Pacific Ethanol's Bets Pay Off

While other ethanol producers got clobbered by high corn prices, analysts say the No. 4 player got it right by hedging

by Moira Herbst

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High corn prices are wreaking havoc for ethanol producers. Archer Daniels Midland (ADM), the biggest U.S. ethanol maker, blamed the pricey grain for nicking its quarterly profits, which came in May 1 below Wall Street forecasts. A week later, VeraSun Energy (VSE) swung to a loss and also blamed corn, currently the lifeblood of the U.S. ethanol supply (see BusinessWeek.com, 5/8/07, "Costly Corn Kills VeraSun's Ethanol Profits").

However, it has been a different story for the industry's No. 4 player, Pacific Ethanol (PEIX). The Sacramento (Calif.) company turned profitable in its most recent quarter, reversing a $612,000 loss a year ago. How? It placed its bets right in the corn market, a commodity casino where wise hedging now represents the difference between red and black ink.

"The market is driven by how much you pay for corn and how much you get for ethanol, and both trends have been going in the wrong direction since the second quarter of last year," says John Roy, senior research analyst with W.R. Hambrecht. "But Pacific went in early and cut deals to get corn at a good price. They figured the right hedging strategy."

Higher Freight Costs an Issue

Pacific Ethanol bought 12 million bushels of corn last year at $3.57, Roy says, while rivals bought later and at a higher price. By contrast, Brookings (S.D.)-based VeraSun paid $4.05 per bushel for corn, cutting into profits. "The two companies bought at different times, presumably because they had different expectations of the cost," says Roy. "That's the tricky thing about this market—your feedstock is a commodity and you can't control the price of it. Being on the wrong side of that bet can mean bad news."

But corn isn't the only commodity that affects ethanol producers' profits. The price of gasoline needs to be sufficiently high, which boosts demand for more ethanol (see BusinessWeek.com, 5/9/07, "Rising Fears of an Ethanol Bust").

Some analysts disagree that the story behind Pacific Ethanol's success and VeraSun's quarterly troubles is all about corn. Pavel Molchanov of Raymond James Financial (RJF), who covers both companies as an analyst, says the divergence between the companies' performances has more to do with other short-term problems VeraSun faced over the winter. "Obviously corn prices are high and obviously that's bad for ethanol producers," says Molchanov. "But VeraSun's hedging loss was a noncash item that didn't factor into its earnings. Their problem this quarter was higher freight costs and higher general and administrative costs, not underlying company fundamentals."

Still, experts say that for any ethanol company to succeed in the short or long term, a successful strategy for navigating commodities, particularly corn, is critical. "You definitely have to manage your risk," says Tanner Ehmke, an analyst for AgResource. "We're seeing volatility in corn prices that we haven't seen for decades, and smart moves in the futures markets are essential. You can't go naked into this industry without the right protection."

Herbst is a reporter for BusinessWeek.com in New York.