From hope to husk

By Kevin Allison and Stephanie Kirchgaessner
Published: October 22 2008 03:00

It was an American dream that has failed to become a reality. For much of the last decade, enthusiasts from President George W. Bush down have touted corn-based ethanol as something approaching a superfuel, a home-grown alternative to foreign oil that would help cut smog and bring hope to struggling farmers.
It has not worked out that way. Instead, the ethanol industry has undergone a great boom and bust in which a Financial Times analysis has found investors as savvy as Bill Gates, Microsoft's founder, have collectively lost billions of dollars.
Despite the billions more in taxpayers' dollars that was spent to subsidise it, ethanol now eats up nearly one-quarter of the US corn crop without so far fulfilling the hopes held for its beneficial effect either on the environment or US dependence on foreign energy.
It may have helped keep gasoline prices lower in the world's wealthiest nation, but a growing band of influential critics say it has also contributed to higher food prices in the world's poorest countries. So far, the only sure beneficiaries from the ethanol promise have been the investors clever enough to get into the industry early and the corn farmers who have enjoyed a lucrative new market for their grain.
In short, the story of ethanol is a cautionary tale of the unintended and costly consequences that can arise when the interests of politicians and influential industries collide.
Today, ethanol is a $32.5bn (£19.1bn, €24.6bn) a year business in the US. But for nearly three decades it was an obscure cottage industry run by farmers trying to scratch out a living in the corn belt in the country's Midwest. Americans had been making bourbon, a drinkable form of ethanol, from corn for centuries. But ethanol got its start as a fuel around the time of the 1970s Arab oil embargo, when a handful of early adherents started to argue that it could lower dependence on energy imports as well as help farmers.
Among these pioneers was a gangly, soft-spoken Minnesotan named Jeff Broin. In 1983, Mr Broin and his father set up an ethanol still on their farm, hoping to sell corn-based fuel to the few companies then operating that had begun blending ethanol into gasoline. Three years later, the Broins bought a disused ethanol plant in nearby South Dakota and went into commercial production. The younger Mr Broin, then just 22, could scarcely have imagined that the family company, known today as Poet, would become an ethanol powerhouse.
"We were simply trying to add value to grain," he says. "If someone had suggested that we would become the largest producer of ethanol in the world, we probably would have laughed at them."
Farmers such as the Broins had powerful allies in Washington. Chief among them was a coalition of 20 Democratic and Republican "corn state" senators including Tom Daschle, the former Democratic majority leader, and Chuck Grassley, a Republican senator from Iowa. But the ethanol boosters had a powerful adversary in big oil companies, which saw ethanol as a potential rival and argued that government support would be just another farm-state giveaway.
This argument resonated in the national capital during the 1980s and 1990s. President George H.W. Bush, for example, disparagingly referred to ethanol as "Daschle gas".
But the president's son thought differently. Mr Grassley remembers taking the younger Mr Bush on a tour of Iowa's cornfields during his first presidential campaign in 2000. "I was one-on-one with him with a couple of other people in a van and I spent two days talking to him about ethanol," says Mr Grassley. Mr Bush appeared to be impressed, Mr Grassley recalls. "He said, 'It's this simple. We've only got so much petroleum and we've got to have renewables. It's got to be ethanol.'"
Not long after Mr Bush took office in 2001, the September 11 terrorist attacks gave grim weight to the ethanol lobby's arguments. "Isn't it more sensible to spend $140 a barrel for ethanol than it is to ship $140 over to Arabia and let their Wahabis be trained to kill you and me?" asks Mr Grassley.
The economics of ethanol were also shifting as rising oil prices made ethanol and other alternative fuels more attractive. On Wall Street, clever investors began to take notice. In May 2003, Morgan Stanley Capital Partners, the private equity arm of the US investment bank, bought Aventine Renewable Energy, an ethanol producer with plants in Illinois and Indiana, for $75m. It paid itself nearly twice that in dividends only seven months later.
In 2004, lawmakers on Capitol Hill passed a law giving refiners an incentive to blend ethanol with gasoline by letting them claim a 51 cent per gallon tax benefit on each gallon of ethanol they used. By the following year, the politicians were under pressure to go even further. The price of a gallon of petrol had jumped over the $3 mark. Global warming worries were adding weight to the ethanol industry's claims that the fuel was an important source of renewable energy. Legislators began work on a law for a renewable fuel standard that would require gasoline producers to blend billions of gallons of ethanol into petrol each year.
Barack Obama, as a freshman Democratic senator from Illinois, a leading corn-producing state, was a big supporter. "If a terrorist hijacked a plane in Kuwait and crashed it into an oil complex in Saudi Arabia, it could take enough oil off the market and cause more economic damage in the United States than if a dirty nuclear weapon exploded in downtown Manhattan," he said in a Senate speech. "Instead of continuing to link our energy policy to foreign fields of oil, it should be linked to farm fields of corn."
Not everyone agreed. New York's Senator Chuck Schumer called the proposal a "boondoggle" and said: "There is no sound public policy reason for mandating the use of ethanol - other than the political might of the ethanol lobby." Big users of corn, such as meat processor Tyson Foods, worried it would lead to higher corn prices.
But ethanol supporters found an important, if unexpected, ally: their old rivals in the US oil industry. That was largely due to a fuel additive known as methyl tert-butyl ether (MTBE), which helped petrol burn more fully and thus lower smog emissions. Oil refiners had been using the additive for years, especially since clean air requirements were enacted in the 1990s.
By the early 2000s, however, MTBE had become a liability after scientists discovered that it lingered in ground water and polluted aquifers. California and other states banned it, leaving the oil industry searching for a substitute that would allow it to comply with environmental regulations and avoid billions of dollars in MTBE-related liabilities. Ethanol fitted the bill. "We saw ethanol as a viable product - it was a product that we knew," says Al Mannato, fuels issues manager at the American Petroleum Institute, the oil industry's leading lobby group.
The support of the API "significantly changed the political calculation on Capitol Hill", says Bob Dinneen, president of the Renewable Fuels Association, the ethanol industry grouping.
This was a turning point. That summer, Congress passed, and Mr Bush signed, the Energy Policy Act of 2005, which required refiners to blend 7.5bn gallons of biofuels into gasoline by 2012. Congress and the president created a multi-billion dollar market for corn-based ethanol virtually overnight. "Wall Street loved it," says Kevin Book, an analyst at Friedman, Billings, Ramsey & Co, an investment bank. "Suddenly, wingtips were covered in corn dust in every state."
Speculators poured into the industry. In November 2005, an investment company owned by Microsoft's Mr Gates struck a deal to pay $84m for a 27 per cent stake in Pacific Ethanol, a California group whose shares had begun trading on the Nasdaq stock market that year but had yet to produce a single drop of fuel.
Not long afterwards, two New York hedge funds - Greenlight Capital, headed by David Einhorn, and Third Point, managed by Daniel Loeb - invested nearly $75m in BioFuel Energy, a Colorado ethanol producer. Thomas Edelman, a Wall Street banker and oil and gas executive, chipped in $8.75m and was appointed chairman.
Ethanol futures prices shot up almost fourfold in the 12 months after the energy bill was signed. Meanwhile, the price of corn required to make a gallon of ethanol continued to languish thanks to surplus stores of the grain. The result was a bonanza for ethanol producers. Ethanol companies whose plants were up and running in time to catch this wave made fat profits for themselves and their investors.
In 1999, there were 50 ethanol plants in the US. By January 2007, there were 110, with 76 more under construction. Most early ethanol plants probably paid for themselves within one or two years, according to Ray Goldberg, a professor of agribusiness at Harvard Business School.
Ethanol's potential as an oil alternative had also begun to take hold in the popular imagination. Advertisements appeared on billboards alongside highways in Missouri showed a Missouri farmer standing next to a cornfield. Opposite him was a picture of the late King Fahd, the former ruler of Saudi Arabia, dressed in traditional Arab robes. Between the two men, in large block letters, was a question: "Who would you rather buy your gas from?"
The growing cost of ethanol production to US taxpayers went largely unnoticed, amid a hype that was reminiscent of the dotcom boom of a few years earlier. As several big ethanol producers announced plans to go public, ordinary investors, largely shut out from ethanol's early years, jumped at the chance to buy into the industry.
In May 2006, Thomas H. Lee Partners, a Boston private equity group, bought an 80 per cent stake in Hawkeye Renewables in a deal that valued the company at $1bn. THL almost immediately announced plans for an initial public offering. Morgan Stanley Capital Partners, which had been spun out of its parent bank and renamed Metalmark, reaped a tenfold return on its 2003 investment in Aventine Renewables when Aventine became one of several biofuel producers to float on the New York Stock Exchange in June. The biggest star was VeraSun of South Dakota, whose shares immediately jumped 34 per cent on their debut.
But the excitement proved to be short-lived. Investors had ignored some glaring warning signs. Few recognised it at the time, but the previous year's boom had also set the stage for a shift in the economics of the industry that would prove disastrous for those who came late to the game. In the same month as VeraSun's IPO, ethanol futures prices fell sharply, reversing the historical correlation between the price of ethanol and the price of a gallon of gasoline. By September, ethanol that had sold for $4 a gallon in June was trading at $1.75, according to DTN, a commodities research group.
The problem was one of oversupply. Dozens of ethanol plants had come online trying to capitalise on the boom, creating a glut that pushed down prices. Corn prices, meanwhile, were rising sharply, driven by increased demand for the crop for use in ethanol production and the rising cost of oil. In the space of just three months, ethanol had moved from boom to bust.
Some of the world's best-known investors were burnt. When Mr Gates' investment fund started disposing of its shares in Pacific Ethanol this April, it sold them at a steep loss. Deals such as the one Thomas H. Lee did with Iowa's Hawkeye Renewables in 2006, which valued Hawkeye's two ethanol plants at $1bn, began to look less wise. Some analysts say the plants could have been built for closer to $400m. When Colorado's BioFuel Energy finally went public in June 2007, it was forced to cut its offer price twice in one week. It eventually raised $101m after expenses in a combined public offering and private placement.
Even Mr Dinneen, the face of the ethanol industry in Washington, admits that, in hindsight, ethanol investors were suffering from "overblown exuberance". "There was a period of growth in the industry, and the economics were uncharacteristically favourable," he says. "People invested thinking every year was going to be like 2006, when history would tell you that was an anomaly. Clearly there was a lot of Wall Street money coming in - and I think it was with unrealistic expectations."
If ethanol were any other industry, it might be on its last legs today. But the dream of turning cornfields into car fuel refuses to die.
Tomorrow: The end that never came
Earnings stream becomes a trickle
Losers
Bill Gates: The best-known investor to lose money in the ethanol frenzy. Cascade Investments, the Microsoft founder's private investment company, paid $84m (£49m, €64m) for a 27 per cent stake in Pacific Ethanol in November 2005. The California company had a profitable business marketing ethanol made by other producers but had yet to produce a drop of the fuel itself.
By the time its first plant came online in October 2006, plunging ethanol prices and the rising cost of corn had squeezed the industry. When Cascade began divesting its stake in April this year, Pacific shares sold for less than $4 - compared with $9 when it announced plans to invest and a $42 boom-time high. As of this summer, Mr Gates had lost at least $37.9m on the investment.
Thomas H. Lee Partners:
When the Boston private equity group took its 80 per cent stake in Hawkeye Renewables in May 2006 - a deal that valued the company at $1bn - a fundamental shift in the economics of ethanol was already under way. THL was forced to pull its planned flotation of Hawkeye in September that year and the company has yet to go public.
Winners
Early investors:
Those who got in to ethanol before the spike in prices in 2005-06 made fat returns. They include Don Endres (right) who in 2001 founded VeraSun Energy, a leading US producer whose hugely successful June 2006 IPO marked the peak of the ethanol boom.
Farmers: Benefited from the surge in corn and land prices created in the boom. In addition, most ethanol plants are controlled by farmer-owned co-operatives. Those built before the end of 2005 are likely to have made a return. Associated industries such as tractor makers and seeds suppliers have also profited.
Copyright The Financial Times Limited 2008