Wall Street sours on ethanol producers as glut looms

By Haitham Haddadin - Analysis

NEW YORK (Reuters) - A potential supply surplus and eroding margins are tarnishing the outlook for ethanol producer stocks that soared last year as the United States began a push to increase biofuel use.

Ethanol companies rushed to build new production capacity for the corn-based gasoline additive over the past year as strong demand pushed the implied internal rate of returns (IRR) on projects to 60 percent.

But return estimates have now fallen to just 8 percent as corn prices have surged on rising demand, clouding the once-sunny outlook for ethanol producers.

"I think we had 'new era' thinking last year," said Mark Flannery, an energy analyst at Credit Suisse. "I don't see any investable future for the ethanol producers."

Shares of big producer VeraSun Energy Corp. VSE.N, which kicked off at over $30 in mid-June 2006, now trade at $19. MGP Ingredients Inc. (MGPI.O) is trading at half of last May's peak of $36, and Xethanol Corp XNL.A fetched $2.33 on Monday, down 80 percent from a high of $11.55.

The picture looks even worse for smaller producers. Shares of Earth Biofuels Inc. EBOF.OB, which trade on the Bulletin Board, fetched 38 cents Monday, down 95 percent from their peak price of $7.23 in May 2006.

PRODUCTION SURGE

Ethanol production capacity could surge from the current 5.6 billion gallons per year to 8 billion by the end of 2007, according to the Renewable Fuels Association, an industry group. Capacity could then tip 11 billion bpy by mid-2008 if all 78 ethanol plants now under construction come on stream.

"Production capacity is already expanded phenomenally and more so in the next few years. I am not sure I would call it a glut ... but there is a production capacity overhang," said Kevin Calabrese of Argus Research Co.

The expected supply boom should keep ethanol stocks under pressure in 2007 unless some projects are scrapped.

"Someone has to stop building ethanol plants or I suspect margins will remain fairly depressed," Flannery of Credit Suisse said during a recent conference call. "We are already building too many ethanol plants for (the) economics to make sense."

Another wild card that could help the industry take off is favorable government legislation such as the Biofuels Security Act of 2007 which is under consideration by the U.S. Senate.

Introduced in January, it would increase the required amount of renewable fuels to be added to the U.S. fuel supply to 30 billion gallons per year by 2020 and to 60 billion gallons annually by 2030. That would be sharply higher than the 7.5 billion gallons required by 2012 under the Energy Policy Act of 2005.

The legislation calls for large automakers to build flex fuel vehicles capable of running on gasoline or ethanol blends by 2017. It also mandates major oil companies to carry the E-85 ethanol-gasoline fuel blend at gas stations by then.

"In the next few months, possibly over the next six months, I don't see anything phenomenal in the industry, but longer-term it could be an attractive business," Calabrese said. "If the legislation gets through (Congress), it would be much more so."