A New Headwind For Pacific Ethanol

Executive summary

Pacific Ethanol returned to profitability in Q2 and experienced improved operating conditions in Q3. The company has also recently taken a number of steps to reduce its feedstock costs and increase its product margins. The market continues to favor Pacific Ethanol's industry peers over the company, however, and a recent leak of proposed regulation from the EPA introduces uncertainty with a bias to the downside to the company's share price.

Introduction

Three months ago I wrote that the stock performance YTD of independent ethanol producer Pacific Ethanol (PEIX) was an "aberration", especially in light of the performance of its industry peers' shares. The discrepancy between Pacific Ethanol's share price and those of its peers has only grown more pronounced since July (see figure). Green Plains Renewable Energy (GPRE) and REX American Resources (REX) have continued to greatly outperform the S&P 500. Even Biofuel Energy, which fell behind on its interest and debt payments over the summer and is facing a shareholder-ruining liquidation, has seen its share price perform significantly better than Pacific Ethanol's in 2013. The oddest part about the stock's performance over the last three months, however, is that the period has been marked by multiple positive announcements from the company. It late July it reported its first positive EPS in almost two years for Q2 (0.07). Its Q2 EBITDA of $3.8 million was its highest since Q4 2011. Its current ratio is well above its previous lows, its ratio of total assets to total liabilities is increasing, and its total shareholders' equity is at a 3-year high. Despite these improvements, the company's price/book ratio is a mere 0.77.

PEIX data by YCharts

Pacific Ethanol at a glance

Pacific Ethanol operates four starch ethanol facilities with a combined capacity of 200 mi! llion gallons per year [MGY] in California, Oregon, and Idaho. Unlike most U.S. ethanol companies, which primarily source their feedstock from and operate in the Midwest U.S., Pacific Ethanol isn't afraid to source its feedstock from abroad and market its product to many of the Pacific Coast's urban centers. Furthermore, it also relies upon natural gas for process heat and power, as opposed to many Midwestern facilities that continue to rely upon coal for this purpose. The company fared well during the summer 2012 drought relative to its Midwestern peers due to its lack of exposure to the Midwest corn crop but was still a loss-maker in absolute terms, generating negative EPS and EBITDA numbers during all four quarters of 2012 (see table). A strengthening crush spread in H1 2013 brought the company back into positive territory, first with gross profit in Q1 and then with EPS and EBITDA in Q2. This crush spread strengthened further in Q3 (see figure), which should translate into a strong earnings report for the quarter.

PEIX Financials

	Q2 2013	Q1 2013	Q4 2012	Q3 2012	Q2 2012
Total Revenue ($MM)	233.81	225.46	197.02	215.86	205.45
Gross Profit ($MM)	6.97	0.85	-4.71	-2.44	-4.90
Net Income ($MM)	0.74	-5.77	-5.80	-6.30	-2.94
Diluted EPS	0.07	-0.04	-0.04	-0.05	-0.03
EBITDA ($MM)	3.8	-0.15	-3.0	-5.3	-8.0

Source: PEIX

CORN data by YCharts

Pacific Ethanol has taken a number of steps this year toward diversifying its feedst! ock suppl! y and increasing its volume of biofuel production qualifying as an advanced biofuel under the revised Renewable Fuel Standard [RFS2]. In March it reported that it was replacing some of its corn feedstock with grain sorghum that, when combined with the company's use of natural gas for process heat and power, allows the resulting ethanol to achieve the 50% greenhouse gas [GHG] reduction threshold relative to gasoline necessary to qualify as an advanced biofuel. Earlier this month it reported that it had purchased enough beet sugar to serve as feedstock for 12 million gallons of ethanol, further increasing the company's advanced biofuel production. These moves will provide Pacific Ethanol with two short-term financial advantages relative to its dedicated corn ethanol peers. First, both advanced biofuel feedstocks are attractively-priced relative to corn at the moment; grain sorghum prices have fallen faster than corn prices since April (see figure) while the beet sugar was purchased from the USDA at a discount to corn.

US Corn Farm Price Received data by YCharts

Second, advanced biofuels qualify for D5 Renewable Identification Numbers [RIN] through the RFS2, which trade at a substantial premium to corn ethanol [D6] RINs. While the spread has narrowed from its highs in previous years, D5 RINs still trade at a 44% premium to D6 RINs. Pacific Ethanol's advanced biofuel production thus combines cheaper inputs with higher product margins (after accounting for RIN value passed through from blenders) relative to corn ethanol production. While the advanced biofuel production only contributes to part of the company's total production, every additional gallon represents an improvement to product margins.

An EPA game-changer?

Unfortunately for Pacific Ethanol, the advanced biofuel margin could be on the verge of losing its financ! ial premi! um relative to corn ethanol. Earlier this month a proposed rule from the EPA, which oversees the RFS2, on the 2014 volumetric mandates was leaked to the press. This proposed rule would respond to the looming 10 vol% ethanol [E10] blend wall by reducing the 2014 total renewable fuel volumetric mandate by almost 3 billion gallons. While roughly half of this decrease would come from a reduction to the corn ethanol mandate, which would be lower in 2014 than in 2013 (let alone relative to the originally-mandated 2014 volumes), the advanced biofuel mandate would be reduced from the originally-mandated 3.75 billion gallons to 2.17 billion gallons. Of this latter number, roughly 2 billion gallons would be attributable to biomass-based diesel, leaving at most a mere 170 million gallons available to ethanol producers qualifying for the advanced biofuel category. This 170 million gallons would be competed for by importers of Brazilian cane ethanol, domestic producers of sorghum and beet ethanol, and any biomass-based biodiesel production in excess of its own mandate. Any advanced biofuel production in excess of this volume would not qualify for D5 RINs. Furthermore, since the proposed rule would also reduce the corn ethanol mandate in 2014 relative to 2013, D6 RINs would also be expected to fall to near-zero, thus depriving advanced biofuel producers from taking advantage of the mandate's nested categories to salvage some value by earning D6 RINs in place of D5 RINs.

It is important to note that the leaked EPA document is a proposed rule that has yet to complete its review with the White House. Following the White House review it will undergo a period of public comment, the response to which will be considered when drafting the final rule. This public comment period is more than a formality, as the EPA has made major revisions to proposed rules on the RFS2 in the past in response to public comments. At the same time, however, the EPA gave itself a deadline of November 30 to publish the final rule and the mai! n lobbyin! g organization for the refining industry has threatened to sue if this deadline is not met (notwithstanding the recent government shutdown). This development could limit the public comment period, depending on how seriously the EPA takes the threat of litigation. A substantial amount of uncertainty relating to the content of the eventual final rule still exists and investors should not be surprised if the proposed rule is modified at some point in the near future. The proposed rule's revisions to the RFS2 were unexpected, however, and did not move in the direction that investors in the biofuel industry prefer to see.

Conclusion

While I remain convinced that Pacific Ethanol's current share price remains an aberration relative to the rest of the industry (it certainly shouldn't be faring worse than Biofuel Energy on the year based on its recent earnings reports), I am no longer as bullish as I was in July on the company's future prospects in light of the EPA's leaked proposed rule. The continued fall by the company's share price despite its return to profitability in Q2 2013 and improved operating conditions in Q3 does raise the question of just how much of an improvement will be necessary for the company's shares to increase in value. It also raises the prospect that the market will punish Pacific Ethanol more than its peers should the EPA's proposed rule remain largely unchanged when its final rule is published. This additional element of uncertainty is biased to the downside, as the share prices of starch ethanol producers largely ignored the leak of the proposed rule (unlike refining shares, which surged in response). Investors in Pacific Ethanol should mark November 30 on their calendars and prepare for increased volatility in the days before the EPA's final rule deadline.

Source: A New Headwind For Pacific Ethanol

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)