nov-03 May-04 Nov-04 May-05 Nov-05 May-06 Nov-06 May-07 Nov-07 May-08 Nov-08 May-09 Nov-09 May-10 Nov-10 May-11 Nov-11 May-12
4.00
Nov-02 May-03 Nov-03 May-04 Nov-04 May-05 Nov-05 May-06 Nov-06 May-07 Nov-07 May-08 Nov-08 May-09 Nov-09 May-10 Nov-10 May-11 Nov-11 May-12
$/gal
Figure 26: Gasoline price comparison
Brazil gasoline premium (discount) to US gasoline
Source: CEPEA, FactSet, Credit Suisse research
In the past, the Brazilian government has allowed Petrobras to increase prices without impacting the price paid by consumers at the pump by decreasing a special tax called CIDE. Today CIDE has already been set to zero, but there are other taxes the government can use (PIS/Pasep/COFINS) as a margin of manoeuvre in order to mitigate the inflationary impact of fuel price increases. Holding consumer prices in check in this way has equally kept prices for anhydrous ethanol at artificially lower prices. However, given burgeoning fiscal and current account pressures in Brazil, this appears to be unsustainable in anything other than the very short term.
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17 September 2012
Figure 28: Brazil â&#x20AC;&#x201C; ethanol and gasoline prices
Figure 29: Ethanol is priced at a discount to gasoline 150%
3.00
125%
2.50
100%
R$/lt
2.00
75% 50%
1.50
25%
1.00
0% -25%
0.50
11/29/2004
11/29/2006
Anhydrous Ethanol R$/lt
11/29/2008
Nov-02 May-03 Nov-03 May-04 Nov-04 May-05 Nov-05 May-06 Nov-06 May-07 Nov-07 May-08 Nov-08 May-09 Nov-09 May-10 Nov-10 May-11 Nov-11 May-12
-50%
0.00 11/29/2002
11/29/2010
Brazil ethanol premium (or discount) to gasoline
Brazil Gasoline R$/Lt
Source: CEPEA, Credit Suisse research
Source: CEPEA, Credit Suisse research
Hence, the premium of US ethanol prices compared to Brazilian ethanol prices looks set to close, which should improve the relative demand outlook for US ethanol producers. Figure 30: US ethanol net imports vs US relative to Brazilian* ethanol prices
150
1.5
100
1.3
Millions of gallons
50
1.1
0 0.9
-50
0.7
-100
0.5
-150 -200 Jan-06
US exports ethanol to Brazil 0.3 Jan-07 Jan-08 Jan-09 US ethanol net imports (lhs)
Jan-10 Jan-11 Jan-12 US relative to Brazilian prices (rhs)
Source: EIA, Thomson Reuters, Credit Suisse research * Historical Brazilian ethanol prices inflated by the 54 USc import tariff up until the end of 2011 when the tariff was not renewed.
However, the growth in demand for fuel in Brazil is not enough (on our forecasts) to offset the declining demand for fuel in the US. In Figure 31 below, we plot the aggregate volume of gasoline and ethanol fuel consumption for Brazil and the US over the last 20 years plus the projections for the next 10 years. Even assuming 4% CAGR in Brazilian fuel demand over the next 10 years, the aggregate fuel consumption for these two markets is set to decline by a CAGR of 1.5%.
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Figure 31: US and Brazilian total ethanol and gasoline fuel consumption (000 barrels per day)
Thousands of barrels a day
12000 10000 8000 Even if Brazilian consumption grows at 4% CAGR, this will not be enough to offset the -2.2% CAGR in US consumption
6000 4000 2000 0 1991
1995
1999
2003
2007
US
Brazil
2011
2015E
2019E
Source: EIA, Credit Suisse estimates
(3) Technology See the report entitled â&#x20AC;&#x153;Advanced Biofuel Enzymesâ&#x20AC;?, 17 September, for more details. Second generation (2G) bioethanol is ethanol produced from cellulosic biomass such as wood, stems, leaves and husks. The advantage is that feedstocks for 2G fuel production will not compete directly with food sources (such as corn) and are likely either to use byproducts of food production or rely on harvesting feedstocks from non-arable land. Additionally, cellulosic biofuels can reduce greenhouse gas emissions by around 90% when compared with fossil petroleum; in contrast, first generation biofuels offer savings of only 20-70% (IES â&#x20AC;&#x201C; Institute for Environment and Sustainability). Converting wood and agricultural waste into fuels requires additional technology development and cost reductions to be economic: The disadvantage is that turning cellulose into sugar is a lot harder than converting simple starches, and the costs are substantially higher. Enzyme producers stand to benefit from 2G commercialisation due to higher enzyme content per gallon: The enzyme volume requirement is substantially higher (currently c10x), which makes production costs higher. We calculate enzyme costs move from c3-4 cents per gallon in 1G to 40-50 cents per gallon in 2G. In time we expect these costs to come down to c30 cents per gallon as technology improves. The US mandate, technical advances in enzyme technologies and constraints on 1G production have spurred considerable investment in 2G pilot plants and initial commercial facilities. Many of the leaders in 1G bioethanol (POET, Valero, Abengoa) have been among the first to invest in 2G initiatives, in addition to new entrants. The first commercial plants are due to open in Europe in Italy during 2012. Pilot plants are also underway in a number of different locations including Canada, Denmark, Sweden and Korea (see Figure 32).
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Figure 32: Commercial plants under construction (selected) Company
Location
Timing
Iowa, US
H2 2013
Capacity (m gallons pa)
Feedstock
Enzyme supply
20-25 Corn cobs, stover (leaves and stalks)
POET are customer of Novozymes but DSM hope to supply future needs Danisco
US projects POET/DSM (Project Liberty)
DuPont/Danisco
Iowa, US
2014
Kansas, US
2013
Michigan, US
End 2013
23 Switchgrass, corn stover, wheat straw 20 Woody biomass
Crescentino, Italy
End 2012
13
Maabjerg, Denmark
2016
13-19
GraalBio
Alagaos, Brazil
End 2013
COFCO/Sinopec
Hei Long,China
2013
Abengoa Valero (Kinross) w/ Technology Partner
27.5
Corn stover
Own technology Proprietary CBP tech from partner allows lower enzyme costs
Europe Beta Renewables (Mossi & Ghisolfi JV) Maabjerg Energy Concept (Dong) Other
Arundo donax (giant cane) / Others Wheat straw
Novozymes Novozymes
22 Sugarcane bagasse and Novozymes (DSM provide straw yeast) 15 Corn stover Novozymes
Source: Company reports, NB Pilot plants not included
It is noticeable that there have been a number of companies pulling out of projects. These include Iogen (with Royal Dutch Shell) which decided a full commercial plant in Canada was not viable at the current time and companies such as Range Fuels that face bankruptcy (according to Bloomberg). Even those projects that are going ahead seem to be delayed including M&Gâ&#x20AC;&#x2122;s Italian plant which was pushed out from H1 12 to the end of 2012. Key reasons for this pull-back in production are: 2G projects are coming on slower than originally anticipated, largely due to high capital costs: Investors are less willing to commit capital to these technologies until cost structures decline further and profitability potential improves.
Market potential may be substantially smaller
Enzyme development work needs to continue to reduce costs: Enzymes need to be present in greater volumes to produce 2G ethanol (up to 10x more enzymes than what is used for 1G production). As a result, enzyme costs per gallon are higher (4050 cents for 2G vs 3-4 cents for 1G). However, this cost is one of the limiting factors, and a lot of work is being done to bring it down. Solutions include more effective pretreatment and integrated enzyme production (fermenting the enzymes in house as part of the process). 30 cents per gallon is possible in the near future (according to Novozymes) but we see values and volumes going down further in time. Potential cannibalisation of 1G ethanol limits overall enzyme market growth: Current mandates look for small growth (or at least maintenance) of 1G ethanol volumes. However, we see increasing political pressures globally to reduce the use of food in ethanol production, and as such believe future growth in 2G could be at the expense of 1G. While there are obvious positive mix effects for the enzyme producers, it does mean growth of the market is not incremental. Alternative transportation options, such as natural-gas fuelled vehicles and electric vehicles, may encourage policy makers to deviate from the commitment to 2G biofuels. Additionally, the sharp increase in natural gas supply (and the low price of natural gas) in the US from shale resources is resulting in increased interest in natural-gas based transportation. US policy makers are taking note and have proposed legislation that supports natural-gas based vehicles. Policymakers could ultimately see natural gas as a partial substitute for more expensive 2G fuels. Natural
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gas is abundant in the US, has a slightly lower carbon footprint than gasoline, is sourced domestically (benefits national security), and does not compete with food resources. Additionally, in the long-term electric vehicles (powered by batteries) are likely to gain momentum as new vehicle models are introduced. Credit Suisse estimates a ~5% penetration of electric vehicles by 2020 is possible, with a further c10% of hybrid vehicles.
Sector and stock implications Our central case is that poor prevailing growing conditions will mean that corn prices remain high for the rest of 2012. However, as weather conditions ease over year end, and in the face of considerable supply side response from farmers next year, we expect softcommodity prices will pull back from their highs and moderate over 2013. Specifically, we forecast global demand growth for agriculture products of c. 2.0% in 2013 vs total supply growth of 2.5% (1.0% driven by growth in acreage and 1.5% driven by yield growth). We forecast no incremental demand growth for agriculture from ethanol producers in 2013. See Agriculture: adverse weather takes its toll, 23 July 2012, for more details on these forecasts. Figure 33: Credit Suisse soft commodity price forecasts 2011
1Q-12
2Q-12
3Q-12f
4Q-12f
2012f
1Q-13f
2Q-13f
3Q-13f
4Q-13f
2013f
New
US¢/bu
680
641
618
700
700
660
650
625
550
550
590
Old
US¢/bu
680
641
650
575
550
600
550
550
550
550
550
Soybean
New
US¢/bu
1,320
1,273
1,425
1,550
1,500
1,440
1,450
1,400
1,280
1,220
1,340
Old
US¢/bu
1,320
1,273
1,400
1,350
1,300
1,331
1,260
1,280
1,280
1,220
1,260
Wheat
New
US¢/bu
710
643
641
800
750
710
750
725
700
700
720
Old
US¢/bu
710
643
650
575
600
617
630
660
680
650
660
Corn
Source: Credit Suisse estimates
In the summary below, we assess the implications and outlook for three closely related industries: ethanol producers, meat and dairy producers and the chemicals sector. (1) Ethanol producers There has been marked divergence in the performance of large US and Brazilian ethanol producers this year. The US producers have suffered a sharp rise in input costs (as the drought has taken its toll on the corn crop), the real has fallen against the dollar (undermining US ethanol exports to Brazil) and over-capacity and production above the mandated RFS level have taken their toll on margins. Brazilian ethanol producers meanwhile have benefited from the relative currency move, cheaper relative sugar prices and strong demand for ethanol (albeit the effective price cap via Petrobras gasoline prices is a negative). We expect the acute profit squeeze in the US corn producers to improve substantially over the next year if, as we forecast, corn prices fall to an average US$5.90 a bushel. We also expect that in the short term, US and Brazilian ethanol prices will rise relative to US gasoline prices as the poor economics limit supply relative to demand in the US and eradicating losses for Petrobras will dictate higher gasoline prices in Brazil. However, corn ethanol producers look set to continue to face significant headwinds over the medium to long-term. Specific concerns are the structural decline in gasoline demand, the loss of momentum in public and political support for the industry, low barriers to entry and over capacity. Price to asset ratios for the sector look cheap but cash-flow and balance sheet fundamentals, according to Credit Suisse HOLT®, look weak. We remain relatively cautious on GPRE (rated Neutral). The Brazilian ethanol sector has somewhat healthier prospects than the US sector. The cost advantage in the production of sugar-cane ethanol compared to corn-based ethanol is the fundamental driver of this relative position. The prevalence of flex-fuel vehicles in
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Brazil and growing demand for gasoline is another advantage. Moreover, stock fundamentals and valuations look more attractive. We rate Sao Martinho and Bunge Outperform. Figure 34: Brazilian and US Ethanol plays
ADM
USA
17.51
11.16
5.3
DY HOLT Warranted Net Book Rating Upside Debt / Downside (%) EBITDA 2.64 32 1.6 O
CSAN3
BRA
6.65
21.26
6.6
1.41
-17
1.5
R
BG
USA
9.26
9.20
6.9
1.58
39
1.9
O
SMTO3
BRA
1.29
17.11
7.7
1.14
-25
2.1
O
REX
USA
0.15
6.65
1.7
0.00
94
1.3
NR
ARCHER-DANIELS-MIDLAND COSAN SA BUNGE SAO MARTINHO SA REX AMERICAN RESOURCES GREEN PLAINS RENEWABLE ENRGY
Ticker
Mkt
Mkt Cap P/E Ratio CFROI 5 (US$bn) FY1 Yr Median
GPRE
USA
0.14
NA
5.8
0.00
-136
3.0
N
PACIFIC ETHANOL INC
PEIX
USA
0.03
NA
4.9
0.00
29
5.1
NR
BIOFUEL ENERGY CORP
BIOF
USA
0.02
NA
-2.6
0.00
-115
5.9
NR
Source: Credit Suisse HOLT, Credit Suisse estimates
(2) Livestock sector Meat and dairy producers have strongly underperformed in recent months as feed costs have escalated. However, we see four reasons to be more optimistic on the sector from here: (a) Valuations – close to historical lows on forward multiples; (b) Earnings revisions – equally close to historical lows; (c) The spread between meat and crop prices – close to 40 year lows; (d) Improved discipline in the industry. Taking each of these in turn, we note: Valuations – 12 month forward multiples for Tyson and Smithfield are trading in line with previous troughs recorded in the last 15 years. China Yurun has equally de-rated to single-digit multiples, Charoen Pokphand Foods’ greater exposure to fishing rather than meat has afforded the stock some degree of differentiation relative to the rest of the sector. Figure 35: 12 mth fwd consensus PEs: China Yurun and
Figure 36: 12 mth fwd consensus PEs: Tyson and
Charoen Pokphand Foods
Smithfield
30
30
25
25
20
20
15
15
10
10
5
5
0 Jan-95
Jan-98
Jan-01
China Yurun Food Group
Jan-04
Jan-07
Jan-10
Charoen Pokphand Foods
Source: Thomson Reuters, Credit Suisse research
0 Jan-95
Jan-98
Jan-01
Tyson Foods
Jan-04
Jan-07
Jan-10
Smithfield Foods
Source: Thomson Reuters, Credit Suisse research
Earnings revisions have also been particularly negative for the sector. 12 month forward revisions are now close to the lows recorded in early 2009 in the wake of the global financial crisis.
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17 September 2012
Figure 37: Global meat and dairy sector: 12 month forward earnings revisions
6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% Earnings revisions, 3 MMA -8.0% Jan-93
Jan-95
Jan-97
Jan-99
Jan-01
Jan-03
Jan-05
Jan-07
Jan-09
Jan-11
Source: Thomson Reuters, Credit Suisse research
The risk to earnings revisions remains skewed to the downside. We estimate that every $1/bushel of corn translates into $0.50/share of EPS for Tyson and Smithfield, so a $2 move in corn theoretically erases all of their earnings power unless they can pass on the cost through higher pricing. Hence, these companies have proved to be value traps during prior cycles of grain inflation. TSN looks particularly vulnerable in the near term because it did not hedge corn as aggressively as SFD for the coming year. Nevertheless, it is interesting that significant downward revisions are already reflected in the base. The spread between meat and corn prices is now close to 40-year lows. From these levels, the probability is that meat prices will improve relative to input costs and this should support some improvement in earnings revisions for the sector. Figure 38: Beef and pork prices relative to corn
160.0 140.0 120.0 100.0 80.0 60.0 40.0 20.0 0.0 Sep/75
Nov/79
Jan/84
Mar/88
May/92
Pork relative to corn prices
Jul/96
Sep/00
Nov/04
Jan/09
Beef relative to corn prices
Source: Thomson Reuters, Credit Suisse research
Finally, we note that the livestock industry has learned some valuable lessons since the last cycle in 2008 put one of the leaders in the chicken industry into bankruptcy and threatened to sink many more: 1) the chicken companies have introduced more cost-plus contracts to their customers to pass on the higher grain costs faster; 2) they have learned to institute faster cutbacks in their herds and flocks to rebalance supply and demand and boost prices; 3) they have radically de-leveraged their balance sheets; 4) in the case of
Equity Themes
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SFD, they sold non-core assets and reduced their dependency on corn; and 5) the banks have instituted tighter parameters for lending to discourage capacity expansion and encourage better financial ratios. As a result, we think these companies are going to be interesting value propositions when the crop cycle turns. We rate Tyson as Neutral but see Smithfield as better value on a 12-month view and so rate it Outperform. Figure 39: Global meat and dairy stocks
MAEIL DAIRY INDUSTRY
Ticker
Mkt
005990
Mkt Cap P/E Ratio CFROI 5 (US$bn) FY1 Yr Median
DY
KOR
0.27
11.49
3.5
0.51
CHAROEN POKPHAND FOODS PUBLIC COMPANY LIMITED NIPPON MEAT PACKERS, INC
CPF
THA
7.79
11.10
6.7
4.13
2282
JPN
2.88
15.92
2.1
ITOHAM FOODS INC
2284
JPN
1.01
18.39
-0.1
CHINA MENGNIU DAIRY
2319
HKG
5.43
19.54
CHINA YURUN FOOD
1068
HKG
1.11
SAPUTO INC
SAP.
CAN
TYSON FOODS INC
TSN
USA
RAINBOW CHICKEN
RBW
HOLT Warranted Net Book Rating Upside Debt / Downside (%) EBITDA -7 3.4 NR 35
2.2
O
1.59
-6
1.2
NR
0.87
-11
0.4
NR
9.8
1.02
-40
-2.3
O
10.13
14.0
3.17
31
0.3
NR
8.40
15.72
21.5
1.81
4
0.5
NR
5.60
9.90
4.5
1.03
47
0.8
N
ZAF
0.50
11.56
7.1
4.92
35
-0.8
NR
ASTRAL FOODS
ARL
ZAF
0.49
9.89
9.3
7.43
25
0.0
NR
SMITHFIELD FOODS INC
SFD
USA
3.01
9.28
4.0
0.00
48
1.6
O
DF
USA
2.97
12.55
11.8
0.00
-59
5.0
R
MFI.
CAN
1.55
10.04
6.7
1.45
-37
2.6
NR
PPFH
SGP
0.55
NA
3.9
0.00
45
-4.7
NR
AAC
AUS
0.42
28.90
-2.9
NA
-59
6.0
NR
DEAN FOODS CO MAPLE LEAF FOODS INC PEOPLE'S FOOD HOLDINGS LTD AUSTRALIAN AGRICULTURAL CO
Source: Credit Suisse HOLT, Credit Suisse estimates
(3) Chemicals Second generation (2G) or cellulosic bioethanol holds great potential to reduce the worldâ&#x20AC;&#x2122;s dependence on fossil fuels, protect the environment by lowering greenhouse gas emissions, and improve national security by shifting to domestically produced non-food fuel sources. The US Renewable Fuel Standard (RFS) mandates 16bn gallons of cellolusic biofuel by 2022, and in the EU, cellulosic ethanol is targeted to represent 10% of fuel by 2020. Danisco sees a total market size of 105bn litres by 2020. While there are numerous ways to produce cellulosic biofuels, the majority of companies are utilising an enzymatic approach. Enzymes are an important cost for the production of 2G bioethanol (c40-50 cents out of a targeted total production cost of $2/gallon), and an important part of the production process. The potential for the 2G enzyme fuel market is considerable: in principal up to $13.5bn by 2020 (27bn gallons by 50 cents), compared to a current 1G enzyme market of c$0.5bn. Additionally, bio-based chemicals that rely on sugar as the foundation, could leverage cellulase enzymes as a means to secure sugar from cellulosic materials instead of traditional corn, sugarcane, and beet sources.
Enzyme market for 2G could be up to $13.5bn by 2020
Enzymatic-based technologies are one of several methods to produce cellulosic fuels; their adoption will not benefit enzyme producers: Enzymatic-based approaches, which rely on microorganisms and enzymes to convert cellulosic matter into fermentable sugars is one possible technology. In our view, other technologies will also be successful. Several companies are developing thermochemical and catalytic routes that do not use enzymes to produce cellulosic biofuels. These technologies would not provide growth opportunities for 2G enzyme producers. For example, KiOR (KIOR, Outperform) is converting wood to diesel/gasoline blendstocks through a proprietary catalytic process. Other companies are gasifying biomass, including municipal solid waste, and then using catalysts to form ethanol.
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Leading enzyme producers threatened by new entrants: The first batch of commercial-size 2G plants currently being built are likely to be primarily supplied by dominant enzyme players Novozymes (rated Underperform) and Danisco (not rated). However some companies that are investing heavily in 2G technology are all looking to produce enzymes in house or to supply to new biofuel plants. In addition a number of new entrants are looking at more innovative enzymes. As a result, we see dominant players as increasingly under threat. For more details on 2G implications for the enzyme producers see report entitled Advanced Biofuel Enzymes, 17 September, 2012. Companies Mentioned (Price as of 12 Sep 12) Archer Daniels Midland, Inc. (ADM, $27.19, OUTPERFORM, TP $33.00) Bunge Ltd. (BG, $65.90, OUTPERFORM, TP $78.00) Charoen Pokphand Foods Public (CPF.BK, Bt33.00, OUTPERFORM, TP Bt46.50) China Mengniu Dairy (2319.HK, HK$23.55, OUTPERFORM, TP HK$27.00) Cosan (CSAN3, R$35.15, RESTRICTED) Dean Foods Company (DF, $16.07, RESTRICTED [V]) E.I. du Pont de Nemours and Company (DD, $50.23, RESTRICTED) Green Plains Renewable Energy (GPRE, $5.40, NEUTRAL, TP $6.00) KiOR (KIOR, $7.42, OUTPERFORM [V], TP $25.00) Koninklijke DSM NV (DSMN.AS, Eu39.40, UNDERPERFORM, TP Eu39.00) Novozymes (NZYMb.CO, DKr165.50, NEUTRAL, TP DKr155.00) Petrobras (PBR, $22.47, NEUTRAL, TP $25.00) Range Resources (RRC, $70.75, OUTPERFORM, TP $72.00) Royal Dutch Shell plc (RDSa.L, 2228 p, NEUTRAL, TP 2,475.00 p) Sao Martinho (SMTO3, R$23.85, OUTPERFORM, TP R$32.00) Sinopec Shanghai Petrochem - H (0338.HK, HK$2.03) SLC Agricola (SLCE3, R$21.75, OUTPERFORM, TP R$24.00) Smithfield Foods, Inc. (SFD, $20.62, OUTPERFORM, TP $25.00) Tyson Foods (TSN, $16.22, NEUTRAL, TP $18.00) Valero Energy Corp. (VLO, $32.78, RESTRICTED)
Companies mentioned but not covered Agrium, Cf Industries Hdg., Coromandel International, Hubei Yihua Chm.Ind.'A', Intrepid Potash, Israel Corporation, K + S, Liaoning Hjtg.Chems.'A', Mosaic, Potash Corporation Of Saskatchewan, Scotts Miracle-Gro, Shandong Hualu, Hengsheng Chm. 'A', Sqm 'B', Tata Chemicals, Terra Nitrogen Uts., The Arab Potash, Uralkali, Golden Agri-Resources, Abengoa, Astral Foods Ltd, Australian Agricultural Company Ltd, Brasilagro, China Yurun, Danisco, Itoham Foods, Nippon Meat Packers, Pacific Ethanol, People’s Food Holdings Ltd, Rainbow Chicken Ltd, Saputo, Sinopec Shanghai Petrochem – H
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factors. For Latin American, Japanese, and non-Japan Asia stocks, ratings are based on a stock’s total return relative to the average total return of the relevant country or regional benchmark; for European stocks, ratings are based on a stock’s total return relative to the analyst's coverage universe**. For Australian and New Zealand stocks, 12-month rolling yield is incorporated in the absolute total return calculation and a 15% and a 7.5% threshold replace the 10-15% level in the Outperform and Underperform stock rating definitions, respectively. The 15% and 7.5% thresholds replace the +10-15% and -10-15% levels in the Neutral stock rating definition, respectively. **An analyst's coverage universe consists of all companies covered by the analyst within the relevant sector. Restricted (R): In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances. Volatility Indicator [V]: A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward. Analysts’ coverage universe weightings are distinct from analysts’ stock ratings and are based on the expected performance of an analyst’s coverage universe* versus the relevant broad market benchmark**: Overweight: Industry expected to outperform the relevant broad market benchmark over the next 12 months. Market Weight: Industry expected to perform in-line with the relevant broad market benchmark over the next 12 months. Underweight: Industry expected to underperform the relevant broad market benchmark over the next 12 months. *An analyst’s coverage universe consists of all companies covered by the analyst within the relevant sector. **The broad market benchmark is based on the expected return of the local market index (e.g., the S&P 500 in the U.S.) over the next 12 months. Credit Suisse’s distribution of stock ratings (and banking clients) is: Global Ratings Distribution Outperform/Buy* 45% (52% banking clients) Neutral/Hold* 42% (49% banking clients) Underperform/Sell* 11% (40% banking clients) Restricted 2%
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17 September 2012 Europe Equity Research
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